Share sale price cannot be apportioned towards transfer of “controlling interest”
The Bombay High court in the case of Vodafone International BV [Writ Petition No. 1325 of 2010] had inter alia held that the ‘controlling interest’ in an Indian Company is by itself a capital asset, the transfer of which is liable to taxes in India. As there was admittedly a transfer of controlling interest in the Hutchison India by Hutchison Hong Kong in favor of Vodafone BV (which was effected through sale of shares of a Mauritian entity) the HC observed there was supposedly transfer of a ‘capital asset’ situated in India.
One offshoot of the judgment is that controlling interest is per se an asset by itself capable of being transferred. Before venturing into the intricacies, let us understand what controlling interest means.
A company is an artificial person, the owners of which are its members (shareholders). The company is to be managed by these members. In a situation where a company has thousands of members, it would not be practicable to empower each member to control the affairs of the company. Hence, the legislature provides for the appointment of Directors to a company, who would, on behalf of the members, control and manage the functioning of the company. Each shareholder is vested with the right of nominating and voting for the appointment of a specific person as a director (through whom the shareholder would eventually control the Company). Each share generally contains one vote and the person holding a majority shareholding would have better say in the affairs of the company.
In this background, the right to appoint the directors and manage the functioning of the company is termed as ‘controlling interest’ in a company. The question of whether ‘controlling interest’ by itself is a capital asset or is it just a right attached to the shares (like a right to receive dividend) is a long drawn debate. While the Bombay HC in the above referred Vodafone’s case has held controlling interest is a capital asset identifiable separately, a plethora of other courts including the Madras HC in Venkatesh (Minor) 243 ITR 367 and the Madhya Pradesh HC in Maharani Ushadevi 131 ITR 445 have firmly held that controlling interest is just a right flowing out of an asset in the form of shares. (It is to be noted that all these judgments are fact specific.)
Now, the next question is, what if ‘controlling interest’ is classified as a separate asset by itself. One of the outcome is the live example in Vodafone’s case. Being an asset situated in India, the transfer of the asset would be liable to taxes in India whether or not he is residents of India. The question is what would be cost of acquisition of the so called asset? Applying the rule laid down by the Apex Court in B.C Srinivas Shetty 128 ITR 294, the right being self generated, cost of its acquisition would be indeterminable. Ultimately, there is no tax liability on the transfer of the said capital asset.
So, is the Bombay HC in Vodafone’s case advantageous or deterrent to the Revenue? The answer is both Yes and No. Yes because the Revenue can bring transfer between non residents to tax in India. No because the cost, unless specifically determinable, is presumed to be indeterminable and hence no tax can be collected. The ‘No’ perspective would not survive long for two reason. Firstly, like in the case of ‘non compete fee’, the Government can any time bring in an amendment to say that cost of acquisition of ‘controlling interest’ is zero. Secondly, the draft Direct Tax Code Bill 2010 (which is supposed to be effective from 1 April 2012) in clause (7) of section 53 provides that the cost of acquisition of a self generated asset shall be ‘Nil’.
With this understanding, let us now look into a recent ruling of the Kolkatta Tribunal in the case of a group of Indian promoters. The facts in the above referred case decided on 3 February 2011 are as under:
• Assessee was a part of the promoter group of an Indian listed company. Though the promoter group held less than 50 percent of the entire shareholding, they controlled and managed the affairs of the company. In other words, the controlling interest in the listed company was purportedly held by the promoter group.
• The entire promoter holding was transferred to a Switzerland based group for a consideration of Rs 105/- per share.
• The share transfer agreement provided that of the total consideration, Rs 90/- is towards sale of shares and the balance of Rs 15/- is towards non compete fee.
• The shareholders, as a mater of precaution, obtained a valuation report from Deloitte Haskins & Sells which opined that the value of the shares was Rs 74.20/-
Before the tax authorities, on the basis of the valuation report, the promoter group claimed that of Rs 105/- received as sale consideration, Rs 74.20/- alone pertains to transfer of shares and the balance Rs 30.80/- relates to transfer of ‘controlling interest’. It was contended that the cost of acquisition of ‘controlling interest’ is not determinable being a self generated asset and hence the receipt is not liable to tax. The balance was offered to tax as capital gain after reducing the cost of acquisition.
The assessing offer deferred with the argument on bifurcation of sale consideration. Relying on the rulings in Maharani Ushadevi (supre), Venkatesh (super), he held that there is no such asset like ‘controlling interest’. Accordingly, he assessed the entire consideration as being towards the sale of shares.
On appeal, the first appellate authority agreed with the argument advanced by the assessee and reversed the order of the assessing officer. The assessing officer filed an appeal before the Tribunal against the order of the first appellate authority. Both the parties extended the same line of argument before the Tribunal.
The Tribunal, primarily analysed various clauses of the share transfer agreement in detail before getting into the argument of ‘controlling interest’ being considered as an asset. The Tribunal made the following observations about the share transfer agreement.
• The ‘preamble’ of the agreement refers to only sale of share between the parties.
• The ‘object of sale’ clause of the agreement states the perspective to be only sale of shares and not ‘transfer of control in management’.
• The clause on ‘sale consideration’ refers to splitting the consideration into two parts, one for sale of shares and the other for non-compete.
Under these circumstances, in the absence of any mention in the agreement about transfer of control in the management of the enterprise, the Tribunal denied any benefit to the assessee.
The effort by the promoter group to split the consideration into two parts is a cleaver tax planning exercise. Though, they went on get a valuation report to support their claim that the consideration for sale of shares is not less than its value, not drafting the agreement according to their claim has let them down. A second thought before signing the agreement would have saved them huge amount of taxes.