DIRECT TAX LAWS Taxability of Capital Gains on By-back of Shares - Debate ignites after AAR s rling in RST s case BACKGROUND 1. Recently, the Athority for Advance Rlings ( AAR ) in the case of RST, In re [2012] 19 taxmann.com 215 (AAR - New Delhi) ( the applicant ) held that the capital gains on by-back of shares is taxable in India in the hands of the German company, being 99.99 shareholders of an Indian pblic company. The AAR rled as nder : Section 46A of the Income-tax Act, 1961 ( Act ) being a specific provision wold apply while dealing with capital gains on byback of shares, and Section 47(iv) (read with section 45) which excldes from the definition of taxable transfer, a transfer of capital assets (inclding shares) held by a holding company to a 100 per cent owned sbsidiary, is not applicable to a case of by-back. 2. FACTS OF THE CASE AMIT AGGARWAL Senior Manager (Tax & Reglatory), KPMG, Grgaon ALOK PAREEK The applicant is a company incorporated in Germany with limited liability. The applicant files income-tax retrns in India as a non-resident. The applicant has a wholly owned sbsidiary in India, which is a pblic limited company incorporated nder the Indian Companies Act, 1956. The applicant holds 99.99 per cent shares in the Indian company. Remaining shares are held by 6 other companies, who are the applicant s nominees, for the compliance of the Companies Act. The shares in the Indian company are held by the applicant as an investment and not as stock-in-trade. Indian sbsidiary is proposing a by-back of shares from the applicant. The by-back wold reslt in transfer of shares of the Indian company from the applicant to the Indian company. CA 12 May 1 to 15, 2012 TAXMANN S CORPORATE PROFESSIONALS TODAY Vol. 24 14

The consideration for the proposed transfer is to be determined on the basis of pricing gidelines prescribed by the Reserve Bank of India (RBI) as applicable to transfer of shares by a non-resident to a resident. 3. ISSUE BEFORE THE AAR Whether the transfer of shares in the corse of by-back of shares by the Indian sbsidiary from the foreign company is taxable in India? 4. STATUTORY PROVISIONS Income-tax Act, 1961 ( Act ) Section 2(24)(vi) Income incldes any capital gains chargeable nder section 45 Section 45 Charging section for capital gains Section 46A Capital gains on prchases by company of its own or other specified secrities. Where a shareholder or a holder of other specified secrities receives any consideration from any company for prchase of its own shares or other specified secrities held by sch shareholder or holder of other specified secrities, then, sbject to the provisions of section 48, the difference between the cost of acqisition and the vale of consideration received by the shareholder or the holder of other specified secrities, as the case may be, shall be deemed to be the capital gains arising to sch shareholder or the holder of other specified secrities, as the case may be, in the year in which sch shares or other specified secrities were prchased by the company. Explanation. - For the prposes of this section, specified secrities shall have the meaning assigned to it in the Explanation to section 77A of the Companies Act, 1956 (1 of 1956). Section 47(iv) Transactions not regarded as transfer. Any transfer of a capital asset by a company to its sbsidiary company, if - (a) The parent company or its nominees hold the whole of the share capital of the sbsidiary company; and (b) The sbsidiary company is an Indian company; Companies Act, 1956 Section 77A This provision enables a company to prchase its own secrities, sbject to certain conditions. The by-back shold be of 25 per cent or less of the total paid-p capital. On byback, the company has to extingish and physically destroy the secrities boght back. If shares are boght back, there can be no fresh isse of shares within six months nless these are bons shares. Section 49 Sbject to certain savings, all investments made by a company on its own behalf shall be made and held by it in its own name. Sb-section (3) enables a company to hold shares in its sbsidiary in the name or names of a nominee or nominees of the company so as to ensre that the nmber of members of the sbsidiary is not redced below seven, if it is a pblic company, and below two, if the sbsidiary is a private company. Sb-section (7) clarifies that secrities inclde stocks and debentres. May 1 to 15, 2012 TAXMANN S CORPORATE PROFESSIONALS TODAY Vol. 24 15 13

DIRECT TAX LAWS In A. Ramaiya s Gide to the Companies Act (16th Edition Reprint 2006) at page 614, the following passage occrs : When the investment of a company consists of shares in another company the qestion arises whether shares held by the company in the name of its nominee mst be deemed to be held by the company and whether the investments shold be transferred to the name of the company. In considering this qestion, it is necessary to bear in mind the provisions of section 153 which provide that no notice of any trst, express, implied or constrctive, shall be entered in the register of members or debentre-holders. A company, therefore, is bond to treat the person in whose name the shares are entered in its register of members as a member. If a company holds shares in the name of its nominee it is not entitled to any of the rights in respect of the shares sch as right to dividend, to allotment of rights shares nder section 81, to exercise voting rights in relation to the shares and other privileges which shareholders have. It does not, therefore, appear to be an implication of the provisions of section 49 that if a company holds shares in another company in the name of its nominee, the shares mst be deemed to be held by the company and not by the nominee. 5. APPLICANT S CONTENTIONS Section 46A of the Act is not a charging section. Frther, by-back of shares wold be chargeable to tax nder section 45(1), read with section 46A for comptation thereof. The transaction shall be covered nder section 45 and section 47(iv) and, therefore, the transaction wold not be taxable in India. The applicant and its nominees together held 100 per cent of the shares in the Indian sbsidiary. Therefore, the transfer in the corse of a by-back wold stand exempted from taxation nder section 47(iv). It is enogh if a share is a capital asset to attract sections 45 and 47. Provisions of India-Germany tax treaty are not invoked since they are not beneficial to the applicant and sch capital gains are taxable in sorce State, i.e., India. 6. TAX DEPARTMENT S CONTENTIONS Existence of the share after the transfer is a mst for attracting section 47(iv). In a by-back the shares get destroyed and, hence, section 47(iv) has no application. Section 47 also does not override section 46A. Section 46A was introdced specifically to deal with by-back of shares and the rate of tax has to be compted in terms of section 48. Section 47 has no relevance in this context. Accordingly, the gains are taxable in India as capital gain, both nder section 46A or nder Article 13(4) of India-Germany tax treaty. AAR S RULING 7. The AAR held in favor of the revene on following two gronds : Section 47(iv) provides exemption if a company holds 100 per cent shares in an Indian sbsidiary, either directly or throgh its nominees. 14 May 1 to 15, 2012 TAXMANN S CORPORATE PROFESSIONALS TODAY Vol. 24 16

In the context of section 49(3) of the Companies Act, there cannot exist a sbsidiary Indian company, whether pblic or private, in which the parent company cold legally hold 100 per cent of the shares. Treating the other six members as not having independent existence, it wold mean that the sbsidiary wold become an illegal entity in the face of section 49(3) of the Companies Act. It wold mean that the applicant wold be fonding its case of action on an illegality. Relying on A. Ramaiya s Gide to the Companies Act [as above], the AAR held that in the applicant s case even if it is taken that the other six members of the sbsidiary are the nominees of the applicant, it cannot be claimed that the applicant is holding 100 per cent of the shares in the sbsidiary. If nder Indian law, a parent company cannot hold 100 per cent in a sbsidiary, it wold only mean that the Parliament did not intend to confer the benefit of section 47(iv) on sch a parent company. Therefore, the AAR held that the applicant is wrong in assming the words nder section 47(iv) of the Act the parent company or its nominees as the parent company and its nominees. Section 46A being a special provision dealing with by-backs, has to prevail over the general provisions incorporated in section 45. Frther, even if the plea of the applicant is accepted to read or as and in section 47(iv), it is of no avail to the applicant in view of the fact that section 46A wold be applicable in the case of a by-back of shares and it is not sbjected to section 47 (which only overrides section 45). Once section 46A is attracted when there is a by-back of shares, the gains have to be taxed in terms of said provision, read with section 48. Therefore, the gains on proposed by-back of shares wold not be exempt nder section 47(iv) and liable to be taxed in India nder special provisions dealing with by-back nder section 46A. SECTION 47(iv) - THE CONTROVERSY AHEAD - VIEWS 8. The AAR s conclsion of reqirement of 100 per cent shareholding by a single shareholder [withot nominee shareholding to comply with minimm nmber of shareholders reqirement as per Companies Act] is highly impracticable, since in sch a scenario, practically no holding company will be able to take benefit of transfer of any capital asset, even other than shares in a by-back scheme. This will render operation of section 47(iv) redndant. Sch redndancy wold not have been the intention of the Legislatre. That apart, since the AAR based its conclsion also on the applicability of section 47(iv) exemption vis-a-vis section 46A [irrespective of the above conclsion], the same needs to be discssed as below: One view As per section 2(24)(vi) income incldes any capital gains chargeable nder section 45. Section 46A is not expressly covered and also cannot be said to be covered nder the inclsive definition, since it is not a receipt of a recrrent natre to fall nder the general connotation of income. When section 47(iv) provides for a transaction of transfer 1 of capital asset not to be regarded as a transfer (sbject to flfilment of conditions). Section 46A is a deeming provision taxing a specific transaction (i.e., by-back), irrespective of whether it is a transfer or not. Going by a strict interpretation of section 47(iv) for its applicability to only a select species of companies, (aligning with the May 1 to 15, 2012 TAXMANN S CORPORATE PROFESSIONALS TODAY Vol. 24 17 15

DIRECT TAX LAWS view of AAR), it can be constred that the benefit of section 47(iv) oght not to be available to a holding company, where it does not hold all shares in its sbsidiary and even a single share is held by its nominees. Second view However, section 45 is the only charging section for capital gains as contemplated nder section 2(24)(vi). There is only one charging section for each head of income, i.e. section 15 for salaries, section 23 for hose property, section 28 for profits from bsiness, section 45 for capital gains and section 56 for other sorces. The Spreme Cort in CIT v. B.C. Srinivasa Setty [1981] 128 ITR 294/5 Taxman 1 has held : The charging section and the comptation provisions together constitte an integrated code And ordinarily the operation of the charging provision cannot be affected by the constrction of a particlar comptation provision. Section 46A provides for deemed capital gains. Conseqently, it can be arged that section 46A derives its chargeability from section 45 itself. Frther, se of the words sbject to the provisions of section 48 in section 46A is a reference to the mode of comptation as per the provisions of section 48, making section 46A also a comptation section providing the extent of charge, i.e., the difference between the cost of acqisition and the by-back consideration received by the shareholder. The intention of the law makers while inserting section 46A is sbjecting the gains arising on by-back of shares to the capital gains tax. However, in the light of the intention of the section alone it cannot be a grond for taxing the by-back in all cases. When a by-back falls nder the exempting provisions [section 47(iv)], it cannot be taxed nder section 46A. Section 46A wold be rendered otiose if it was not regarded to fall nder the charging provisions of section 45 and, hence, nder the definition of income nder section 2(24). The second view appears to be more wellfonded based on the provisions of law. 9. CONCLUSION The force of section 46A alone shold not be sfficient to tax capital gains arising on by-back in every sitation. Ths, the benefit of exemption vide provisions of section 47(iv) shold be possible in respect of transactions involving by-back of shares by the wholly owned Indian sbsidiaries. Given that AAR rling only has a persasive vale and is not binding on other taxpayers, it remains to be seen what interpretation is placed by the tax Tribnals/corts in interpretation of these provisions. The AAR rling has opened a debatable isse on interpretation of section 47(iv) which cold lead to redndancy of the section in almost all cases, since practically no holding company will be able to take benefit of transfer of any capital asset, even other than shares (in a by-back scheme). This is highly negative fall ot of the decision. 1. The Spreme Cort in the case of Anarkali Sarabhai v. CIT [1997] 90 Taxman 509, held that redemption of preference shares by the company is considered to be a sale and also transfer of asset by shareholder. DT - Secs. 46A and 47(iv). 16 May 1 to 15, 2012 TAXMANN S CORPORATE PROFESSIONALS TODAY Vol. 24 18