[Post by Shreya Rao.
The earlier posts in this series can be found here and here]
A quick recap
This is the third in a three-part series of posts about the ruling of the Delhi ITAT in the NDTV case. As readers may recall, part 1 commented on how the NDTV tax case paints a poor picture of all actors:
- The facts as described by the tribunal portray NDTV in a poor light (note that NDTV disputes several facts and claims that it is the victim of an attempt to silence the press).[1]
- On the flip side, the tax department and tribunal do not make a convincing case/ judgment based on the law at the time. In Part 1, we examined the relevant specific anti-avoidance rules and concluded that they were wrongly applied (note that the law has since been amended – the current form of section 68 and the introduction of the GAAR may lead to vastly different consequences against similar facts).
Part 2 advanced first principles relating to the piercing of the corporate veil in tax law. This post (part 3), is a segue into a most striking aspect of the NDTV case: that the tax was applied to NDTV in India, in spite of all transactions taking place entirely outside India, and in spite of there being no express provision in the law to allow such an extension. To make this possible, the revenue authorities and tribunal disregarded an entire chain of corporate entities leading to the entities in question. In this respect, the ruling and arguments are reminiscent of the Vodafone case turned upside down.[2]
Whether we choose to exercise such an expansive jurisdiction is a political and constitutional choice; however, the least we should aim for is to prevent the arbitrary application of rules. This means that we think through and develop a scholarship on conditions where we believe an extension of tax jurisdiction is constitutionally, legally and politically justified – i.e., when and why do we respect the form of one multinational group structure and disregard the form of another – and then ensure that we apply the standard consistently.
The next section analyses the specifics of the NDTV case.
Piercing NDTV’s Corporate Veil
As is clear from the diagram provided in Part 1, the NDTV group structure was complex. The assessing officer (“AO”) laid out the following reasons justifying piercing of the veil (see para 5.7):
- No business activities at the level of NNIH (Netherlands) and NNPLC (UK). NNIH was a holding company and NNPLC UK “promoted the interests of group companies”;
- NDTV India being the ultimate holding company and in control of all its subsidiaries;
- Commonality of directors, including Indian resident directors, across the boards of companies;
- No fixed assets or leased office space being owned by the relevant offshore entities;
- Low authorized capital of NNPLC UK;
- Loss making business of NNPLC UK;
- No due diligence or independent valuation conducted when NNIH received an investment from Universal Studios [This fact is disputed by NDTV];
- Share repurchase at steep discount: One year after the transaction, NNIH shares were sold back to another shareholder, NDTV Net BV, at a steep discount. This generated a loss for Universal Studios and left substantial cash on the books of NNIH. This left the AO to conclude that “the arrangement had neither commercial purpose nor any economic substance but was only for tax evasion. The AO concluded that it is sham, colourable or bogus transaction with the pretence of corporate and commercial trading.” Therefore, the AO concluded that “the money so received by the assessee is received through a sham transaction. The corporate veil should be lifted.”
- The dispute resolution panel (“DRP”) accepted the AO’s conclusions (see para 5.10 onwards). In the process, it relied on high level introductory paras from the BEPS reports which discuss base erosion and profit shifting, without actually referencing specific action plans or examining their status as law.[3] The DRP referred to NDTV’s group structure and held: “It is not possible to fathom out the intention of the assessee or the business rationale to float the companies in Netherlands to indulge in such complex and layered transactions. This is the precise kind of holding structures which are the subject matter of BEPS project.” (sic) The DRP then cited the rulings of the Supreme Court in McDowell and Vodafone to arrive at the conclusion that a veil piercing was justified, after making periodic reiterations that the “transaction is not a normal transaction and lacks commercial purpose or economic substance”.
Let us unpack this.
The ITAT, DRP and AO were rightfully concerned that the Universal Studios transaction seemed suspect – it is unusual for a listed company to put in a large sum of money without a diligence or valuation report, and then to sell back at a steep discount a year later, again without a diligence or valuation report. A second unusual fact is for cash to be distributed upwards as dividend soon after an investment – if Universal’s intention was to fund the growth of the entertainment business held by NNIH, the transaction documents would have restricted the improper extraction of funds from NNIH. However, is a “suspect fact” sufficient to pierce the corporate veil? Note that NDTV has disputed some of these critical facts – however, for the purpose of this post, we will assume the revenue department’s version of facts is accurate and examine if the standard under law is met.
Whether NDTV India had an existing obligation that was subverted through a fraud/ colourable device?
As discussed in Part 2, there is a finite list of well understood exceptions on the basis of which the corporate form of an entity may be disregarded. Commonality of directors, lack of business activities etc. do not (in themselves) allow for a piercing of the veil. Fraud, colourable device or sham need to be proven. Agency may also in some circumstances result in tax implications.
In order for NDTV’s corporate structure to be disregarded on account of it being a fraud/ colourable device, it is first important to establish that the structure was set up to subvert an existing obligation. To put this differently, if NDTV India (instead of NNIH Netherlands) had received the Universal Studios investment, and shareholders of NDTV India repurchased the shares in the subsequent year at a loss, would it have resulted in tax consequences that were different from those accomplished through creation of the structure? If yes, an argument could be made that the incorporation of offshore entities was a means to subvert an existing obligation, which may lead the structure to be scrutinized as a fraud/ colourable device.
To answer the question, we would need to evaluate two transactions to determine whether NDTV India subverted an existing obligation.
- The first is the (hypothetical) subscription by Universal into NDTV India. Share subscriptions are generally not taxable events under Indian law, unless they fall within a specified list of exceptions targeted at anti-avoidance events. One set of such exceptions is contained in section 56 of the Income Tax Act (ITA); however, these took effect from June 1, 2010 and were not applicable at the time when the NDTV transaction took place. Another set of anti-avoidance principles in sections 68 and 69 were incorrectly applied by the tribunal (see Part 1). In the absence of specific exceptions, the (hypothetical) investment by Universal Studios into NDTV India should not have resulted in a tax.
- The second relevant transaction is the subsequent (hypothetical) repurchase by NDTV India shareholders from Universal at a discount. FEMA pricing regulations would not restrict an Indian shareholder buying at a discount from a non-resident. Further, tax law would only impose a transfer price restricting a sale at a discount if Universal Studios and NDTV India shareholders are considered “related parties” and if Universal avoided an Indian capital gains tax by selling at a discount. Universal should not have been considered “related” to NDTV India shareholders under section 92A of the ITA. Furthermore, even if they were related parties, a capital gains tax would only be payable if the applicable transfer price was in excess of the subscription price paid in the previous year – given that there was a significant economic depression in the intervening period and the company was performing badly, it is likely that the arm’s length transfer price of the company would have dropped in the period since subscription. Note that transfer pricing analysis is highly fact specific, and one can only provide hypothetical possibilities for a hypothetical situation.
As discussed in Part 1, the same set of facts in 2017 would have led to very different conclusions on both legs of the transaction, both on account of the GAAR and the SAARs contained in section 56. However, in AY 09-10, NDTV India is unlikely to have derived a tax benefit out of receiving the Universal investment in an offshore entity. It is then difficult to argue that the offshore structure was set up as a fraudulent/ colourable device to avoid that obligation.
Whether the NDTV group structure was a sham?
The second condition allowing for a disregarding relates to “sham” or artificial transactions. As discussed in Part 2, a sham is found if parties create the appearance, a pretence, of rights and obligations that do not in fact exist. If a transaction is found to be a sham, it is imperative to ask: what is the “real” transaction i.e. the transaction that the artificiality hides? Questions of sham cannot be divorced from the factual circumstances of a case.
On sham, NDTV argued that the revenue’s arguments on sham were mere conjecture (para 26.10) and based on a finding that the NDTV structure was complex (para 27). NDTV also argued that it was undisputed that there has been no finding or adverse observation that the relevant offshore companies were dummy or non-existing (para 27).
The Tribunal concluded that the transaction was engineered to result in claim of loss to Universal and corresponding routing of NDTV’s own undisclosed money through its subsidiary. The Tribunal did not satisfactorily explain away the fact that Universal Studios confirmed making the investment and provided details regarding the source of funds for the investment. When NDTV made a request to produce representatives of Universal before the bench, the Tribunal observed as follows: “When the assessee is ready to produce investor before the bench but is not in a position to enquire from the investor about any due diligence process at the time of investment, term sheets etc. the mere assertion of the assessee of production of investor before us is a hollow legal argument without any substance”.
Even assuming there was no diligence/ valuation done, this is a confusing line of analysis. Questions of sham require a proof of artificiality and are entirely dependent on the intentions of the parties to give legal effect to the relevant transaction. If Universal and NDTV were to come together to demonstrate such intention, it should be sufficient (in the absence of contrary evidence) that they intended the transaction to have effect. The lack of a valuation report may demonstrate poor corporate governance practices (at best) or money laundering activities (at worst), but it does not prove that the structure is artificial, particularly when both parties attest to the “realness” of the investment. Unfortunately, the Tribunal analysis contains much repetition along these lines, but little explanation or evidence regarding what the other “real” structure could be, which the sham is created to hide.
One angle I would have liked to see more analysis on relates to the distribution of dividend by NDTV BV shortly after the investment. The Tribunal refers to this on page 308, and states that the intention of the parties was clearly to execute a transfer of money from one group to the other. If this is true, and if there were sufficient evidence that the funds were never intended for the development of the underlying business but were merely being transferred from one party to the other, it could be argued that the subscription agreement is a sham. This is the strongest legal ground that the Tribunal may have had to pierce the veil. However, the ruling provides limited factual clarity in this regard. It is also relevant to note that even if a finding of sham were successful, it would not have resulted in a different tax treatment due to the reasons examined in the section on “fraud/ colourable device” above.
A Morality based taxation
If applicable laws do not allow a tax to be levied based on the regime at the time, what is the desirability of exploring a levy of tax on a moral basis? Two decades ago, this question would have been blasphemy. However, increasing income inequality, capital flight and tectonic shifts in the rules governing the global economy have recast focus on this issue.
The following quote from a Kluwer Tax Blog post is instructive:
Nowadays…the traditional legal borders between the states’ power to impose and the taxpayers’ behavior vis-à-vis the application of taxes are deeply shaken because of the increasing influence of somehow conflicting approaches to taxation coming from other disciplines, such as ethics and political science…. Under this approach, the well-settled distinction (and associated legal consequences) among legitimate tax planning, tax avoidance and tax evasion started to disappear in the political language. In other words, unable to fight the new realities efficiently with existing legal tools, political leaders jump over traditional legal concepts, and focus their speeches on more flexible, all-embracing ethical standards pursuant to which the taxpayers’ behavior is judged as equally reproachable beyond legal standards.
It may be argued that shifting standards of morality and the “social responsibility” of corporate tax payers are already influencing tax adjudication. For example, the purview of what is considered “acceptable tax avoidance” has been shrinking over the last few decades. The scope of the “colourable device” exception has been expanding, as has the role of substance in tax matters. This trend is likely to continue. While there are good reasons for questions to be raised along these lines, if morality begins to be more relevant in determining tax liability, it is vital to determine how flexible, ethics based standards will co-exist with the rule of law, particularly considering that expropriatory taxation has been used as an intimidation device by states in the past (as in Yukos v. Russia). Existing legal frameworks – for example, the requirement under Article 265 of the Constitution that tax be imposed only by the authority of legislated law – could also pose a challenge.
Meanwhile, NDTV’s appeal is pending before the Delhi High Court. The ruling is likely to be significant in more ways than one, and we can only wait and watch.
– Shreya Rao
[1] See http://www.ndtv.com/communication/income-tax-department-lies-about-ndtv-silencing-the-press-1728015. Also see generally https://www.nytimes.com/2017/09/03/world/asia/cambodia-daily-newspaper.html and https://www.rferl.org/a/azerbaijan-turan-tax-charges-reinstated/28744788.html for recent developments along similar lines.
[2] This is unfortunate: even as countries around the world are struggling with how to tackle base erosion and profit shifting by MNCs, India has earned flak for its unilateral, large scale disregarding of entire chains of corporate entities (as in Vodafone and NDTV).
[3] BEPS reports are not law – as policy reports, they do not always have cohesive instructions/ directions. Reliance upon these reports, prior to their enactment through the MLI/domestic legislative action, is premature and problematic. We do not dwell on it further in this post, but see generally the Delhi ITAT ruling by Mr. Pramod Kumar in Baker Hughes and Kolkata ITAT ruling in Instrumentarium Corporation.
