27 February 2016

Artificial computation provisions – Unintended cross roads with anti-avoidance rules

by S. Sriram

In the law of Income-tax, the main principles are fairly simple – the whole difficulty arise in their application.  The first question, what is income, is a dark cat in the bag of the income-tax code [See End Note 1].  Over the years, the question has been more focussed, is it a black cat or a little mouse.  Tax payers and professionals, when forced with their back to the corner, often find a way out of their situation by mis-reading the code and convincing the Courts of their interpretation.  Thanks to the voluminous statute which leaves some way out for most of the situations.  Such stray cases of tax avoidance provoke the legislator to fill-in the gap by introduction of innovative artificial Section, but many a time, such temporary solutions fail to synchronise with the larger scheme of the statute as a whole. 

On the other side of the octagon, business houses expanded their horizon to various jurisdictions and the tax arbitrage being offered by operating in more than one country tempted them to adjust the prices at which they transact inter se, so as to park higher profits in jurisdictions which had lower tax costs.  With the developed economies feeling the brunt of losing tax revenues due to such tax planning, provisions relating to Transfer Pricing were introduced to ensure economic value add in every jurisdiction is adequately compensated.  India caught up with the rest of the developed world in 2002 by introducing elaborate Transfer Pricing regulations in the Income-tax Tax Act, 1961 (‘the Act’) and the Income-tax Rules, 1962 (‘the Rules’).  The Transfer Pricing regulations, briefly, require the value of any international transaction (i.e. any transaction between Associated Enterprises) to be determined at Arm’s Length Price (‘ALP’), as determined in the manner and method provided in the Rules. 

Coming back to the amendments made to overcome mischiefs, the fact that they are short sighted and do not fit the larger structure of the Act, is proved time and again as the taxpayers who were earlier unaware of the loop hole, start making a business decision around certain gaps in the hurriedly introduced provisions.  When the Supreme Court in the case of PNB Finance [See End Note 2] held that a ‘slump transfer’ would not be chargeable to tax as the computation mechanism failed, the Act was emended to introduce an artificial mechanism by way of Section 50B to overcome the lacuna pointed out by the Supreme Court.  A thoughtful legislator would have gone back to his drawing board to conceptualise all the problems that might arise from a situation of slump before bringing in an artificial computation mechanism.  But the knee-jerk reaction, rather lack of time and skill, lead to other tax payers take advantage of the lacuna in the artificial mechanism, as in the case of Bharat Bijlee [See End Note 3] where the taxpayer contended and succeeded that the artificial mechanism would not cover slump exchange. 

The list of such Sections to overcome certain judicial rulings or unintended lacuna in the statute includes introduction of Section 55(2)(a) to overcome the judgment of Supreme Court in B.C. Srinivasa Shetty [See End Note 4], Section 46(2) to overcome the judgment of Supreme Court in Sunil Siddharth Bhai [See End Note 5], Section 50C/ 43C to overcome unaccounted sale consideration in case of transfer of land and building, introduction of Section 56(2)(viia)/ (viib) to curb introduction of unaccounted money by issue of shares at high premium, etc.  These amendments too, like in the case of Bharat Bijlee (supra), are facing misuses. 

The common thread between these sections is that they introduce a manner for computation of income in the specific fact situation covered therein.  In the absence of the computation mechanism provided therein, the general provisions of computation of income would not be sufficient to bring the transactions to tax.  These sections do not prima facie treat the consideration agreed to by the parties as the actual value of the transaction, but seek to provide their own mechanism for determining taxable profits.  In the context of treating a notional lettable value as the income from house property in place of actual income that had accrued, the House of Lord in the case of Salisbury House Estate [See End Note 6] observed that “if the measure is an imperfect one and when applied does not ascertain the actual income derived from the property, so much the worse for the Revenue.  Discrepancies one way or the other between actual income and statutory income for tax purposes are familiar features of Income-tax law….. if they part company one way or the other, the fault lies with the imperfection of the statutory machinery for ascertaining the income from landed property, and the Inland Revenue authorities are not entitled to resort to a different measure, designed for a different source of income, if the actual rent happen to exceed the annual value”.

The core issue is now the interplay between the artificial provisions (like Section 50C, 45(2) etc.) which provide a statutory method for determination ‘consideration’ in a transaction and the transfer pricing regulations which require the consideration to be at ALP.  As artificial rules seldom corresponds with the ALP, the debate always remains fresh as to which of them would apply over the other.  Transfer pricing provisions, being specific to transactions between Associated Enterprises holds its fort from one perspective and the specific provisions, without which the whole levy would fail, stand as important charging Sections on their own ground. The judicial authorities in India have been called upon a few times to set this dispute to rest, but have only raised new questions while answering the facts in their own case. 

The Authority of Advance Ruling in Canoro Resources [See End Note 7] observed that no transaction, whether covered by the normal computation mechanism or a special computation mechanism, can be kept outside the preview of transfer pricing and further held that the transfer pricing provisions would override the general computation provision contained in Section 45(2) of the Act.  This position was duly followed by the Authority in the case of Castleton Investment [See End Note 8] and a series of other judgments.  However, the same Authority in Amiantit International [See End Note 9] took a different view holding that the transfer  pricing provisions are mechanisms to avoid shifting of tax base and would not apply to cases when there is no liability to tax in the first place. 

When the taxable income is not based on the value of transaction determined by the parties, but computed based on a statutory mechanism or presumption, the question that begs an answer is, whether ALP can be substituted to such artificially determined income.  Doing so might however render such section redundant in the cases of transactions between Associated Enterprises.  As more and more artificial computation mechanisms are being introduced in the Act and as even domestic transactions now coming within the ambit of transfer pricing, this question would see a deeper examination by the Courts in the near future. 

 [The author is a Principal Associate, Direct Tax Practice, Lakshmikumaran & Sridharan, Mumbai]
End Notes:

1. In introduction to the Law and Practice of Income-tax
2. PNB Finance Ltd. v. CIT, [2008] 307 ITR 75 (SC)
3. CIT v Bharat Bijlee Ltd, [2014] 365 ITR 258 (Bom)
4. CIT v. B.C. Srinivasa Shetty, [1981] 128 ITR 294 (SC)
5. Sunil Siddharth Bhai v CIT, [1986] 156 ITR 509 (SC)
6. Salisbury House Estate Ltd v Fry, 15 TC 266 (HL)
7. Canoro Resources Ltd., In re  [2009] 313 ITR 2 (AAR)
8. Castleton Investment Ltd., In re. AAR NO. 999 OF 2010
9. Amiantit International Holding Ltd., In re. AAR NO. 817 OF 2009

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