Transfer Pricing on Issue of Equity Shares to Foreign Investors

The financial newspapers have covered this (here and here) and The Firm has an interesting discussion on this. The income tax authorities have sought to challenge the valuation on which certain Indian companies have issued shares to their foreign parents. While the shares were previously issued based on the erstwhile formulation adopted by the Controller of Capital Issues (CCI) that was applicable in the past, the tax authorities appear to have challenged that and instead imposed a higher valuation on the basis of the discounted cash flow (DCF) method that is now applicable to unlisted companies. The difference between the notional value and the actual value is treated as a loan by the foreign parent to the Indian subsidiary on which tax is now levied.

It is understood that the amounts involved are quite substantial, and this issue could lead to prolonged litigation. It might also possibly have an adverse impact on the sentiment pertaining to foreign direct investment (FDI) in India.

The phenomenon of recharacterising equity into debt poses some concerns from a legal perspective. Such a recharacterisation is not novel in the India context. The FDI policy treats any optionally convertible instrument as debt and therefore outside the purview of FDI and consequently within the external commercial borrowings (ECB) regime. Similarly, the Reserve Bank of India (RBI) had been treating foreign equity investments accompanied by put or call options as debt under the ECB policy. The regulator’s role has only been further enhanced in bringing about such a recharacterisation.

Generally, it is courts that exercise the power to recharacterise commercial transactions. But, this power is usually exercised in limited circumstances and with considerable restraint. The basic premise is always to give effect to the stated intention of the parties. However, in India, especially in the foreign investment arena, we find extensive recharacterisation of investment securities by the regulators. In some cases, such recharacterisation is expressly stated in policy, but in others it is effected merely by a “view” adopted by the regulators in individual cases rather than as a matter of general policy pronouncements. While powers of recharacterisation are useful in certain circumstances to avoid blatant abuse of policy, its extensive and unbridled use by the regulators gives rise to uncertainty and would affect the investment climate in the country.