KPMG Tax Highlights. Table of contents. KPMG Highlights. 1 General Anti-Avoidance Rules 9 ESOP 2 Overseas Mergers and

Transcription

1 KPMG Highlights KPMG IN INDIA KPMG Tax Highlights 9 January 2014 Table of contents 1 General Anti-Avoidance Rules 9 ESOP 2 Overseas Mergers and 10 Direct Tax - Miscellaneous Acquisitions 3 Tax Residency Certificate 11 Excise 4 Royalty 12 Customs 5 Fees for Technical Services 13 Service Tax 6 Permanent Establishment and 14 Foreign Trade Policy Force of Attraction 7 Transfer Pricing 15 VAT 8 Depreciation 1

2 General Anti-Avoidance Rules Central Board of Direct Taxes notify the rules for the application of General Anti-Avoidance Rules The General Anti-Avoidance Rules (GAAR) had first been introduced in the Direct Taxes Code (DTC) in 2009 to curb Impermissible Avoidance Arrangement (IAA) entered into by a person to avoid taxes. The GAAR had been introduced to deal with aggressive tax planning involving use of sophisticated structures. Although originally forming a part of the DTC, now it is a part of the Income-tax Act, 1961 (the Act). Under the current provisions, Chapter X-A, dealing with the provisions of GAAR would come into force with effect from 1 April 2015 (Financial Year ). The Central Board of Direct Taxes (CBDT) has notified the rules relating to application of GAAR, which shall deal with the following: The provision of GAAR shall not apply to: An arrangement where the tax benefit arising to all the parties to the arrangement in the relevant assessment year does not exceed INR 30 million in aggregate. A Foreign Institutional Investor (FII): Who is an assessee under the Act. Who has not taken benefit of an agreement referred to in Section 90 or Section 90A of the Act. Who has invested in listed securities, or unlisted securities, with the prior permission of the competent authority, in accordance with the Securities Exchange Board of India (Foreign Institutional Investor) Regulations, 1995 and such other regulations, as may be applicable, in relation to such investments. A non-resident person who has investment by way of offshore derivative instruments or otherwise, directly or indirectly, in a FII. Any income accruing or arising to, or deemed to accrue or arise to, or received or deemed to be received by, any person from transfer of investment made before 30 August Other issues: GAAR to apply to tax benefit obtained from the arrangement on or after 1 April Where a part of an arrangement is declared to be an IAA, the consequences in relation to tax shall be determined with reference to such part only. Certain mechanism has been prescribed for reference of cases for application of GAAR Certain time limits have been prescribed for issuance of directions, reference by the tax department authorities. Notification 75/2013, dated 23 September 2013 For further details please refer to our Flash News dated 26 September 2013 available at this link 2

3 Overseas Mergers and Acquisitions Andhra Pradesh High Court in the case of Sanofi, based on the facts of this case, held that gains from transfer of shares between two foreign companies with underlying Indian asset is not taxable under India-France tax treaty Murieux Alliance (MA) and Group Industrial Marcel Dassault (GIMD), French companies, were holding 100 percent shares of ShanH, another French company. Further ShanH was holding shares in Shantha Biotechnics Ltd (Shantha), an Indian company. With a view to further improve the business and performance, MA and GIMD sold their shares in ShanH to Sanofi, French company. The Indian revenue authorities passed an order under Section 201(1)/(1A) of the Act holding Sanofi as an assessee-in-default for not withholding taxes on payments made by it to MA and GIMD for acquiring the shares in ShanH. Thereafter, MA and GIMD made an application to the Authority for Advance Rulings (AAR) to determine the taxability, if any, of the transaction in India. The AAR ruled that the capital gains arising from the sale of shares in ShanH by MA and GIMD to Sanofi was taxable in India in terms of Article 14(5) of the India-France Tax Treaty. Subsequently, all the parties, i.e., Sanofi, MA and GIMD filed writ petitions before the Andhra Pradesh High Court. Based on the facts of the case, the Andhra Pradesh High Court (High Court), inter alia, held as follows: ShanH was an independent corporate entity, registered and resident in France and it has a commercial substance and a purpose (FDI in Shantha). It was neither a mere nominee of MA and/or MA/GIMD, nor is a contrivance/device for tax avoidance. Since inception till date, ShanH had acquired and continues to hold the Shantha s shares. There is no warrant for lifting the corporate veil of ShanH. The retrospective amendments made in the Finance Act, 2012 have no impact on interpretation of the tax treaty. The said transaction falls within Article 14(5) of the India-France tax treaty and the tax resulting there from is allocated exclusively to France. Accordingly, the AAR ruling was quashed. Sanofi Pasteur Holding SA v. Dept. of Revenue [2013] 354 ITR 316 (AP) For further details please refer to our Flash News dated 19 February 2013 available at this link AAR s ruling in the case of Goodyear on the taxability of transfer of shares of an Indian company without consideration in a group reorganisation upheld by the Delhi High Court Goodyear Tire & Rubber Company (US company) held 74 percent shares of Goodyear India Limited (GIL), which was a listed entity. The US Company has a 100 percent subsidiary in Singapore, named as Goodyear Orient Company (Pte) Limited (Singapore company). Both the US Company as well as the Singapore Company had approached the AAR with respect to the tax liability of the proposed transfer by the US company of its 74 percent share-holding in GIL to its 100 percent subsidiary in Singapore. The AAR after examining the various provisions of the Act had ruled that there would be no tax liability on either the US Company or the Singapore Company, in case of transfer of shares without consideration. Based on the facts of the case, the Delhi High Court, inter alia, held as follows: The High Court on a perusal of the related provisions reaffirmed that income arising from the transfer of a long-term capital asset, if it is an equity share in a company or a unit of an equity oriented fund, where the transaction of sale of such equity share is chargeable to Securities Transaction Tax (STT), then such income would be exempt under Section 10(38) of the Act. The High Court rejected the argument of the tax department that the transaction in question was 3

4 entered into to avoid capital gains liability in India, by taking note of the exemption under Section 10(38) of the Act referred to above. DIT v. Goodyear Tire and Rubber Company [2013] 214 Taxman 669 (Del) For further details please refer to our Flash News dated 7 March 2013 available at this link Capital gains arising on transfer of shares by one foreign company to another foreign company of an Indian company which in turn holds infrastructure facilities in India are taxable in Netherlands The taxpayer company was a tax resident of Netherlands. The taxpayer made investment into the equity share capital of Vanenburg IT Park Private Limited, Indian company (VITP) which was into the business of developing, operating and maintaining infrastructure facilities of an industrial park in India. The taxpayer sold its 100 percent share holding in VITP to Ascendas Property Fund (India) Pte Limited, a Singapore based company (Ascendas), and has earned long term capital gains. The issue for consideration before the Hyderabad Tribunal was whether gains from transfer of shares of an Indian company by the taxpayer were taxable in India Based on the facts of the case, the Hyderabad Tribunal, inter alia, held as follows: The meaning of immovable property defined under the Act is specific to that section only and not a general definition and therefore, cannot be used while interpreting a tax treaty. Therefore, the Capital gain arising from the sale of Indian company s shares will not get covered under Article 13(1) of India- Netherland tax treaty as there was no sale of immovable property. Further Article 13(4) of the India-Netherlands tax treaty is also not applicable as the immovable property of Indian company is used in the business of company. Accordingly, as per Article 13(5) of the India-Netherlands tax treaty, capital gain on transfer of shares of Indian company would be taxable in Netherland. The shares of the Indian company were notified and approved for the benefit of Section 10(23G) of the Act at the time of sale of such shares and therefore, such capital gain is exempt under the Act. Vanenburg Facilities B.V. v. ACIT (ITA Nos. 739 & 2118/Hyd/2011, dated 15 March 2013) For further details please refer to our Flash News dated 11 April 2013 available at this link Tax Residency Certificate Trade tax paid in Germany and Tax Residency Certificate issued by the authorities are sufficient evidence for a limited partnership to claim the benefit of India-Germany tax treaty The taxpayer was a foreign limited partnership and in the return of income it claimed the benefit of Article 12(2) of the India-Germany tax treaty in respect of royalties and Fees for Technical Services (FTS). On the basis of the OECD Publication, the Assessing Officer (AO) held that the taxpayer is not eligible to claim the benefit of the India-Germany tax treaty since it is not liable to tax in Germany being a limited partnership. The issue for consideration before the Bombay High Court was whether the limited partnership is eligible to claim benefit of the tax treaty. Based on the facts of the case, the Bombay High Court, inter alia, held as follows: In terms of Article 2(3) of the India Germany tax treaty, the trade tax paid in Germany is one of the taxes to which tax treaty applies. Further, as per Article 3(d) of the India-Germany tax treaty person 4

5 includes any entity treated as a taxable unit in Germany. The term 'resident' in terms of Article 4 of the India-Germany tax treaty means any person who, under the laws of Germany is liable to tax therein by reason of his domicile, residence, place of management or any criterion of a similar nature. The taxpayer is filing trade tax return in Germany and therefore is paying tax to which the tax treaty applies. Further, the Tax Residency Certificate (TRC) issued by German authorities indicates that the taxpayer is considered as a taxable unit under the taxation laws of Germany. Accordingly, the India-Germany tax treaty is applicable to the taxpayer and the benefit of Article 12(2) of the India-Germany tax treaty cannot be denied. Therefore, the taxpayer is eligible for the benefit of lower tax rate on royalty and FTS earned in India as per the India-Germany tax treaty. DIT v. Chiron Bearing Gmbh & Co. [2013] 351 ITR 115 (Bom) For further details please refer to our Flash News dated 21 January 2013 available at this link Since TRC issued by the Netherlands tax authority is sufficient evidence of beneficial ownership, the beneficial tax rate under the India-Netherlands tax treaty will apply The taxpayer, a tax resident of Netherland, belonged to the Universal group of companies whose various companies entered into contract with various artists, singers, etc. and these companies were known as Repertoire Companies. The taxpayer had acquired musical recording rights from other Repertoire Companies. During the years under consideration, the taxpayer received royalty from Universal Music India Private Limited for granting commercial exploitation rights of musical tracks and offered royalty income to tax at 10 percent under Article 12 of the India-Netherlands tax treaty. The Tribunal held that the TRC issued by the Netherlands tax authority had to be accepted as sufficient evidence regarding the status of the taxpayer and the beneficial ownership in terms of the CBDT Circular No.789. The issue for consideration before the Bombay High Court was whether the taxpayer is the beneficial owner of the royalty income received from an Indian entity. Further, whether the taxpayer is entitled for beneficial tax rate under the India-Netherlands tax treaty. Based on the facts of the case, the Bombay High Court, inter alia, held that since the tax department had not been able to show anything on record to controvert the finding of the CIT(A) and the Tribunal that the taxpayer is the beneficial owner of the royalty received on the musical tracks given to Universal Music India Private Limited, it was held that the taxpayer was the beneficial owner of the royalty income and it is entitled for beneficial tax rate under the India-Netherlands tax treaty. DIT v. Universal International Music B.V.[2013] 214 Taxman 19 (Bom) For further details please refer to our Flash News dated 14 March 2013 available at this link CBDT notifies additional details to be furnished by non-residents along with the TRC The Finance Act, 2012 had provided that in order to be eligible to claim relief under the tax treaty, a taxpayer is required to produce the TRC issued by the Government of the respective country or the specified territory in which such taxpayer is resident, containing certain prescribed particulars. Subsequently, the CBDT prescribed the details to be included in the TRC. The Finance Act, 2013 has done away with the requirement of obtaining prescribed particulars in the TRC. In other words, the taxpayer can continue to obtain the TRC as issued by the foreign authorities. The Finance Act, 2013 also introduced a provision to clarify that the taxpayer shall now be required to 5

6 furnish such other information or document as may be prescribed. The CBDT has now issued a notification amending the Income-tax Rules, 1962 (the Rules) prescribing the additional information required to be furnished by non-residents along with the TRC. The details are required to be furnished in Form 10F. Notification No. 57/2013, dated 1 August 2013 For further details please refer to our Flash News dated 5 August 2013 available at this link Royalty Royalty received for licensing of patents, by a foreign company to a foreign equipment manufacturer, used for manufacture of CDMA technology enabled equipments for sale to Indian telecom service providers is not taxable in India The taxpayer was incorporated as a company in USA and had developed key patents to CDMA, a method for transmitting simultaneous signals over a shared spectrum, most commonly applied to digital wireless technology. The taxpayer had licensed its patents to Original Equipment Manufacturers (OEMs) who were situated outside India and were not residents of India. The OEMs used the patents to manufacture the products outside India and sold the products to wireless carriers worldwide. The OEMs paid royalty to the taxpayer for use of patented technology in the manufacture of products and was determined with reference to the net selling price of the product sold to unrelated wireless carriers worldwide. The products manufactured by the OEMs outside India were purchased by Tata Teleservices and Reliance Communications (the Indian Carriers) from the OEMs. The Indian Carriers, in turn, sold the products to end users in India and the products were used by customers of the Indian Carriers in India. Based on the facts of the case, the Delhi Tribunal, inter alia, observed and held as follows: To tax the royalty income earned by the taxpayer from OEMs located outside India, under the deeming provision of Section 9(1)(vi)(c) of the Act, the burden is on the tax department to prove that the OEMs carry on business in India and that they have used the taxpayer s patents for the purposes of, such business in India; or that they have used the taxpayer s patents for the purpose of, making or earning income from a source in India; The OEMs manufactured products outside India and sold them to not only service providers in India but also to number of others in other countries. The license to manufacture products by using the patented Intellectual Property of the taxpayer has not been used in India as the products were manufactured outside India and when such products were sold to parties in India, it cannot be said that OEMs have done business in India; Technology for manufacturing products was different from products which were manufactured from the use of the technology for which the taxpayer has patents. The role of Qualcomm ends when it licenses its patents on IPR s pertaining to CDMA products for manufacture and when it collects royalty from OEM s on these products, when they are shipped out of the country of manufacture; The source of the royalty is the place where patent (right, property or information) is exploited, viz. where the manufacturing activity takes place, which is outside India. Hence, the Indian telecom operators would not constitute source of income for the OEMs; The title and risk of loss passes to the buyer, on the physical delivery of the equipment by the OEM to the carrier, at the port of shipment. The term port of shipment is definitely not a port in India; The propositions laid down by the Delhi High Court in the case of Ericsson and Nokia, in relation to 6

7 taxability of GSM equipment with embedded software were squarely applicable in the present case to taxability of OEMs supplying CDMA handsets and equipment. Accordingly, the title in the goods in this case has passed outside India; The software was embedded in the chipset and was an integral part of the chipset. Further, the chip set was embedded in the handset/equipment and these were sold outside India. The total price was fixed for the equipment as a whole and there was no separate consideration for the licensed material. The software supplied was a copyrighted article and not a copyright. Accordingly, the income from embedded software cannot be taxed in India; Regarding insertion of Explanation 4 to Section 9(1)(vi) of the Act, it was observed that the amendment has no effect in the present case as a controversy in this case was taxability of royalty on patents relating to intellectual property for manufacture of CDMA handsets and equipment and does not relate to royalty on licensing of any computer software. The OEMs sells handsets/equipments to the service providers, outside India and hence the OEMs have no source of income in India; Accordingly, the royalty paid to the taxpayer by the OEMs cannot be brought to tax under the Act. Qualcomm Incorporated v. ADIT [2013] 23 ITR 239 (Del) For further details please refer to our Flash News dated 7 February 2013 available at this link Fees for Technical Services IT support services does not make available any technical know-how, therefore, it cannot be taxed as FTS under India-Australia tax treaty The taxpayer, a company incorporated in Australia, during the year under consideration, received payments from Sandvik Asia Ltd. and Walter Tools India Pvt. Ltd for rendering of IT support services. The nature of the services under the agreement between the taxpayer and Sandvik Asia Ltd., an Indian affiliate, includes giving advice to the receiving parties, help desk support, contacting Sandvik s IT personnel, providing IT operations and support services, infrastructure, disseminating related IT information, etc. The issue for consideration before the Pune Tribunal was whether payments for IT support services are taxable as FTS under the India-Australia tax treaty. Based on the facts of the case, the Pune Tribunal, inter alia, held as follows: The technology will be considered as made available when the person receiving the services is able to apply the technology by himself. The Tribunal relied on the Karnataka High Court decision in the case of De Beers India Minerals Pvt. Ltd. The taxpayer had not imparted any technical know-how, skill, process or technical plan or design and hence, in view of Article 12(3)(g) of the India Australia-tax treaty, the amount received by the taxpayer cannot be taxed in India. Accordingly, though the services are technical in nature but is not covered under Article 12(3)(g) of the India-Australia tax treaty and hence, the same is not taxable in India. Sandvik Australia Pty. Ltd v. DDIT [2013] 141 ITD 598 (Pune) For further details please refer to our Flash News dated 13 February 2013 available at this link Payments for bio-equivalent studies do not make available technical skill, knowledge or expertise, etc. and therefore are not taxable under the tax treaty The taxpayer was engaged, inter alia, in research and development of bulk drugs and pharmaceuticals. 7

8 In order to market its products in USA and Canada, the taxpayer was required to get approval from the respective regulatory authorities. For this purpose, the taxpayer was required to get its products tested through certain specialised organisations in USA/Canada which were called as Contract Research Organisations (CRO). The testing process was called bio-equivalence study. During the bio-equivalence study, the CROs do clinical research and analyse the impact of the drug on human beings. For conducting the bio-equivalence studies, the taxpayer has made the payments to the CROs without deducting tax at source. The issue for consideration before the Hyderabad Tribunal was whether payments for bio-equivalent studies are taxable under India-USA and India-Canada tax treaty. Based on the facts of the case, the Hyderabad Tribunal, inter alia, held as follows: As per Article 12 of the tax treaty, Fee for Included Services is taxable in the source country only if such services make available any technical knowledge, expertise, etc. or there is transfer of technical plan or design. There was neither transfer of technical plan or technical design nor making available of technical knowledge, experience or know-how by the CROs to the taxpayer. Accordingly, the amounts paid by the taxpayer do not fall under Article 12, but come within the purview of Article 7 (Business Profits) of the tax treaty. The amounts paid are to be considered as business receipts of the said CROs and in absence of CRO s PE in India, the payments were not taxable in India. DCIT v. Dr. Reddy s Laboratories Limited [2013] 144 ITD 392 (Hyd) For further details please refer to our Flash News dated 5 June 2013 available at this link When FTS clause is missing and such payment is not connected with the PE, it would not be taxable under miscellaneous income article under India-Thailand tax treaty The taxpayer, a company incorporated in Thailand, entered into a technical know-how agreement with an Indian company for transfer of glass technology know-how to the Indian company and for providing technical assistance to the employees of the Indian company to operate the glass plant in India. The issue for consideration before the Madras High Court, inter alia, was whether the consideration for technical assistance would be taxable in India in the hands of the taxpayer. Based on the facts of the case, the High Court, inter alia, observed and held as follows: The services rendered by the taxpayer cover transfer of know-how as well as giving technical assistance and therefore a part of the payment has to be classified as royalty and the other part has to be assessed as technical services. As the taxpayer did not have a Permanent Establishment (PE) in India, the consideration for technical services cannot be brought to tax under Article 7 of the India-Thailand tax treaty. The income which would be taxable in India in the instant case is only the income falling under Article 12 of the India- Thailand tax treaty as royalty income and nothing beyond that. Further, the consideration for technical assistance cannot even be taxed under the other income article of the India-Thailand tax treaty since it does not classify as miscellaneous income. Bangkok Glass Industry Co. Ltd. v. ACIT [2013] 215 Taxman 116 (Mad) For further details please refer to our Flash News dated 9 July 2013 available at this link 8

9 Permanent Establishment and Force of Attraction Payments made for online advertisement on the search engines of Google and Yahoo are not taxable in India The taxpayer, a florist, had made payments in respect of online advertisements to Google and Yahoo without deducting taxes on the basis that since these entities did not have any PE in India, the payment made to them was not taxable in India. The AO disallowed the payments in the hands of the taxpayer under Section 40(a)(i) of the Act on the basis that tax was required to be deducted from the payments made to Google and Yahoo. The issue for consideration before the Kolkata Tribunal was whether the payment in respect of online advertising on search engines of Google and Yahoo is taxable in India. Based on the facts of the case, the Tribunal, inter alia, observed and held as follows: A search engine s presence in a location, other than the location of its effective place of management, is only on the internet or by way of its website, which is not a physical form of presence. In accordance with the High Power Committee report, so far as the basic rule of PE is concerned, a website per se cannot be a PE under the Act. The interpretation of the expression PE, even in the context of tax treaties, does not normally extend to websites unless the servers on which websites are hosted are also located in the same jurisdiction. A search engine, which has only its presence through its website, cannot be treated as a PE unless its web servers are also located in the same jurisdiction. As Yahoo and Google s servers are not located in India, its presence in India merely through websites cannot be construed as PE in India. The Government of India s reservations on OECD (relating to websites constituting a PE in certain circumstances) does not have an impact in the instant case. Relying on the decisions of the Mumbai Tribunal in the case of Pinstorm Technologies Pvt. Ltd. and Yahoo India Pvt. Ltd, the Tribunal held that the payments to Google and Yahoo are not in the nature of Royalty. As long as there is no human intervention in a technical service, it cannot be treated as a technical service under Section 9(1)(vii) of the Act. As there was no human touch involved in the whole process of the advertising service provided by Google and Yahoo, the payments are not in the nature of FTS. Therefore, the payments were not taxable in India and there was no requirement for the taxpayer to deduct tax at source. ITO v. Right Florists Pvt Ltd [2013] 143 ITD 445 (Kol) For further details please refer to our Flash News dated 15 April 2013 available at this link Purchase of advertisement space on foreign websites by an Indian company from a foreign holding does not constitute a PE under the India-USA tax treaty The taxpayer, an Indian company, and its holding company in US, engaged in the business of providing services of internet advertising and marketing services including e-commerce transactions and provision of related technologies, systems, consultancy, devices, etc. When Indian clients desire to place their advertisement over a foreign website, the taxpayer would get in touch with the US Company which in turn would get in touch with the foreign website owner to book advertisement space. Thereafter, the parent company would sell the space on the foreign website to the taxpayer which in turn is provided to 9

10 the Indian client. The reverse procedure is followed, when the parent company intends to book an advertisement space on Indian websites for its overseas clients. When the taxpayer places an order to its parent company, the parent company books space on the relevant foreign website and then sells space to the taxpayer at cost plus mark-up. The taxpayer in turn sells the said space to its Indian client at cost plus profit. During the year under consideration the taxpayer made payments to the US Company for purchases of online advertisement space. The taxpayer claimed that the business income of the US Company was not taxable in the absence of PE and therefore, withholding of tax was not required on such payment. The issue for consideration before the Mumbai Tribunal was whether the purchase of advertisement space on foreign websites by the Indian company from foreign holding company constitutes PE under the tax treaty. Based on the facts of the case, the Mumbai Tribunal held as follows: On perusal of the arrangement made between the taxpayer and the US Company it indicates that neither of the party is doing the business activity on behalf of other. Further, the transactions are independent business transaction wherein the respective margins are recovered from each other. The transaction of payment towards the purchase of space on the foreign website by the taxpayer for its client in any case does not constitute a transaction carried out by the taxpayer on behalf of its US Company. The taxpayer was doing the business on behalf of its client and offering the income earned from the said business transaction for taxation in India. Therefore, the transaction of purchase of space on the foreign website by the taxpayer from US Company cannot be treated as PE. None of the party is dealing with the clients of the other party, hence the activity between the taxpayer and US Company are independent business activities. The transaction between the taxpayer and the US Company are independent business between two parties. The risk and reward of the business carried out by the taxpayer is born by the taxpayer which indicates that it is the taxpayer who is answerable to the customers and therefore, the activity of purchase of space on website from the parent company is on principle to principle basis. Thus, purchase of advertisement space on foreign website falls under business income of US Company under the tax treaty. However, in the absence of PE of US Company, the said business profits were not taxable in India. Accordingly, the taxpayer was not required to deduct tax in respect of said amount which is trading receipt in view of the decision of the Supreme Court in case of GE India Technology Centre Pvt. Ltd. ITO v. Pubmatic India Pvt. Ltd. [2013] 36 taxmann.com 100 (Mum) For further details please refer to our Flash News dated 26 August 2013 available at this link IT enabled customer management services provided by a foreign company result in a PE in India and profit is attributable at the rate of 15 percent. Software payment and link charges are not taxable as royalty The taxpayer, a company incorporated in and a tax resident of USA is engaged in the business of providing IT enabled customer management services. In order to service its customers, the taxpayer had procured certain IT enabled call centre / back office support services from its subsidiary company in India (Indian subsidiary). The Indian subsidiary also made payments to the taxpayer towards reimbursement for link charges and license charges (for use of software). The AO held that the taxpayer has various forms of PE in India such as Fixed place PE, Service PE and DAPE and attributed huge profits to the PE in India. The AO also held the link charges / license charges 10

11 to be taxable in India as Royalty under Section 9(1)(vi) of the Act and Article 12 of the India-USA tax treaty. The issue for consideration before the Delhi Tribunal, inter alia, was whether the taxpayer had a PE in India and whether the link charges / license charges are in the nature of royalty. Based on the facts of the case, the Tribunal, inter alia, observed and held as follows: PE The taxpayer had a fixed place PE in India on the following account: The employees of the taxpayer frequently visited the premises of the Indian subsidiary to provide supervision, direction and control the operations of the Indian subsidiary and such employees had a fixed place of business at their disposal. Indian subsidiary was practically the projection of taxpayer s business in India and it carried out its business under the control and guidance of the taxpayer, without assuming any significant risk in relation to its functions. Certain hardware and software assets were provided by the taxpayer to the Indian subsidiary on a free of cost basis. The Indian subsidiary did not constitute a DAPE of the taxpayer in India as the conditions provided in Article 5(4) of the India-USA tax treaty were not satisfied. The Tribunal also outlined the manner in which the profits were to be attributed to the PE so created in India. Taxability of link charges/ license charges Relying on the decision of the Mumbai Tribunal in the case of B4U International and the decision of the Delhi High Court in the case of Nokia Networks OY, the Tribunal held that the amendment to Section 9(1)(vi) of the Act does not affect the provisions of the tax treaty in any manner. Purchase of software would fall within the category of copyrighted article and not towards acquisition of any copyright in the software and hence the license charges are not in the nature of royalty. With regard to the taxability of the link charges, the Tribunal held that since neither the taxpayer nor the Indian subsidiary had any control or possession over the equipment, link charges do not qualify as equipment royalty in terms of Article 12 of the tax treaty and hence are not taxable in India. Convergys Customer Management v. ADIT [2013] 58 SOT 69 (Del) For further details please refer to our Flash News dated 14 May 2013 available at this link Indian branch of a foreign company providing pre-sale activities and incidental post sale support activities for products supplied by the parent and overseas group companies cannot be treated as dependent agent PE and in the absence of PE the force of attraction rule under relevant tax treaties does not apply The Mumbai Tribunal in the case of VIPL India branch (the taxpayer) held that Indian branch cannot be constituted Dependent Agent Permanent Establishment (DAPE) of US parent and overseas group companies under the tax treaty since the taxpayer does not have authority to negotiate or conclude contracts on behalf of the foreign companies; it does not maintain stock of goods sold by such foreign companies and it does not secure order on behalf of foreign companies in India. Accordingly, since the taxpayer does not have DAPE under the tax treaty, the profit attributable to such foreign enterprises cannot be taxed in India. 11

12 Further, since the taxpayer does not constitute a PE of the various group companies, profits of foreign enterprise shall not be taxed in the hands of the taxpayer in India under the Force of Attraction Rule in the respective tax treaties. Varian India Pvt Ltd v. ADIT [2013] 33 taxmann.com 249 (Mum) For further details please refer to our Flash News dated 24 July 2013 available at this link Transfer Pricing Discounted Cash Flow Method is preferable over CCI Guidelines for determining the ALP for sale of shares The taxpayer and L&T Infocity Limited (LTIL) entered into an agreement with Ascendas Property Fund India (AFPI), an Associated Enterprise (AE), for selling their respective stake in L&T Infocity Ascendas Limited (LTIAL). The taxpayer was also involved in another transaction pertaining to sale of shares held in Ascendas IT Park Ltd (AITPL) to AFPI. For sale of shares in LTIAL, the taxpayer adopted the Comparable Uncontrolled Price (CUP) Method by comparing the price at which LTIL sold its shares to AFPI. For the transaction of sale of shares in AITPL, the sale price of AITPL shares was supported by a valuation certificate provided by a Chartered Accountant in accordance with the previous CCI Guidelines LTIL s sale price as CUP for taxpayer s sale of LTIAL shares The Transfer Pricing Officer (TPO) rejected the argument that the sale price of shares by LTIL constituted a CUP for the purpose of determining the ALP for sale of shares by the taxpayer, as the sale of shares by LTIL is an intimate connection and it is an AE by virtue of common participation. The Tribunal held that the sale of shares by LTIL and the taxpayer is through a single agreement and treatment of one part of the agreement as an uncontrolled transaction and another as a controlled transaction is not acceptable. Hence the transactions cannot be considered a CUP for sale of shares in LTIAL. CCI Guidelines v. Discounted Cash Flow Method The TPO rejected the valuation based on the CCI Guidelines and adopted the Discounted Cash Flow (DCF) method for valuation of shares for both the companies. The Tribunal held that difficulty may arise in ascertaining the Fair Market Value (FMV), but such difficulties should not be a reason for not adopting the rules and method prescribed. Subtle adjustment can be made in the methodology prescribed for evaluation. The Tribunal observed that CCI Guidelines were for a totally different purpose and could not be used for pricing methodology prescribed for ALP. Further, Rules prescribed for determination of the FMV under Section 56 of the Income-tax Act (the Act) cannot be taken as a basis for valuation in a transfer pricing matter. Valuation of shares based on DCF Method The Tribunal held that in the taxpayer s case, where market value of the investment is not readily ascertainable, the DCF was the most appropriate valuation method. Observing some mistakes in the workings of the TPO, the Tribunal restored the matter to the TPO for working out the value afresh as per standard practises. With regard to illiquidity risk, the Tribunal rejected any adjustment for the same by observing that the discounting factor (adopted for ascertaining the present value of future cash flows) takes into account all related risks. Ascendas (India) Private Limited v. DCIT (ITA No.1736/Mds/2011) For further details please refer to our Flash News dated 10 January 2013 available at this link 12

13 Delhi Special Bench of the Tribunal held that TP adjustment in relation to Advertisement, Marketing and Promotion expenditure incurred by the taxpayer for creating or improving the marketing intangible for and on behalf of the foreign AE is permissible The taxpayer, a wholly owned subsidiary of LG Electronics Inc., Korea (LG Korea) was given a right to use the technical information, designs, drawings and industrial property rights for the manufacture, marketing, sale and services of the agreed products from LG Korea on payment of a royalty. The taxpayer was also allowed to use the brand name and trademarks owned by LG Korea without payment of any royalty during the relevant period. The Special Bench inter alia held: Whether TPO could suo-moto assume jurisdiction without any reference from the AO on this transaction Suo-moto assumption of jurisdiction of the TPO in this case was covered by Section 92CA(2B) of the Act, which had retrospective operation from 1 June The challenge to the retrospective operation of the sub-section was rejected. Whether Advertisement, Marketing and Promotion spend construes a Transaction Display of the brand in the advertisements coupled with proportionately higher Advertisement, Marketing and Promotion (AMP) spend by the taxpayer indicated an oral or tacit understanding between the taxpayer and its foreign AE regarding Brand promotion by the taxpayer. Tribunal held that a `transaction can be both express as well as oral. So long as there exists some sort of understanding between two AEs on a particular point, the same shall have to be considered as a transaction, whether or not it has been formalised as part of a written agreement. Whether AMP spend construes an International Transaction The Special Bench held that in view of brand advertisement by the taxpayer, coupled with higher AMP spend, it could be concluded that the taxpayer had provided services to its AE, which owned the brand. Provision of services was an international transaction in terms of Section 92B(1) of the Act. Bright Line Test The Special Bench upheld the tax department s stand that the Bright Line Test is simply a tool to ascertain the cost of the international transaction. The method used to determine the ALP in this case is the cost plus method. In this case, since the taxpayer did not declare any cost/value of the international transaction of brand building, the onus comes upon the TPO to determine the cost/value of such international transaction in some rational manner. Interplay amongst Sections 37(1), 40A(2) and 92 of the Act The Special Bench held that in regard to international transactions, TP provisions as special provisions shall prevail over the other regular provisions governing the deductibility or taxability of an amount from such transactions. Relevant factors for determining cost/value of international transaction of AMP expenditure What does not constitute AMP Expenditure? Special Bench accepted the taxpayer s contention that expenditure incurred directly in connection with and not for promotion of sales should not be put in the same basket as AMP expenditure. Testing of entity level profits v. Transaction level profits and whether use of more than one method is permissible? Transactional Net Margin Method (TNMM) could be applied only on a Transactional Level and not on an Entity Level. The only exception would be when all the international transactions are of sale by the taxpayer to its foreign AE and there is no other transaction of sale to any outsider and also there is no other international transaction. 13

14 There is no bar on the power of the TPO in examining all international transactions under the TP provisions, even when the overall net profit earned by the taxpayer is higher than the comparable companies. The fact that the taxpayer has a better net profit rate in comparison with other comparable companies does not substantiate that the taxpayer purchased the goods at a concessional rate from its foreign AE as net profit is not dependent only on purchase cost. Only one method, as against combination of the prescribed methods, can be used for determining the ALP of an international transaction. The DRP and the AO were right in applying the spirit of the cost plus method to the facts of the instant case. The mere fact that DRP did not specifically mention it in so many words, will not ipso facto mean that it did not apply the cost plus method. The Dispute Resolution Panel (DRP) went wrong by arbitrarily determining the rate of mark-up at 13 percent without showing as to how much an independent comparable entity would have earned from an international transaction similar to that which is under consideration. Whether mark-up is permissible? The Special Bench held that the addition of mark-up to the costs has the sanction of law as seen from iv) of clause (c) to Rule 10B(1) of the Rules. Thus, mark-up can be validly imposed. However, the mark-up should be based on the mark-up charged by comparable companies for rendering similar services and should not be an ad-hoc mark-up. LG Electronics India Private Limited v. ACIT [2013] 22 ITR(T) 1 (Del) For further details please refer to our Flash News dated 25 January 2013 available at this link Mumbai Tribunal accepts a company incurring losses in two out of three years based on similarity in nature of services; in applying CUP method emphasises on similarity in business profiles vis-a-vis ownership profile The taxpayer was engaged in securities broking, merchant banking and financial advisory services. The TPO made an upward adjustment to the following international transactions (1) Business support services (2) Brokerage services and (3) Investment advisory services. Business Support Services The taxpayer adopted the TNMM as the most appropriate method. TPO rejected one of the comparables from the taxpayer s set as a loss-making concern. The Taxpayer provided a detailed description of its business and submitted that the company was loss-making only for the last two years and had an operating profit of percent in The Tribunal held that since the nature of services rendered by the company was similar to that of the taxpayer, it cannot be disqualified as a comparable even though it had incurred a loss during the year. Brokerage services The Taxpayer adopted CUP as the most appropriate method and considered the average brokerage rate charged by third party unrelated Indian brokers to its AE to benchmark its broking transaction. TPO segregated the comparables applied by the taxpayer into foreign-owned and Indian-owned comparables and determined the arm s length brokerage rate based on the brokerage rate charged by foreign-owned Indian brokers to the AE as the taxpayer was also a foreign-owned broking house. The Tribunal held that both foreign owned brokers and Indian-owned brokers matched the business profile of the taxpayer. All third party brokers were providing services in an uncontrolled regime and there was nothing contrary in the conduct and management of business of the comparables and the taxpayer. Thus, the CUP method applied by the taxpayer was appropriate. 14

15 Investment advisory services The TPO rejected the taxpayer s set of comparables and substituted it with his own set of comparables engaged in providing merchant banking activities. The Tribunal, relying on Carlyle India Advisors Private Limited v. ACIT [2012] 53 SOT 267 (Mum), rejected the comparables of the TPO as they were engaged in merchant banking activities. The Tribunal took cognizance of the fact that the taxpayer did not have a license to enter the merchant banking business. Goldman Sachs (India) Securities Pvt. Ltd. v. ACIT (ITA No. 7724/Mum/2011) For further details please refer to our Flash News dated 6 February 2013 available at this link Safe Harbour rules notified To reduce increasing number of transfer pricing audits and prolonged disputes, the CBDT had issued the draft Safe Harbour rules (SHR) on 14 August 2013, inviting public comments. The final SHRs are notified on 18 September 2013 after considering the comments of various stakeholders. Safe harbours for various sectors, shall be as under Eligible International Transaction Software development services (IT services) and Information Technology Enabled services (ITES), with insignificant risks where the aggregate value of such transactions < INR 500 crores where the aggregate value of such transactions > INR 500 crores Knowledge processes outsourcing services (KPO services), with insignificant risks Intra-group loan to wholly owned subsidiary (WOS) where the amount of loan: < INR 50 crores > INR 50 crores Explicit corporate guarantee to WOS where the amount guaranteed < INR 100 crores > INR 100 crores, and the credit rating of the borrower, by a SEBI registered agency is of the adequate to highest safety Specified contract research and development services (Contract R&D services), with insignificant risks, wholly or partly relating to software Safe Harbour ratios Operating profit margin to operating expense 20 percent 22 percent. Operating profit margin to operating expense 25 per cent Interest rate equal to or greater than the base rate of State Bank of India (SBI) as on 30th June of the relevant previous year: plus 150 basis points plus 300 basis points Commission or fee of 2 per cent or more per annum Commission or fee of 1.75 per cent or more per annum Operating profit margin to operating expense 30 per cent 15

16 development Contract R&D services, with insignificant risks, wholly or partly relating to generic pharmaceutical drugs Manufacture and export of: core auto components non-core auto components where 90 percent or more of total turnover relates to Original Equipment Manufacturer sales Operating profit margin to operating expense 29 per cent Operating profit margin to operating expense: 12 per cent 8.5 per cent The final SHRs are applicable for a period of 5 years starting with assessment year (AY) for the prescribed sectors. The option of being governed by SHRs shall continue to remain in force for the period specified by the taxpayer in the prescribed form (Form No. 3CEFA) or a period of five years whichever is less. The taxpayer can opt-out of the safe harbour regime from the second year onwards, by filing a declaration to that effect with the AO. The Rules provide for a time bound procedure for determination of the eligibility of the taxpayer and of the international transactions for SHR. In case action is not taken by AO/TPO within the prescribed time lines, the option exercised by the taxpayer shall be treated as valid. The taxpayer shall also have a right to file an objection with the Commissioner against an adverse order regarding the eligibility of taxpayer/international transaction. Even where the taxpayer opts to be governed by the SHRs, they will be required to comply with the regulations regarding mandatory documentation and filing the Accountant s report for each AY under consideration. Source: CBDT Notification No. 73/2013, dated 18 September 2013 available at this link Transfer Pricing reporting requirement expanded. Additional clauses and Specified Domestic Transactions reporting introduced in Revised Accountant s Report The CBDT has issued a Notification amending the relevant rules and revising the Accountant s Report in Form No. 3CEB to align the reporting requirements with the amended definition of international transaction and the extended provisions of Transfer Pricing covering Specified Domestic Transactions (SDT). Salient features of the revised Form include: Specific reporting for International Transactions - The details of international transactions like guarantees received or given, issue/buyback of equity shares/ convertible preference shares/convertible debentures, purchase/sale of marketable securities, capital financing transactions including receivables and any transaction arising out of business restructuring or reorganization are to be reported in separate clauses. Deemed international transactions are also to be reported under a separate head. Reporting of Specified Domestic Transactions A separate Section Part C has been introduced in Form 3CEB for reporting of SDT. The details of the transactions of expenditure to persons specified under Section 40A(2) (b) of the Act, acquisition or transfer of goods and services with reference to Section 80A(6), 80-IA(8) and 80-IA(10) of the Act as well as any other transactions covered under SDT are to be reported in specific clauses along with quantitative details, wherever relevant. 16

17 Reporting is required for SDT resulting in more than ordinary profits to an eligible business under Section 80-IA(10) or Section10AA of the Act. Notification No. 41/2013 dated 10 June 2013 For further details please refer to our Flash News dated 13 June 2013 available at this link CBDT provides breather to taxpayers in relation to Circulars issued on contract R&D centres and application of Profit Split Method thereto Based on representations received from various stakeholders, CBDT has: I) Issued Circular No. 5 of 2013 dated 29 June 2013 which rescinds Circular No. 2 of 2013 dated 26 March 2013 The CBDT had issued Circular No. 2 wherein it provided guidance on application of the PSM for entrepreneurial R&D work that may be undertaken in India. The CBDT has now issued Circular No. 5 of 2013 which rescinds the aforesaid Circular No. 2 of In its Press release on this matter, the CBDT clarified that the crux of Rule 10C of the Rules is that the tax officer shall take into account the factors enumerated thereunder to choose the most appropriate method which is best suited to the facts and circumstances of the case and which provides the most reliable measure of an arm s length price in relation to that transaction. It was felt that Circular 2 appeared to give the impression that there was a hierarchy among the six methods listed in Section 92C of the Act and that PSM was the preferred method in cases involving unique intangibles or in multiple interrelated international transactions. Accordingly, Circular 2 is rescinded to eliminate this perceived conflict between provisions of Section 92C/ Rule 10C and contents of Circular 2. II) Issued new Circular No. 6 of 2013 dated 29 June 2013 (amending Circular No. 3 of 2013 dated 26 March 2013) Circular 6 recognises that the R&D Centres set up by foreign companies in India can be classified into three broad categories based on functions, assets and risk assumed by them. These are: Centres which are entrepreneurial in nature (these would be entities performing significantly important functions and assumes substantial risks); Centres which undertake contract R&D (these would be entities with minimal functions, assets and risk; and Centres which are based on cost-sharing arrangement (these entities would have a profile that would fall between the entrepreneurial model stated in 1 above and the contract R&D model stated in 2 above) CBDT observes that in a large number of cases taxpayers claim that they must be treated as a contract R&D service provider with insignificant risk and consequently the Transactional Net Margin Method (TNMM) is adopted as the most appropriate method. The CBDT has laid down the following guidelines for identifying contract R&D service providers with insignificant risk. Functions: All economically significant functions involved in research or product development cycle are performed by foreign Associated Enterprise (AE) either through its own employees or through other AEs while the Indian Development Centre carries out the work assigned to it by the AE. Economically significant functions would include critical functions such as conceptualisation and design of the product and providing the strategic direction and framework. Funding: The foreign principal or its AE provides funds/ capital and other economically significant assets including intangibles for R&D. The foreign principal or its AE provide remuneration to the Indian development centre. 17

18 Supervision and Control: The Indian development centre works under direct supervision of the foreign principal or its AE. The foreign principal or its AE to be actually in-charge of strategic decisions relating to performance of core functions as well as monitor activities on regular basis. Risk profile: The actual conduct of the Indian development centre and the AE show that significant risks are borne by the AE which are in line with the contractual arrangement. Location of AE: In case the AE is located in low or no tax jurisdiction then it will be presumed that the AE does not bear any risk unless the taxpayer can prove to the contrary; Low tax jurisdiction shall mean any country or territory notified in this behalf under Section 94A of the Income-tax Act, 1961 (the Act) or any other country or territory that may be notified for the purpose of Chapter X of the Act. Ownership Rights: The right of the intangible (legal or economic) developed vests with the AE and the Indian development centre does not have any ownership over the same. Further this should be evident from the conduct of the parties. The Circular states that pursuant to the aforesaid analysis, the AO or the TPO, as the case may be, shall consider the application of the most appropriate method as elaborated in Section 92C of the Act and Rule 10A to Rule 10C of the Income-tax Rules, 1962 (the Rules). Key Changes: Some of the key changes are highlighted below: It is recognised that economically significant functions to be performed by foreign principal could be performed either through own employees or through its AEs. The term economically significant functions has been explained to include critical functions such as conceptualization and design of the product and providing the strategic direction and framework. It is clarified that funding to the Indian development centre could be provided either by the foreign principal or its AEs. It is clarified that remuneration to the Indian development centre could be provided either by the foreign principal or its AEs. In terms of supervision, it is clarified that the Indian development centre could work either under the supervision of the foreign principal or its AEs. The term Low tax jurisdiction has been defined to mean any country or territory notified in this behalf under Section 94A of the Act or any other country or territory that may be notified for the purpose of Chapter X of the Act. Circular 6 eliminates the words cumulatively complied with in relation to the conditions stated in Circular 3. Instead Circular 6 lays down guidelines thereby allowing the tax authority to take a final decision based on the totality of the facts and circumstances of the case. III) Side Note on Safe Harbour The CBDT has, vide its Press Release, provided that Safe Harbour Rules under Section 92CB of the Act are under consideration and will be issued shortly by the CBDT and the Safe Harbour Rules are expected to bring further certainty in assessment of Development Centres that are engaged in providing contract R&D services. Circular No. 05/2013 and 06/2013 dated 29 June 2013 For further details please refer to our Flash News dated 1 July 2013 available at this link 18

19 Depreciation Supreme Court rules that the leasing company is entitled to claim depreciation at higher rate on the leased vehicles used in business of running on hire The taxpayer, a Non Banking Finance Company was engaged in the business of hire purchase, leasing etc. As a part of its business, the taxpayer purchased the vehicles against direct payment to the manufacturers and leased out vehicles to its customers. Lessees were registered as the owners of the vehicles, in the certificate of registration issued under the Motor Vehicles Act, 1988 (the MV Act). On such vehicles, the taxpayer claimed depreciation at a higher rate on the ground that the vehicles were used in the business of running on hire. The AO disallowed both the claims i.e., normal depreciation and higher rate of depreciation, on the grounds that the taxpayer s use of the vehicles was only by way of leasing out to others and not as actual user of the vehicles in the business of running them. The issue for consideration before the Supreme Court was whether the taxpayer is the owner of the vehicles which are leased out to its customers and also eligible to claim depreciation on the same. Further, whether the taxpayer is entitled to claim higher rate of depreciation on the said vehicles on the ground that they were hired out to its customers. The Supreme Court held that the taxpayer is the owner of the assets and entitled to higher rate of depreciation since: The vehicle, along with its keys, was delivered to the taxpayer upon which, the lease agreement was entered into by the taxpayer with the customer and the ownership was with the taxpayer. MV Act creates a legal fiction of ownership in favour of lessee only for the purpose of the MV Act. It is not a statement of law on ownership in general. Also, the lessee has not claimed depreciation on the vehicles. The entire lease rent received by the taxpayer is assessed as business income in its hands and the entire lease rent paid by the lessee has been treated as deductible revenue expenditure in the hands of the lessee. This reaffirms the position that the taxpayer is in fact the owner of the vehicle, in so far as Section 32 of the Act is concerned. The taxpayer is the owner of the vehicles and as an owner, it used the assets in the course of its business, satisfying both the requirements of Section 32 of the Act and hence, is entitled to claim depreciation on the same. The taxpayer uses the vehicles in the course of its leasing business and hence, is entitled to claim a higher rate of depreciation. I.C.D.S Ltd v. CIT [2013] 350 ITR 527 (SC) For further details please refer to our Flash News dated 18 January 2013 available at this link ESOP SEBI amends ESOP Guidelines to prohibit companies from acquisition of own securities in secondary market The SEBI, had issued guidelines in 1999 (referred to as ESOP Guidelines) to provide a regulatory framework for listed companies to implement security based compensation schemes. These ESOP Guidelines were amended by SEBI by its Circular issued on 17 January The amendments were brought in since it was noticed that some listed companies have ESOP schemes wherein an Employees Welfare Trust (EWT) is set-up. The EWT s purpose is to deal in the company s 19

20 own shares in the secondary market, for issuance to the employees. Such dealing was not envisaged in the ESOP Guidelines. SEBI feared that the EWT route may be utilized for inflating, depressing, maintaining or causing fluctuation in the price of the securities, by engaging in fraudulent and unfair trade practices. This could also give rise to concerns vis-à-vis compliance with the SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to the Securities Market) Regulations, 2003 and SEBI (Prohibition of Insider Trading) Regulations, SEBI has therefore issued a Circular to amend the ESOP Guidelines and the Equity Listing Agreement (which are conditions set for listing on a stock exchange), to prohibit listed companies from framing any employee benefit schemes involving the acquisition of own securities from the secondary market. Further, companies that have already implemented ESOP schemes that are not in accordance with the amended ESOP Guidelines, are required to furnish certain information to SEBI before 16 February 2013 and to align such ESOP schemes with the amended ESOP Guidelines before 30 June 2013 (for example, by transferring the securities to the employees or selling them in the market for transferring the benefit to the employees). The amended ESOP Guidelines will impact both existing ESOP schemes as well as new schemes to be framed and implemented. Circular No. CIC/CFD/DIL/3/2013 dated 17 January 2013 For further details please refer to our Flash News dated 18 January 2013 available at this link Special Bench held that discount on issue of ESOP is an allowable business deduction during the vesting period The taxpayer framed an ESOP pursuant to which it granted options to its employees to subscribe for shares at the face value of INR 10. As the market price of each share was INR 919, the taxpayer claimed that it had given a discount of INR 909, which should be allowable as a deduction as employee compensation under Section 37 of the Act in the Assessment Years (AYs) to Although the options vested equally over four years, the taxpayer claimed a larger amount in the first year than was available under the SEBI guidelines. The Bangalore Special Bench held as follows: The difference (discount) between the market price of the shares and their issue price is expenditure in the hands of the taxpayer because it is a substitute for giving a direct incentive in cash for availing the services of the employees. There is no difference between a case where the company issues shares to the public at market price and pays a part of the premium to the employees for their services and another where the shares are directly issued to employees at a reduced rate. In both situations, the employees are compensated for their effort. The liability cannot be regarded as being contingent in nature because the rendering of service for one year is sine qua non for becoming eligible to avail the benefit under the scheme. Once the service is rendered for one year, it becomes obligatory on the part of the company to honor its commitment of allowing the vesting of 25 percent of the option. There is likely to be a difference in the quantum of discount at the stage of vesting of the stock options (when the deduction is allowable) and at the stage of exercise of the options. The difference has to be adjusted by making suitable northwards or southwards adjustment at the time of exercise of the option depending on the market price of the shares then prevailing. The fact that the SEBI Guidelines do not provide for the adjustment of discount at the time of exercise of options is irrelevant because accounting principles cannot affect the position under the Act. 20