Ijtl PDF

INDIAN JOURNAL OF TAX LAW
VOL. 1 2014
Missing the Woods for the Trees: Ishikawajima v.

Vodafone Crisis in Turnkey Contract -Neha Pathakji
Theoretical Issues in the Management of Property

Rates Tax: A Case for Kampala Capital City
Authority
-Justice Joseph
Murangira
Taxation of the Income of Investment Funds:

Applying the ‘First Purchase’ Principle and Recent
Developments in Characterisation of Income -Vishal Achanta
Royalty Taxation in India Post Reliance Infocom:

Setting a Perilous Precedent -Deekshitha Srikant,
Enakshi Jha, &
Sindhuja Satti
Indian GAAR: Is Uncertainty Causing a Setback to

Foreign Investments? -Ameya Mithe &
Rohan Shrivastava
Subscription of Shares vis-à-vis Transfer Pricing and

Related Issues: A Critical Analysis of the Law -Deepak Joshi
VOL. 1 INDIAN JOURNAL OF TAX LAW 2014
ADVISORY BOARD
Narayan Prasad Jain Neha Pathakji
Advocate, Calcutta High Court, Asst. Prof. of Law,
Kolkata NALSAR University of Law,
Hyderabad
Karthik Ranganatha Dr. Sanjay Kumar Yadav
Advocate, Karnataka High Court, Assoc. Prof. of Law,
Bangalore NLIU, Bhopal
EDITORIAL BOARD
EDITOR-IN-CHIEF
Praveen Shankar
MANAGING EDITORS
Pratik Shanu Satish Padhi
SENIOR EDITORS
Pawan Girdhar Satyam Khandelwal Sreejayan Menon
EDITORS
Abhijeet Kumar Adrija Mishra Akshita Srivastav
Anand Narayan Anil Vishnoi Anupam Pillai
Apurva Taran Ashutosh Singh Divya Murlidharan
Gautam Mohanty Ipsita Mishra Neelabh Shreesh
Risa Das Shreya Singh
COPY EDITORS
Ashish Patel Aishwarya Dubey Dhruv Tiwari
Riyanka Roy Choudhary Ujjawal Satsangi
SUBMISSION COORDINATORS
Eshna Saxena Disha Kapoor Mandar Bhatodkar
Namrata Srivastav Sourjya Das
IJTL
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VOL. 1 INDIAN JOURNAL OF TAX LAW 2014
TABLE OF CONTENTS
Editorial I
Missing the Woods for the Trees: Ishikawajima v.

Vodafone Crisis in Turnkey Contract ...Neha Pathakji 1
Theoretical Issues in the Management of Property Rates

Tax: A Case for Kampala Capital City Authority ...Justice Joseph 14
Murangira
Taxation of the Income of Investment Funds: Applying the

‗First Purchase‘ Principle and Recent Developments in
Characterisation of Income ...Vishal Achanta 29
Royalty Taxation in India Post Reliance Infocom: Setting a

Perilous Precedent ...Deekshitha Srikant, 38
Enakshi Jha, &
Sindhuja Satti
Indian GAAR: Is Uncertainty Causing a Setback to

Foreign Investments? ...Ameya Mithe & 55
Rohan Shrivastava
Subscription of Shares vis-à-vis Transfer Pricing and

Related Issues: A Critical Analysis of the Law ...Deepak Joshi 85
Notes to Contributors II
I
EDITORIAL
The Editorial team is pleased to bring forth the first publication of the Journal. We
show our gratitude to the Contributors for their scholarly work and to our Advisors for their
help and support.
The Journal is first of its kind in India in the area of taxation. It is edited by the
students and alumni of National Law University Odisha, Cuttack, independently from the
University, and to advice the Editorial Board on the matters of content and policy, there is an
Advisory Board which is a group of academicians and legal practitioners with a strong
interest in taxation.
The Journal‘s object is to promote greater interest among students, and others to
undertake serious academic research and discussion on issues involving taxation.
This issue focuses on International Taxation and has two special articles on other
areas, one by Neha Pathakji and another by Justice Joseph Murangira. Ms. Pathakji is a
member of the Advisory Board of the Journal and Asst. Prof. of Law at NALSAR University
of Law, Hyderabad. Joseph Murangira is Judge of the High Court of Uganda.
Ms. Neha Pathakji‘s article ‗Missing the Woods for the Trees: Ishikawajima v.
Vodafone Crisis in Turnkey Contracts‘ put important debate over the interpretation of
Tumkey Contracts. One test applied over them is the ‗look at it as whole‘ test which was
given in the landmark Vodafone judgment, whereas another test ‗purpose of contract test‘ is
also applied by the courts. Ms. Pathakji‘s article is an important read over this current debate.
‗Theoretical Issues in the Management of Property Rates Tax: A Case for Kampala
Capital City Authority‘ is a special article by Joseph Murangira, J., High Court of Uganda.
The article examines the key theories, like the principal-agent theory, the game theory,
Nozick‘s state of nature theory and Bentham‘s utilitarianism, in the management of property
rates tax with specific focus on their relevance to Kampala Capital City Authority.
Other articles cover the current local debates of International Taxation. We hope the
readers would find them interesting and useful.
Board of Editors
MISSING THE WOODS FOR THE TREES:
ISHIKAWAJIMA v. VODAFONE CRISIS IN
TURNKEY CONTRACTS
Neha Pathakji
Abstract
Recently when Delhi High Court in Linde AG reaffirmed application of

Ishikawajima‘s dissected approach to turnkey contracts and rapped the knuckles
of AAR for having read principles of Vodafone without context; it provided some
settled shores to foreign companies engaged in turnkey contracts and their
liability to tax in India. Post Vodafone several rulings of AAR and Tribunal had
applied ‗look at‘ approach to turnkey contracts to hold that ‗dissected‘ approach
of Ishikawajima stood impliedly overruled by Vodafone. This newfound
controversy on Ishikawajima v. Vodafone added further complications in an
already muddled issue on taxation of turnkey contracts. However, to merely view
issue of turnkey contracts as a tussle between dissected approach of Ishikawajima
v. ‗look at it as a whole‘ approach propounded by Vodafone would be an over
simplification of the problem. I argue that the problem has much deeper roots.
Whilst Ishikawajima decision required determination of taxability of turnkey
contracts to necessitate combined application of ‗purpose and object of contract‘
test and ‗source of receipt‘ test; judicial authorities have applied tests in mutual
exclusion to one another. Evidently, when one set out to inquire only one of the
tests, different answers are derived depending upon the test applicable. It is
during the application of ‗purpose of contract test‘ and manner of reading
contract that courts entangled with Vodafone decision. It is therefore suggested
that both tests need to be applied in conjunction with each other so as to attain
some consistency in decisions. Further it is suggested that Vodafone ratio ought
be applied to those matters where question have been reserved for consideration
whether parties had resorted to sham transaction or tax avoidance mechanism
through contractual arrangement.
 Assistant Professor of Law, NALSAR University of Law, Hyderabad; E-mail: nehapathakji@gmail.com

2014 Missing the Woods for the Trees: Ishikawajima v. Vodafone Crisis in 3
Turnkey Contracts
PART I INTRODUCING THE CONTROVERSY
Contemporary times have witnessed proliferation of turnkey contracts and consortium

form of executing work. Turnkey contracts entails coming together of several companies in
accordance to their expertise and to that extent member companies form a consortium to bid
for contract. On successful bidding members perform activities according to their expertise.
Taxation of turnkey contracts has remained problematic on more than one count. First,
taxation of such consortium model as ‗Association of Person‘ u/s 2(31) of Income Tax Act as
separate legal entity other than companies forming such consortium has been subject matter
of constant litigation. At the heart of the controversy however lies the issue regarding tax
liability of non-resident consortium members on offshore supply and services in Indian
projects under domestic tax statute and DTAA. An extension of this is also comprised in
determining a consequential query on apportionment of income to Indian jurisdiction and
establishment of PE.
In 2007 when two Judge Bench of the Supreme Court in Ishikawajima – Harima
Heavy Industries Limited vs. DIT1 (hereinafter ‗Ishikawajima‘) held that a turnkey contract
was capable of being dissected and it was open to the assessee to raise the contention that
parts of offshore contract should be treated separately for the purpose of taxation in India; it
was expected that legal position has been settled. However, the issue gained a fresh lease of
life after Supreme Court‘s three judge bench in Vodafone International Holdings BV v. UOI
and another 2 (hereinafter ‗Vodafone‘) held that it is the ‗task of the Revenue/Court to
ascertain the legal nature of the transaction and while doing so it has to look at the
transaction as a whole and not to adopt a dissecting approach (emphasis are mine)‘.
Consequent to Vodafone judgement it was opined by several rulings of Authority for

Advance Ruling (hereinafter ‗AAR‘), Income Tax Appellate Tribunal (hereinafter ‗ITAT‘)
that the dissected approach adopted in Ishikawajima stands disapproved or overruled on
account of Vodafone decision, if not expressly, definitely by clear implication. A natural
corollary of such understanding was diametrically opposite views taken by different judicial
authorities at different levels on seemingly similar fact scenario. While decisions in Roxar
Maximum Reservoir Performance WLL 3 , Alstom Transport SA 4 , and Linde AG 5 relied on
1 Ishikawajima – Harima Heavy Industries Limited vs. DIT, (2007) 288 ITR 408.
2 Vodafone International Holdings BV v. UOI and another, (2012) 341 ITR 1.
3 Re: Roxar Maximum Reservoir Performance WLL, (2012) 349 ITR 189 (AAR).
VOL. 1] I N D IA N J O U R NA L OF TAX LAW 4
Vodafone to apply ‗look at‘ test to hold that composite contracts of commissioning and
installation cannot be dissected for tax purposes and hence entire contract is liable to tax in
India; Nokia Networks OY 6 and National Petroleum Construction Company 7 followed
Ishikawajima to apply a ‗dissected approach‘ and held that only that part of income that has
territorial nexus with India should be liable to tax in India.
Recently Delhi High Court decision in Linde AG, Linde Engineering Division v.
DCIT8 (hereinafter ‗Linde AG (HC)‘) overturned decision of AAR to hold that Ishikawajima
was clearly applicable to the facts and dissected approach of turnkey contract is applicable.
High Court categorically held that AAR‘s reading of Vodafone was out of context. Whilst
Delhi High Court judgment is hailed as a provider of relief to foreign companies and bringing
in much required clarity on Ishikawajima v. Vodafone conundrum, I argue that the dissected
approach v. look at approach of understanding the issue may be an over simplification of a
much deeper problem. The main issue comprise in the different object of inquiry pursued by
different judicial authorities. Whereas for certain courts object of inquiry in taxation of
turnkey contract is determination whether ‗purpose and object of contract‘ is to avail piece
meal supply and service onshore and offshore; for others it is determination whether ‗source
of income‘ being under question was in India.
The paper proceeds in V parts. Part I introduces the controversy, outlines the argument
and provides scheme of paper. Part II briefly narrates foundational pillar of dissecting
approach Ishikawajima and introduces context Vodafone ratio. Part III analyse rulings post-
Vodafone to demonstrate how several judicial authorities have been taking diametrically
opposing views on seemingly similar fact situation and discusses recent Delhi High court
judgement in Linde AG(HC). Part IV examine set of inquires made by different judicial
authorities. It argues that it is this difference of inquiries that has led to reading of Vodafone
and consequent divergent conclusion regarding turnkey contracts. Part V sums up the
discussion and concludes.
4 Alstom Transport v. DIT, (2012) 349 ITR 292 (AAR).

5 Linde AG v. DIT, (2012) 349 ITR 172 (AAR).
6 DIT v. Nokia Networks OY, (2012) 253 CTR 417 (Delhi).
7 National Petroleum Construction Company v. ADIT, (2013) 151 TTJ 47 (ITAT Delhi).
8 Linde AG, Linde Engineering Division v. DCIT, W.P.(C) No.3914/2012 & CM No.8187/2012.
Turnkey Contracts
PART II FOUNDATION PILLARS OF DISSECTED APPROACH AND LOOK

AT APPROACH
Ishikawajima is considered to be foundation pillar of dissecting approach to turnkey

contracts. In this matter Petronet LNG Limited had entered into an agreement with a five
member consortium for setting up its plant in India on turnkey basis. The contract involved
onshore supply and service as well as offshore supply and service and construction and
erection. The scope of work, the role and responsibility of each member of consortium was
specified separately. Dispute arose regarding taxability of offshore supply and service in
India. Whilst Ishikawajima, Japanese member of consortium contended that the contract is a
divisible one and it did not have any liability to pay any tax with regard to offshore services
and offshore supplies; Revenue contended that the contract was a composite and integrated
one, and thus could not be split for the purposes of tax. Two judge bench of Supreme Court
held that merely because it is a turnkey contract would not mean that even for the purpose of
taxability the entire contract must be considered to be an integrated one. The taxable events in
execution of a contract may arise at several stages in several years. The contract was a
divisible one as offshore and onshore supply and service and offshore supply and service not
taxable in India.
The Supreme Court held that offshore supplies were not amenable to tax in India since
these were procured outside India and payment received outside India. Offshore services
though utilised in India were rendered outside India hence not taxable in India. 9 In addition to
this, Supreme Court also held that the said offshore services were inextricably linked to
offshore supply and it must be considered in same manner.10Consequently, turnkey contract
could not be taxed in its entirety and only onshore activities were liable to tax in India. The
decision also applied principle of apportionment envisaged under Clause (a) of Explanation 1
to Section 9(1)(i) of Income Tax Act. Accordingly that only such part of the income as is
attributable to the operations carried out in India, are taxable in India. 11
9 Ishikawajima – Harima Heavy Industries Limited vs. DIT, supra note 1 at ¶ 51.
10 This implies where offshore services are subservient to main element which is offshore supply an
inextricably linked to same, such supply being outside purview of domestic taxation laws renders
services also beyond purview of tax liability.
11 [Explanation 1].—For the purposes of this clause—(a) in the case of a business of which all the
operations are not carried out in India, the income of the business deemed under this clause to accrue or
arise in India shall be only such part of the income as is reasonably attributable to the operations carried
out in India.
While efforts were being made to bring turnkey contracts under tax ambit through
several amendments in the statute and insertion of explanations12; Vodafone judgment and its
‗look at‘ approach was sought to provide renewed support to these efforts. The Supreme
Court was considering a matter which, inter alia, involved a transfer of sale and purchase of
shares of an overseas company by one non-resident company to another non-resident
company. Revenue sought to tax this as transfer of capital asset situation in India under
section 9(1)(i) of Income Tax Act. Additionally it was contended on behalf of the Revenue
that the said transaction was arranged under a scheme to avoid payment of tax in India and
hence required to be ‗looked through‘. Rejecting this argument, Supreme Court applied the
‗look at‘ approach. It clearly held that while ascertaining genuineness of transaction it is the
task of the Revenue/Court to ascertain the legal nature of the transaction and while doing so it
has to look at the transaction as a whole and not to adopt a dissecting approach.
Thus Vodafone decision when contextualised in turnkey contracts once again set the
hare running not knowing which direction it would take. Juxtaposing Vodafone and
Ishikwajima the two were soon found to be at loggerheads with each other in court rooms.
Since Ishikawajima was a two-judge bench decision while Vodafone was three judge bench
decision, the later was readily received with much funfair.
PART III OSCILLATING DECISIONS POST VODAFONE
A quick survey of rulings delivered post-Vodafone, provides fair amount of

understanding about divided opinions amongst several judicial authorities. Thus AAR ruling
in Linde AG v. DIT13 was amongst early followers of Vodafone. AAR held that the contract
entered into by the consortium with resident company in India is a composite contract and
‗dissecting approach‘ is not permissible. Considering that consortium members had furnished
joint and several liability for performance of contract; the contract must be read as indivisible
one in the light of Vodafone judgment. Perhaps AAR was so enthusiastic about Vodafone
12 An Explanation to sec. 9 as inserted by the Finance Act, 2007.—For the removal of doubts, it is hereby
declared that for the purposes of this section, where income is deemed to accrue or arise in India under
clauses (v), (vi) and (vii) of sub-section (1), such income shall be included in the total income of the non-
resident, whether or not the non-resident has a residence or place of business or business connection in
India." This explanation has been largely criticised as a hasty move on the part of legislature to supersede
Supreme Court‘s decision in Ishikawajima.
13 Alstom Transport v. DIT, supra note 4.
Turnkey Contracts
judgment that it did not follow its decision in Hyosung Corporation v. DIT14 which had quite
similar facts to the facts of this matter.
In Re: Roxar Maximum Reservoir Performance WLL15where ONGC floated a tender

calling for ―services for supply, installation and commissioning of 36 manometer gauges‖ for
carrying out its operations; the assessee company sought ruling whether supply, title to which
passed outside India, was taxable in India. Referring to Vodafone judgement AAR held that
the Supreme Court in that matter had advocated ‗look at approach‘ to the transaction. In the
light of three judge bench decision of Vodafone, two judge bench decision of Ishikawajima
and its dissected approach cannot be applied.AAR held that the contract in question has to be
read as a whole. The purpose for which the contract is entered into by the parties is to be
ascertained from the terms of the contract. Since it is a contract for supply and erection at
sites within Indian territory, it is a composite contract.
Alstom Transport v. DIT16went on to hold that the approach adopted in Ishikawajima

now stands disapproved or overruled, if not expressly, definitely by clear implication by
Vodafone. In this matter Bangalore Metro Rail Corporation Limited floated a tender for
design, manufacture, supply, installation and commissioning of train control and
communication systems; and consortium was jointly and severally responsible for the work
tendered. Emphasising that the basic principle in interpretation of a contract is to read it as a
whole and to construe all its terms in the context of the object and purpose sought to be
achieved; AAR arrived at conclusion that contract cannot be split up into different parts for
the purpose of taxation.
There however have been judgements that followed the dictum of Ishikwajima to hold
that nomenclature of turnkey contract itself is not determinative and regard being had to
contract dissection is permissible. Thus in National Petroleum Construction Company v.
ADIT17, a UAE based assessee had entered into contracts with ONGC for the ―fabrication
and installation of onshore and off-shore oil facilities and submarine pipelines and
pipelines‖. The assessee contended that their contracts with ONGC itself had bifurcated two
different and distinct components—one for designing, procurement, fabrication and supply of
14 Hyosung Corporation v. DIT,(2009) 314 ITR 343 (AAR)

15 Vodafone International Holdings BV v. UOI and another, supra note 2.
16 Re: Roxar Maximum Reservoir Performance WLL, supra note 3.
17 DIT v. Nokia Networks OY, (2012) 253 CTR 417 (Delhi).
material and the other, for installation and commissioning of the project. The Tribunal held
that even where the contract is a turnkey contract, the fact that contract itself provided for
such segregation and it was open for ONGC to accept the supply and not proceed with
installation was conclusive that contract was divisible one. Reliance placed on CIT v.
Hyundai Heavy Industries Co. Ltd.18case which echoes the Ishikawajima ratio.
In DIT v. Nokia Networks OY 19 , the assessee (Nokia Networks) was a Finnish

company having operations in India. Its activities involved supply of hardware and software
as well as installation and commissioning and also after sale services. It entered into
agreements with various Cellular Operators and entered into three contracts with them
namely (1) Overall Agreement, (2) the Supply Agreement and (3) the Installation Agreement.
The question came up before Delhi High Court whether Supply Agreement is a standalone
Agreement. Revenue‘s argument proceeded on the basis that the three agreements are to be
taken to form an integrated business arrangement between the parties which was governed by
the Overall Agreement. The assessee relied on the judgment of Ishikwajima and contended
that such supplies being made overseas and property in goods passed outside India, the same
would not be liable to tax in India. The Court did not find it as being one composite contract
and held that supply has to be segregated from installation and only then apportionment of
income can be made.
The aforementioned discussion demonstrates how turnkey contracts were subject to

constant litigation and attempts on part of foreign companies to rely on Ishikwajima while the
Revenue placed relevance on Vodafone. Recent decision of Delhi High in Linde AG (HC)20
has delivered a landmark judgment which seeks to provide some relief in this constant battle.
Overturning AAR ruling, Delhi High Court held that Ishikawajima is applicable to the fact of
present case and that the turnkey contract under issue was divisible in nature. It also
categorically observed that in absence of any controversy involving lifting of corporate veil
or ‗looking at‘ any scheme of sham transaction, reading principles of Vodafone was out of
context. While decision of Delhi High Court has put judicial authorities on alert and carries a
visible ratio to keep in check tendencies to blankly follow Vodafone decision, it is crucial for
judiciary to provide clear guidance as to composite nature of contract and how it can be
safely discerned.
18 CIT v. Hyundai Heavy Industries Co. Ltd, (2007) 291 ITR 482 (SC).
19 DIT v. Nokia Networks OY, supra note 17.
20 National Petroleum Construction Company v. ADIT, supra note 7.
Turnkey Contracts
PART IV TWO DETERMINANT TESTS
It emerges from the discussion so far that turnkey contracts involve contract for
manufacture, installation wherein sale or supply of goods and/or elements of services will be
invariably present. Depending upon nature of work to be executed, such supply of goods and
provisioning of services take place offshore and onshore. The core of the issue has been
regarding tax liability of such turnkey contract under Income Tax Act and DTAA. Reading
Sec.5 with Sec.9 of the Income Tax Act, where sec. 5 defines scope of total income in India
and sec.9 provides source based taxation of income accruing or arising or deemed to have
accrued or arisen in India. Thus when contextualised in terms of turnkey contracts following
propositions emerge:
1) Where equipments and materials are manufactured by a non-resident outside

India, consideration for sale is received abroad and property in goods passes to resident
purchaser outside India- Such supply of material and equipments under the contract is
nothing but a sale of goods simpliciter outside India and would not be amenable to tax
in India even though said goods are to be utilised within India.
2) Where equipments and materials are manufactured by a non-resident, procured

outside India by a resident in India and such sale is a part of a composite contract
involving onshore and offshore operations- Such supply would be taxable in India if the
said income arises through or from a business connection in India and such non-
resident has Permanent Establishment under DTAA.
3) Where offshore services are provided as a part of a composite contract

involving various onshore and offshore operations and such offshore services are
inextricably linked with the offshore supply of equipments and materials- such offshore
services cannot be taxed as FTS in India.
4) Where it cannot be sufficiently provide that the offshore services formed an

integral part of offshore supply- such offshore services are fees for technical services
taxable in India provided they are utilized in India.
Thus what is enumerated above is possible tax implication of a transaction. Situation

(1) and (4) are instances of either independent transactions or a standalone element of a
divisible contract; situation (2) and (3) emanate from a composite contract. What lies behind
each of this proposition is a common thread of inquiry whether the source of income had any
linkage with India. Thus in situation (1) and (3) there is no linkage found and hence it is not
amenable to tax whereas situation (2) and (4) results into liability to tax in India provided
there is a live linkage.
The answers derived here, call for a combination of two key objects of inquiries: one, to
determine whether turnkey contract under question is divisible into onshore-offshore
components. Since this is fact based query and requires further inquiring nature of contract, I
call this ‘purpose and object of contract test’. Two, to determine whether such offshore
supply/service was on account of any business connection, permanent establishment or
utilisation of service in India. This tends to establish territorial nexus of income to India. I
call this ‘source of receipt test’.
While we have probable answer before us, the difficulty is we do not have a dedicated
set of questions to be asked in order to arrive at these answers. And this is where the main
problem lies. An analysis of judicial rulings already discussed above follows that the tests,
instead of being applied in combination to each other, have been applied in a mutually
exclusive manner.
PURPOSE AND OBJECT OF CONTRACT TEST
Thus in Alstom, AAR whilst discerning whether contract under consideration was
composite took on board purpose of tender invited. It thereby concluded that contract was not
for supply of offshore equipments independently of the installation and commissioning, nor
was it for independent installation and commissioning, divorced form design and supply of
necessary equipments. Such contract has to necessarily be read as a whole and is not capable
of being split up. Similarly in Roxar Maximum it was viewed that the purpose for which the
contract is entered into by the parties is to be ascertained from the terms of the contract. On
reading of the contract, AAR arrived at conclusion that the contract is clearly not one for sale
of equipment. Nor is it one for mere erection of the equipment. It is a composite contract for
supply and erection at sites within the territory of India.
Another close cousin of this test is found in performance test or cross fall breach clause.
This also helps in determining composite nature of contract. This clause is said to be helpful
in determining whether there is an intricate link between the offshore activities and onshore
Turnkey Contracts
activities so that breach of offshore element would result in breach of the whole contract. If
the answer is in affirmation the contract is a composite contract.
Interestingly AAR ruling in Ishikawajima21 had referred to the breach clause in order to
discern if the offshore-onshore elements of contract are so inextricably linked that the breach
of the 'offshore' element would result in the breach of the whole contract. Based on this set of
query, AAR ruling concluded that each component of the contract was directly relatable to the
performance of the integrated contract since any breach of any terms would result in breach of
entire contract and not just particular obligation. Hence, contract was indivisible and taxable
in its entirety.
SOURCE OF RECEIPT TEST
The Supreme Court in Ishikawajima, however accorded prominence to source of

receipt test that entails territorial nexus. It took a pragmatic line of decision that where
income arises from operations carried out in more than one jurisdiction, it would have such
territorial nexus with each of these jurisdictions. If that be so, it may not be correct to contend
that the ‗entire income‘ accrues or arises in each of the jurisdiction. Supreme Court thus went
on to hold that the fact that contract was fashioned on turnkey basis by itself would not mean
that even for the purpose of taxability the entire contract must be considered to be an
integrated one so as to make the assessee to pay tax in India.
Delhi High court ruling in Linde AG (HC)once again echoed the ratio of Supreme Court
in Ishikwajima and steered the object of inquiry altogether from purpose of contract test to
source of receipt test. While overturning AAR decision Delhi High Court held that the
Authority erred in proceeding on the basis that the contract as a whole was the subject of
taxation. The subject matter of taxation was not the Contract between the parties but the
income that the petitioner derived from the Contract. Delhi High Court sidesteps inquiry into
divisible or composite nature of contract and accords prominence to determination of situs of
income. It was thereby held that the object of inquiry would have to be determination to situs
where the income had accrued or arisen. According to Delhi High Court the assertion that
21 A.A.R. No. 618 of 2003.

contractual obligations mandated due performance of entire contract was not necessary since
the same would not necessarily imply that entire income had its source in India. 22
Such mutually exclusive application of tests resulted into divergent tax implication.
While under the ‗purpose and object of contract’ test prominence was accorded to contract
entered into between the parties to determine if the contract was composite in nature or
divisible; the ‗source of receipt’ test directly launch an inquiry into situs of income
rendering the ‗purpose and object of contract‘ test totally irrelevant in the process. Delhi
High Court goes on to assert that even where such composite nature of contractual
obligations are established the same would not necessarily imply that entire income had its
source in India. In other words ‗source of receipt‘ test supersedes ‗purpose of contract‘ test.
Whilst one concedes that source based taxation is the overarching principle of taxation
in sec.9; the difficulty I have with such proposition is that source of receipt test cannot be
answered in absence of purpose and object of contract test. Thus even where source of receipt
test helps in fixating ultimate tax liability and provides sound theoretical grounding; purpose
of contract test provides factual assertions on the issue.
It is important to note that Supreme Court in Ishikawajima had not denounced the
‘purpose and object of contract’ test. In fact the Court had taken terms of contract into
account while arriving at its decision. Whilst deciding the question of division of taxable
income of offshore services Supreme Court held that ‗parties were ad idem that there existed
a distinction between onshore supply and offshore supply. The intention of the parties, thus,
must be judged from different types of services, different types of prices, as also different
currencies in which the prices are to be paid.... But it is trite that the terms of a contract are
required to be construed having regard to the international covenants and conventions. In a
case of this nature, interpretation with reference to the nexus to tax territories will also
assume significance (emphasis are mine).‘23
PART V CONCLUSION
22 The fact that the contractual obligations of Linde were not limited to merely supplying equipment, but
were for due performance of the entire Contract, would not necessarily imply that the entire income
which was relatable to the Contract could be deemed to accrue or arise in India.
23 Ishikawajima – Harima Heavy Industries Limited vs. DIT, supra note 1 at ¶¶ 48-49.
Turnkey Contracts
Thus Ishikawajima had applied both tests in order to arrive at its conclusion.
Subsequent cases however resorted to one such test and hence the confusion. While one may
concede that nomenclature of a turnkey project or works contract is not relevant in
determining whether any profit arising pursuant to such contract was entirely chargeable to
tax in India; it is imperative to carefully proceed with the inquiry. Even where source of
receipt test is an overarching principle to impose source based taxation on non-resident
entities; it needs to be appreciated that factual inquiry into nature of contract cannot be
dismissed altogether. Thus in order to ensure consistency and clarity it is important that both-
purpose and object of contract test as well as source of receipt test are applied in conjunction
with each other.
Insofar as application of Vodafone is concerned it needs to be carefully examined that

Vodafone ratio and its look at approach has been referred whilst applying the purpose and
object of contract test. Since this test accords prominence to contract and the basic tenet of
interpretation of contract entails it to be read as a whole, Vodafone ratio was found applicable
and thus it ended up adding to the existing confusion. It is humbly suggested that Vodafone
ratio will be helpful in instances where question have been reserved for consideration
whether parties had resorted to sham transaction or tax avoidance mechanism through
contractual arrangement.
A classic instance of matters where Vodafone decision has application is found in

Dongfang Electric Corporation v. DIT. 24 The core dispute before Calcutta Tribunal was
adjustment to value assigned to the onshore supplies and services which was alleged to have
been kept for a lower amount with a view to avoid tax in India. Whilst deciding the matter
made a profound observation regarding applicability of Vodafone and its ‗look at‘ approach.
Tribunal conceded to the fact that there may be doubts expressed regarding application of
‗looking at the transaction as a whole and not adopting dissecting approach‘ to all matters
pertaining to offshore-onshore supply and service; nevertheless this is certainly applicable in
cases where values assigned to onshore services are prima facie unreasonable vis-à-vis values
assigned offshore supply contract. Tribunal held ‗to that limited extent......, the transactions
are to be essentially looked at as a whole, and not on standalone basis, when the overall
transaction is split in an unfair and unreasonable manner with a view to evade taxes.‘
24 Dongfang Electric Corporation v. DIT, (2012) 147 TTJ 579 (ITAT Calcutta).
THEORETICAL ISSUES IN THE MANAGEMENT
OF PROPERTY RATES TAX: A CASE FOR
KAMPALA CAPITAL CITY AUTHORITY
Joseph Murangira
Abstract
This article examines the key theories in the management of property rates
tax with specific focus on their relevance to Kampala Capital City Authority
(‗KCCA‘). The theories discussed include the principal-agent theory, the game
theory, Nozick‘s state of nature theory and Bentham‘s utilitarianism. The purpose
of the review is to enable KCCA to properly manage property rates tax and
property rates actors.
1. INTRODUCTION
Property rates tax is one of the taxes levied by local governments in Uganda. Other
taxes that are levied by local governments include: ground rent; royalties; stamp duties; and
registration and licensing fees. 1 Kampala Capital City is a designated as an urban area under
the control of the central government, through Kampala Capital City Authority (hereinafter
‗KCCA‘). KCCA has the powers to levy taxes levied by other local governments, including
property rates tax.2 Property rates tax, from the statistics available at KCCA, is underutilized
and is characterized by its limited understanding by the taxing authorities and the rate payers.
This affects the performance of the property rates tax system. The purpose of this article is to
analyse key theories underpinning the operation of the property rates tax system for KCCA to
enable it improve property rates tax management in Kampala.
 LLB, LLM (Makerere University), MMS (UMI), P.G Dip. in Private Practice (LDC), P.G Dip. n
Management studies (UMI), Judge of the High Court of Uganda, email: josephmurangira@yahoo.co.uk.
This article is extracted from the LLD thesis entitled: ‗The Law and Property Rates Tax System in
Uganda: A Case Study of Kampala Capital City Authority,‘ being undertaken by the author, at Makerere
University, Kampala, Uganda.
1 The Local Governments Act, Cap 243, § 80.
2 Kampala Capital City Act, 2010 §50 cl. 2.
2014 Theoretical Issues in the Management of Property Rates Tax: A Case 15
for Kampala Capital City Authority
2. PROPERTY RATES TAX EXPLAINED
Property rates tax is a principal source of revenue for local governments, a significant
operating cost for business, and one of the biggest components of housing costs for many
consumers.3 As a source of revenue for Local Governments in light of decentralisation, it has
been noted that increasing the autonomy for the districts and other levels of the local
government over planning, budgetary and spending has potential for ensuring that delivery of
services is tailored toward the specific needs of each local government and call for collection
of some taxes like rates on their own to finance their budgetary needs. 4 Property rates tax is
levied by local governments on the taxable properties within their jurisdiction.
Property rates tax is coined in two concepts: property and rate. Osborn‘s Concise Law
Dictionary defines property as that which is capable of ownership whether real or personal,
tangible or intangible. It can also mean a right of ownership, for example the property in the
goods.5 In the context of property rates tax, the term property is used to refer to buildings and
the land they sit on but vacant land without buildings is not regarded as property. 6 The Local
Government (Rating) Act defines property to mean ―immovable property and includes a
building (industrial and non-industrial) or structure of any kind, but does not include a vacant
site.‖ 7 The Act also defines ―rate‖ to mean a rate on the property levied by the Local
government (under the Act).8 According to Halsbury‘s Laws of England,9 the rate is not a tax
on the land, but a personal charge. 10 Under the Act, the rate is ascertained by reference to the
rental value of the property. 11
From the above concepts, property rates tax in Uganda can be defined in simple terms
as a tax on properties (private houses, commercial houses, factories, banks, e.t.c.) paid to
3 Goodman J Houses, Apartments, and Property Tax Incidence American Real Estate and Urban
Economics Association (January 2005), Joint Center for Housing Studies Harvard University February
2005 W05-2, p.1.
4 The Republic of Uganda, Ministry of Local Government, Participants Handbook, Property rates
Training for Local Governments.
5 Rutherford L & Bone S, OSBORN‘S CONCISE LAW DICTIONARY 266 (8h ed. 2003).
6 The Republic of Uganda, Ministry of Local Government, supra note 3.
7 Local Government (Rating) Act No. 8 of 2005 §2 cl. 1.
8 Id.
9 39 HALSBURY‘S LAWS OF ENGLAND 9 ¶10 (4th Ed).
10 This position is fortified by the case of R. v. S.T. Luke‘s Hospital (1760) 2 Burr 1053 at 1063, it was held
that the remedy for the failure to pay rates is a personal one, that is, by distress on the defaulter‘s goods.
11 The Local Government (Rating) Act No. 8 of 2005, § 11.
local governments based on their rental value. 12 The base for the property rates tax is ―real
property‖ defined as land and improvements or attachments to the land. According to Mila
Freire, et al,13 property rates tax can be differentiated from other taxes by virtue of their two
main characteristics: its visibility as in its local context within which it is implemented; and
diversity with regard to the range of properties on which it can be imposed.
The property rates tax is a highly visible tax. Unlike income tax, for example, the
property rates tax is not withheld at the source. Rather, taxpayers generally have to pay it
directly in periodic lump sum payments. 14 This means that taxpayers tend to be much more
aware of the property rates tax they pay. The property rates tax also finance services that are
highly visible such as roads, garbage collection, street lighting, drainage, security. Visibility
is desirable from the decision-making perspective because it makes taxpayers aware of costs
of local public services.15 This awareness enhances accountability to the taxpayers and the
members of the public.
Property rates tax, aside from the characteristics of visibility and diversity afore–
mentioned, has other unique characteristics which include the favourable treatment of
residential property. It is common for the property rates tax to favour residential over
commercial and industrial properties. 16
Property rates tax is one of the primary sources of funding for local governments. 17 In
Uganda, it can better be expressed as a hand-maid of the fiscal and budgetary realization of
the local governments under decentralization. 18 It has been estimated that property rates tax
accounts for about 14% of the total local revenue of local governments in Uganda. 19 The
revenue generated from property rates tax collection is usually used to finance services of a
12 Kampala District: Local Government Budget Frame Work Paper for Financial Year 2001/2002,41
(2001/02).
13 F. MILA et al, THE CHALLENGES OF URBAN GOVERNMENT; POLICIES AND PRACTICE 269 (2001, World
Bank Publications) .
14 M De Cesare Claudia, Challenges to Property Tax Administration in Porto Alegre, Brazil, 11 LAND
LINES 5, 3 (1999).
15 Id.
16 This can be illustrated by the Local Government (Rating) (Amendment) Act 12 of 2006, which exempts
residential buildings which are owner – occupied from being liable to levy of the property rates tax.
17 M Wayne & S McCullough, Arkansas Property Tax: A Local Tax Supporting Local Services, 3 (2005
University of Arkansas Cooperative Extension Service Printing Services).
18 Nsibambi A, Making Democratic Decentralization an instrument of Poverty Eradication, Uganda‘s
challenge74 (1997).
19 The Republic of Uganda, Ministry of Local Government, op cit note 4.
local public goals nature, that is amenity services- the benefits from their provision tend to be
geographically concentrated for example physical infrastructure, street lighting, waste
disposal and environmental health. Thus, the Local Government (Rating) Act provides that
revenue raised from property rates be used to deliver such services to the rate payers of the
areas.20 The very nature of these services dictates that they cannot be financed through user
charges but have to be financed through taxes. 21
Property rates tax also has the advantage of being progressive. The presumption is that
those who have properties to rent out are rich and they are the ones liable to pay rates. As
ones income grows, he/she establishes more structures and pays more taxes in terms of rates.
On the other hand, owner-occupied residential houses are exempt and therefore those with no
properties to rent out but only have their residential houses (who are the poor) are not liable
to pay property rates tax. This meets the desired principle of taxation that as one‘s income
increases, the tax should also increase and vice versa.
The other advantage of property rates tax lies in the fact that it is difficult to avoid. The
tax is assessed basing on the rental value which is easy to ascertain. Again it is assessed on
immovable property, so there is nothing like the taxpayer has moved out of jurisdiction.
Further, under the Local Government (Rating) Act, the tax is payable by the owner. However,
if the owner cannot be found, then the occupier is liable to pay this tax. This illustrates that in
all circumstances the property rates tax has to be paid and is very hard to avoid thereby
providing the local governments with a realistic, stable and predictable financial base from
which a local authority can make reasonable forecasts of likely future income, with a
substantial certain and predictable yield.
Further, the tax burden needs to be apportioned according to the benefits that the
individuals gain from the local government expenditures, which are funded by the taxation.
Therefore, property owners whose properties are protected by the taxing authority should pay
more in tax for the expenses so incurred than those who do not receive such protection.
Property rates tax is justified on this ground because property owners are the major
beneficiaries for the services provided as they increase the value of real properties. An
example is where a person owns a property in an area with a poor road. If the road is
20 The Local Government (Rating) Act No. 8, 2005, §37 cl. 2.

21 The Republic of Uganda, Ministry of Local Government, op cit note 4.
afterwards repaired by the local authority, the rental value of the property will increase and in
this case it is only just that the person pays for the enhanced value in terms of property rates.
Although the benefit approach may be challenged on account of the benefits not being
traceable to individual property ownership and the fact that the bulk of property rates tax
revenue is spent on provision of general public services such as street lighting, property
owners view property rates tax and public services as closely linked. There is likely to be
more willingness to pay where property tax revenue is spent on public services. Thus besides
the criticisms, the benefit approach is seen to gain some support.
On the other hand, property rates tax has been seen as terribly unpopular with voters,
and as a result, politicians detest relying too heavily on it. Revenue raised in form of property
rates tax may generate more negative reaction than any other levy. 22 There are several
reasons for this degree of unpopularity. One is that the property rates tax is levied on
(unrealized) accretions to the wealth of an individual or a business, and these accretions do
not necessarily correspond to income received. The unpopularity of the property rates tax is
also a bi-product of the judgmental approach to assessment. A proposed increase in the tax
rate on a tax base that is determined in uncertain or even mysterious ways is bound to
provoke negative reactions. Again, the property rates tax is unpopular in part because it is so
visible. Most income tax payers are subject to withholding, but even so, may not be able to
accurately report their annual payments. Consumption taxes are paid in small increments, and
are often obscured in the final price of the merchandise. Most could not even estimate the
annual amount of Value Added Tax (VAT) that they may pay. The property rates tax, on the
other hand, is highly visible in that it is usually billed annually or quarterly, and property
owners are much more likely to know exactly what they pay. 23
Property rates tax is also said to be bad because of its inelasticity. Local government
officials desire a tax that exhibits an automatic revenue growth. This protects them from
returning regularly to the voters for permission to increase the tax rates every time the
demand or cost of public services increases. The property rates tax is not an income-elastic
tax. The basic problem is that reassessments occur only on a periodic basis; hence year-to-
year growth in revenues is mostly due to the addition to the tax base through construction.
22 R. Bahl & J. Martinez-Vazquez, The Property Tax in Developing Countries: Current Practice and
Prospects, Lincoln Institute of Land Policy Working Paper WP07RB16 (2007).
23 Id.
When revaluation is too infrequent, say every 5 or 10 years, it leads to large one-time
increases in tax liability, and to voter uproar from the shock. 24
3. THEORIES IN ADMINISTRATION OF PROPERTY RATES TAX AND

THEIR RELEVANCE TO KCCA
3.1 PRINCIPAL-AGENT THEORY
This theory is a very important management tool in the property rates tax system.
Under a principal-agent interaction, at least two people are to collaborate in the creation of a
service that has value. The two persons are, however, not partners or of equal legal standing.
The agent is the person who works for the principal, who puts up the remuneration for the
agent‘s effort against the value that the agent hands over to the principal in the form of a
product of some sort. 25 Thus, principal-agent interaction is fundamentally a contracting
problem concerning how much of the value that the agent produces should go back to
him/her in the form of a payment.
However, what makes the principal-agent model distinctive is the additional

assumption of asymmetric information, meaning that the agent knows more than the principal
about the service in question in a manner that affects the contracting outcomes. 26 A
distinction may be made between short-term contracting as with the buying and selling of
goods on the one hand and long-term contracting on the other hand whereby one person hires
another person or group of persons to work for them against remuneration. 27
The principal is the residual owner of the output that the agent contributes to. Thus, the
ultimate consequences of the principal-agent interaction fall upon the principal (in this case,
KCCA). The agent typically works for the principal, meaning that his output is accredited to
the principal who bears the full responsibilities for it. The agent is paid for his service,
whereby the final payment terminates the interaction. The principal and the agent are not
24 Id at 7.
25 Jan-Erik Lane (2003), Relevance of the Principal-Agent Framework to Public Policy and
Implementation, (University of Geneva and National University of Singapore)available at
http://www.spp.nus.edu.sg/Handler.ashx?path=Data/Site/SiteDocuments/wp/2003/wp29.pdf (15
December, 2013).
26 Id.
27 Id.
partners or merely collaborators.28 The principal is the owner and the ultimate initiator and
goal setter. The agent gives advice, suggests means and takes alternative action to promote
the goals of the principal, for which activities he/she is compensated by means of a payment
of a salary of some sort.
The agent will only demand a contract from the principal which has incentives. Agents
are motivated by the manner in which they are rewarded for their work. The principal-agent
approach starts from incentives and looks at the strategies that the two sets of players –
principal and agents – will engage in when interacting in order to accomplish a collective
effort. The quality of the work done by the agent under the principal agent framework is also
greatly improved by adequate monitoring of the agent‘s activities by the principal. 29
This theory is important in understanding the relationships among the key actors in
property rates tax system. Property rates tax practice presents relationships of central
government, local authority, tax administration system and taxpayers at different levels.
Kampala Capital City Authority as the principal body responsible for property rates in
Kampala City usually hires independent firms of valuers to value the properties. Given this
situation, how can the work of these valuers, as agents, be improved under the principal-agent
theoretical framework by KCCA, the principal?
The principal-agent framework is not only of interest in understanding the relation

between various administrative levels within the taxing authority, but is also useful to the
understanding the relation between citizens (property owners) and the political leaders
(KCCA). The leaders, having been elected to serve would also be regarded as the agents of
the citizens to whom they are accountable.
The principal-agent approach can be looked at starting from incentives and the
strategies that the two sets of players – principal and agents – will engage in when interacting
in order to accomplish a collective effort. Under this model, the quality of the work done by
the agent can be viewed to be greatly improved by adequate monitoring of the agent‘s
activities by the principal. The firms, for example, involved in the valuation process in
KCCA have limited finances to accomplish the valuation process. This is because, owing to
the competition in the bidding process, they quote a low figure in order to be awarded the
28 Id.
29 D. E. Stevens & A. A. Thevaranjan , Moral Solution to the Moral Hazard Problem, (2008)
http://ssrn.com/abstract=1138279 (10 February, 2014).
contracts. KCCA pays them the quoted low figure to carryout the valuation and in the end
they employ very few data collection personnel which delays the valuation process and which
renders it ineffective. The limited incentives (limited funds) from the principal (KCCA)
makes the private firms (agents) to perform the work with less perfection under the principal-
agent model. The Divisions of KCCA have less control over the contracted firms. Most of the
monitoring is done from KCCA head office which is ineffective. Limited monitoring from
the KCCA or its Divisions, the principal, as established in this article, has negatively affected
the quality of the work done by the private firms, the agents.
The principal-agent framework can also be used to understand relationship between

citizens (property owners) and KCCA under a decentralised system of governance. The local
councillors and executive members of local councils, having been elected to serve are
regarded as the agents of the citizens to whom they are accountable. Property rates tax payers
are concerned with lack of transparency on the part of KCCA in relation to property rates tax
management and there is poor service delivery. It is on the basis of these that the rate payers
have been reluctant to pay property rates tax as they fall due to KCCA. The local councillors,
executive members at all levels and area members of Parliament exert political interference in
the valuation, collection and enforcement processes of property rates tax system.
3.2 GAME THEORY
Game theory is a decision making tool that has wide application in making decisions in
various complex situations that confront legal persons and organisations as well as natural
persons. A game represents a situation involving players with at least partly opposing
interests and where each player is assumed to act from their own interests. According to
Davis, 30 in a game, there are others present who are making decisions in accordance with
their own wishes, and they must be taken into account. In a game, each player must assess the
extent to which his or her goals match or clash with the goals of others and decide whether to
cooperate or compete with all or some of them. 31 Thus, on the basis of these views, any
decision made in a conflict environment must take into account the position and the likely
behaviour of the opposing side.
30 M. D. DAVIS, GAME THEORY: A NON TECHNICAL INTRODUCTION, xiv (1983).

31 Id.
In a tax environment, there are distinct set of goals representing the tax authority on one
side and the taxpayer on the other. In this article, tax compliance is partly viewed as a game
involving interactions of the tax authority (KCCA) and the rate payers, each selecting
strategies with the view of winning as many rounds as are played. In a tax game theory,
KCCA is assumed to seek to maximise net tax revenue while a rate payer seeks to minimise
expected rate payments and therefore maximise his/her net income. Each of the players
adopts different strategies in accomplishing the intended motive. The rate payer takes
advantage of the information he possesses about the rental value of his property and might
evade taxes at the declaration stage.
On the other hand, KCCA ascertains the correct rental value of the rate payer‘s property
by adopting a valuation system. Where cheating is detected (for instance in self declaration
forms for the rental value), tax evasion penalties are applied. However, if evasion is not
detected, the outcome is a gain to the rate payer since his expected tax payments will be
lower, and his income will increase. Conversely, the outcome is a loss to the taxpayer if
found guilty of evasion and is punished as his expected tax payments increases plus penalties
and subsequently receives lower net income. This reflects one feature of payoffs in a game
where a player gains when the opponent loses and vice versa.
Tax compliance can be viewed as a repeated game because declarations and valuations
are repeatedly done. Where cheating has been detected and the rate payer convicted, the rate
payer‘s decision about evasion in future is likely to take into account the consequences of the
previous evasion. It is presumed that rate payers who have been convicted of evasion will
become more compliant in the subsequent periods of the game due to the threat of being
detected and punished.
Furthermore, a tax compliance game indicates existence of both competitive and

cooperative elements. According to Davis, 32 tax compliance game portrays a situation where
the interests of the players are opposed in some respects and complementary in others. The
interests are opposed in the sense that KCCA plays strategies intended to generate more
revenue while the rate payers employ strategies aimed at seeking to pay less than required.
Conversely, the interests are considered complementary because they all focus on revenue
that the local government spends for the benefit of the citizens in form of public goods and
32 Id.
services. While each player employs different strategies in realising her/his own interests, the
opposing interests may indicate that parties have no common interest but in reality they do.
The primary objective of KCCA in imposing property rates tax on individuals is to

raise revenue intended for the provision of public services. Subsequently, if rate payers
choose not to pay the designated taxes, the probability of KCCA providing the envisaged
public goods and services becomes low. In this article, therefore, the game theory is used to
understand the relationship between KCCA and the rate payers, in property rates tax
assessment, collection and enforcement.
A game represents a situation involving players with at least partly opposing interests
and where each player is assumed to act from their own interests. Whereas KCCA seeks to
maximise net tax revenue, the rate payers seek to minimise expected rate payments and
therefore maximise the net income. It is for these reasons that the rate payers fail to disclose
accurate information on the rental value of the properties and accurate names of some
property owners. It is for this reason that KCCA hires private firms which may be more
effective to carryout the valuation process, to detect the frauds in the system and institute
penalties where it is necessary. To maximise tax collection, KCCA contracts private firms to
enforce the law and collect property rates from the rate payers.
In the tax authority – rate payer game situation, if a rate payer thinks that KCCA will
not provide the services, then he/she will be hesitant to pay the rates. Thus, from the rate
payer‘s point of view, it is more profitable not to pay the tax as the payoffs under this option
are higher than if one paid. The equation in this game theory is that KCCA cannot provide
public services as required under the law because people do not pay rates. Equally, people are
unwilling to pay rates citing the inefficiency of KCCA to provide them with the required
services.
3.3 NOZICK’S STATE OF NATURE THEORY
Robert Nozick developed this theory from an initial ―state of nature;‖ 33 a state of affairs
in which isolated individuals use whatever means available in order to live and obtain goods
and services, with no governing body to bring them together. 34 Under these conditions,
33 R. Nozick, Anarchy, State, and Utopia 10 (1974 Basic Books).

34 Id.
Nozick argues that individuals decide to form a protective society. Nozick's basic assumption,
which lays the foundation to an overall rejection of almost all forms of taxation, is that this
society ―naturally‖ results in a state very limited in powers and responsibilities. 35 The
meaning of entitlement under the Nozickian regime includes the right of the individual to
own goods and services justly acquired, but also the right to dispose of these holdings as one
chooses.36 These aspects of entitlement, Nozick prescribes, cannot be challenged without a
compelling justification.
As Nozick puts it, individuals have rights, and there are things which no person or
group may do to anyone else without violating those rights. So strong and far-reaching are
individuals‘ rights that they raise the question of what, if anything, the state and its officials
may do.37 Protecting individuals‘ rights demands that the state‘s powers will be limited to
narrow functions, such as enforcement of contracts and protection against force, theft and
fraud. 38 In Nozick's view ―any more extensive state will violate persons‘ rights not to be
forced to do certain things, and is unjustified.‖ 39 Nozick reaches this conclusion by, in effect,
presupposing that individuals are entitled to the holdings they possess. According to this line
of thinking, a just distribution of income and wealth is the distribution that results from
individuals' free exchanges. 40
Government interference with personal holdings, such as through the system of taxation,
is perceived to be equivalent to forced labour,41 a violation of individuals' basic rights and not
merely of efficiency. That Government intervention by means of redistributive taxation,
when taking from the fortune of one person to improve the lot of another, is further unjust
because it is a more extreme form of undermining the existing distribution of holdings. It is
hence clear why in the Nozickian description of the state there is no place for public
education or municipal transportation, roads or parks, since these services necessarily involve
the taxation of some people against their will.
35 Id.
36 Id., at 160
37 Id., at 140.
38 Id., at 15-17.
39 Id., at ix.
40 Id.
41 Id., at 224-27, 229.This is because the individual will in effect be coerced to exercise more labour or
talent in order to compensate for the tax.
Nozick presents three main principles as the foundation of his theory: (1) a principle of
transfer: whatever is justly acquired can be freely transferred; 42 (2) a principle of initial
acquisition: an account of how people initially came to own their holdings; 43 and (3) a
principle of rectification of injustice: how to deal with holdings that were unjustly acquired or
transferred.44 According to the Nozickian theory‘ only private possessions that comply with
these three principles are rightfully held. If all private possessions are rightfully held, then the
entire distribution of private property is just and should not be disturbed.
The first and second principles of the Nozickian doctrine state that in order to justify
the existing distribution of holdings, past acquisitions in the chain of transfers must be
legitimate. If the first person who took possession of something did so through an illegitimate
use of force or deception, then this person has no legitimate claim over the asset and, hence,
no legitimate right to transfer it to someone else. Conversely, when past acquisitions and
transfers are legitimate, there is no justification for forced taking of privately held possessions.
Notwithstanding the general tenet against forced taking of private resources, according to the
third principle of the Nozickian doctrine, redistributive measures, aimed at remedying
injustice in past acquisitions or transfers of holdings, are morally justified. 45
Nozick‘s theory, however, faces challenges over the description of the initial position
and the reliance on this description to generate what he offers as the foundation of a just
social system. The historical view of the beginning of time, compared to the philosophical
view, describes this period as one in which natural resources came to be someone‘s property
by force rather than through a free willed exercise of effort and talent, as implied by
Nozick. 46 Since the use of force makes acquisition illegitimate according to the Nozickian
doctrine, such historical description suggests that the current distribution of holdings is, in the
very least, problematic.
42 Id., at 150-151. According to Nozick, the topic of transfer involves ―complicated truth,‖ which he does
not attempt to develop. He does mention, however, that this principle includes ―descriptions of voluntary
exchange, and gift and - on the other hand - fraud.‖
43 Id.,, at 150. Unfortunately, Nozick does not develop this principle of acquisition either. He does,
however, note that the principle has several problematic issues including figuring out which ―unheld‖
things came to be held and how.
44 Id.,at 152-3, 230-3.
45 Id., at 152.
46 See W. KYMLICKA, CONTEMPORARY POLITICAL PHILOSOPHY : AN INTRODUCTION 108 (1990).
This theory can be used to understand issues surrounding the imposition of rates, in
particular, whether it is appropriate to require a person owning a rateable property to pay
rates and the revenue used for instance in the construction of roads to be used by the general
public; and whether this method of taxation amounts to an unjust encroachment on the
property owner‘s wealth which he acquired by his effort. In circumstances where two people
hold different properties but one resides in the property and the other lets it out but obtains an
alternative place to rent, the latter pays rates on his property while the former does not. This
theory can also be used to assess whether in such circumstances it is just to impose rates on
the latter while exempting the former.
Whereas it would be just that every property owner pays property rates tax since this is
a local service tax that increases the value of the properties in question. This tax could,
therefore, be equitable where all rate payers pay the assessed rates and the same is effectively
applied to the delivery of services. It would also be just where all the property owners in a
particular locality are liable to rates, regardless of the status of occupation (that is whether
owner occupied or rented out). The examination of the property rates tax system in KCCA
reveals that not all rate payers pay the assessed rates; the money collected from property is
not fully applied to the provision of services; and persons in owner occupied properties are
not liable to pay rates, yet they enjoy the same services as the rate payers. In these
circumstances, the property rates system in KCCA amounts to unjust encroachment on
personal wealth within the framework of Nozick‘s state of nature theory.
3.4 THE THEORY OF UTILITARIANISM
Utilitarianism is one of the dominant contemporary moral theories and no less essential
to modern tax discourse. The theory has its roots in the work of Jeremy Bentham, 47 and can
be broken down into two main parts: the first part forces policymakers to concentrate on
human welfare, or ―utility,‖ 48 while the second contains an instruction to consider utility by
giving equal weight to each individual.
Utilitarianism is grounded on a vision of equality in that no one person should be

worth more than another.49 In its simplest formulation, utilitarianism holds that the right act
47 J. BENTHAM, THE THEORY OF LEGISLATION 2 (1931 C.K. Ogden Ed.).

48 Id.
49 Id., p. 1.
or policy is that which produces the greatest utility among members of the society, calculated
by totaling all individuals‘ pleasures and pains. Jeremy Bentham believed that man was
placed in this world as an individual and is ultimately governed by two masters, pain and
pleasure. According to this line of thinking, the entirety of human behaviour can be
understood as the pursuit of utility, based on a reasoned calculation designed to maximize
pleasure and minimize pain.
The utilitarian principle suggests that public policy should be based on the general
pursuit of happiness, the maximization of aggregate utility and fundamental equality. When it
comes to the design of the property rates tax system, utilitarianism can therefore be
interpreted to result in two main policies: The first policy alternative calls for the extraction
of the least total sacrifice, in terms of collective utility loss caused by taxation, while
maintaining social welfare at a maximum level. The second policy option demands the
extraction of an equal tax burden from each person, in terms of individuals‘ utility losses
caused by taxation, while following the fundamental notion of equal consideration for all
members of society. 50
Early utilitarianism advocated the second policy alternative. Taxes were prescribed to
be levied so that the loss in marginal utility of income - that is, the loss in utility from taking
money away from an individual - was the same for all individuals. 51
The contemporary utilitarian paradigm holds that for each individual, the relation
between the loss in utility from taxation, and the gain in utility from revenue, ought to be the
same and that, taken as a whole, the loss of aggregate utility will be minimal, and that there
will be some gain in social welfare. 52
This theory can be used to justify adoption of the annual rental value basis of
assessment such that the higher the rental value, the higher the rates thereby maximizing
aggregate utility and fundamental equality as expounded under this theory. Secondly the use
of revenue from property rates for public purposes such as development of roads and garbage
collection which benefit the rates paying community, thus gaining utility from the revenue
paid. Under this theory, payment of rates with corresponding development of roads, garbage
50 W. BLUM & K KALVEN, THE UNEASY CASE FOR PROGRESSIVE TAXATION, 41-44 (1953); MUSGRAVE, THE
THEORY OF PUBLIC FINANCE 77 (1959).
51 J. S. MILL, PRINCIPLES OF POLITICAL ECONOMY, 258-259 (5th ed. 1883).
52 See F. P. Ramsey, A Contribution to the Theory of Taxation, 37 ECON. J. 145, 47-61 (Mar. 1927).
collection and street lighting to benefit the rates paying public would bring about same utility
from the revenue paid. However, in KCCA, the special treatment given to owner occupied
properties and the limited services offered by KCCA to the rate paying public imply that the
property rates tax system in KCCA does not meet the equality and same utility principles
under the utilitarianism theoretical model. In the same vein, KCCA is by law required to take
back 75% of the rates so collected to the rate payers for provision of various services. 53
4. CONCLUSION
I had the benefit of interviewing senior officials in KCCA and some few property rates
tax payers and have doubts whether KCCA understands the theories discussed above and
whether they are being applied for better performance and efficient service delivery to the tax
payers. Equally, the rate payers might be ignorant about these theories and they end playing
no role other than paying the tax in the property rates tax administration system. The way
forward is for KCCA to continuously mount educational programmes through the media and
encourage participation of the people in the payment and management of property rates tax.
53 The Local Government (Rating) Act, section 37 (2).

TAXATION OF THE INCOME OF INVESTMENT
FUNDS: APPLYING THE ‘FIRST PURCHASE’
PRINCIPLE AND RECENT DEVELOPMENTS IN
CHARACTERISATION OF INCOME
Vishal Achanta
1. INTRODUCTION
The question of whether income arising from the sale of shares is capital gains or
business income has been something of a constantly evolving conundrum. Investment funds
would prefer a characterization of their income that would allow them to avail exemptions or
treaty benefits easily. Over time, courts have formulated numerous ‗indicators‘ to determine
the nature of income; courts have also repeatedly held that none of these ‗indicators‘ are
conclusive in themselves, and that in each case the facts, circumstances and indicators taken
as a whole must determine the head under which the income will be taxed.
This has resulted in this aspect of the law of taxation becoming quite subjective and
murky; and thus, investment funds, as well as strategic and financial investors, (‗investors‘)
cannot always be certain with regard to which indicators will be applied to characterize their
income, with rulings being highly circumstantial.
This article will proceed in four parts to analyze the law relating to characterization of
income of investment funds. Part I will summarize the indicators employed to characterize
income, Part II will describe the first purchase principle, Part III will review the application
of the first purchase principle and Part IV will attempt to cull out a new indicator from recent
case law and conclude the discussion.
2. INDICATORS FOR CHARACTERIZING INCOME
By way of a very broad generalization, one can describe the activity of an investors
thus: investors contribute monies towards the financing of a company, in return for which
they receive an interest in the company either in the form of equity or a debt that is
 Student of Law, National University of Advanced Legal Studies, Kochi; E-mail:

vishalachanta@gmail.com
convertible into equity; subsequently, the investor will ‗exit‘ i.e. sell his interest at a
company, hoping to profit from the appreciation in the shares‘ value.
Whether this kind of activity will lead to ‗capital gains‘ or ‗business income‘ is a
question that essentially turns on whether the shares are held as capital assets or as ―stock in
trade‖1; this would in turn depend upon whether the activity of the fund is in the nature of an
investment or an ―adventure in the nature of a trade‖2, for which courts have listed numerous
indicators. These ―indicators‖, none of which are conclusive, have been summarized by the
Central Board of Direct Taxes (‗CBDT‘) in Circular No. 4/2007, dated 15-6-2007 (‗Circular‘)
and Instruction No. 1827 [F. No. 181/1/89-IT(AI), dated 31-8-1989] (‗Instruction‘).
The mass of indicators laid down in case law and the CBDT‘s Instruction and Circular
can be summarized in four general principles: Firstly, cases of realization of investment,
through purchase and sale of assets, though profitable, are not ‗adventures in the nature of
trade‘.3
Secondly, the intention of the assessee when the purchase of shares is made is of
paramount importance when deciding whether the shares are held as an ‗investment‘ or not. 4
A lack of intent to purchase shares as stock-in-trade to carry on business is seen as fatal to the
finding of the income being ‗business profits‘. 5
Thirdly, the frequency, continuity and regularity of these transactions of purchase and
sale might suggest ‗trading‘ 6 , but the volume of shares bought/sold is not taken as an
indication of ‗trading‘7. That said, even a single, isolated transaction could be an ‗adventure
in the nature of a trade‘8.
1 This term is not defined in the Income Tax Act, 1961, but one illustrative definition can be found in H.
Mohmed & Co. v CIT, [1977 107 ITR 637 Guj]: ―It appears to us that the question has to be considered
from the point of view of general commercial practice of the market. To put it in a proper compass, a
stock-in-trade is something in which a trader or a businessman deals; whereas his capital asset is
something with which he deals…in the case of an assessee who carries on the business of buying and
selling land, land may be his stock-in-trade but in the case of an assessee who has invested his savings in
land and gets income from the land or the structures put up on the land, the land is his capital asset‖.
2 Raja Bahadhur Kamakhya Narain Singh v. CIT, [1970] 77 ITR SC.
3 G. Venkataswami Naidu & Co. v. CIT, [1959] 35 ITR 594 (SC).
4 CIT v. Trishul Investments Ltd., [2008] 305 ITR 434 (Mad).
5 Examples of this tendency are Felspar Credit and Investment (P.) Ltd. v. CIT, [2012] 346 ITR 121.
(Mad) and Janak S. Rangwalla v. Asstt. CIT, [2007] 11 SOT 627 (Mum).
6 CIT v Rewashankar A. Kothari, [2006] 283 ITR 338 (Guj).
7 Janak S. Rangwalla v. Asstt. CIT [2007] 11 SOT 627 (Mum).
8 G. Venkataswami Naidu & Co. v CIT, supra note 3 at 607, 608.
2014 Taxation of the Income of Investment Funds: Applying the ‗First Purchase‘ 31
Principle and Recent Developments in Characterisation of Income
Fourthly, if the transactions are diversified, and are ―gradual according to the
opportunities offered by fluctuating market prices‖, it would indicate that the transactions are
an ‗adventure in the nature of a trade‘.9
From the four principles extracted above, it is easy to see that the ‗indicators‘ are
occupied with finding external manifestations of the subjective mental ‗intent‘ of the
assessee: does he simply wish to resell the shares he bought as an investment at a profit, or
are the shares the ‗goods‘ with which he deals in the course of his business? The question is
answered by examining the behaviour of the assessee and the circumstances surrounding his
transaction to ascertain whether he is a ‗dealer‘ (this is often used synonymously with
‗trader‘) or an ‗investor‘.
3. THE FIRST PURCHASE PRINCIPLE
To the four indicators mentioned above, a fifth may be added. This is the ‗first
purchase‘ principle. Like the other ‗indicators‘ listed above, it seeks an answer to the question
of whether the purchase and sale of shares was a ‗trading activity‘ or simply the realization of
an investment. It was first enunciated in the opinion authored by Mukherji, J (as his Lordship
then was) in CIT v. H. Holck Larsen10, wherein he paraphrased Lord Reid‘s dicta in J.P.
Harisson (Watford), Ltd. v Griffiths (H.M. Inspector of Taxes) 11 to this effect: ―The real
question…was not whether the transaction of buying and selling the shares lacks the element
of trading, but whether the later stages of the whole operation show that the first step - the
purchase of the shares - was not taken as or in the course of, a trading transaction‖.
The most authoritative judicial body that has discussed the first purchase principle since
it was first laid down was the Madras High Court in Felspar Credit and Investment (P.) Ltd. v
CIT12. It was observed by Charita Venkatraman, J that ―the Supreme Court pointed out that
the question as to whether the buying and selling of shares had an element of trading has to
be seen from the first step of investment made, viz., purchase of the shares. When there is
evidence to show that the purchase of the shares was not in the course of the trade/business,
then the sale of the shares could not be held as one in the nature of business…given the fact
9 Raja Bahadhur Kamakhya Narain Singh v. CIT, [1970] 77 ITR SC.

10 CIT v. H. Holck Larsen, AIR 1986 SC 1695.
11 J.P. Harisson (Watford), Ltd. V. Griffiths (H.M. Inspector of Taxes), [1962] 40 TC 281 (HL).
12 Felspar Credit and Investment (P.) Ltd. v CIT, [2012] 346 ITR 121 (Mad), ¶¶ 14, 15 & 16.
that the purchase itself was only by way of an investment, gain on the sale of shares, must
receive the same treatment by extending the principle, which govern the investment at the
purchase point…If the (first) purchase is a mere investment, then the result on the sale must
necessarily be taken to the logical end to treat it as an asset yielding to capital gains.
However, when investment itself is for the purpose of making it as a business then the
income earned on dealing with such shares is to be treated as business income only‖.
Thus, the first purchase principle turns the focus on the inquiry into the initial
acquisition of shares, and asks whether this initial acquisition has taken on the colour of the
beginning of a trading transaction from the later acts of sale and purchase.
The first purchase principle, due to its origin from a Supreme Court decision, has great
weight and authority; an inquiry into the nature of income arising from the sale of shares
cannot be done without paying heed to the ‗first purchase‘ principle. Strangely, neither the
CBDT‘s Instruction nor does its circular mentions the first purchase principle. This omission
is peculiar for two reasons: firstly, the Instruction as well as the Circular were published after
the ‗first purchase‘ principle was laid down, and should therefore have taken note of it;
secondly, the principle is directly relevant to the subject matter dealt with in the Instruction
and the Circular.
Whatever the omissions made by the CBDT, the ‗first purchase‘ principle cannot
simply be disregarded; it is a ratio decidendi laid down by the Supreme Court, and a decision
rendered by any judicial forum without taking note of it will be per incuriam, as can be seen
in the succeeding section.
4. AAR ON CHARACTERIZATION OF INCOME
This section will review certain recent rulings of the Authority for Advanced Rulings
(‗AAR‘) with regard to investment funds to examine their application of the first purchase
principle.
In XYZ/ABC Equity Fund, In re13, a private equity fund‘s income was held to be in the
nature of business income. The AAR placed heavy reliance on the object clause of the
company‘s memorandum (even though an entity‘s objects clause has been held to be a non-
13 XYZ/ABC Equity Fund, In re, (2001) 167 CTR (AAR) 533.

conclusive indicator14), and observed that ―…for this purpose, the company has raised share
capital and acquired money from other sources with which it has acquired very large blocks
of shares in fledgling Indian companies.‖ 15 The Applicant‘s ―large systematic activity‖ of
selling shares frequently led the AAR to conclude: ―the entire object is to sell these shares at
profit when the value of the shares appreciates in the market‖ 16. The AAR also remarked on
the structuring employed by the fund: ―…the scheme devised appears to be elaborate
business scheme to invest money from Mauritius in India. Such activity cannot be treated as
investment activity. These activities reveal an elaborate business set up for trading in shares
in India.‖17 There was no mention or application of the first purchase principle.
In Fidelity Advisor Series VIII USA, In re18 , a Foreign Institutional Investor (‗FII‘)
claimed that the income from its portfolio investments were in the nature of business income.
The AAR accepted the FII‘s claim, citing the sheer magnitude of transaction of shares that
had taken place, the fund‘s stature as an FII and its objectives, as reasons for its finding.
Again, there was no mention or application of the first purchase principle.
Three years later, in Fidelity Northstar Fund, In re 19 , an FII again claimed that its
investments would yield business income, but the AAR held that the income would be capital
gains, contradicting its earlier stand by ruling that the frequency and volume of the FII‘s
transactions would be irrelevant 20. The AAR also indicated that holding on to securities for a
few months to a few years would be enough to characterize the holding as an investment. 21
In large part, this determination was made due to the application of the first purchase
principle by the AAR. The AAR went further than simply applying the principle however: it
also effectively declared its earlier ruling in Fidelity Advisor Series VIII USA as per
14 Oriental Investment Co. Ltd. v. CIT, [1957] 32 ITR 664; See also A. V. Thomas and Co. Ltd. v. CIT
[1963] 48 ITR (SC) 67.
15 XYZ/ABC Equity Fund, In re, supra note 13 at ¶28.
16 Id.
17 XYZ/ABC Equity Fund, In re, supra note 13 at ¶31.
18 Fidelity Advisor Series VIII USA, In re, [2004] 271 ITR 1.
19 Fidelity Northstar Fund, In re, [2007] 288 ITR 641 (AAR).
20 Id. at ¶ 5.
21 Fidelity Northstar Fund, In re, supra note19 at ¶5.
incuriam 22 for its failure to apply the ‗first purchase‘ dictum found in CIT v H. Holck
Larsen23, an error that XYZ/ABC Equity Fund24, is equally guilty of.
The manner in which the AAR applied the first purchase principle to understand the
nature of the income made by an FII broke new ground, in that it has possibly led to another
‗indicator‘ being added to the law on this subject. This will be explored in the next section.
5. REGULATORY FRAMEWORK OF INVESTORS: THE SIXTH

INDICATOR?
To understand the exact character of the first purchase made by the FII, the AAR in
Fidelity Northstar Fund25 took its cue from the SEBI regulations that governed the FII, the
SEBI Foreign Institutional Investor Regulations, 1995 and other instruments related to the
activities of FIIs to conclude that FIIs were not allowed to ‗trade‘ in securities. 26The AAR
also examined s.115AD of the Income Tax Act, 1961 before finally concluding that ―...the
circumstances and the framework of the plethora of legislative provisions unmistakably point
out that a FII is not registered for carrying on trade in securities; it can only invest in
securities for the purpose of earning income by way of dividends and interest and realizing
capital gains on their transfer‖27. Similar reasoning had been adopted by the AAR in In Re
General Electric Pension Trust Fund.28
This led to the crux of Syed Shah Mohammed Quadri, J‘s argument: that it would not
be possible to impute an intention to ‗trade‘ to the FIIs when the regulatory framework they
functioned in prohibited them from ‗trading‘ in that sense. Thus, the intention behind the first
purchase made by an FII could have only been to ‗invest‘, and thus their income was capital
gains and not business income.
22 Id. at ¶ 31.
23 CIT v H. Holck Larsen, [1986] 160 ITR 67.
24 XYZ/ABC Equity Fund, In re, supra note 13.
25 Fidelity Northstar Fund, In re, supra note 19.
26 After reviewing numerous instruments that regulated FIIs, the AAR concluded that they ―do not deal
with the subject of trading in securities much less do they permit activities of trading in securities by a
FII‖, Fidelity Northstar Fund, In re, supra note19 at ¶6.
27 Fidelity Northstar Fund, In re, supra note 19 at ¶7.
28 In Re General Electric Pension Trust Fund, [2006] 150 Taxmann 545 (AAR) at ¶1, ―The fact that
deductions under sections 28 to 44C and section 57 are not allowed in computing the income from
securities would also indicate that the intention of the Legislature was not to allow a FII to take up
business venture‖.
This ruling furnishes the principle that the nature of an investor‘s income may be
determined by factoring in the regulatory framework within which it functions, particularly,
the relevant SEBI regulations or any special taxing provisions under which the investor is
taxed. The nature of the assessee‘s activities was determined by reference to the SEBI FII
Regulations. Similarly, in In re Morgan Stanley International Limited29 it was held that a
SEBI Circular that permitted ‗trade‘ in exchange traded derivatives ―could not be ignored‖,
while arriving at a determination that the asseseee‘s income was ‗business income‘.
The principle that emerges is that income made by private equity funds, mutual funds,
real estate investment trusts, infrastructure investment funds, hedge funds, venture capital
funds, or in the course of collective investment schemes, may be characterized as business
income or capital gains after paying due regard to the SEBI regulations that govern such
investments. While Fidelity Northstar Fund30 does not specifically lay down that proposition,
it could reasonably be construed to mean that an argument based on the relevant SEBI
regulations as an indicator of the nature of an investor‘s income may be accepted in future by
the AAR.
An illustrative example of this ‗indicator‘ at work would be the taxation of privately

pooled domestic funds regulated by the SEBI Alternative Investment Funds Regulations,
2012 (‗AIF Regulations‘), which divide Alternative Investment Funds (‗AIFs‘) into three
Categories based on their activities. In the terms of the AIF Regulations, a Category I fund
may be a venture capital fund, and a Category III fund will be a hedge fund; the language and
intent of the Regulations clearly suggests that the former will be an ‗investor‘ and the latter, a
‗trader‘.31 It is likely that the AIF Regulations will be pressed into service to characterize a
fund‘s first purchase and income.
The AAR subsequently determined an FII‘s income to be business income and not
capital gains in Royal Bank of Canada v DIT32, by demonstrating the misinterpretation of the
SEBI FII Regulations in Fidelity Northstar Fund: the narrow interpretation given to the word
‗investment‘ could not stand in the face of the fact that the word ‗investment‘ was also used
29 In re Morgan Stanley International Limited, [2005] 272 ITR 416 (AAR).

31 Regulations 2(1)(z), Regulation 16(2) and Regulation 18 of the SEBI Alternative Investment Funds
Regulations, 2012.
32 Royal Bank of Canada v. DIT, [2010] 323 ITR 380 (AAR).
to describe the FII‘s purchase of commercial papers and security receipts 33. It was therefore
concluded in that there was no restriction on an FII engaging in ‗trading‘; the basis of the
reasoning in Fidelity Northstar Fund34 had thus been destroyed.
The ruling in Royal Bank of Canada35 does not necessarily displace the new indicator
suggested above. The AAR in that case still relied on the SEBI FII Regulations; it merely
pointed out the faulty interpretation employed in Fidelity Northstar Fund36. It did however
lay down that the undertaking usually given by an investor to SEBI when it registers as an
investor to abide by the concerned regulations has no bearing on the characterization of its
income37.
In any case, the ruling in Royal Bank of Canada resulted in the law being less counter
intuitive: any reasonable layman who observes the FIIs‘ almost daily, frantic buying and
selling in response to external market stimuli would consider them ‗traders‘ rather than
‗patient investors‘.
The FII Regulations were again used as a tool to characterize the income of an FII in
LG Asian Plus 38 , in this instance by the Mumbai Income Tax Appellate Tribunal
(‗ITAT‘).However, the ITAT categorically held that the income made by an FII from the
transfer of securities (in this particular case, derivatives) was capital gains and not business
income; the ITAT did not examine the indicators listed earlier in this note, but merely
interpreted s.115AD to hold that the income made by FIIs was never intended to be taxed as
anything other than capital gains. It is humbly submitted that this decision, while perhaps
applicable only to the income arising from derivatives, is erroneous for two reasons: firstly, it
did not apply the first purchase principle, and secondly, its conclusion, which effectively
restores the position under Fidelity Northstar Fund,39 is highly counter intuitive, as pointed
out above.
33 Id, at ¶12.1. Commercial paper and security receipts are traditionally understood to be debt instruments
that are traded, not invested in.
35 Royal Bank of Canada v DIT, supra note 32.
37 Id, at ¶12.2.
38 LG Asian Plus Ltd. v ADIT, (2011) 46 SOT 159, affirmed and followed in Platinum Asset Management
Ltd v DDIT, ITA No. 2787/M/2012 & 2788/M/2012.
Interestingly, the FII Regulations have been replaced by the SEBI (Foreign Portfolio
Investor) Regulations, 2014, (‗FPI Regulations‘); the FPI Regulations also contain language
from which it can be seen that FPIs are clearly considered to be ‗investors‘ as opposed to
‗traders‘ 40 . The Finance Ministry, anxious to prevent any uncertainty and to pre-empt
possible future litigation over characterization of income has inserted a deeming provision
vide the Finance Act, 2014 41 that effectively ensures that the income of an FII 42 will
henceforth always be characterized as ‗capital gains‘.
6. CONCLUSION
In the conclusion, two points can be noted: Firstly, that due to the subjective nature of
the criteria employed to characterize income from the sale of shares, there will always be a
slight uncertainty as to the tax treatment of an investment fund‘s income; in the case of FIIs,
this had been exacerbated by numerous flip-flops of the judicial fora to whom it fell to
resolve that controversy, (as noted above, the legislature seems to have set this controversy to
rest for good).
Secondly, it is worth noting that the rulings of an AAR or ITAT have persuasive value
and therefore, it is likely that when any judicial forum rules on the characterization of the
income of an investment fund, pointers will be taken from the regulatory framework the
investment fund functions within. This ‗sixth indicator‘ assumes relevance when we consider
that the incomes of numerous new or recent investment vehicles like Real Estate Investment
Trusts, Infrastructure Investment Trusts and AIFs might be characterized by taking into
account their respective regulatory frameworks.
In view of the uncertain characterization of the income made by an investment fund on

the sale of shares, any light shed (either by a judicial tribunal or the CBDT) on this rather
murky area of the law would bring much needed clarity to investors, both foreign and
domestic.
40 The CBDT has clarified that FPIs will be taxed in the same manner that FIIs have been taxed vide CBDT
Notification No.9/2014, dated 22nd January 2014. Clarity on the characterization of the income of an FPI
on the sale of shares is however, still elusive.
41 The insertion has been made into s. 2(14) of the Income Tax Act, 1961.
42 While the Finance Act, 2014 refers to ‗Foreign Institutional Investors‘, s.8 of the General Clauses Act,
1897 (which deals with the interpretation of a statute which refers to a legislation or regulation that no
longer exists due to replacement by a new legislation) can be relied upon to read this to mean ‗Foreign
Portfolio Investors‘ as well.
ROYALTY TAXATION IN INDIA POST RELIANCE INFOCOM:
SETTING A PERILOUS PRECEDENT
Deekshitha Srikant, Enakshi Jha, & Sindhuja Satti
Abstract
Taxation of software payments in India has proven to be an extremely

contentious topic with the level of uncertainty it has entailed over the years. This
article seeks to discuss the connotations of the recent Mumbai Tribunal ruling in
the case of DDIT v Reliance Infocomm Ltd/Lucent Technologies, a fine example
reiterating the ugliness of the façade of software payments by universalizing the
taxation of transactions having varying standings under copyright law. The
article explores the implications of such ambiguity in the field of taxation by
elucidating essential concepts like royalty taxation, copyright law, and the law on
permanent establishments by tracing the judicial lineage on these issues both in
the domestic and international spheres. The article also seeks to provide a
glimpse of the wide spectrum of judicial perspectives by shedding light on the
plethora of conflicting cases, statutes and lacunae in the law on the issue. Once
the fissures in the present law in India has been displayed through this process,
the article then critiques the judgement and suggests a viable alternative tax
model successfully utilized abroad.
1. INTRODUCTION
Since the dawn of the information technology age, the proliferation of transactions that
involve fairly young ideas has created its share of ripples in older and more established
realms, such as taxation. In addition, the transferability of such ideas across borders has
further complicated the situation, as evident from the endless diatribes on taxation of cross-
border software purchases in India. The problem here is twofold: one, with respect to the
characteristics of the software itself and accordingly, how it must be taxed; and two, the
added impediment of taxing such software in a cross-border transaction. In the face of such a
 Students of Law, NALSAR University of Law, Hyderabad. E-mails: deekshithasrikant@gmail.com,

jhaenakshi@gmail.com, sindhuja.satti@gmail.com
2014 Royalty Taxation In India Post Reliance Infocom: 39
Setting A Perilous Precedent
conundrum, this paper seeks to study a recent case, DDIT v Reliance Infocomm Ltd/Lucent
Technologies 1 (hereinafter ‗Reliance Infocomm‘) by the Income Tax Appellate Tribunal,
Mumbai (hereinafter ‗ITAT Mumbai‘) in the backdrop of a history of conflicting
jurisprudence on the matter. It seeks to locate essential concepts that the case has ruled on,
such as the difference between a ‗copyrighted article‘ and ‗copyright‘, the definition and law
surrounding royalties and permanent establishments in the domestic sphere vis-à-vis the
position under international treaties and models, before discussing the legal coherence of the
Reliance Infocomm judgement in light of the enumerated concepts and judicial decisions. It is
the authors‘ assertion that a careful analysis of the debate on taxation of software purchases
in India displays the flaws in the Reliance Infocomm decision. However, the authors
recognize the need to examine the debate in light of the retrospective amendment to the
Income Tax Act, 1961 (hereinafter ‗IT Act‘) through the Finance Act, 2013, yet maintain that
the adoption of a different approach towards such taxation would be incommensurably
helpful.
2. FACTUAL BACKGROUND
The case centres around a transaction between Reliance Infocomm (now dubbed
Reliance Communications Ltd.), an Indian telecom company that sought to establish wireless
networks in India, and the Indian and USA-based offices of Lucent Technologies for the
supply of said wireless software. The transaction involved purchase of hardware from Lucent
India, and a corresponding purchase of software from Lucent USA. The intellectual property
rights of the software remained vested in Lucent USA. Reliance Infocomm‘s license
prohibited the company from making any copies of the software other than for internal
purposes, or transferring, assigning, sub-licensing, modifying, decompiling, reverse
engineering, disassembling or decoding the software in any manner. Reliance Infocomm
approached the Revenue in an application for a ‗no withholding‘ certificate for the payments
to Lucent USA, which the Assessing Officer (hereinafter ‗AO‘) rejected on the ground that
the payment constituted a royalty and therefore mandated withholding of tax. Reliance
moved an appeal to the Commissioner of Income Tax (Appeals), who ruled against the AO‘s
decision and categorized the transaction as the sale of a copyrighted article, which meant that
1 DDIT v Reliance Infocomm Ltd/Lucent Technologies, (2014) 159 TTJ (Mum) 589.
the transaction could not be taxed as royalty in the absence of a permanent establishment of
Lucent USA in India.
Meanwhile, the AO simultaneously reconsidered Lucent USA, which moved to the

Dispute Resolution Panel in appeal, who confirmed the AO's order that the transaction
constituted a royalty. The common appellate forum for both claims was the ITAT Mumbai,
which clubbed both claims together to decide whether payment for software licenses
constitutes ‗royalty‘ under the Indian Income Tax Act or the India-US tax treaty and thereby,
whether Reliance Infocomm was obliged to withhold tax on the transaction.
The ITAT ruled in favour of the Revenue, stating that in absence of the license, the
end-user of the software would be infringing upon the intellectual property rights of the
vendor, even in case of sale of a copyrighted article. Other noteworthy parts of the judgement
are:
(a) Reliance contended that despite the existence of separate agreements for the
purchase of hardware and software, the two would be integrated; but the software was
not an integral part of the transaction. The ITAT distinguished this case from previous
precedent with embedded software as there two separate agreements existed.
(b) Reliance argued that the software comprised of a copyrighted article while the
Revenue argued that there existed a right to copyright. ITAT held that even though an
explicit right to the copyright was not transferred in the licence, certain rights had
been conveyed to use the software. In the absence of this license, such use would have
been an infringement of the copyright itself. The ITAT further relied on previous
cases and stated that the dichotomy between copyrighted articles and right to
copyright was irrelevant for this purpose. The ITAT also stated that in every case
where there is a transfer of rights and the intellectual property rights remained with
the vendor, it would be a situation of royalty.
3. THE COPYRIGHT CONTROVERSY
While the Indian judiciary has often encountered a quandary in adjudicating upon the
payment of taxes in software purchases, no precedent has been set to explicate the difference
between royalty and expense as revenue expenditure, taxable under Section 37(1) of the IT
Act.2 However, when faced with this predicament on a case-to-case basis, the courts have
deduced general principles regarding the taxability of software purchases, making it
paramount for India‘s biggest software giants and other small and medium technology
enterprises to apprehend whether payment for importing software amounts to ‗royalty‘, which
is taxable under Indian law.
Software protection in India lies within the ambit of the Indian Copyright Act, 1957.
This Act attempts to protect and promote innovation that can be commercially exploited by
the innovator. Computer programmes are considered to be ‗literary works‘ under this Act.
The right to exploitation of such works is extended to assignees for a fixed time period on the
payment of a fee. This fee is known as ‗royalty‘ and lies in the crux of the debate that this
article shall attempt to decipher. On licensing his patent, the author retains the intellectual
property of his invention. In the case of software protection, this premise can be extended to
conclude that licensing of software does not amount to the transfer of intellectual property of
the software or its program. Further, Section 51 of the Copyright Act also provides for the
infringement of the author‘s copyright without prior authorization. However, Section 52
elucidates upon the situations a prima facie infringement will not be deemed (unless
infringement is made for a commercial exploitation), such as in the case of computer
infringements specified by this Section. While Section 51 has been drafted to curb
unauthorized multiplication of software programs considering the smaller scale of the
consideration paid to the author, Section 52 provides for exceptions that include copying the
software to prevent its loss in case of any damage or destruction. 3 This is often done with the
permission of the author (owner of the copyright).
Computer programs are usually of two types. The first includes ‗shrink-wrapped‘
software that is devised for personal usage by the licensee, and the second includes computer
programs that are made for commercial exploitation. Shrink-wrapped programs are available
in the market, on the purchase of which the customer enters an End-User License Agreement
with the author of the program that grants him a license to merely use a copy of the software
program. The customer does not receive any ownership of the intellectual property of the said
2 PATHAK AND GODIAWALA, BUSINESS T AXATION 36 (2013).

3 A. J. Majumdar, Taxation of Royalty Income from Computer Software under Income-tax Act and Double
Taxation Avoidance Agreements, TAXMANN ,
http://www.taxmann.com/TaxmannFlashes/Articles/flashart13-1-11_1.htm (June 30 June 2014,
04.30PM)
program. If the customer distributes or replicates the software, he is bound to pay a royalty to
the author of the software, in return of a right to commercially exploit the software. 4 This
leads us to the crucial difference between a ‗copyright‘ and a ‗copyrighted article‘, a
dichotomy that is pivotal in determining the taxation policies that govern the import of
software programs in India, as has been discussed in the latter sections.
On licensing the software the author retains his ‗copyright‘, which is the intellectual
property of the software. The licensee attains a copy of the same software, which is a
‗copyrighted article‘, but does not receive any ownership of the intellectual property of the
said software. 5 Copyrights are a privilege created and are intangible in nature and are
independent of any material existence. Copyrighted articles on the other hand allow for the
use of a program after paying a consideration to the author. This sale is analogous to the
consideration paid in the sale of goods and does not amount to royalty. 6 In copyrighted
articles, the assignee does not have ownership over the copyright and cannot claim the same
rights as the author. On paying the owner of the program a royalty, the user can attain the
owner‘s right over the program, thereby giving the user the copyright. This classification is
crucial in determining whether payments advanced towards computer software and their
programmes can be classified as ‗royalty‘, which is taxable under Indian Law. In 2005, the
Supreme Court of India in the Tata Consultancy Services v. State of AP7 held that shrink-
wrapped software were ‗goods‘ and that the licensing of such software programs amounts to
the transfer of a copyrighted article and not the copyright itself. Hence the Court concluded
that the consideration provided in the case of shrink-wrapped software would not amount to
royalty. 8 A Special Bench of the Delhi Tribunal in the case of Motorola Inc v. Dy. CIT and
4 Id.
5 Taxation of shrink-wrapped software: India and International Perspectives, DELOITTE (December,
2013), http://www.deloitte.com/assets/Dcom-
India/Local%20Assets/Documents/Thoughtware/Tax_thoughtpapers_Dec_19/Deloitte_Taxation%20of%
20shrink-wrapped%20software.pdf (30 June 2014, 05.00PM).
6 India‘s Delhi High Court distinguishes Copyright Rights and Copyrighted Article in Software
Transactions, EY (04 December, 2013)
http://www.ey.com/Publication/vwLUAssets/India_Delhi_High_Court_distinguishes_copyright_rights_a
nd_copyrighted_article_in_software_transactions/$FILE/2013G_CM4015_India‘s%20Delhi%20High%2
0Court%20distinguishes%20copyright%20rights.pdf (30 June 2014, 04.00PM).
7 Tata Consultancy Services v. State of AP (2005) 1 SCC 308.
8 Sagar Mal Pareek, Dealings In Information Technology Software – In New Service Tax Regime – A
Study, MANUPATRA, http://www.manupatrafast.com/articles/PopOpenArticle.aspx?ID=07b15aed-5695-
4d73-96e0-0f68c91bd4e6&txtsearch=Subject:%20Indirect%20Tax (30 June 2014, 05:00PM).
Dy. CIT v. Nokia9 gave a judgment along the same lines as the Supreme Court by reiterating
that payment for a copyright would amount to a ‗royalty‘, while payment for a mere
copyrighted article would not. The Court specified that in deciding between a copyright and a
copyrighted article it is essential to take note of the benefits and burdens of the transferred
ownership, while analyzing the facts and circumstances of the case.10 Similarly, in the DIT v.
Ericsson AB11case the Delhi High Court placed reliance on Section 14(a) (i) and (vi) of the
Copyright Act, 1957 in establishing that a copyright exists only in cases of reproduction for
commercial exploitation, thereby cementing that the consideration paid for such copyright to
be a royalty, taxable under Section 9 of the Income Tax Act. This case further specified that
shrink-wrapped software was not taxable in the form of royalty as it was a copyrightable
article and not a copyright.12
4. ROYALTY TAXATION
The concept of royalty taxation has been the source of much controversy in India
because the line drawn between what is subject to such taxation and what is not has remained
blurry and undefined. If an Indian company purchases certain designs from a company based
in the United Kingdom, would such a transaction be taxed as royalty (thereby being eligible
for tax being withheld) or as a mere purchase of a good? 13 As discussed in the previous
section, the issue in the Reliance Infocomm case is analogous to the question posed above: is
the purchase of software from the US based Lucent Technologies to be considered a
transaction conferring a right to the copyright of the software, subject to royalty tax; or a
purchase of software subject to sales tax? To be able to successfully answer this quandary,
the definition of ‗royalty‘ must be examined, both in the context of domestic legislations and
jurisprudence and international instruments.
9 Motorola Inc v DCIT, [2005] 95 ITD 269 (Del) (SB).

10 Ajay Prasad and Rohit Bhat, Domestic and International Tax Treatment of Royalties and Fees for
Technical Services 22(1) NAT‘L L. SCH. INDIA REV. 174 (2010).
11 DIT v. Ericsson AB, TS-769-HC-2011 (DEL).
12 Deloitte, International Tax Alert 29 December 2011, DELOITTE, http://www.deloitte.com/assets/Dcom-
India/Local%20Assets/Documents/International%20Tax/2011/ITX-53-2011.pdf (30 June 2014,
12:45PM)
13 See Akil Hirani and Hemen Asher, Taxation of Royalty Payments in India, MAJUMDAR & CO.,
http://www.majmudarindia.com/pdf/Taxation%20of%20royalty%20payments%20in%20India.pdf. (30
June 2014, 06:33PM).
A ‗royalty‘ in its very essence is a payment made to the owner of an intangible asset
(such as a patent or copyright), for the use of this asset. While income from such royalty
payments is taxable in India under the Income Tax Act, 1961, income accruing from an
import of the software must be viewed in the context of the definition of ‗royalty‘ under the
concerned Double Taxation Avoidance Agreement (hereinafter ‗DTAA‘). For the
government, taxation of royalty payments becomes a sizeable source of revenue due to the
typically higher rate of returns, 14 while it is detrimental to the tax-payer.
In order to fully appreciate how the concept of royalty taxation pans out in reality, it is
necessary to first delve into the various aspects of domestic law and judicial decisions that
discuss royalty taxation and then examine the same under relevant international treaties,
before examining their positions vis-à-vis each other.
4.1 ROYALTY - THE DOMESTIC PERSPECTIVE
Before the advent of the Finance Act in 1976, Indian tax law did not expressly deal
with the question of royalty payments. Post 1976, however, clause (vi) was inserted into
Section 9(1), elucidating circumstances where royalty income shall be deemed to accrue in
India.15 ‗Fees for technical services‘ was also inserted vide clause (vii).
Section 9 of the IT Act discusses income that is deemed to arise in India, where the
payment is to the government, an Indian resident or an Indian business establishment of a
non-resident. The place of usage of the intellectual property dictates place of accrual where
the payee is not the government. The definition under the IT act brings into its purview both
lump-sum and inveterate payments, but does not include an outright conveyance of assets
which would be taxed as capital transfers. 16 Section 9(1)(vi) deals specifically with royalties.
This provision merely deems income to accrue in India when in actuality it accrues abroad,
and does not consider any capital receipt to be an income receipt.17Section 9(1)(vi) discusses
the consideration for the conveyance of all or any rights (including the granting of a license)
14 See Ajay Prasad and Rohit Bhat, Domestic and International Tax Treatment of Royalties and Fees for
Technical Services, 22(1) NAT‘L L. SCH. INDIA REV. 174 (2010).
15 See generally, K CHATURVEDI & S. M. PITHISARIA, CHATURVEDI AND PITHISARIA‘S INCOME TAX LAW I
(5th ed., 1998).
16 IT Act, Explanation 2 of §9 cl. 1 ¶vi.
17 IT Act, §9 cl. 1 ¶vi.
in the context of any copyright, literary, scientific or artistic work. 18Income is said to accrue
from royalty if the government or a resident makes the said payment to a non-resident for the
purposes of generating income from the overseas country.
In the process of determining which category the transaction falls under, the type of
information that was transferred becomes extremely pertinent. In CIT v HEG India,19 the
Madras High Court exemplified this by stating that to qualify for withholding tax, the
information transferred must have some unique features that elevate it to a transaction not of
mere commercial nature, which is utilized for the earning of income from any source in India.
A right to the copyright of a software, as in the present case, would qualify the transaction to
the level of a royalty, and the Indian payee would be considered a defaulting assessee if tax is
not deducted at the source.20For the purpose of determining the existence of the same, the
definition of ‗copyright‘ under Section 14 of the Indian Copyright Act is usually relied upon,
as the term has not been defined under the IT act. Section 14 stipulates that copyrights can be
assigned to literary work, within which computer programmes, databases, tables and
compilations are included, 21 while Section 52 discusses infringement of such copyright. The
interplay between these two sections was examined in CIT v Samsung Electronics, which
ruled that making copies of a software would in itself amount to copyright work, which in the
absence of the license would constitute an infringement of copyright, thereby suggesting that
such a license would be more than a mere purchase of a good. 22 This judgement has
effectively managed to erase the discretion that previously existed to the Indian payer in
deciding whether payments to a non-resident constituted royalty or not, by requiring an
application to the Assessing Officer for withholding at a lower rate or refraining from
withholding, pursuant to the procedure in the Act.
This stance was a fresh one compared to the previous line of thought espoused by Tata
Consultancy Services v State of AP, 23 relied on by the judiciary in a plethora of cases,
foremost of which were the Ericsson 24 and Motorola 25 cases. Considering that the
18 Id.
19 CIT v HEG India, (2003) 182 CTR MP 353.
20 IT Act, §201 (1961).
21 Indian Copyright Act, §14 (1951).
22 CIT v Samsung Electronics, (2012) 345 ITR 494.
23 Tata Consultancy Services v State of AP, AIR 2005 SC 371.
24 Motorola Inc v DCIT, Supra note 9.
predominant position rejects the distinction between copyrighted articles and copyrights, and
the wide definition of royalty under Section 9(1)(vi) when payment is made to a non-resident
of India, the Indian payee is compelled to withhold tax at the source for transactions
involving purchase of software. The Supreme Court in GE India Technology Centre Private
Limited v Commissioner of Income Tax26dealt with a remittance by the assessee to a non-
resident which, according to the assessee, was not taxable in India and did not involve tax
withholding. The AO and the CAT were of the opinion that, post the Samsung Electronics
case, the assessee did not have the discretion to decide upon whether to withhold the tax or
not (as per Section 195) and was liable for not doing so under Section 201 of the IT Act. The
Court stated that such a remittance would be subject to tax only if it is ‗chargeable in India‘
under the non-resident‘s hands, overruling Samsung Electronics and restoring some amount
of discretion to the payee. The Court also recognized that composite payments with an
element of income in them are also subject to withholding under Section 195.27
The case is strikingly similar to the Reliance Infocomm case, wherein the non-resident
retained all rights to the copyright of the shrink-wrapped software, and the Indian payee only
redistributed the software or used it for internal purposes. By drawing the difference between
what transactions are liable to tax deduction at the source under Section 195, the judgement
sheds some clarity on a provision hitherto shrouded with uncertainty. Further, the Court also
directed the identification of the type of transaction based on the ultimate use of the article. 28
Clarity was brought in through a retrospective amendment to the IT Act by the government
through the Finance Act 2012, which inserted Explanations 4, 5, and 6 to Section 9 of the IT
Act. These Explanations contained an express reference to software licenses that constitute a
right over the copyright of the software. Explanation 4 essentially sought to clarify that the
transfer of the right to use software has always been covered by Explanation 2, irrespective of
the medium of transfer. Explanation 5 further illuminated that even rights that do not vest
with the resident are to be considered. 29 Post this, the Central Board of Direct Taxes issued a
25 DIT v. Ericsson AB, supra note 11.

26 GE India Technology Centre Private Limited v Commissioner of Income Tax, 327 ITR 456 (SC).
27 News Alert, PWC (13 September 2010),
https://www.pwc.in/services/Tax/News_Alert/2010/pdf/PwC_News_Alert_13_September_2010_GE_Ind
ia_Technology_Centre_Pvt_Ltd.pdf. (27 June, 2014, 03.00PM).
28 Id.
29 Recent Amendments to the Royalty Provision, KPMG (13 September 2012)
http://www.kpmg.com/Global/en/IssuesAndInsights/ArticlesPublications/taxnewsflash/Documents/india-
sept14-2012no1.pdf (28 June, 2014, 04.00PM); Richard Murphy, Decoding Finance Bill 2012, TAX
circular dated June 13, 2012, that stated that tax deduction at the source is not required for the
purchase of software from a resident transferor if the software is bought in a subsequent
transfer without any modification, and tax has been deducted as per Section 195 or Section
194J for the previous transfer. Effective from April 2013, the Finance Act, 2013 also
increased the rate of royalty tax from 10% to 25%,30 higher than most DTAA‘s, which means
that taxation under the latter would be more beneficial to the taxpayer.
This however left some scope for uncertainty. The Mumbai ITAT in 2012 considered
the impact of the newly inserted Explanation 4 on the interplay between Sections 9 and
40(a)(ia) of the IT Act, which deals with disallowance. The Tribunal ruled that Explanation 4
does not alter the latter provision, which shall continue to follow the definition of royalty laid
down in Explanation 2.31
In DIT v Nokia Networks 32 the High Court held that the right to use a copyrighted
article itself is a copyright and that there need not be any distinction outlined between
copyrighted article and right to copyright. The ITAT was swayed in the Reliance Infocomm
case due to the existence of a license. CIT v Neyveli Lignite involved a situation similar to
Reliance Infocomm, where a company located abroad supplied designs along with machinery.
However, no license was involved, so the Court ruled that the payment was outside the
purview of the section. 33 Generally, the judiciary has made the distinction between cases
where a license is not involved (such as in CIT v Ahmedabad Calico)34 and cases where
licenses were involved, placing the latter under the class of taxable income. Another pertinent
factor in such cases is whether a permanent establishment of the non-resident company in
India exists. For example, in Microsoft Corporation v ADIT, Microsoft contented that the
transaction selling copies of software produced by various foreign subsidiaries for
redistribution to the Microsoft Regional Sales Corporation did not amount to a royalty as the
SUTRA http://www.taxsutra.com/microsite/Budget2012/expert/32/Richard_Murphy_-
_Director__Tax_Research_LLP (30 June 2014, 17:31PM).
30 Deloitte, Taxation of shrink-wrapped software: India and International Perspectives, DELOITTE,
http://www.deloitte.com/assets/Dcom-
20shrink-wrapped%20software.pdf. (30 June, 2014, 03.00PM).
31 Sonata Information Technology Ltd v. DCIT, [2012] 25 taxmann.com 124 [Mum].
32 DIT v. Nokia Networks OY, TS-700-HC-2012 (Del).
33 CIT v Neyveli Lignite,243 ITR 459; See also KANGA, PALKHIVALA AND VYAS, THE LAW AND PRACTICE
OF INCOME TAX, 387 (2008).
34 CIT v Ahmedabad Calico,139 ITR 806.

Regional Sales Corporation did not amount to a ‗permanent establishment‘. The ITAT,
however, rejected this argument. 35 Part IV of this paper will further discuss permanent
establishments and their implications on royalty taxation.
An additional point of debate in the Reliance Infocomm case was the fact that there
existed two different agreements that separately procured the software and hardware from
Lucent Technologies. Reliance argued that the transaction must be viewed in totality, as the
software and hardware were to be integrated, whereas the Revenue asserted that there existed
two standalone contracts and that software was not an essential part of the purchase of the
equipment. The existence of two agreements stepped the balance and the ITAT ruled that
software was not intrinsically linked to the purchase of hardware.36
4.2 ROYALTY UNDER DTAA’S AND THE INTERNATIONAL POSITION
Taxation follows one of two generic models: a source based approach, or a residence
based approach. The former entails taxation by the country at which the income is sourced,
while the latter taxes its residents worldwide. 37 India follows a hybrid model involving both.
The purpose of DTAA‘s, therefore, is to ensure that taxation does not happen twice in the
both parties‘ resident countries. 38 Such treaties do not confer the right to tax upon any
country, but provide a framework for the accommodation and conciliation of competing tax
claims. 39
In addition to examining the provisions for royalty under the India-USA DTAA, the
authors believe it is significant to scrutinize the discourse on royalty taxation under, first, the
OECD Model Tax Convention on Income and on Capital (hereinafter ‗OECD Model‘) and
second, The United Nations Model Double Taxation Convention between Developed and
Developing Countries (hereinafter ‗UN Model‘). The differences between these two models
35 See, Microsoft Corporation v. ADIT (ITAT Delhi) (2010) TII 154 ITAT.
36 The ITAT relied on CIT v. Sunrays Computers [2011] 16 taxmann.com 268, as similar case with two
agreements, where purchase of software was considered royalty.
37 R. S. Avi-Yonah, The Structure of International Taxation: A Proposal for Simplification 74 TEX. L. REV.
1301, 1303-06 (1996).
38 A.C Warren Jr., Income Tax Discrimination against International Commerce, 54 TAX L. REV. 131
(2001).
39 A Forgione, Weaving the Continental Web: Exploring Free Trade, Taxation and the Internet, 9 L. &
BUS. AM.513 (2003).
will significantly impact any DTAA that follows either model, 40 as both are examples of the
approaches elucidated above.
The OECD Model follows the residence approach, while promulgating drastic
curtailment to the scope of a source country‘s jurisdiction in taxing international income or
diminishing its tax rates where jurisdiction is retained. 41 The UN Model came into existence
subsequently, providing for a model structure for taxation between developing and developed
nations and employs both a source-based and residence-based approach. Other than the
differences in their holistic approaches, the two models are uniform in their approach to
software purchases as royalty. 42On scrutiny, it is discernable that both the OECD Model and
the UN Model differentiate between a right to copyright and a copyrighted article. The
OECD Model provides that where the usage of software would amount to an infringement of
the copyright in the absence of the said license, the transaction would be taxed as royalty.
However, if only the right to use the software without affecting its copyright in any manner is
transferred, the same would be taxable as business income in accordance with Article 7of the
OECD. The UN Model follows a similar path, only considering transactions where
substantial rights are transferred to constitute a royalty. 43Article 12 of the former Model only
deals with royalties arising in one party‘s territory and beneficially owned by a resident of the
other party, but does not cover royalties arising in third party countries or attributable to a
permanent establishment.44
Article 12 of the India-USA DTAA provides for royalty payments. Although the USA
typically follows the residence approach, the India-USA DTAA adopts an amalgamation of
40 See, Ajay Prasad and Rohit Bhat, Domestic and International Tax Treatment of Royalties and Fees for
Technical Services, 22(1) NAT‘L L. SCH. INDIA REV. 174 (2010); See also Veronica Daurer and Richard
Krever, Choosing between the UN and OECD Tax Policy Models: An African Case Study, EUROPEAN
INSTITUTE UNIVERSITY (EUI Working Paper RSCAS 2012/60).
41 Id.
42 Michael Lennard, The UN Model Tax Convention as Compared with the OECD Model Tax Convention –
Current Points of Difference and Recent Developments (Asia-Pacific Tax Bulletin January/February
2009) http://www.taxjustice.net/cms/upload/pdf/Lennard_0902_UN_Vs_OECD.pdf. (30 June 2014,
05.00PM)
43 Deloitte, Taxation of shrink-wrapped software: India and International Perspectives, DELOITTE,
http://www.deloitte.com/assets/Dcom-
20shrink-wrapped%20software.pdf (30 June 2014, 05.00PM)
44 OECD, Model Tax Convention on Income and on Capital 2010, Commentary on Article 12: Concerning
the taxation of royalties, OECD, http://www.keepeek.com/Digital-Asset-
Management/oecd/taxation/model-tax-convention-on-income-and-on-capital-2010/commentary-on-
article-12-concerning-the-taxation-of-royalties_9789264175181-46-en#page4 (27 June 2014, 06:30PM).
both approaches, allowing India to tax royalties. The DTAA has a provision similar to the
UN Model on source taxation of income, at an agreed rate between the parties, only for the
beneficial owner of a royalty, which means intermediaries do not benefit from these
provisions. 45
4.3 POSITION vis-à-vis EACH OTHER
The majority view in determining the liability of a non-resident company in India on

the interplay between the domestic and international definitions of royalty taxation specifies
that any relevant DTAA under Section 90 of the IT Act overrides the provisions of the IT
Act.46 The Supreme Court in Azadi Bachao Andolan & Another reaffirmed this position.47 In
the Reliance Infocomm case, as well, the definition of royalty under the India-USA DTAA
was studied. The ITAT ruled that the present case falls under the ambit of the said definition.
5. PERMANENT ESTABLISHMENT – A TWIST IN THE TALE
The concept of permanent establishments has always proven to be a game changer for
the purpose of taxation. The concept of permanent establishments is to sort out the competing
tax jurisdictions where an entity is legally resides in one country and carries out business
activities in another country. The OECD Convention has defined a permanent establishment
to be ―a fixed place of business through which the business of an enterprise is wholly or
partially carried on.‖48 This understanding of a PE forms the foundational cornerstone to
which most DTAA‘s subscribe to and revolve around, including most DTAA‘s that India is
party to. The primary understanding of permanent establishments is central in determining
the right of a country to tax an entity of a foreign country for carrying out business in its
territory. It is one of the fundamental principles in avoiding double taxation.
5.1 DOMESTIC PERSPECTIVES ON PERMANENT ESTABLISHMENTS
45 DTAA Between India and USA, Article 12. No. GSR 992(E), dated 20-12-1990.
46 CIT v. Visakhapatnam Port Trust, [1983] 144 ITR 146.
47 Azadi Bachao Andolan & Another v. Union of India, 263 ITR 706.
48 OECD Model, Article 5(1).
As discussed throughout this article, the main contention of taxing computer software is
twofold. One is that the end users of software merely receive a copy of the ‗copyrighted
article‘ and not a right to the copyright of the software and the income that they receive
through such purchase is in the nature of business profits. This income is taxable if the
payment is made to a permanent establishment.49 Before the tax can be levied, it must be
ascertained that the entity in question is indeed a permanent establishment.
Countries across the world are grappling with the uncertainty that determination of
permanent establishments entails, generating a plethora of cases in every jurisdiction on the
matter. When cross border software payments are rendered as royalty, they are subjected to
withholding tax, but rendering the same software payments as business profits would no
longer be taxable unless the foreign company has a permanent establishment in India. 50
In light of such a proposition two types of permanent establishments elucidated upon by

the OECD model can be discerned. The first is where the establishment is part of the same
company and is under the common ownership of an entity. This could include a branch of the
main entity or an office. These permanent establishments are covered under Articles 5(1) to
5(4) and are referred to as ‗associated permanent establishments‘. The second includes an
entity that is legally separated from the main company, yet is dependent on the enterprise.
Such permanent establishments are referred to as unassociated permanent establishments and
are covered by Article 5(5) and 5(6).51In the event that the foreign company has a permanent
establishment in India, the assessment is to consider that such business profits that the
company received from the Indian company are connected to the fixed place of business or
the said permanent establishment. A tax rate of 40% would be levied on the income that is
computed as head profit or gains of the IT Act.
49 Taxing Times: Copyright or Copyrighted Article? The Debate Continues, NISHITH DESAI,
http://www.nishithdesai.com/information/research-and-articles/nda-hotline/nda-hotline-single-
view/article/taxing-times-copyright-or-copyrighted-article-the-debate-continues-copy-1.html (29 June,
2014, 07:36PM).
50 EY Tax Alert, EY (11 September 2013),
http://www.ey.com/Publication/vwLUAssets/Tax_Alert_Reliance_Infocom/$FILE/Tax_Alert_Reliance_
Infocom.pdf (30 June, 2014, 07.30PM)
51 Shefali Goradia, Business Connection and Permanent Establishment, NISHITH DESAI,
http://www.nishithdesai.com/fileadmin/user_upload/pdfs/Business_Connection_and_Permanent_Establis
hment.pdf. (30 June, 2014, 08.00PM)
The case of Velankani Mauritius v. DDIT52 establishes that business profits would not
be subject to tax in the absence of such an Indian permanent establishment. In this case the
shrink-wrapped licensed software was supplied to Infosys Technologies. The tax authorities
assessed that the payments would be treated as royalties and not business profits, and thereby
were not subjected to taxation in the absence of a permanent establishment. Upon close
scrutiny of the Reliance Infocomm case, it is seen that this argument was also put forth but
not delved into by the ITAT.
6. CRITIQUE AND SUGGESTIONS – TOWARDS A BETTER MODEL
The Reliance Infocomm case is yet another milestone in the much-trodden path of the
debate regarding the taxation of software purchases. Until Reliance Infocomm, if a transaction
fell under the ambit of the IT Act and the non-resident party was from a state with which
India did not have a DTAA, the Indian party was obliged to withhold taxes. If a DTAA
existed but the definition of royalty under the treaty did not cover software purchases, the
taxpayer could assert that the transaction amounted to purchase of a copyrighted article, until
the Reliance Infocomm case turned the tables by blurring the distinction between the two. In
light of the Finance Act and jurisprudence post the retrospective Amendment, it is safe to
state that the distinction between a copyrighted article and right to copyright has been
rendered irrelevant.
In the pre-Reliance Infocomm era, the Indian judiciary adopted diverse stances in
drawing the distinction between copyrighted articles and right to copyright, as elucidated in
Section III. It is the authors‘ opinion that the position taken by the Supreme Court in the GE
India case, allowing an element of discretion to the taxpayer with respect to determining
whether a transaction qualifies as a royalty or not is more in consonance with international
norms than the present law in India. By following the Samsung Electronics case, the Reliance
Infocomm case does not allow an assessee to argue that a transaction involving software
could be a copyrighted article, while there is evidently conflicting case law on this point. The
fact that this distinction is rendered obsolete is cause for concern. This could also have
damaging implications for the taxation of shrink-wrapped software, for instance, where no
rights are transferred at all, but it still taxed as royalty because Indian law refuses to see the
existence of a distinction.
52 Velankani Mauritius v. DDIT, 132 TTJ 124(Bang).

Instead of the present approach in India, the authors‘ contend that a rights-based
approach to such taxation issues could prove to be less problematic. The first and most
pertinent advantage of such a system is the recognition of the right to copyright-copyrighted
article dichotomy. In early 2013, Singapore brought in such a model to characterize payments
for software, which earlier followed the Indian position and mandatorily deducted tax at
source for software purchases, which fell under royalty payments. A rights-based approach
essentially involves differentiating between a right over the copyright and a copyrighted
article, something that Indian law, through the judiciary, has attempted to blur. Where the
payee can commercially exploit the copyright, by modifying, reproducing, adapting before
redistributing, or preparing derivatives from the software, the transaction would constitute a
right to copyright and therefore, a royalty. A copyrighted article, on the other hand, would be
where limited rights that are necessary for operating the software are conferred for personal
consumption or within the business. The latter would not constitute a royalty. 53 Thus, it is the
authors‘ suggestion that first, the copyrighted article-right to copyright distinction must not
be lost; and second, while determining the distinction between a copyright and a
copyrightable article, the courts must focus on the benefits and the burden transferred from
the owner of the software to the purchaser or licensee. This model will expose the real nature
of the transfer of the software in question and establish the link with royalty taxation.
The crux of the issue in the Reliance Infocomm case can be boiled down to a tug-of-war
between the source-based approach and the residence-based approach, as royalty involves the
withholding tax by the source country. A conceivable answer here could be to share the right
to tax: the source country could have the priority to tax low-rate royalties and the country of
residence can also obtain some tax revenues. The former will encourage the source countries,
which are usually developing nations like India, to improve their technology market and
effectively regulate their economies. In addition to this, such a system will also aid combating
tax avoidance more effectively. 54
53 Inland Revenue Authority of Singapore, Rights-Based Approach for Characterising Software Payments
and Payments for the Use of or the Right to Use Information and Digitised Goods IRAS,
http://www.iras.gov.sg/irashome/uploadedfiles/e-Tax_Guide/etaxguides_CIT_rights-
based%20approach_2013-02-08.pdf (30 June, 2014, 07.30PM); See also KMPG, Rights-Based Approach
for Characterizing Payments for Software, Information and Digitised Goods (Tax Alert: April 2013),
KPMG,
https://www.kpmg.com/Global/en/IssuesAndInsights/ArticlesPublications/taxnewsflash/Documents/sing
apore-april17-2013.pdf (30 June, 2014, 07.30PM).
54 Bin Yang and Chun Ping Song, A comparative study of the OECD model, UN model and China‘s treaties
with respect to rights to tax income and capital, 9 E-JOURNAL OF TAX & RESEARCH 254 (2011).
The need of the hour is to shed some light into the prevailing uncertainty. The sheer
number of cross-border transactions takes place with Indian parties involving software is
evident from the plethora of cases on the matter. In order to reduce litigation and ensure
certainty, clarifications are needed on the position of Indian law on this matter.
7. CONCLUSION
The Reliance Infocomm case has brought about much anguish to the already wavering
nature of interpretation of software payments. The 2012 Finance Act came as an aftershock to
the already ambiguous and unclear position on taxation of software payments. This legal
position needs to adopt a sense of urgency in clarifying the status quo, even more so in this
ever changing scenario of the software industry. The following decade is touted to be one of
the most exciting periods for the development of technology and there would be new
emerging trends in the way businesses would be conducted. At the forefront of all of this is
the emergence of e-commerce at an accelerating rate, which would provide new challenges
on the front of software payments. Thus, the issues discussed in this paper give an outline as
to the way the Indian judiciary has dealt with the conundrums of software payments and
provides a viable way forward.
INDIAN GAAR: IS UNCERTAINTY CAUSING A SETBACK TO
FOREIGN INVESTMENTS?
Ameya Mithe & Rohan Shrivastava
Abstract
This paper discusses the historical view point of anti-avoidance in light of

Judicial Anti-Avoidance Rule in India and United Kingdom. It deals with
intricacies of treaty override and analyses its permissibility under the
Constitution. The paper focuses on the uncertainty impending around due to the
limited grandfathering of investments and clarifications made thereon. This paper
also addresses the uncertainty in application of SAAR and GAAR and the
possibility of their co-existence. The authors have elucidated the effects of GAAR
on Foreign Investments and have pin pointed the investors‘ concerns. At the end
the paper, the authors analyse the Indian GAAR in comparison with its
contemporary in the UK to show how certainty can be achieved in a statutory
GAAR. The paper aims to bring into light the uncertainty looming around the
current structure of GAAR in India and showing the repercussions of such
uncertainty on Foreign Investments.
1. INTRODUCTION
The Indian taxation system is at such a point of inflection, that it defies the wisdom of
great thinkers by making the word ‗certain‘ an inappropriate adjective to describe tax. The
advent of the much dreaded General Anti-Avoidance Rule (hereinafter ‗GAAR‘) in Chapter
X-A of the Income Tax Act, 1961 (hereinafter ‗the Act‘) has marked a threshold in the
process of tax planning, which brings in a very dense atmosphere of uncertainty among the
investors. This is not because of the introduction of a statutory GAAR itself, but because of
the confusion which the current structure of the GAAR as introduced in the Act has created at
so many levels. The Finance Act, 2013, although being an improvement to its predecessor in
 Students of Law, Symbiosis Law School, Pune; E-mails: ameya.mithe@symlaw.ac.in,

rohan11992@gmail.com. Authors would like to thank Mr. Sriram P. Govind, Associate Nishith Desai
Associates for his invaluable guidance and support. They would also like to thank Advocate Mihir C.
Naniwadekar, Bombay High Court, Mumbai for his valuable suggestions and discussions.
terms of GAAR, has not done enough to clarify the position. It is much feared, and correctly
so, that GAAR as it exists in the Act gives wide powers to the Revenue to question each and
every arrangement, or a step in or a part thereof, of an investor, with a scope that these
powers may be abused to an extent that the ultimate onus of escaping the scrutiny falls on the
investor himself. The drafting of the GAAR provisions give a wide scope of discretion in
favour of the Income Tax Department (hereinafter ‗Department‘) to do so, and a very
negligible opportunity for an assessee to challenge the authority of the Department in this
regard. The clarifications by the Finance Ministry, followed by the recently notified GAAR
Rules1 have failed to adequately answer several questions, and the answers to the questions
they have answered have not been entirely satisfactory. Such an ambiguous situation has
cropped an atmosphere of uncertainty in the midst of investors.
The appetite of a country for tax being insatiable, and the ingenuity displayed by the
modern taxpayers of playing with the letter of the law has led to a change in approach of the
tax authorities and the courts for preventing the erosion of tax base, or rather, for maximising
the coffers of the government. A country which adopts a statutory GAAR appears to have
exercised its choice of prioritizing prevention of erosion of tax base over the principle of
certainty in taxation. Certainty in taxation is viewed as an inseparable principle to govern the
tax policy of an economy. Adam Smith, cited as the ―father of modern economics‖, has
premised four basic canons of taxation, of which ‗Certainty‘ is the second canon of taxation. 2
The uncertainty in taxation encourages the insolence, and the favours of corruption, of an
order of men who are naturally unpopular, even where they are neither insolent nor corrupt. 3
The effect of uncertainty can deter the investors from the economy or can lead to exploitation
of taxpayers. The need of certainty, at very basic level, can be understood with the aid of an
example. Suppose there is a ―standard‖ providing that motorists should ―drive carefully‖.
This can mean anything and can be interpreted to suit one‘s own convenience. On the other
hand, if there is a ―rule‖ stating that motorists should not exceed a speed limit of 60 kmph,
there is no scope for confusion and everyone knows what the rule means. Such certainty is
missing out from the present structure of GAAR.
1 Income Tax (17th Amendment) Rules, 2013, CBDT Notification dated 23-09-2013. The notification
inserted Rules 10U to 10UC in the Income Tax Rules, 1962.
2 ADAM SMITH, AN INQUIRY INTO THE NATURE AND CAUSES OF THE WEALTH OF NATIONS 676,
(Unabridged ed, 1776).
3 Id,. at 677; Certainty is also described as one of the ten principles envisaged by the American Institute of
Certified Public Accountants (AICPA) in one of its report of 2001. Certainty in addition to other
principles makes a structure more fair and workable.
2014 Indian GAAR: Is Uncertainty Causing a Setback to Foreign Investments? 57
The present structure of GAAR needs many more clarifications with respect to various
aspects so that a certain degree of certainty is achieved. The Press release 4 issued by Finance
Minister, on behalf of the government, accepted most of the recommendations of the Expert
committee set up to look into the grievances on GAAR. But even after such acceptance the
uncertainty looms upon. The authors are not of the view of opposing the introduction of
GAAR in India. The authors are trying to propose that the present structure of GAAR needs
much more certainty and it should also keep up the investor‘s legitimate interests.
2. INDIA’S JUDICIAL ANTI-AVOIDANCE RULE
Years of judicial interpretation have resulted in a settled position of distinguishing

between tax evasion and tax avoidance in terms of legal consequences. ―Avoidance of tax is
not tax evasion and it carries no ignominy with it, for it is sound law and, certainly, not bad
morality, for anybody to so arrange his affairs as to reduce the brunt of taxation to a
minimum.‖5 On the other hand tax evasion as an illegal means of preventing tax liability has
been accepted unanimously by the judiciary. 6 Therefore, tax planning as distinguished from
tax evasion, has historically been an accepted right of a tax payer. This right was given
judicial protection in the famous case of IRC v. Duke of Westminster. 7In the words of Lord
Tomlin in this case-
"Every man is entitled if he can to order his affairs so that the tax attaching
under the appropriate Acts is less than it otherwise would be. If he succeeds in
ordering them so as to secure this result, then, however unappreciative the
Commissioners of Inland Revenue or his fellow tax gatherers may be of his
ingenuity, he cannot be compelled to pay an increased tax."
The supposed doctrine that in revenue cases ‗the substance of the matter‘ may be
regarded as discrete from the form or the strict legal position, was given its quietus by the
House of Lords in the Westminster case. 8 This case settled the law that a taxpayer‘s
4 PRESS INFORMATION BUREAU, GOVERNMENT OF INDIA, Major Recommendations of Expert Committee on

GAAR accepted, (14 January, 2013, New Delhi).
5 Per Jagadisan J, Aruna v. State of Madras, 55 ITR 642, 648.
6 Tax and Corporate Social Responsibility, David F. Williams,
http://www.kpmg.co.uk/pubs/Tax_and_CSR_Final.pdf (June 07, 2013, 10:50 AM).
7 [1935] All ER 259.
8 KANGA, PALKHIWALAAND VYAS, THE LAW AND PRACTICE OF INCOME TAX, (9th ed. 2004) (hereinafter
‗KANGA‘).
transaction can be judged only under the letter of the law, and to give regard to the underlying
substance of the transaction seems to involve substituting ―the uncertain and crooked cord of
discretion‖ for ―the golden and straight mete wand of the law‖. In other words, this principle,
often known as the Westminster principle, allows for individuals and corporations to
structure their financial arrangements in such a way as to attract minimum tax liability, so
long as the structure is within the four corners of the law.9
There was a significant change in approach after the Second World War when the
House of Lords began to emphasize on purposive interpretation in tax law. The Ramsay
principle, which was established by the House of Lords in WT Ramsay v. IRC10 is often seen
as ―the New approach‖ to anti-avoidance. 11 This principle is seen in contradistinction to the
Westminster principle as it authorizes the court to ascertain the legal nature of the transaction
in order to determine tax liability in light of the nature and purpose of the statute. This
judgement emerged as an antidote to a preordained series of self-cancelling transactions with
no business purpose other than avoidance of tax, designed to give a single composite result. 12
The House of Lords stood to ignore the individual steps for the purpose of tax, and decided to
ascertain the true legal effect of the series as a whole. 13 This decision was followed
subsequently in Burmah Oil14and Dawson15.
This trilogy of cases was interpreted by the Inland Revenue to give rise to a new
judicial doctrine superseding the Westminster Principle, which empowers the Revenue to
question every single transaction lacking business purpose, and which is entered into with the
motive of minimising a taxpayer‘s burden. 16 This misconception has been finally laid to rest
in the later decisions of Craven v. White17 and Macniven18 where the two seemingly distinct
9 PrateekAndharia, Azadi no more?, LETS TALK ABOUT THE LAW,

http://letstalkaboutthelaw.wordpress.com/2011/09/25/azadi-no-more/#comments , (June 12, 2013, 10:15
AM).
10 WT Ramsay v. IRC, (1981) 54 TC 101 (hereinafter ‗Ramsay‘).
11 MURRAY& PROSSER, TAX AVOIDANCE, 11(2012).
12 THURONYI VICTOR, COMPARATIVE TAX LAW, 176 (2003).
13 Id.
14 IRC v.Burmah Oil Co. Ltd., (1982) STC 30 (hereinafter ‗Burmah Oil‘).
15 Furniss v. Dawson, (1984) STC 153 (hereinafter ‗Dowson‘).
16 Barclays Mercantile Business Finance Limited v. Mawson (Her Majesty‘s Inspector of Taxes), [2004]
UKHL 51.
17 [1988] 3 All ER 495.
18 Macniven v. Westmoreland Investments, [2001] 1 All ER 865.
doctrines of Westminster and Ramsay were reconciled. These decisions emphasized that in
Ramsay, both, Lord Fraser and Lord Wilberforce, were careful to stress that they were not
departing from the Westminster principle. The Ramsay principle, it has been held, does not
make it a judicial function to strike down every step which is taken to mitigate the burden of
tax, and it is still open to a taxpayer to choose the most tax efficient alternative out of the
multiple alternatives available to him. 19 Thus, the Ramsay principle has been reinterpreted as
a parallel rule of statutory construction, and not anew judicial doctrine. 20
Now, the Indian judicial system has been experimenting with anti-avoidance for quite
some time, and has referred to the Westminster principle on numerous occasions. The Indian
equivalent of the Westminster case is Raman & Co.21wherein Shah J. legitimized the use of a
device ―to divert the income before it accrues or arises‖ to a taxpayer, and recognized that
the effectiveness of such device ―depends not on considerations of morality, but on operation
of the Income tax Act.‖
Indian judiciary for the first time, although temporarily, announced its complete
intolerance to tax avoidance in the form of a separate opinion of Chinnappa Reddy, J in
Mcdowells.22 This opinion was only meant to supplement the majority judgment delivered by
Ranganath Misra, J. who had legitimized tax planning not involving ‗colourable devices‘,
‗dubious methods‘ and ‗subterfuges‘ under the guise of tax planning. 23 Chinnappa Reddy, J.,
in his controversial separate opinion, placed a radical position of law stating therein that ―the
ghost of Westminster has been exorcised in England‖ in light of Ramsay24, Burma Oil25, and
Dawson26, and that any transaction aimed at avoiding tax must be disregarded. 27
Mcdowell led to a lot of litigation since the Revenue saw in the case more than that was
justified by treating every instance of tax saving as intended avoidance, susceptible to the
19 Supra note 17.

20 Judith Freedman,Converging Tracks? Recent Developments in Canadian and UK Approaches to Tax
Avoidance, , 53 CANADIAN T AX JOURNAL (2005).
21 CIT v. Raman & Co., 67 ITR 11, 17 (SC).
22 Mcdowell and Co. Ltd. v. Commercial Tax Officer, (1985) 154 ITR 148 (hereinafter ‗Mcdowell‘).
23 Id.
24 Ramsay, supra note 10.
25 Burma Oil, supra note 14.
26 Dawson, supra note 15.
27 McDowell and Co. Ltd. v. Commercial Tax Officer, supra note 22.
Mcdowell‘s rule. 28 Then the Supreme Court later emerged as the tax planner‘s messiah in
Azadi29and diluted the evil initiated by Mcdowell. It carefully examined Ramsay, and relying
on Craven v. White 30and Macniven 31 , negatived the erroneous decision of Justice Reddy,
upheld the Westminster principle as being ―alive and kicking‖ in the country of its birth, and
hence the law of the land in India too.
In the recently decided Vodafone case32 the apex court has held that there is no conflict
between Azadiand and Mcdowell, since Azadi upholds the majority decision in Mcdowell and
only departs from it to the extent of the separate opinion of Reddy, J. 33 However, K.S.
Radhakrishnan, J., while reiterating the right of a taxpayer to arrange his affairs in the most
tax efficient manner, has also stated that it is equally important for a transaction to have a
business or commercial substance. Moreover, he also emphasized on the necessity of an
―effective legislative measure‖ with respect to tax-avoidance ―what is inequitable and
undesirable‖34.Thus, to say that the Courts have been tolerant to tax avoidance, and that the
very introduction of a legislative GAAR topples the existing position of taxation law in India
is counterfactual.
Since the landmark judgement in Vodafone, there have been some landmark decisions
which have upheld the stance of the Judiciary on anti-avoidance, which has not been
undermined by the government‘s recent efforts to stretch the arms of taxation even beyond its
own jurisdiction in the name of tax avoidance. The Andhra Pradesh High Court upheld the
28 IYENGAR SAMPATH, LAW OF INCOME TAX, 232, (11th ed. 2011).

29 Union of India v. Azadi Bachao Andolan, [2003] 263 ITR 706 (hereinafter ‘Azadi‘).
30 Craven v. White, supra note 17.
31 Macniven v. Westmoreland Investments, supra note 18.
32 Vodafone International Holdings BV v. Union of India,(2012) 341 ITR 1 (hereinafter ‗Vodafone‘).
33 In the Majority Judgement in Mcdowell, RanganathMisra, J., held in para 45 that ―tax planning may be
legitimate provided it is within the framework of the Law.‖ In the latter part of that para, he stated that
―colourable devices cannot form a part of tax planning‖ and that it is the duty of every taxpayer to pay
taxes without any subterfuges. This para is to be read with ¶ 46 where he states that "on this aspect one of
us, Chinnappa Reddy, J. has proposed a separate opinion with which we agree". This is the statement in
the majority opinion which had created the confusion that the majority agreed with the Justice Reddy‘s
separate opinion in its entirety. However the phrase ―this aspect‖ expresses the majority‘s agreement
with the separate opinion only with respect to tax avoidance with the use of colourable devices and
subterfuges. The Separate opinion makes repeated references to this aspect. Although, he makes a
number of observations with regard to the need to depart from the Westminster principle, these must be
read as only in the context of artificial tax avoidance. Such a reading of the Mcdowellcase removes any
perceived conflict between the Mcdowell and Azadi. See, per S.H. Kapadia, C.J., Vodafone, Id., ¶ 64.
34 Macniven v. Westmoreland Investments, supra note 18 at ¶55.
arrangement in Sanofi 35 as being tax legitimate and rejected the application of the
retrospectively amended section 9 of the Act on the basis that the same cannot override a tax
treaty.
India‘s judicial anti-avoidance rule is restricted to sham transactions or colourable

devices.36 Thus, in general, the principle of form over substance has prevailed in India, with
the courts occasionally examining the substance of a transaction to determine its true legal
effect. GAAR, however, is a codification of the substance over form doctrine, empowering
the department to ascertain not only the legal substance, but also commercial or economic
substance, consequently superseding the Supreme Court decisions in Azadi and Vodafone.
3. TREATY OVERRIDE
With the introduction of Chapter X-A in the Act, GAAR was given an apparent
overriding effect over the DTAAs of India with various other countries. This effect is sought
to be achieved by the insertion of sub-section 2A in Section 90 of the Act, which makes
GAAR applicable whether its provisions are beneficial to the assessee or not. The
qualification of the provision with a non-obstante clause clearly eliminates the interference of
sub-section (2) of S.90 with the applicability of the provisions of GAAR. 37 This makes
GAAR paramount Law in terms of international transactions, notwithstanding the existence
of an international treaty governing that transaction.
3.1 INTERNATIONAL LAW ON TREATY OVERRIDE
35 Sanofi Pasteur Holding v. The Department of Revenue, [2013] 213 Taxman 504 (Andhra Pradesh); In
this case, Institut Merieux (IM) and Groupe Industriel Marcel Dassault (GIMD), both French companies,
held 80 per cent and 20 per cent shares, respectively, in ShanH SAS (ShanH), another French company.
ShanH, in turn, held shares in Indian company Shantha Biotechnics Ltd. (SBL). In August 2009, IM and
GIMD sold its shareholding in ShanH to another French company, Sanofi Aventis. The transaction was
carried out in France. The bone of contention was similar to that in the Vodafone case, where the
Revenue Authorities contended that the transaction was a tax avoidance transaction, and that in reality
the controlling interest in SBL was sold, and therefore it should be taxed in India. Moreover, the
authorities also contended that the transaction was hit by the retrospective amendment to S. 9 of the
Income tax Act, which overruled the Supreme Court judgment in the Vodafone Case.
36 Killick Nixon v. DCIT, ITA No. 5518 of 2012. The Hon‘ble Bombay High Court relied on the Vodafone
case and observed that ―where a transaction is sham and not genuine as in the present case then it cannot
be considered to be a part of tax planning or legitimate avoidance of tax liability.‖
37 S.90A of the Income Tax Act, 1961 incorporates the DTAAs into the domestic law, and subsection (2)
thereof provides for the application of the Act over the DTAAs to the extent to which it is more
beneficial to the assessee concerned.
Article 26 of the Vienna Convention on the Law of Treaties codifies the accepted
International law principle of pacta sunt servanda and states that ―treaties are binding on the
parties to it and must be performed by them in good faith.‖Article 27 of the Convention acts
as a corollary to this principle by prohibiting parties to a treaty from ―invoking the provisions
of its internal law as a justification for its failure to perform a treaty‖. Thus the Convention
places reciprocal obligations on the parties to a treaty, and all such parties are under the same
obligation to perform a treaty in good faith. 38 Although India is not a party to the Convention,
the abovementioned principles are binding on India as part of customary international Law. 39
The Convention is a law-making treaty40 on all the international treaties entered into by
its parties. 41 However, the principle of pacta sunt servanda is subject to certain limitations,
and an international treaty is often not considered unconditionally sacrosanct. The OECD
commentary recognizes two conflicting approaches followed by different states as regards
cases which result in abuse of treaty provisions. As per the first approach, certain States
consider the right of taxation as emanating solely from the domestic law, which is narrowed
by the application of DTAAs. Therefore, an abuse of the provisions of a treaty is in effect
considered an abuse of the provisions of domestic law. Thus, to the extent that domestic anti
abuse rules are a part of the domestic tax law for determining which facts result in a tax
liability, they are not addressed by the tax treaties and are therefore not affected by them. 42
The other States consider some abuses as being abuses of the provisions of the treaty
themselves rather than abuse of domestic law, and view to combat them by a more rational
construction of the treaty itself, especially in terms of those transactions which aim to claim
38 Edwards-Ker, Michael, Tax Treaty Interpretation, Ph.D thesis, QUEEN MARY AND WESTFIELD COLLEGE,
UNIVERSITY OF LONDON (1994).
39 Vellore Citizens Welfare Forum v. Union of India, (1996) 5 SCC 647.
40 A law-making treaty is one which establishes general patterns of behaviour for the parties over a certain
period of time in certain areas. See, M. FITZMAURICE & A. QUAST, LAW OF TREATIES, Study Guide,
(UNIVERSITY OF LONDON, 2007), http://www.londoninternational.ac.uk/sites/default/files/law_treaties.pdf
(June 03, 2014, 06.00PM).
41 Interpretation of Human Rights Treaties, ICELANDIC HUMAN RIGHTS CENTRE
http://www.humanrights.is/en/human-rights-education-project/human-rights-concepts-ideas-and-
fora/part-i-the-concept-of-human-rights/interpretation-of-human-rights-treaties, ( 09 June, 2014, 6:42
P.M.); See also, European Court of Human Rights in Wemhoff v. Federal Republic of Germany, 2122/64
[1964] ECHR 4, the court has noted that because the Convention is a ‗law-making treaty, it is [...]
necessary to seek the interpretation that is most appropriate in order to realise the aim and achieve the
object of the treaty‘.
42 OECD (2012), ―Commentary on Article 1 concerning the persons covered by the convention‖ ¶ 9.2, in
Model Tax Convention on Income and on Capital 2010: Electronic version(eMTC): ON USB Flash
Memory Key, OECD Publishing.
benefits which a treaty does not intend to confer. This approach attempts to uphold the
principle of good faith in respect of interpretation of treaties, as enshrined in Article 26 of the
Vienna Convention. 43 Both these approaches nonetheless recognize the rights of States to
prevent the conferment of benefits under a treaty when arrangements constituting an abuse of
treaties have been entered into.44
3.2 LEGAL POSITION IN INDIA
The issue can be narrowed down to the legal position in India regarding interface
between an international treaty and a subsequent legislative enactment. 45 Although this issue
has not been directly dealt by the Constitution, a harmonious reading of some of the
constitutional provisions can be a helpful guide in determining the same. The Indian
Constitution directs the State to endeavour to foster respect for international law and treaty
obligations. 46 From a combined reading of Article 246 of the Constitution along with the
relevant entries in List I of the 7th Schedule, particularly entries 13 and 14, it can be
concluded that treaty making power is primarily a parliamentary function. In addition, the
Parliament is also authorized to ―make any law for the whole or any part of India for
implementing any treaty with any country or countries or any decision made in any
international conference, association, or other bodies‖47.This power is not fettered by the
legislative competence of the states under Lists II and III of the 7 th Schedule, and has an
overriding effect over the same.
The Executive power under the Constitution extends to matters in respect of which the
Parliament is empowered to make laws, in the absence of a parliamentary legislation and
subject to constitutional limitations. 48 Thus, it is only in the absence of such Parliamentary
legislation regarding procedure for entering into treaties that it is left upon the Executive to
43 Id., ¶ 9.3.
44 Id., ¶ 9.4.
45 Amit M. Sachdeva, Can the Proposed Tax Code Override Indian Tax Treaties?, TAX NOTES
INTERNATIONAL, shttp://www.vaishlaw.com/article/Indian%20DTC%20and%20Tax%20Treaties-
Amit%20Sachdeva.pdf (June 14, 2013, 06:40 P.M.).
46 The Constitution of India, 1950, Article 51.
47 Id., Article 253.
48 Id., Article 73.
do the same. 49 The bottom line however remains that so far as implementation of
international treaties is concerned, the constitutional mandate is clear that it is only the
Parliament which has exclusive power to make laws for implementation of treaties and
international agreements.50
As stated above, that unlike other jurisdictions, the treaty making power under the
Indian Constitution is not conferred on the executive, but is placed squarely within the
domain of the Parliament.51 Articles 246(1) 52 and 253 are merely enabling provisions, and do
not place an obligation on the Parliament to implement treaties through enactment. 53 The
Parliament being so empowered is equally competent to choose not to legislate in order to
give effect to such treaty. The scheme of international taxation in India is such that all the
DTAAs are entered into by India under S.90 of the Act. Thus they are essentially delegated
legislation. 54 They are considered to be mini legislations containing in them all the relevant
aspects or features which are at variance with the general taxation laws of the respective
countries. 55 They hold an important position in the scheme of Indian income-tax legislation,
inasmuch as they lay down an alternate scheme of taxation. 56 In ABN Amro Bank N V v.
JCIT57, the Tribunal observed that in case of any conflict between a tax treaty and a domestic
law, the former must yield to the law passed independently by the parliament. This decision
is based on the principle laid down by the Supreme Court in the case of Gramophone
49 NATIONAL COMMISSION TO REVIEW THE WORKING OF THE CONSTITUTION, Treaty Making Power under
Our Constitution, (January 8, 2001), http://lawmin.nic.in/ncrwc/finalreport/v2b2-3.htm. (June 25, 2014,
05.00 PM)
50 2, BIMAL N. PATEL, INDIA AND INTERNATIONAL LAW 17 (2008).
51 ―If the national executive, the government of the day, decide to incur the obligations of a treaty which
involve alteration of law, they have to run the risk of obtaining the assent of Parliament to the necessary
statute or statutes.‖ See, Per Lord Atkin, Attorney General for Canada v. Attorney General of Ontario,
(1937) A.C. 326, 347. Also see, Gujarat v. VoraFiddali, AIR 1964 SC 1043, where the Supreme Court
held that in India Treaties occupy the same status, and adopt the same treaty practice as in United
Kingdom; Shiva Kant Jha, Treaty Making Power: The Context, SHIVAKANTJHA.ORG,
http://www.shivakantjha.org/openfile.php?filename=articles/3_treaty-making.htm#_ftn4, (July 06, 2013,
3:33 P.M.).
52 Read with entries 13 and 14 of List I, The Constitution of India, 1950, supra note 46.
53 Id., Article 253 reads ―Parliament has power to make any law...for implementing any treaty‖, and does
not read as ―Parliament shall make a law...‖
54 Azadi, supra note 29.
55 DCIT v. Boston Consulting Group Pvt. Ltd.,(2005) 93 TTJ 293 (Mum).
56 Kotak Mahindra Primus Ltd. v. DDIT, (2006) 105 TTJ 293 (Mum); Western Union Financial Services
Inc.v. ADIT, (2006) 101 TTJ 56 (Del).
57 (2005) 96 TTJ 1041(Kol).
Company58that in the event of a conflict between a municipal law and an international law,
―the sovereignty and integrity of the Republic and the supremacy of the constituted
Legislature in making the laws may not be subjected to external rules….‖ However, there are
few decisions in India which deal with the issue of tax treaty override in light of S. 90 of the
Act. The Apex Court in Azadi59ventured into this sphere to some extent but the conclusion of
the Court is of little significance in the context of GAAR because the court declared the
overriding effect of a treaty over the provisions of the Act where a notification regarding
implementation of a treaty is issued pursuant to S. 90 of the Act. This is hardly the issue in
question today. Moreover, the Court has quoted the findings of a Report 60 with respect to
anti-abuse provisions to be incorporated either in the treaty or in the domestic legislation, but
has refused to opine on the same. However, the Court in Vodafone61 has recognized that lack
of clarity and appropriate provisions in the statute or treaty regarding circumstances when
62
Judicial Anti-Avoidance Rule would apply has generated litigation in India, thus
recognizing the importance of a statutory law on the same.
Since all the DTAAs are in the form of delegated legislation under S. 90 of the Act,
under the scheme of Indian taxation law and Constitutional Law, there seems to be no
restriction on the power of the Parliament to legislate in a manner so as to override a treaty,
just as the Parliament can amend or overturn an earlier enacted law. 63
4. GRANDFATHERING OF INVESTMENTS
The Finance Bill, 2012 brought in an environment of uncertainty and fear among
investors who were cynical about the lack of protection to existing structures and
arrangements. This resulted in a major withdrawal of investments from the economy and loss
of confidence in the Government as such a major change in tax law was undertaken without
58 Gramophone company of India Ltd. v. Birendra Bahadur Pandey, AIR 1984 SC 667.
60 Report of Working Group on Non Resident Taxation , Chairman Shri Vijay Mathur, MINISTRY OF
FINANCE AND COMPANY AFFAIRS, GOVT. OF INDIA (January 2003),
http://finmin.nic.in/reports/NonResTax.pdf. (June 25, 05.00PM).
61 Vodafone, supra note 32.
62 Id., per Kapadia, C.J., ¶ 68.
63 Sohrab E. Dastur, Senior Advocate, Principles of Interpretation of issues in Double Taxation Avoidance
Treaties,TAXATION,http://itaxation.wordpress.com/2008/08/31/principles-of-interpretation-of-issues-in-
double-taxation-avoidance-treaties/, (June 02, 2013, 4:10 P.M.).
any consultation from investors.64 Moreover, the legitimate expectations of the investors were
denied as they had set up their structures and planned investments under the umbrella of
Azadi 65 as the law of the land. The newly introduced GAAR, over and above giving
unconditional power to the department, also seemed to target these investors who believed
the department to be capable of sending Show Cause Notices under the law even for existing
structures in the absence of any grandfathering clause. 66
The Parliamentary Standing Committee on Finance, with respect to the Direct Taxes
Code Bill, 2010 (hereinafter ‗DTC Bill‘), had recommended the grandfathering of all existing
67
structures against application of GAAR provisions contained therein. The Shome
Committee report 68 which was prepared to give recommendations to the Finance Ministry
after consulting various investors corrected the same as this ―would allow an impermissible
arrangement to exist in perpetuity if created before commencement of GAAR and
grandfathered under GAAR provisions.‖ 69 In addition, it gave an example similar to the
instant case where if the recommendations of the Standing Committee70 are to be followed,
then a conduit company incorporated in a favourable jurisdiction in 2008 will enjoy tax
exemption indefinitely for all the future investments made by it. 71 Thus, it was recommended
72
that ―investments (though not arrangements)‖ should be grandfathered. This
recommendation sought to extend the grandfathering provision to the date of applicability of
GAAR.
64 Since the announcement of Budget 2012 on March 16 (2012), net FII inflows have slowed dramatically,
showing an effective daily average drop of 95% since March 16. See, Nicolas De Boursac, FIIs will quit
Indian markets if swords of GAAR, indirect transfer rules hang over their heads, THE ECONOMIC TIMES,
(May 6, 2012), http://articles.economictimes.indiatimes.com/2012-05-06/news/31588238_1_net-fii-
inflows-gaar-global-funds, (July 10, 2013, 06:53 P.M.).
66 A grandfathering clause is a provision which states that the old law will continue to apply in some
existing situations, whereas the new law will apply to all future cases.
67 49TH REPORT OF STANDING COMMITTEE ON FINANCE (2011-12), MINISTRY OF FINANCE (DEPARTMENT OF
REVENUE), The Direct taxes Code Bill, 2010 (hereinafter ‗STANDING COMMITTEE‘).
68 EXPERT COMMITTEE 2012, Report on General Anti-Avoidance Rules (GAAR) in Income Tax act, 1961,
September, 2012 (hereinafter ‗SHOME‘).
69 Id., at 40.
70 STANDING COMMITTEE, supra note 68.
71 SHOME ,supra note 68, at 40.
72 Id., at 41.
The press release73 issued by the Finance Ministry later in the financial year accepted
the major recommendations, but only partially accepted the recommendation with respect to
grandfathering of investments. Although investments were grandfathered, the exemption was
provided only to those undertaken before the date of August 30, 2010, which was the date on
which the DTC Bill was tabled in the Lok Sabha. Thus, though the relief of deferment of
GAAR to April 1, 2016 was provided to the investors, investments made after August 2010
and before April 2016 were left totally unprotected. The press release has been crystallized in
the form of the recently notified GAAR Rules.74
The authors are of the view that the restriction of relief of grandfathering only to
investments made before a date in the past (August 30, 2010) selected on arbitrary
considerations (hereinafter ‗limited grandfathering‘) smacks of an intention of the
Government to keep the ambit of GAAR as wide as possible.
There are two major reservations which the authors have regarding the reasonability of
the limited grandfathering as introduced through the GAAR Rules.
a) Whether the limited grandfathering in the GAAR Rules can be challenged as

unconstitutional?
There is no doubt about the fact that GAAR shall be applied prospectively as regards
income and is not intended to target income received or accrued before its date of
enforcement. 75 However, the limited grandfathering of investments only till August 2010
may trigger challenge on grounds of retrospectivity.
A retrospective law has been defined by the Supreme Court, using the definition given
in ‗Words and Phrases, Permanent Edition, Volume 37A‘ as ―one which takes away or
impairs vested or accrued rights acquired under existing laws, or creates a new obligation,
imposes a new duty, or attaches a new disability, in respect of transactions or considerations
already past.‖76 The investors, who have undertaken investments, have done so in light of the
73 Supra note 4.
74 Supra note 1.
75 Speech of Finance Minister whilst moving amendments to Finance Bill, 2012, May 7, 2012; Draft
guidelines regarding implementation of General Anti Avoidance Rules (GAAR) in terms of §101 of the
Income Tax Act, 1961; SHOME, supra note 69; Explanatory memorandum to Finance Bill, 2013.
76 Virender Singh Hooda and Ors.v. State of Haryana and Anr., AIR 2005 SC 137.
conclusive position of law as declared by the Supreme Court in Azadi 77 as regards the
precedence of form over substance. This position has been followed in effect in subsequent
cases including the recent decision of Dynamic India Fund I.78This decision has also been
approved by the Supreme Court in the recent landmark judgement of Vodafone BV79.With the
law so clearly in place, they have acquired a vested right under it, and imposing GAAR on
these investments ―imposes a new duty, or attaches a new disability, in respect to
transactions or considerations already past.‖ 80 Therefore, it may be argued that such an
application of GAAR makes it a retrospective law under the aforementioned definition.
It is a cardinal principle of construction that every statute is considered to be prima

facie prospective, unless it is made to have retrospective application either expressly or by
necessary implication. 81 As explained above, GAAR has been given a retrospective effect
through the Income Tax Rules. However, it is a well settled principle of Administrative Law
that a retrospective law can even be introduced through a delegated legislation, if the parent
statute so authorizes. 82 An administrative body has power to give retrospective effect to a rule
only to the extent to which the parent statute so permits it. The Supreme Court in Yadav83 has
held in addition to the above, that the rule making authority must show that there was
sufficient, reasonable and rational justification to apply the rules retrospectively.
The Income-Tax Rules are made by the Central Board of Direct Taxes (―CBDT‖) under
Section 295 of the Act. Sub-section (4) of this section expressly authorizes the CBDT to give
retrospective effect to the rules. However, retrospective effect cannot be so given if it
prejudicially affects the interests of the assesse, unless the contrary is permitted by the section
of the statute for the purpose of which the rule is made. 84Whether the limited grandfathering
provision prejudicially affects the interests of the assessee or not is again a moot point. If the
rule is challenged on the ground of retrospectivity in light of the limited grandfathering

78 In re, Dynamic India Fund I, AAR No.1016 of 2010.
80 Supra note 76.
81 Zile Singh v. State of Haryana, (2004) 8 SCC 1; Keshvan v. State of Bombay, AIR 1951 SC 124; Gem
Granites v. Commr.of Income Tax,(2005) 1 SCC 171.
82 The State of Madhya Pradesh v. Tikamadas, A.I.R. 1975 S.C. 1429; Also see, Income Tax Officer,
Alleppey v. M.C. Ponnoose, A.I.R. 1970 S.C. 385).
83 B.S. Yadav andors. v. State of Haryana, AIR 1981 SC 561.
84 Union of India v. Dr. S. Krishna Murthy, (1989) 4 SCC 689.
provision, then the court may look it from two angles. It may be argued that the GAAR as
originally introduced does not impliedly grandfather past investments, and therefore a
grandfathering provision, even if limited, provides a relief to the assessees, and is in fact not
prejudicial to their interests. On the other hand it may even be argued that the GAAR has an
implied grandfathering, and a limited grandfathering provision introduced through the rules
limits the relief to the investors, and attempts to apply GAAR to past investments. To this
extent the rule may be struck down for being prejudicial to the interests of the assessees since
chapter X-A does not permit (either expressly or impliedly) making of a retrospective rule for
its purpose. Moreover, even if so authorized, the board has to give a reasonable and rational
justification to such retrospective application of GAAR provisions in light of the Yadav
ruling.
Assuming that the board has an implied authority to apply GAAR retrospectively (in
terms of investments and not income), then the constitutional validity of the limited
grandfathering needs to be determined. It has been upheld on several occasions that a
retrospective law legitimately passed cannot be challenged except on the grounds of violation
of fundamental rights.85 The authors are of the opinion that if GAAR is applied to all past
investments after the date of August 30, 2010, even if through an express law validly passed,
it is open to challenge on the ground of violation of Article 14 and 19 (1) (g) of the
Constitution.
Article 14 permits the Legislature (including the delegate) to make reasonable

classification of persons, objects and transactions for the purpose of achieving specific ends. 86
However, such a classification must be founded on an intelligible differentia and this
differentia must have a rational relation to the object sought to be achieved by the statute. 87
Also, it is a well- established Constitutional law principle, recognized by the Supreme Court,
85 State of Gujarat and Anr. v. Raman Lal Keshav Lal Soni, AIR 1984 SC 161; This follows from the
general constitutional mandate that no law, whether prospective or retrospective, can be made which
contravenes fundamental rights; The Constitution of India, Article 13, supra note 47.
86 Western U.P. Electric Power and supply Co. Ltd. v. State of Uttar Pradesh, AIR 1970 SC 21; R.K. Garg
v. Union of India, AIR 1981 SC 2138.
87 State of West Bengal v. Anwar Ali Sarkar, AIR 1952 SC 75; Budhan v. State of Bihar, AIR 1955 SC
191; Harakchand v. Union of India, (1969) 2 SCC 166: AIR 1970 SC 1453; State of Bombay v. F.N.
Balsara, AIR 1951 SC 318.
that Article 14 is violated not only when equals are treated unlike, but also when unequals are
treated alike, i.e., if there is similar treatment of groups situated in dissimilar circumstances. 88
The limited grandfathering provision satisfies both sides of the aforementioned

inequalities. Firstly, it treats the similarly placed investments before and after the date of
August 30, 2010 differently by imposing retrospective burden on the latter while exempting
the former. The basis of classification is that since the DTC Bill was tabled on August 30,
2010, investors undertaking investments after this date are aware of the possibility of GAAR
provisions contained therein to have effect in the near future. However, the tabling of a bill is
just the first step in the process of enactment. The fact that the DTC Bill has not yet been
enacted further goes against the government‘s reasoning. Therefore the classification of
investments on the basis of their timing with respect to such arbitrary date does not qualify as
―intelligible differentia‖ having a ―rational nexus with the object sought to be achieved‖.
Secondly, the limited grandfathering provision also affords similar treatment to investments
made before and after the date of applicability of GAAR, consequently treating unequals
equally. Thus, it is argued that the provision violates every facet of equality guaranteed under
Article 14.
Article 19(1)(g), in granting the right to practice any profession, or to carry on any
occupation, trade or business, carries with it a further safeguard against imposition of an
unreasonable tax burden. 89 In determining whether the retrospectivity of a law is so arbitrary
and burdensome as to violate Article 19(1)(g)90, the criteria declared by the Supreme Court
include the period of retrospectivity and the degree of any unforeseen financial burden
imposed for the past period.91 The investors having acquired a vested right to invest, in light
88 ChiranjitLal v. Union of India, AIR 1951 SC 41; Om Narain v. Nagar PalikaShahjahanpur, (1993) 2
SCC 242.
89 PrateekAndharia, The Validity of Retrospective Amendments to the Income Tax Act: Section 9 of the Act
and the Ishikwajma Harima Case, 4 NUJS L.REV. 269 (2011).
90 The Constitution of India, supra note 47; the freedoms under Article 19 are available only to ―citizens‖.
Since many of the investors affected by GAAR will be corporations, their locus standi for a challenge
under Article 19 is questionable, i.e., even if the corporation is Indian in every sense, e.g., it is registered
in India, has Indian capital and all of its shareholders and directors are Indian, it can claim no right under
Art. 19. See, State Trading Corporation of India v. The Commercial Tax Officer, AIR 1963 SC 1811;
Tata Engineering v. State of Bihar, AIR 1965 SC 40. However, in the course of time, the rigours of the
above pronouncements have been diluted by resorting to the strategy of joining a natural person along
with a company in the writ petition challenging violation of Art. 19(1)(g). See, JAIN M.P., INDIAN
CONSTITUTIONAL LAW, 801 (5th ed. 2008); Sakal Papers v. Union of India, AIR 1962 SC 305; R.C.
Cooper v. Union of India, AIR 1970 SC 564; Bennett Coleman & Co. v. Union of India, AIR 1973 SC
106.
91 Ujagar Prints v. Union of India, (1989) 3 SCC 488.
of various judgements of the Supreme Court as discussed above, the retrospective burden of
scrutiny for the purposes of GAAR under Section 144BA of the Act will be imposed on
them. This burden is completely unforeseen as the DTC Bill tabled in the Lok Sabha on
August 30, 2010 is far from a conclusive Law capable of directing the investors on their
proposed investments. An unforeseen retrospective burden of taxation denies the taxpayer the
rightful opportunity of carrying out cost-benefit analysis of the proposed transaction and to
decide whether or not to enter into such a transaction.92
b) The protection of grandfathering should have been afforded not only to the
transfer of existing investments, but also to returns accruing or arising from
these investments.
The Shome Committee report has recommended the grandfathering of investments to

cover exit of such investments even after the date of commencement of GAAR (the date of
grandfathering being the same as the date of commencement of GAAR). 93 This is because
most of the foreign investment in India being made from Mauritius and Singapore, the same
is made on the condition of availing of treaty benefits, which include non-taxation of capital
gains in India on exit or sale of such investments. 94This scope of grandfathering has been
accepted and followed in the GAAR Rules which limits the protection of grandfathering only
to the transfer of investments. Thus, the tax benefit on sale of grandfathered investments even
after the date of commencement of GAAR would not attract the provisions of GAAR.
In the opinion of the authors, the grandfathering provision must be broad enough even
to cover returns from investments such as dividends, interests etc. Thus, in light of the limited
grandfathering provision, if an investment made before August 30, 2010 is grandfathered,
and if such investment otherwise qualifies as an impermissible avoidance arrangement, then
the consequences of GAAR should not apply to the returns accruing or arising from such
investments even after this date.
92 Pradip R. Shah, Retrospective Amendments – High-time for Introspection by India, CA CLUB INDIA,
(April 1, 2010) , http://www.caclubindia.com/articles/retrospective-amendments-hightimefor-
introspection-by-india-5144.asp (May 07, 2014, 4:35 PM).
93 SHOME, supra note 68, at 41.
94 Id., at 40.
5. GAAR AND ITS COUNTER PRODUCTIVITY TO FOREIGN

INVESTMENTS
5.1 TAX AS A VARIABLE OF FOREIGN INVESTMENT
―India needs investment for employment generation and advancement of its economy
and everyone needs to keep that in mind‖. 95 The ex-chief justice of India implanted the
96
comment, aftermath of Vodafone judgement, with the intention of reminding the
government‘s rough neck policies of tax collection which were driving away the foreign
investments from the country. The ex-chief justice, from his own personal experience,
reiterated the importance of a sensible tax strategy to attract foreign investors. Globalisation
is a fact which cannot go unnoticed. Globalisation and taxation are two faces of the same
coin. Modern International taxation practice also views taxation as a means for directing and
regulating the flow of investments.97 In this era, scope of taxation is a factor which makes or
breaks the foreign investment in any country. ―A country which is as yet developing, both in
its global economic confidence and in its taxation regime, needs the encouragement and
support of its contemporaries‖.98 Justice Swatanter Kumar, a party to the Vodafone judgment,
reinstituted the need of framing the law and policies in consonance with the current economic
scenario of the country. Another significant concern pointed out by the Hon‘ble judge was
the administration of tax laws in a complex and unfriendly manner. He prioritized the need
from simplification of tax laws to simplified and friendly administration of tax laws.
The policy makers introducing or revising its FDI Policy may rely on one or more
economic models or frameworks to examine the possible channel of influence. The Policy
Framework for investment99 primarily focuses on developing and transition economies. Tax,
one of the issues influencing FDI, has to be studied keeping in mind various factors which
may affect FDI in such countries. In setting the tax burden on inbound investment, policy
95 Spare Vodafone – Save Thousands of Job: Ex Chief Justice Kapadia, (May 17, 2013),
http://www.itatonline.org/articles_new/index.php/spare-vodafone-save-thousands-of-jobs-ex-chief-
justice-kapadia/, (July 27, 2014, 01:13 PM).
97 Justice Swatanter Kumar, Complex Tax Laws & Hostile Tax Dept Are Responsible For Tax Avoidance,
(January 26, 2013), http://www.itatonline.org/articles_new/index.php/complex-tax-laws-hostile-tax-
dept-are-responsible-for-tax-avoidance/, (July 27, 2014, 1:07 PM).
98 Id.
99 OECD (2007), Tax Effects on Foreign Direct Investments- No.17, http://www.oecd.org/tax/tax-
policy/39866155.pdf, (July 05, 2014, 4:15 PM).
makers are encouraged to assess whether their host country offers attractive risk/return
opportunities, taking into account framework conditions, (e.g. political/monetary/fiscal
stability; legal protection; public governance) market characteristics and the prevalence of
location-specific profits. 100
The authors are of the view that the impediment created by the tax
authorities/governments by imposing taxes with discretionary powers and uncertainty, deter
the foreign investors to make the location specific decision in favour of the host countries. 101
Therefore, this issue can be mooted on two facets i.e. first on the scheme of discretionary
power and second on the scheme of legal uncertainty102.
On the point of discretionary power, it can be contended that the present structure of
statutory GAAR, introduced by the government, overlay a gigantic scope of exercising
discretion at the lowest level by the Assessing Officer. Difficulty to administer discretionary
regime results in delays and uncertainty for investors. This can even increase the overall cost
of making an investment in some countries. 103 If the overall cost of the investment will
increase, then why would an investor look forward to such investment?
On the question of legal uncertainty, ―legal certainty‖ would imply dynamic and
efficient substantive laws clearly stating the rights, obligations, and liabilities of all business
parties, rule-based business transactions, and procedural law providing prompt and
inexpensive means to the courts, an institutional framework that supports business
development and sustainability, strict adherence to the principles of ‗rule of law‘ and
‗supremacy of the law‘, and an efficient and independent judiciary. Legal uncertainty on the
other hands always occurs when individual actors are uncertain of the effects of the
100 Id.
101 "The sudden and unprecedented move in the [Budgetary] bill has undermined confidence in the policies
of the government of India toward foreign investment and taxation and has called into question the very
rule of law". See, Rahul Bedi, George Osborne says Indian tax plans could harm investment, THE
TELEGRAPH, (April 2, 2012),
http://www.telegraph.co.uk/finance/newsbysector/industry/9179558/George-Osborne-says-Indian-tax-
plans-could-harm-investment.html. (July 07, 2014, 7:30 PM).
102 The tax uncertainty now anticipated creates significant risk that these global funds will choose to avoid
the Indian capital markets altogether and redirect their resources to other opportunities. See, Nicholas de
Boursac, FIIs will quit Indian markets if swords of GAAR, indirect transfer rules hang over their heads,
THE ECONOMIC TIMES, (May 6, 2012), http://articles.economictimes.indiatimes.com/2012-05-
06/news/31588238_1_net-fii-inflows-gaar-global-funds. (July 07, 2014, 7:50 PM).
103 Jacques Morisset, Neda Pirnia, How Tax Policy and Incentives affect the Foreign Direct Investment: A
Review, THE WORLD BANK E-LIBRARY, Policy Research Working Papers, 22, (1999).
provisions of the dominant legal system on the results of their actions. 104 The objective legal
uncertainty, which does not form a reliable and sure basis for decisions, always affects the
investment decisions. This uncertainty can be best explained with an example mentioned in
the first section of this paper wherein the uncertainty is created by the standard laid down for
driving speed. If there is a legal uncertainty in the minds of the investors for decision making,
then how would a foreign investor make such an investment? The foreign investors will be
more deterred, as the cost of international legal disputes is much greater than domestic
disputes.105
Therefore the discretionary power entrusted in Chapter X-A in favour of tax authorities
and uncertainty looming in the minds of foreign investors, will result in loss of foreign
investor‘s confidence in the economy and tax structure.106 This loss may defeat the purpose
of revising the FDI Policy. Moreover, cases like Vodafone give a reason to foreign investors
to ponder over their investment decisions. 107
The controversy over introduction of GAAR has haunted not only the foreign investors
but also raised concerns in the minds of countries from where the investments are brought in
India. Mauritius, top investing country through FDI with 38% 108, is also concerned over the
effects of Indian GAAR on their role as a preferred investment route to India. 109 Not only
Mauritius, this concern is raised from every corner of the world to maintain the balance
between the reform measures in the form of FDI and introduction of GAAR. 110 The
104 Martin Zaglar& Cristiana Zanzottera, Corporate Income Taxation Uncertainty and Foreign Direct
Investment, SSRN, 3, (2012).
105 Hanno von Freyhold, Volkmar Gessner, Enzo L. Vial & Helmut Wagner, Cost of Judicial Barriers for
Consumers in the single Market, A report for the European Commission, Brussels, 117, (Oct.-
Nov.,1995).
106 Supra note 101.
107 Investors into India rely on good governance, a predictable regulatory regime and a hassle-free, rules-
based business environment because they are making major long-term commitments, large sums of
money, long gestation and long operation periods, needing as much predictability and consistency as
possible. See, Singapore PM Lee HsienLoong says business environment in India 'complicated', THE
INDIAN EXPRESS, July 11, 2012.
108 Fact Sheet on Foreign Direct Investment, From April, 2000 to April, 2013, (April, 2013)
http://dipp.nic.in/English/Publications/FDI_Statistics/2013/india_FDI_April2013.pdf (June 20, 2014,
06.00PM).
109 Mauritius is looking to balance India‘s concerns over misuse of a tax treaty between the two countries,
with its desire to remain a preferred investment route into India, according to a Mauritius delegation
comprising officials from the investment promotion board and financial sector regulators. See, Remya
Nair, Mauritius to address India‘s concerns over tax treaty, THE ECONOMIC TIMES, July 11, 2013, at 9.
government unleashed huge FDI reforms in order to attract foreign investments in the country
in light of the harsh economic environment;111 but how far these reforms will prove to be
adequate enough to regain the investor‘s confidence, keeping in mind the upcoming GAAR
in two years, is still a pending question to be answered.
It is an economic reality, as mentioned in detail above, that FDI flows towards a

location with a strong governance infrastructure which includes enactment of laws and a
well-oiled legal system. Certainty is integral to rule of law. Certainty and stability form the
basic foundation of any fiscal system. Certainty in tax policy is crucial for taxpayers
(including foreign investors) to make rational economic choices in the most efficient manner.
In the opinion of the authors, it is for the government of the day to have certainty
incorporated in the Treaties and in the laws so as to avoid conflicting views. Investors should
know where they stand. It also helps the tax administration in enforcing the provisions of the
taxing laws. This would serve the purpose of having an anti-avoidance rule as well as the
investors will not lose confidence in the economy.
5.2 GOVERNMENT EFFORTS TO ATTRACT FOREIGN INVESTMENT
Foreign Direct Investment (―FDI‖) is an investment involving a long term relationship

and reflecting a lasting interest and control of a resident entity in one economy in an
enterprise resident in an economy other than that of the foreign direct investors. 112
The initiation of new economic policy in 1991 is remarked as the stepping stone of
Indian foreign investment regime. The removal of restrictive and regulated trade practices, by
the policymakers, was welcomed by the foreign investors then. Subsequently, with the
process of reforms, India has witnessed a change in the flow of FDI in the country. The
whole reform process has turned the investors‘ faces towards India making it a preferred
investment destination. 113
110 With the introduction of General Anti-Avoidance Rules (GAAR) which were intended to plug taxation
loopholes and the announcement on retrospective amendments to income tax law have affected business
sentiments and investors' confidence globally. See, Follow Obama order on FDI, reforms: CII, THE
INDIAN EXPRESS, 17 July, 2013.
111 To lure foreign money, boost growth, India eases FDI curbs, THE HINDUSTAN TIMES, 17 July, 2013.
112 UN Conference on Trade and Development, World Investment Report, Foreign Direct Investment and
the Challenge of Development, (1999).
113 Id.
The table and chart below show the total FDI inflows from the financial year 2000-01
to 2012-13.
Figure 1: FDI Inflow Table
(Amount in US $ Million)
Financial Year Total FDI Inflows
2000-01 4,029
2001-02 6,130
2002-03 5,035
2003-04 4,322
2004-05 6,051
2005-06 8,961
2006-07 22,826
2007-08 34,843
2008-09 41,873
2009-10 (P) 37,745
2010-11 (P) 34,847
2011-12 (P) 46,556
2012-13 (P) 36,860
Source: Based on DIPP, ―Fact Sheet on Foreign

Direct Investment‖, April 2013.
(P): All figures are provisional. Financial Year is

April-March.
Total FDI Inflow comprises of Equity inflows

(FIPB/SIA, Automatic Route & Acquisition route,
Equity capital of unincorporated bodies and Re-
invested earnings.
Figure 2: Total FDI Inflows Chart

50,000
45,000
40,000
35,000
30,000
25,000
20,000
Total FDI Inflows
15,000
10,000
5,000
0
2000-01
2001-02
2002-03
2003-04
2004-05
2005-06
2006-07
2007-08
2008-09
2009-10
2010-11
2011-12
2012-13
Source: Based on DIPP, ―Fact Sheet on Foreign Direct Investment‖, April
2013.
(P): All figures are provisional. Financial Year is April-March.
Total FDI Inflow comprises of Equity inflows (FIPB/SIA, Automatic

Route & Acquisition route, Equity capital of unincorporated bodies and
Re-invested earnings.
The era before 2005 shows a mixed development of FDI in India. The quantum of FDI
inflows fluctuated till 2005. After 2005 there seems to be a significant development in the
figures. The increase in the year 2005 was a result of many policy initiatives framed by the
government in order to attract FDI inter alia enactment of Special Economic Zones Act and
the decision of allowing upto 100% FDI under the automatic route for townships, housing,
built-up infrastructure and construction development projects. 114 The opening up of the
automatic route for specific sectors for investment rather than FIPB route by the government
yielded in opening up of the market and thus the foreign investors enjoyed freedom in
decision making. 115 The acquisition of shares of the domestic enterprise by the foreign
114 K.S. CHALAPATI RAO & BISWAJIT DHAR, INDIA‘S FDI INFLOWS TRENDS AND CONCEPTS, RESEARCH AND
INFORMATION SYSTEM FOR DEVELOPING COUNTRIES & INSTITUTES FOR STUDIES IN INDUSTRIAL
DEVELOPMENT (2011), http://ris.org.in/images/RIS_images/pdf/FDI_Book-Final.pdf (June 20, 2014,
07.00PM).
115 Id.
investors was also one of the prominent reasons behind the increase in FDI inflow after
2005.116 The increase in inflow of FDI since 2005 is a result of policy initiatives taken by the
government. Emergence of service sector over the manufacturing sector was also responsible
for the rise in FDI. 117 Increase in inflow of foreign capital from tax haven countries also
contributed towards rise in FDI in India. 118 The relationship between growth and FDI in a
country is positive i.e. higher the growth rate leads to more FDI.119
The authors propose to draw a comparative analysis between the FDI during the time of
Azadi120 and that during the time when the Finance Bill, 2012 was introduced. The decision
in Azadi was given in October 2003, i.e., in the Financial Year 2003-04. As is evident from
the table and the graph shown hereinabove, the FDI inflows in that Finance Year were below
the 5000 mark, which is 10 times lesser than its peak in 2011-12, which is the Financial Year
when GAAR was first introduced. The Supreme Court had upheld the Circular 789 121 ,
thereby validating treaty shopping. It had emerged as the tax planner‘s messiah by upholding
the Westminster principle as being applicable even today, and is viewed as a watershed in the
Indian Jurisprudence on international taxation. 122 The Supreme Court had adapted a
favourable attitude towards foreign investors at a time when the government was not too
committed towards attracting foreign investment. This was a time even before the major
reforms took place in 2005 as mentioned above.
Ironically, the controversial Finance Bill, 2012 which increased uncertainty and
discretionary power (both of which are deterrents to foreign investment), was introduced at
the time when FDI inflows were at their peak because of committed measures being taken by
the Government. The Finance Act, 2012 proved to be a nightmare for the foreign investors in
India. Apart from introducing the much dreaded GAAR, it also brought in a retrospective
amendment to S. 9 of the Act by broadening the definition of capital asset being a share or
116 Id.
117 Id.
118 Id; See, Singapore replacing US at number 2 after Mauritius and in top 10 investing countries, Cyprus
and UEA were also added as they are tax havens.
119 Chandana Chakraborty & Peter Nunnenkamp, Economic Reforms, FDI, and Economic Growth in India:
A Sector Level Analysis, WORLD DEVELOPMENT VOL. 36, Elsevier Ltd,
http://58.194.176.234/gjtzx/uploadfile/200904/20090401152836328.pdf, 2008
121 CBDT Circular No.789, 13-4-2000. The Circular clarifies that a Certificate of residence issued by the
Mauritian authorities will constitute sufficient evidence for accepting status of residence as well as
beneficial ownership for the purpose of availing benefits under the India-Mauritius double tax treaty.
122 KANGA, supra note 8.
interest in a company incorporated outside so as to include underlying Indian assets of that

company within the definition. This was specifically done to overrule the Supreme Court
Judgment in Vodafone123which had held otherwise. The enactment also disturbed the settled
position of law declared by Azadi by overriding the Circular 789.124 The enactment shook the
confidence of foreign investors, and was predicted, in India as well as abroad, to have adverse
impact on inflow of foreign investment.125
Thus, in the opinion of the Authors, the current structure of GAAR is counterproductive
to the Governments efforts at increasing inflow of foreign investment. This argument is
supported by figures showing that the annual FDI flow fell by 38% in India in the financial
year 2012-13 126 despite all the Government efforts in the nature of reforms, targeted at
attracting foreign investments to India. 127 The FDI attracted in November 2012 was a two-
year low.128
Even after an improvement in GAAR through the Finance Act, 2013, and the GAAR
Rules, many of the recommendations of the Shome Committee report which aim at greater
certainty have not been included. The government is introducing new and heavy FDI reforms,
but it is doubtful whether this is going to help the foreign investors in fading out the
123 Vodafone, supra 32.

124 Finance Bill, 2012 introduced sub-section (4) to S. 90 of the Act which required the assessee, being a
foreign resident, to have a ―certificate, containing such particulars as may be prescribed‖ in order to avail
the benefits of the tax treaty.‖ This disturbed the settled position of a Tax Residency Certificate being a
sufficient proof of residence.
125 Senior Advocate Harish Salve comments in Finance Act 2012. Mr. Slave also said that GAAR will affect
foreign investments. See, Proposed Change to Finance Bill to impact Foreign Investment, THE
ECONOMIC TIMES, 28 April, 2012, http://articles.economictimes.indiatimes.com/2012-04-
28/news/31453430_1_impact-foreign-investment-tax-case-income-tax-act. (July 26, 2014 11:00 PM).
Italy Trade commissioner raises concern. See, Retrospective Amendment to I-T Act may FDI in India,
THE BUSINESS STANDARD, 20, May, 2012,http://taxmantra.com/inflow-fdi-impacted-retrospective-
amendment-laws.html/. (July 26, 2013 10:00 PM).
126 Annual FDI flow dips 38%, THE TELEGRAPH, 03 June, 2013,
http://www.telegraphindia.com/1130603/jsp/business/story_16965052.jsp#.UfEO99Kotf8. (July 23,
2014 04:30 PM).
127 The government had taken several policy decisions in the past few months to attract foreign investments.
Important among these include, allowing FDI in multi-brand retail and civil aviation sectors and seeking
legislative approval for increasing FDI cap in insurance and pension sectors. See, FDI dips by 38% to $
22.4 billion in 2012-13, THE TIMES OF INDIA, 03 June, 2013,
http://timesofindia.indiatimes.com/business/india-business/FDI-dips-by-38-to-22-4-billion-in-2012-
13/articleshow/20392486.cms. (July 26, 2014 1:30 PM)
128 Supra note 126.
ambiguity around or the effect of the retrospective amendments on indirect transfers or non-
acceptance of certain key recommendations of the Shome Committee on GAAR. 129
The government is still continuously making efforts in order to attract FDI in India in a
desperate attempt to spur the economy and to stem the rupee‘s slide. Recently on July 16,
2013 the government raised caps in a range of sectors such as telecom, asset reconstruction
firm, credit information services, defence etc. 130 The Government has also been taking
measures to attract other forms of foreign investment. The Qualified Foreign Investor (QFI)
scheme was introduced in 2011-12 by allowing foreign investors to invest in Mutual Funds,
which was further expanded on 1st January, 2012 to allow them to invest directly in the
Indian Equity Market. FII investments in debt securities have also been progressively
enhanced and debt limit allocation mechanism for FII has been rationalised by allowing
reinvestment to FII, and adopting First Come First Serve (FCFS) method of allocating limits
in case of the long term infra bonds. Rationalisation has also taken place in the terms and
conditions for FII investment scheme in infrastructure debt and non-resident investment
scheme in terms of the lock-in period and residual maturity criterion. 131 Furthermore, the
Chandrasekhar Committee 132 formed by the SEBI published its report on June 12, 2013,
wherein it recommended the merging of existing FIIs, Sub-accounts, and QFIs into a single
investor class to be termed as Foreign Portfolio Investor (FPI) with the aggregate limit as
24%. As regards Foreign Venture Capital Investor (FVCI), the committee recommended the
considerable expansion of the present list of 9 sectors. Consequently, the Government is
expected to prepare a negative list so that the rest of the sectors are open to Venture Capital
Fund (VCF) activity. 133
These efforts of the government are expected to be received stoically by foreign

investors since a lot of other key issues in India still linger in a cloud of uncertainty, and these
129 Indian Budget & its Impact for Foreign Investors, 5 SKP Tax Alert,Issue 33, (March 2013),
http://www.skpgroup.com/newsletters/tax-alerts/skp-tax-alert-V-33-Indian-Budget-and-its-impact-for-
foreign-investors.html (June 25, 2014, 05.00PM)
130 Supra note 111.
131 PRESS INFORMATION BUREAU, GOVERNMENT OF INDIA, Government takes several initiatives to attract
foreign investment, (December 6, 2012), http://pib.nic.in/newsite/erelease.aspx?relid=90127 (June 12,
2014)
132 REPORT OF THE COMMITTEE ON Rationalization of Investment Routes and Monitoring of Foreign
Portfolio Investments, June 12, 2013.
133 Id.
issues include the current tax structure.134 The authors being concerned only with GAAR, the
government efforts to attract foreign investments will go in vain unless the uncertainty in
GAAR is addressed.
6. CONCLUSION: CONTEMPORARY SETTING AN EXAMPLE
The Authors would like to reiterate their position that they are not opposed to the
concept of a statutory GAAR, but are critics of the form in which the Indian GAAR has been
drafted, and is expected to be implemented. A statutory GAAR in itself is not characterized
by uncertainty and unfettered power which is a major deterrence to the inflow of foreign
investment. These are characteristics which are unique to the Indian GAAR and should not
lead to a prejudicial generalisation against the concept of a statutory GAAR. This can be
evidently seen from the GAAR introduced in the UK, which became effective recently on
July 17, 2013 when the Finance Bill, 2013 received the royal assent. 135
Although the two GAARs are contemporaries, the approaches followed by the two are
completely different. Philip Baker QC 136, while comparing the Indian GAAR as introduced in
the Finance Bill, 2012 and the draft UK GAAR in the Aaronson Report 137 , states, ―The
Aaronson GAAR seems to have bent over backwards in trying to achieve as much certainty as
possible. One wonders whether the draftsman of the Indian GAAR has not tried to bend over
backwards in the opposite direction.‖138
The Aaronson Report advocated a moderate and focussed Anti-Avoidance Rule for the
UK, which aims at targeting abusive and contrived arrangements without disturbing
reasonable tax planning. The Report rejected the idea of a broad spectrum GAAR as being
unnecessary to the UK tax system, and a GAAR along the lines of the Report was accepted
134 Reforms Fail to enthuse Foreign Investors, EQUITY MASTER‘S-THE 5 MINUTE WRAP UP,
http://www.equitymaster.com/5MinWrapUp/detail.asp?date=07/22/2013&story=2&title=Reforms-fail-
to-enthuse-foreign-investors (July 27, 2014, 8:46 PM).
135 Christopher Groves et.al., United Kingdom: UK Finance Act 2013-Royal Assent on 17 July 2013,
WITHERS WORLDWIDE, (July 27, 2013)
http://www.mondaq.com/x/254390/Income+Tax/UK+Finance+Act+2013+Royal+Assent+on+17+July+2
013, (June 27, 2014, 08:50 PM).
136 Philip Baker, Tax Barrister and Queens Counsel, UK.
137 REPORT BY GRAHAM AARONSON QC, GAAR Study, November 11, 2011(hereinafter ‗AARONSON‘).
138 Philip Baker, THE UK GAAR AND THE INDIAN GAAR,
http://www.taxmann.com/taxmannflashes/flashst13-6-12_DTL_3-UKGAAR.pdf, (July 23, 2013, 3:42
PM). (hereinafter ‗Baker‘).
by the Government in the Budget of 2012.139Thus, the GAAR which has recently come into
force in the UK is along the lines of the GAAR suggested by the Aaronson Report, with some
material differences reflecting the formal consultation process. 140
One of the major causes of uncertainty in the Indian GAAR is that it is extremely broad
and targets an ―impermissible avoidance arrangement‖, the main purpose of which is to
obtain a tax benefit, and this condition must be qualified with any of the stipulated conditions
which include misuse or abuse of the legislation and deemed lack of commercial
substance. 141 The GAAR therefore threatens to undermine legitimate tax planning. Senior
Tax Advocate Sohrab E. Dastur while commenting on the Finance Bill, 2012 states certain
situations where the Assessing Officer may deny tax benefit for the reason that the main
purpose therein is to obtain a tax benefit, such as, dividend stripping; a situation where shares
are sold under private arrangement rather than on stock exchange only to be able to book a
loss because a loss on stock exchange is not allowed; Sale and lease bank transactions, etc. 142
In contrast to the Indian GAAR, its British counterpart is a General Anti-Abuse Rule
which targets only ―abusive‖ tax arrangements, whose classification as such will depend
upon circumstances which, inter alia, include exploitation of any shortcoming in the
provisions and use of abnormal steps to achieve the substantive results of the arrangement. 143
The UK GAAR is expressly designed to exclude reasonable tax planning. 144
The HMRC has also provided an official GAAR Guidance on how it is to be operated,
and also provides elaborate examples of situations when GAAR will or will not be
attracted. 145 This Guidance is expressly recognized by the legislation for its aid to the
interpretation and application of GAAR. 146 In India, the Shome Committee Report147 does set
139 Full Transcript, UK Budget speech 2012, George Osborne, March 21, 2012,
http://www.newstatesman.com/economy/2012/03/tax-rate-today-britain-billion (June 27, 2014, 08:00
PM).
140 Antony Seely, Bussiness and Transportation Section, TAX AVOIDANCE: A GENERAL ANTI-ABUSE RULE
(2013), SN6265, Library of House of Commons.
141 Baker, supra note 138.
142 Soli Dastur on Finance Bill, 2012, LET‘S TALK ABOUT THE LAW, March 23, 2012
http://letstalkaboutlaw.wordpress.com/2012/03/21/soli-dastur-on-finance-bill-2012/, (June 23, 2014, 4:27
PM).
143 UK Finance Bill, 2013, Cl. 204(2).
144 HM REVENUE AND CUSTOMS, HMRC‘s GAAR Guidance, B4.1,
http://www.hmrc.gov.uk/avoidance/gaar.htm (June 23, 2014, 6:57 PM).
145 Id., C.
146 Id., A4.
out examples of situations which GAAR should or should not cover, but this report does not
form a part of the legislation like the HMRC Guidance, and the degree to which its
recommendations have been accepted is unclear.
The HMRC Guidance provides for an independent Advisory Panel whose function is to
provide its opinion on cases referred to it in order to bring in an independent and non HMRC
perspective to the application of GAAR. 148 This goes a long way in ensuring certainty and
keeping discretionary power at check. In the Indian GAAR, the Approving Panel is to be
chaired by a sitting or a retired High Court Judge, and one out of the two remaining members
is an independent academic or a scholar. 149 Although a positive composition, the Approving
panel is involved at a later stage when the assessee objects to the Shown Cause Notice sent
by the Commissioner, 150 unlike UK where the independent Advisory Panel is involved before
any action is taken under GAAR. 151 Moreover, the Indian GAAR is to be applied ―in
accordance with such guidelines and subject to such conditions and the manner as may be
prescribed‖. 152 The investors and taxpayers are still awaiting such guidelines or conditions
from the Government.
Under the Indian GAAR, once an arrangement is characterized as an impermissible

avoidance arrangement, the Assessing Officer is empowered to disregard or recharacterise the
whole transaction, look through the arrangement by disregarding any corporate structure,
change the place of residence of a party or situs of an asset for tax purposes, treat equity as
debt or vice-versa etc.153 Thus such wide powers have been conferred at a an extremely low
level. The UK GAAR on the other hand provides for a designated HMRC officer who alone
can send a show cause notice to the taxpayer for the purposes of GAAR. 154 Such a safeguard
is absent in the Indian GAAR, which is likely to go a long way in shaking investor
confidence, more so with foreign investors.
147 SHOME, supra note 68.

148 GAAR Guidance, supra note 144, E4.
149 Income Tax Act, 1961, S. 144BA (16).
150 Id., sec. 144BA (4).
151 GAAR Guidance, supra note 145, E3.2
152 Income Tax Act, 1961, sec. 101
153 Id., S. 98.
154 UK Finance Bill, 2013, Schedule 41, Cl. 3.
It is pertinent to point out a few positive steps which have been taken by the
government since the Finance Act, 2012. Section 90(4) has been amended by the Finance
Act, 2013 to provide that a person resident in a foreign country which has a DTAA with India
must mandatorily have a ―certificate of his being a resident‖. This substituted the previously
amended section where the foreign resident was required to have a ―certificate, containing
such particulars which may be prescribed‖. This had created a lot of ruckus among investors
from low tax jurisdictions such as Mauritius and Cyprus who had a valid tax residency
certificate which was granted immunity by the Supreme Court in Azadi155where it had upheld
the Circular 789 156. The Finance Act 2013 provided the required respite by restoring the
existing position of a valid Tax Residency Certificate as an accepted proof of residence.
However, such Certificate is a necessary but not a sufficient proof by virtue of the newly
introduced sub-section (5) to section 90, wherein the assessee may be required to produce
such further documentation as may be prescribed. The implication of this provision on
Circular 789 and Azadi is yet to be seen.
The GAAR Rules157 provide for a monetary threshold of Rs. 3 crores of tax for the
invocation of GAAR provisions, which provides the much required relief to the investors
since it reduces the possibility of every tax planning being questioned. Furthermore, the FIIs
which choose not to take any tax treaty benefit have been proposed to be left out of GAAR,
and so have the foreign investors in FIIs. This is expected to reduce the repulsion of foreign
investors from investing through FIIs.
Even after these positive steps taken by the Government, the current structure of GAAR
leaves much to be desired. How far this is going to be addressed before GAAR becomes
effective is yet to be seen. However, the time for procrastination is running out.

156 Supra note 121.
157 Supra note 1.
SUBSCRIPTION OF SHARES VIS-À-VIS TRANSFER PRICING AND
RELATED ISSUES: A CRITICAL ANALYSIS OF THE LAW
Deepak Joshi
Abstract
In recent years, the Indian tax department has identified various new issues
so as to plug tax leakage. More often than not, issues have been identified in the
international tax arena. One such attempt is to treat subscription of shares as an
international transaction. So much so that a retrospective amendment was made
to Chapter X of the Indian Income tax Act, 1961 for substantiating the same. The
issue pertains to interpretation rather than question of facts. In the present article
the author has tried to critically analyze the stand taken by both the tax
department as well as the assessee in light of the statutory provisions and judicial
precedence. While undertaking such analysis, international jurisprudence has
also been resorted to. The issue involves a primary question about subscription of
shares and a related issue about secondary adjustments. The author has
concluded that the tax department has taken an over-aggressive stand in the
current issue. The result is there for everyone to see with plummeting FDI
numbers and rising voices of concern. The author has pointed out that answers
are needed to such issues and other issues which haven‘t faced litigation yet, not
purely from a taxation point of view but also to deliver a message of confidence
and allay any fears that the foreign investors may have.
1. INTRODUCTION
During 2013-14, additions to the income of the companies conducting international

transactions amounted to Rs 60,000 crore. 1 There is a growing perception that such
adjustments are often hostile in nature. Recently a new measure of adjustment has come to
 Student of Law, Campus Law Centre, Faculty of Law, University of Delhi, New Delhi; E-mail:
zone.joshi@gmail.com. The author expresses his gratitude to Akshay Sachthey and Sanjana Saddy for
their valuable inputs and suggestions.
1 Santosh Tiwari, Transfer Pricing Income Adjustments Decline 14% In 2013-14, FINANCIAL E XPRESS
(March 10, 2014) http://www.financialexpress.com/news/transfer-pricing-income-adjustments-decline-
14-in-201314/1232330 (June 25, 2014, 07.00PM) (hereinafter ‗Santosh Tiwari‘).
fore which has received much attention from the press as well as tax practitioners. There have
been cases where the tax department has sought to tax undervaluation of shares issued by
treating subscription of shares as an international transaction. As reported in the press, Shell
India Private Ltd. (‗Shell India‘) had issued shares at Rs 10 per share (based on valuation by
an independent company) to its parent company Shell Gas BV. The tax authorities contended
that Shell India had under-priced its shares and determined a value of Rs 183 per share,
thereby treating the short fall of approximately Rs 15,000 crore as a loan extended by the
Indian subsidiary to its overseas parent. The Transfer Pricing Officer (‗TPO‘) held that this
shortfall along with interest accruable thereon should be brought within the ambit of taxation.
Shell India has preferred a writ petition before the Hon‘ble Bombay High Court in this
regard.2
There are some variants of the abovementioned adjustment as well. In the case of
Vodafone India Services Pvt. Ltd. (‗VIPL‘), a wholly- owned subsidiary of a Mauritian entity
Vodafone Tele-Services (India) Holdings Ltd. (‗VHL‘) issued 2,89,224 equity shares of face
value of Rs 10 each at premium of Rs 8,591 per share. On reference, the TPO held that the
shares should have been valued on Net Asset Value basis after considering preceding years‘
Transfer Pricing (‗TP‘) adjustments and accordingly enhanced the value of each share to INR
53,775. Accordingly, the difference was considered to be deemed loan by VIPL to VHL, on
which notional interest at the rate of 13.5% per annum was also levied. 3
The issue has become so contentious that the Chairman of Shell group of companies
has reportedly said that such an adjustment is ―...a tax on foreign direct investment...‖4 The
matter is currently pending at different stages of litigation all over the country without any
conclusive solution at hand. In this light, it is imperative that an exhaustive analysis about the
merits of the case is undertaken to understand the law better. Part II of the article explains the
statutory provisions in relation to TP. Furthermore, the positions taken by both the tax
department as well as assessee have been analyzed in light of these provisions and judicial
precedents. Part III discusses the related issue of secondary adjustments. An attempt has been
2 Sridhar & Radhika Jain, Issue of Shares by Indian Subsidiary to Overseas Parent Company – Transfer
Pricing Implication, LEAPRIDGE, http://www.leapridge.com/wp-content/uploads/2014/02/Issue-of-Share-
by-Indian-Subsidiary-to-Parent-Company-Is-there-any-Transfer-Pricing-implication.pdf (June 10, 2014,
09.00AM).
3 Santosh Tiwari, supra note 1.
4 Ashwin Mohan, Shell India Says Tax Order Contrary To FM‘s FDI Drive; To Challenge Strongly, THE
ECONOMIC TIMES (February 4, 2013), http://articles.economictimes.indiatimes.com/2013-02-
04/news/36743166_1_income-tax-shell-india-tax-authorities (June 10, 2014, 09.10AM).
2014 Subscription of Shares vis-à-vis Transfer Pricing and Related 87
Issues: A Critical Analysis of the Law
made to understand the concept and trace its existence in the Income Tax Act, 1961 (‗the
Act‘). Part IV briefly discusses the international jurisprudence around the issue. It has been
concluded in Part V that the stand taken by the tax department is very aggressive which may
not stand the test of time in Court.
2. DOES SUBSCRIPTION OF SHARES COME UNDER THE PURVIEW OF

TRANSFER PRICING REGULATIONS?
2.1 BASIC TENANTS OF TRANSFER PRICING
A separate code on transfer pricing under Sections 92 to 92F of the Act covers intra-
group cross-border transactions which is applicable from 1 April 2001. Section 92(1) of the
Act provides that any ‗income‘ from an ‗international transaction‘ shall be computed having
regard to the arm‘s-length price. Thus, the pre-requisite for invoking TP provisions is that
there must be an income arising from international transaction and if there is an income, the
determination of the same shall be done having regard to the arm‘s length price. The term
―income‖ is not defined under sections 92 to 92F of the Act. Income is defined by way of an
inclusive definition in section 2(24) of the Act. An inclusive definition is normally a
definition of expansion and not of restriction. ‗Income‘, according to Concise Oxford English
Dictionary, means ―money received, especially on a regular basis, for work or through
investments.‖ A receipt can be brought to tax under the inclusive definition of term ―income‖
as defined in section 2(24) of the Act, only if it is expressly covered within the scope of the
said definition. A capital receipt, it is reiterated is fairly well settled, not being income per se,
does not attract the levy of tax under the provisions of the Act.
What is an international transaction has been defined under the Act 5 as a transaction
between two or more associated enterprises, either or both of whom are non-residents, in the
nature of:
(a) Purchase or sale or lease of tangible and intangible property
(b) Provision of services
(c) Lending or borrowing of money
5 Indian Income Tax Act, 1961, §92B.

(d) Mutual agreement or arrangement on allocation or apportionment or

the any contribution of cost or expenses
(e) Any other transaction having a bearing on the profits, income, losses or assets.
One may notice that the definition of ‗international transaction‘ is very wide and
attempts to cover every likely transaction that may take place between associated enterprises.
It is the relationship in the nature of associated enterprise that governs the TP

regulations all around the world. In India, section 92A of the Act defines the term ‗associated
enterprise‘ in a very broad manner. It refers to two situations. In the first situation 6 , one
enterprise directly or indirectly participates in the management or control or capital of the
other enterprise. The second situation7 refers to a situation when the same person directly or
indirectly participates in the management or control or capital of the two enterprises. It is
interesting to note that the definition is similar to the definition as contained in Article 9 of
the OECD Model Convention. Furthermore, the Act has supplemented the above definition
by enlisting several situations under which two enterprises shall be deemed to be associated
enterprises.8
The Arm‘s length price is to be determined by any one of the prescribed methods. The
tax payer can select the most appropriate methods to be applied to any given transaction, but
such selection has to be made by taking into account the factors prescribed in the transfer
pricing regulations with a view to allow a degree of flexibility in adopting the arm‘s length
price, a variance allowance of 5% have been provided under the transfer pricing regulation.
The prescribed method for determining it is as follows:-
(a) Comparable uncontrolled price method (CUPM)
(b) Resale price method (RPM)
(c) Cost plus method (CPM)
(d) Profit split method (PSM)
(e) Transactional net margin method (TNMM)
(f) Any other method as may be prescribed by the CBDT
6 Id., §92A cl. 1 §§ i.

7 Id., §92A cl. 1 §§ ii.
8 Id., §92A cl. 2.
2.2 RETROSPECTIVE AMENDMENT BY FINANCE ACT 2012
Prior to Finance Act 2012, section 92B of the Act defined ‗international transaction‘
in very wide terms. However, Finance Act 20129 has clarified this definition by way of an
explanation with retrospective effect from April 1, 2002 i.e. the date on which comprehensive
TP provisions were introduced under the Act. Explanation (i) has clarified that the expression
‗international transaction‘ shall include -
―…(c) Capital financing, including … purchase or sale of marketable securities…
(e) a transaction of business restructuring or reorganization…irrespective of the fact

that it has a bearing on the profit, income, losses or assets…at the time of the
transaction or at any future date‖
The memorandum10 explaining the amendment stated the following rationale:
―Certain judicial authorities have taken a view that in cases of transactions of business
restructuring etc. where even if there is an international transaction Transfer Pricing
provisions would not be applicable if it does not have bearing on profits or loss of
current year or impact on profit and loss account is not determinable under normal
computation provisions other than transfer pricing regulations. The present scheme of
Transfer pricing provisions does not require that international transaction should have
bearing on profits or income of current year…
It is, therefore, proposed to amend section 92B of the Act, to provide for the
explanation to clarify meaning of international transaction and to clarify the term
intangible property used in the definition of international transaction and to clarify that
the ‗international transaction‘ shall include a transaction of business restructuring or
reorganisation, entered into by an enterprise with an associated enterprise, irrespective
of the fact that it has bearing on the profit, income, losses or assets or such enterprises
at the time of the transaction or at any future date.‖ 11
9 Id., § 92B.
10 FINANCE BILL, 2012, http://indiabudget.nic.in/budget2012-2013/ub2012-13/mem/mem1.pdf (June 10,
2014, 10.00AM)
11 Id.
This amendment is seen as a shot in the arm of the tax department as it has strengthened
its stand for making additions. For the purpose of this article, the constitutional validity of the
aforementioned retrospective amendment is not being discussed.
2.3 REVENUE’S STAND
Let us understand how the income tax department‘s claim can be substantiated.
a) Shares’ Impact on Assets
Before moving ahead, it is necessary to have a look at the accounting treatment done
at the time of issue of shares:
Bank A/c Dr
To Share Capital A/c
To Share Premium A/c (if any)
One part of the journal entry affects the reserves and share capital in the balance sheet
while the other part affects the current assets of the company. It is thus undisputable that
assets of the company are affected by the amount of shares issued. On a bare perusal of
Section 92B(1), in the above light, it is clear that the transaction of subscription of shares is
an international transaction as defined under the provision which includes: ―any other
transaction having a bearing on the profits, income, losses or assets‖.
b) Capital Financing includes Issue of Shares
By way of Explanation to 92B the term international transaction has been clarified to
mean, inter alia, ―capital financing, including…‖ The Hon‘ble Supreme Court in the case of
Shree Gollaleshwar Dev v. Gangawwa 12 held that when by an amending Act, the word
‗includes‘ was substituted for the word 'means' in a definition section, the intention was to
make it more extensive. Thus it can be argued that the definition of capital financing is
inclusive in nature. The term ‗capital‘ can be said to be including equity contribution and the
term ‗finance‘ as per Oxford dictionary connotes management of money. The term ‗finance‘
12 Shree Gollaleshwar Dev v. Gangawwa, AIR 1986 SC 231.

is also defined in Webster‘s Ninth New Collegiate Dictionary as the science of the
management of funds that includes circulation of money, the granting of credit, the making of
investments, and the provision of banking facilities. The term ―financing‖ has been defined in
Black‘s Law Dictionary as ―the act or process of raising or providing funds‖. The other
dictionaries carry similar meaning of the term ‗finance‘. The Black law dictionary also has a
definition of ―equity financing‖ as ―the raising of funds by issuing capital securities (shares in
the business) rather than making loans or selling bonds‖. Accordingly, the term ―capital
financing‖ would include issuance of shares. Therefore, a wider interpretation should be
given to the term ―Capital Financing‖ as defined in the Explanation to 92B which has been
introduced with retrospective effect from 1-4-2002.
It is pertinent to note that the purpose of the Explanation to 92B has been explained in
the explanatory memorandum to the Finance Bill, 2012, which clarifies that the present
scheme of Transfer Pricing provisions does not require that international transaction should
have bearing on profits or income of current year. Therefore, it is not necessary for
international transaction to have a bearing on the profits of the assessee in India.
c) Share Subscription and Share Premium amount Impacts Income
Furthermore, Section 78 of the Indian Companies Act, 1956 mandates creation of

―Share Premium Account‖ and restricts the use of this account for specific purposes only. It
is pertinent to note that what is regulated is the account itself and not the amount received.
Hence, amount received can be utilized without restriction. In a case where a freshly set up
company issues shares at a premium, the bank funds are increased by the amount of share
premium and share capital. Now that enterprise purchases fixed assets out of the funds kept in
the bank. Thus what is actually affected is bank balance and assets but not the Share Premium
Account. The income or profits will be impacted in this case due to depreciation on fixed
assets. The only condition precedent for invoking provisions of Chapter X is that there should
be income arising from international transaction, this view was affirmed by the Hon‘ble
Punjab & Haryana High Court in Coca Cola Inc v. Asstt. CIT.13
13 Coca Cola Inc v. Asstt., CIT [2009] ITR 194 (P&H).

Furthermore, the concept of opportunity cost also comes into play. The company could
have earned some income by deploying the funds in income generating assets. However, such
funds were foregone which resulted in foregoing of income.
2.4 ASSESSEE’S STAND
The assessee in such cases has gone all out to defend its position. It is worthwhile to
analyze the claims of the assessee in the following manner:
a) Principal of Ejusdem Generis to be Applied
It would be apposite to consider the definition of ‗international transaction‘ given

under section 92B (1) wherein it is clear that a transaction is an international transaction if,
inter alia, it is in nature of: a) purchase, sale or lease of tangible or intangible property; b)
provision of services; c) lending or borrowing money; or d) any other transaction having a
bearing on the profits, income, losses or assets
It is a well settled rule of interpretation that when general words follow specific words
of the same nature, the rule of ejusdem generis shall apply. The Hon‘ble Calcutta High Court
in the case of CIT v The Statesman14 has held that the maxim serves to restrict the meaning of
a general word to things or matters of the same genus as the preceding particular words.
Thus the meaning of the words ―any other transaction having a bearing on the profits,
income, losses or assets‖ has to be imported to mean the same as what the earlier mentioned
words signify. A careful reading of the definition gives rise to a generic unity in nature of
―having an impact on income or loss‖. Hence, a transaction shall mean to be an international
transaction if it has an impact on the profit or loss of that enterprise and not otherwise.
Furthermore, the clause in the explanation reads as follows: Capital financing,

including any type of long-term or short-term borrowing, lending or guarantee, purchase or
sale of marketable securities or any type of advance, payments or deferred payment or
receivable or any other debt arising during the course of business;
In clause (c), the words coming after ―capital financing‖ indicate that the transactions
have to have an impact on the income or loss. An interpretation that Explanation (i) would
14 CIT v The Statesman, [1992] 198 ITR 582 (Cal).

fall within the scope of the expression international transaction even if the ingredients of
section 92B(1) are not satisfied would render redundant. Hence, issue of shares and receipt of
share premium though forms part of ―capital financing‖ but it impacts neither income nor
loss. Issue of shares being a balance sheet transaction impacts only the assets of the company.
The word ―assets‖ should be read in light of the words preceding it. Thus, if a capital
transaction does not impact the income or loss then it should not form part of ―capital
financing‖ for the purposes of applicability of transfer pricing provisions.
In relation to capital financing, the Guidance Note on transfer pricing issued by the
Institute of Chartered Accountants of India (ICAI) states under paragraph 4.10 that ―the
pricing of these arrangements will have a bearing on the profits or losses of the associated
enterprises‖.
b) Harmonious Interpretation of Section 92(1) & Section 92B
The provisions of a code should be read together and not independent of each other.
The Hon‘ble Kerala High Court in the case of CIT v Parekh Brothers15 has held that one
provision of a statute should be construed with reference to another provision so as to make a
consistent enactment of the whole statute.
Section 92B defines the term ―international transaction‖ but it does not anywhere cast a
charge on the income nor does it give rise to computation of income arising from that
international transaction. This charge is enshrined under section 92(1) of the Act. Section
92B and 92(1) should be given a conjoint reading and should not be read independent of each
other. In this regard, it may be noted that even section 92B of the Act starts with the words:
―for the purposes of this section and section 92,92C, 92D and 92E…..‖ which supports the
view that the international transaction as defined under section 92B of the Act has to be read
harmoniously along with other provisions of Chapter X and cannot be read in isolation.
The analysis of both the sections follows that in case no income (or loss) arises from an
international transaction (as defined under section 92B), then the transfer pricing provisions
fail to apply (as required under section 92(1)). Any interpretation contrary to the
abovementioned analysis would be contrary to the intention of the legislature.
15 CIT v. Parekh Brothers, [2002] 258 ITR 43 (Kerala).

c) Case of ‘Issue’ of Shares and Not ‘Transfer’ of Shares
By no stretch of imagination can we read issue of shares as a part of purchase or sale

of marketable securities. Purchase or sale of marketable securities, refers to transfer of
marketable securities which are already in existence. The Hon‘ble Supreme Court in the case
of Sri Gopal Jalan & Company v. Calcutta Stock Exchange Association Ltd16 has held that
'allotment' means the appropriation out of the previously unappropriated capital of a
company, of a certain number of shares to a person. Till such allotment the shares do not
exist as such.
Under the commercial/accounting parlance, subscription of shares is a capital

transaction and not a revenue transaction and it can be concluded that issuance of shares does
not have an impact on income or loss of the enterprise.
The Hon‘ble Supreme Court in the case of Khoday Distilleries Ltd v CIT17 relied on Sri
Gopal Jalan & Company case (supra) and held as follows:
―There is a vital difference between ―creation‖ and ―transfer‖ of shares. As stated

hereinabove, the words ―allotment of shares‖ have been used to indicate the creation
of shares by appropriation out of the unappropriated share capital to a particular
person. A share is a chose in action. A chose in action implies existence of some person
entitled to the rights in action in contradistinction from rights in possession. There is a
difference between issue of a share to a subscriber and the purchase of a share from an
existing shareholder. The first case is that of creation whereas the second case is that
of transfer of chose in action…….For the aforestated reasons, we hold that the word
―allotment‖ indicates creation of shares by appropriation out of the unappropriated
share capital to a particular person and that such creation did not amount to transfer.‖
Further, the view of the learned authors in the book “The Law and Practice of Income
Tax‖18 which is: ―The issue of shares by a limited company is not a trading transaction at all.
Upon an issue of shares, the assets of the company are increased by the amounts obtained
from the subscribers. These amounts are obviously not profits or gains of the trade, and they
are not liable to be brought into the accounts for income tax. This is so whether the shares
16 Sri Gopal Jalan & Company v. Calcutta Stock Exchange Association Ltd., AIR 1964 SC 250.
17 Khoday Distilleries Ltd v. CIT, [2009] 176 Taxmann 142 (SC).
18 1 KANGA, PALKHIVALA & VYAS ,THE LAW AND PRACTICE OF INCOME TAX, 303 (9th ed., 2004).
are allotted at par or at a premium. The amount of the premium, or the fee charged on the
issue of fresh capital, is not a trading profit.‖
The learned authors in their book ―The law and practice of Income Tax‖19 have the
made the following observation on the question of treating capital receipt as income under
section 2(24) of the Act: ―Though the definition of income is inclusive, capital receipts do not
come within the ambit of the charging section except to the extent of any capital receipt
expressly covered by this sub-clause. A capital receipt is not income under section 2(24)
unless it is chargeable to tax as capital gain under section 45.‖
d) Being a Capital Transaction, No Income Arises
A catena of decisions has held that section 92(1) is not an independent charging
provision but only a computation provision. Section 92(1) does not propose to bring to tax
international transactions not taxable as per substantive charging provisions of the Act. In the
case of Dana Corporation, In re20 it was held that the expression ‗income arising‘ postulates
that the income has arisen under the substantive charging provisions of the Act. In other
words, the income referred to in Section 92 is nothing but the income captured by one or the
other charging provisions of the Act. Section 92 obviously is not intended to bring in a new
head of income or to charge the tax on income which is not otherwise chargeable under the
Act.
It is pertinent to discuss the decision of Hon‘ble Calcutta High Court in case of CIT v
Kusum products Ltd.21 It is in the context of old S.92 of the Act and the court held that the
transaction on capital account can have no impact on profit calculation of the taxpayer. The
question of profit and/or loss may not arise when one is contributing towards capital. The
contribution of capital, in no circumstances, will result in profit.
In light of the above, it is contended that section 92(1) neither enlarges nor reduces the
scope of the definition of income under section 2(24) but only acts as a tool to compute the
same.
19 Id.
20 Dana Corporation, In re, [2010] 321 ITR 178 (AAR).
21 CIT v. Kusum products Ltd., [1993] 203 ITR 672 (Cal).
In the case of Ranbaxy Laboratories Ltd v ACIT22, the Hon‘ble Tribunal held that by
issuing shares at a price less than the market price, the assessee cannot be said to have
incurred any expenditure; rather, it amounts to short receipt of share premium. The receipt of
share premium is not taxable and hence, any short receipt of such premium will only be a
notional loss and not actual loss for which no liability was incurred. Therefore, such notional
losses were held not allowable under the Act. This observation has been affirmed by the
Hon‘ble Mumbai Tribunal in its recent judgment in the Green Infra Ltd. v. ITO.23
Even if share premium would have been collected by the assessee it would have been a
capital receipt. After referring to Section 78 of the Companies Act, which restricts the use of
share premium account and after analysing the provisions of the Company Law, it was held
by the Court that share premium cannot be brought to tax as revenue receipt or trading receipt
but was exempt as capital receipt in the hands of the company -Addl. CIT v. Om Oils & Oil
Seeds Exchange Ltd.24 Thus the uncollected share premium cannot be regarded as an income
foregone.
Clause 21 & 22 of the Finance Bill, 2012 which seeks to amend Sections 56 & 68 of the
Act respectively, do contemplate taxing share premium, only when the assessee offers no
explanation about the nature and source thereof or when the consideration for issue of shares
exceeds face value. However, these amendments will take effect from 1st April, 2013 and
will, accordingly, apply in relation to the assessment year 2013-2014 and subsequent
assessment years. Therefore, is not to be considered for the case at hand.
Furthermore, the heading of Chapter X reads ―SPECIAL PROVISIONS RELATING TO

AVOIDANCE OF TAX‖. The heading of the chapter that contains transfer pricing provisions
contemplates ―avoidance of tax‖. Where no income arises under any of the substantive
charging provisions of the Act, there can be no avoidance of tax also. Thus the Act intends to
capture those transactions which impact income or loss and leave out the capital receipts.
Reliance is placed on the decision of the Hon‘ble Supreme Court in case of CIT v Vadilal25
wherein it was held that marginal notes and headings may throw light on the intention of the
legislature.
22 Ranbaxy Laboratories Ltd v. ACIT, (2009) 124 TTJ (Delhi) 771.

23 Green Infra Ltd. v. ITO, TS-420-ITAT-2013(MUM).
24 Addl. CIT v. Om Oils & Oil Seeds Exchange Ltd., [1985] 152 ITR 552 (Delhi).
25 CIT v. Vadilal, [1972] 86 ITR 211 (SC).
It is pertinent to refer to the Circular 12/2001, dated 23-8-2001 wherein it has been
stated that: ―The aforesaid provisions have been enacted with a view to provide a statutory
framework which can lead to computation of reasonable, fair and equitable profit and tax in
India so that the profits chargeable to tax in India do not get diverted elsewhere by altering
the prices charged and paid in intra-group transactions leading to erosion of tax revenues.‖
3. APPROACH TAKEN BY THE COURTS
The Hon‘ble Bombay High Court had the opportunity to look into the matter, though
not at the merits of the case. A writ petition was filed on the same issue by VIPL. The court
in the case of Vodafone India Services Pvt. Ltd. v Union of India26 observes in Para 32 that
―It is clear that in view of Section 92(1), there must be income arising and/or affected or
potentially arising and/or affected by an International Transaction for the purpose of
application of Chapter X. This would appear to be in the nature of jurisdictional requirement
and the Assessing officer must be satisfied that there is an income or a potential of an income
arising and/or being affected on determination of an ALP before he proceeds further in
determining the ALP or referring the issue to the TPO to determine the ALP.‖
The Hyderabad Bench of the Hon‘ble Tribunal has in a recent case of Vijai Electricals
Ltd v ACIT27 held that investment in share capital is not an international transaction as per
section 92B as there is no income. The operative part of the judgment is reproduced below:
―In our opinion, the amount representing 2118.84 is towards investment in share
capital of the subsidiaries outside India as the transactions are not in the nature of
transactions referred to section 92-B of the IT Act and the transfer pricing provisions are not
applicable as there is no income.‖
It is pertinent to note that the aforesaid decision has been pronounced after the
enactment of Finance Act 2012. However the transaction involved pertained to an outbound
investment.
Very recently, the Hyderabad bench of the ITAT in the case of Prithvi Information
Solutions Ltd. v ACIT28 while following the Vijai Electricals decision (supra) has held that-
26 Vodafone India Services Pvt. Ltd. v Union of India, [2013] 39 taxmann.com 201 [Bombay].
27 Vijai Electricals Ltd v. ACIT., TS-142-ITAT-2013(HYD)-TP.
28 Prithvi Information Solutions Ltd. v. ACIT, TS-237-ITAT-2014(HYD)-TP.
―Unless there are evidences and material to show that assessee has made investment of
Rs. 30,60,50,000/- in shares in addition to the amount mentioned as loan in form No. 3CEB,
it cannot be presumed that loans stated in auditor‘s report in Form No. 3CEB and shares
allotted are different. Unless this fact is verified properly by examining the books of account
and final accounts of the assessee, no inference can be drawn merely on presumption and
surmises. If the assessee‘s claim that the investment was towards equity is correct, then, it
cannot be brought within the purview of ‗international transactions‘ as defined u/s 92B of the
Act.‖
Similar issue arose again before the Hyderabad Bench of the ITAT in the case of M/s
Hill County Properties Ltd v Addl. CIT29 wherein the tribunal followed its own decision in
case of Vijai Electricals (supra).
While examining clause (c) of the explanation to section 92B the Delhi bench of the
ITAT30 observed that
―the scope of these transactions, as could be covered under Explanation to Section 92 B

read with Section 92B(1), is restricted to such capital financing transactions, including
inter alia any guarantee, deferred payment or receivable or any other debt during the
course of business, as will have ―a bearing on the profits, income , losses or assets or
such enterprise‖. This pre-condition about impact on profits, income, losses or assets
of such enterprises is a pre-condition embedded in Section 92B(1) and the only
relaxation from this condition precedent is set out in clause (e) of the Explanation
which provides that the bearing on profits, income, losses or assets could be immediate
or on a future date. The contents of the Explanation fortifies, rather than mitigates, the
significance of expression ‗having a bearing on profits, income, losses or assets‘
appearing in Section 92 B(1).
32. There can be number of situations in which an item may fall within the description
set out in clause (c) of Explanation to Section 92 B, and yet it may not constitute an
international transaction as the condition precedent with regard to the ‗bearing on
profit, income, losses or assets‘ set out in Section 92B(1) may not be fulfilled.‖
In the case of M/s Allcargo Global Logistics Ltd v ACIT31, the facts before the Mumbai
bench of the ITAT were slightly different. The appellant in that case had invested in shares of
29 M/s Hill County Properties Ltd v. Addl., CIT TS-214-ITAT-2014(HYD)-TP.

30 Bharti Airtel Limited v. ACIT, TS-76-ITAT-2014(DEL)-TP.
its AEs but the shares were allotted after a delay of approximately 11 months. The
department had alleged that this transaction is akin to a loan. However the Tribunal rejected
this argument and deleted the TP adjustment on account of interest chargeable on the amount
of share application money paid by the assessee and lying unutilized with its AE treating the
same as the transaction of loan.
It is interesting to note that in case of Aminatit International Holding, In re32, the AAR
held that TP provisions are not applicable where income is not chargeable to tax. It was held
that shares transferred to AE without consideration during restructuring process is not subject
to capital gains tax and hence TP provisions will not apply. However, this decision was
pronounced before the enactment of Finance Act 2012.
4. SECONDARY ADJUSTMENTS
4.1 CONCEPT
The Transfer Pricing adjustments are of two types viz. primary adjustment and
secondary adjustment. The primary adjustment is an adjustment which is attributable to a
transaction which has been ―entered into‖ by the parties during the accounting year. Once the
adjustment is made, the income as assessed would represent the sum of revenue as would
have been reported had the transaction been always concluded at the right value. The
secondary adjustment, if and to the extent, specifically authorized by the statute, may seek
to make unilateral adjustment which accommodates a derivative consequence of the primary
adjustment. In the impugned case, adjustment made by the AO is a secondary adjustment. For
example, the derivative loan transaction has been deemed to exist or has been deemed to have
resulted on the basis of a presumption that had the Indian company recovered correct value
towards shares, the Indian company would have had the liquidity which is presently enjoyed
by the parent company.
The secondary adjustment, if and to the extent, specifically authorized by the statute,
may seek to make unilateral adjustment which accommodates a derivative consequence of the
primary adjustment. Para 4.66 of the OECD TP Guidelines states that:
31 M/s Allcargo Global Logistics Ltd v. ACIT, TS-176-ITAT-2014(Mum)-TP.

32 Aminatit International Holding, In re, TS-42-AAR-2010.
―The exact form that a secondary transaction takes and of the consequent secondary
adjustment will depend on the facts of the case and on the tax laws of the country that
asserts the secondary adjustment‖
Further Para 4.69 of the OECD TP Guidelines states the following:
―The commentary on paragraph 2 of Article 9 of the OECD Model Tax Convention

notes that the Article does not deal with secondary adjustments, thus it neither forbids
nor requires tax administrations to make secondary adjustments. …. Many countries
do not make secondary adjustments either as a matter of practice or because their
respective domestic provisions do not permit them to do so.‖
4.2 SECONDARY ADJUSTMENT vis-à-vis INCOME TAX ACT, 1961
The Indian statute supports solely primary adjustments through section 92(1) of the
Act, which states the following: ―Any income arising from an international transaction shall
be computed having regard to the arm's length price.‖ Hence, the adjustment is a result of
the international transaction which has in fact been undertaken between the two associated
enterprises.
In the present case, the derivative loan transaction has been deemed to exist on the basis
of a presumption that had the assessee recovered correct value towards shares, the Indian
company would have had the liquidity which is presently enjoyed by the parent company.
Adjustment made by the AO is a secondary adjustment. Present Indian tax regime does not
permit or authorize such secondary adjustment.
The statute merely recognizes the transaction which has been ―entered into‖ by
associate enterprises. It does not authorize revenue authority to multiply or rewrite the
transaction. In the impugned case, the only transaction which can, therefore, be recognized by
the Indian statute is the transaction of share subscription.
Since a transaction of the nature of loan or receivable has not been entered into, it
cannot at all be presumed to be an international transaction warranting any adjustment.
Reliance is placed on the observation given by the Hon‘ble Mumbai Bench of the ITAT in
the case of Besix Kier Dabhol, SA Vs. DDIT(IT).33
33 Besix Kier Dabhol, SA v. DDIT(IT), [2011] 134 TTJ (Mum) 513.

The Hon‘ble Tribunal in this case was dealing on the question of applicability of thin
capitalization rules to an Indian assessee. Under the thin capitalization rules (as understood
generally), the amount of debt taken by a company is treated as a capital investment in the
company and hence any interest expense is disallowed for the purpose of taxability. The
Hon‘ble ITAT has ruled against the recharacterisation of debt into equity which was based on
the international practice which was still to find its place in the Indian Income Tax Act, 1951.
Taking the ratio of the judgment and applying the same to the present case we can reach the
same conclusion. Recharacterising a transaction is permissible under the GAAR framework
which is yet not present under the ITA.
It is a well settled law that there can be no presumption about the acting of two parties
in concert. This has been very clearly laid down by the Hon‘ble SC in case of Daiichi Sankyo
Co. Ltd. v. Jayaram Chigurupati & others.34
It is further arguable that a secondary adjustment which is connected with a fictional

transaction should not be allowed to hold the field if the existence thereof is in conflict with
FEMA or other law. To assume that the Indian company has granted a loan from an overseas
company without permission of FEMA authorities and to assume that the loan is, under Civil
Law, of a nature which is non-enforceable, would be in conflict with FEMA. The legislature
cannot be expected to permit existence of state of affairs which is in conflict with another
statute of the legislature.
In a recent decision by the Hyderabad Bench of the Hon‘ble Tribunal in case of

Northgate Technologies Ltd v DCIT35, it has been held as follows:
―Unless the price paid as premium is justified in an arm‘s length situation, the same
will be treated as NIL under CUP method as no independent party would like to pay such
huge amounts in the form of premium without any basis. Therefore, the monies parked with
its subsidiaries in the form of share premium have to be treated as loan transactions‖
In the aforementioned case, the assessee had invested funds in its subsidiaries outside
India. The TPO questioned the huge payout of share premium and in absence of any
economic rational given by the assessee, treated that share premium as loan. Hence, he
proposed an addition of notional interest on this deemed loan. The Tribunal has rightly
34 Daiichi Sankyo Co. Ltd. v. Jayaram Chigurupati & others, (2010)157 Company Cases 380 (SC).
35 Northgate Technologies Ltd v. DCIT TS-164-ITAT-2013(HYD)-TP.
observed that in case no justification is provided, the share premium amount has to be treated
as a loan. This is implied from the decision that in absence of economic or commercial
rationale, any short receipt or excess payment of share premium has to be treated as a loan
transaction. The economic rational says that a company will issue shares at its fair market
value and not below that fair market value. Thus the short receipt of share premium amount
actually constitutes a loan given to the overseas entity.
Even if discount on share capital is regarded as being in capital account and not taxable,
there could be a case to treat on revenue account, the income by way of interest foregone on
the funds not collected due to issuing of shares at a discount, and make transfer pricing
adjustment. Thus the funds received from issue of shares not only affect the assets of the
entity but also play a major role in operations of the business. Thus somehow and somewhere
it impacts income, expense or profits of the entity.
In this regard, the Hon‘ble Tribunal in case of Logix Micro Systems Ltd. vs. ACIT36 has
observed that the ALP of an outstanding amount should not calculated considering the same
as loan but it should be determined considering the factor that if the fund were brought back
by assessee within reasonable time it would have earned income on the said funds
(opportunity cost).
In the case of Perot Systems TSI (India) Limited v DCIT37 it has been held by the Delhi
bench of the Hon‘ble Tribunal that ―if Assessee's contention that whenever interest-free loan
was granted to associated enterprises, there should not be any adjustment, was accepted, it
will tantamount to taking out such transactions from the realm of Section 92(1) and Section
92B. Section 92(1) mandates that any income arising from an international transaction shall
be computed having regard to the arm's length price. Furthermore, as rightly observed by the
CIT(A), RBI's approval did not put a seal of approval on the true character of the transaction
from the perspective of transfer pricing regulation as the substance of the transaction has to
be judged as to whether the transaction was at arm's length price or not.‖
Furthermore, the Finance Act 2012 has added a clarification to section 92B by way of
an explanation as per which any type of receivable or debt arising during the course of
business is considered as an international transaction. Thus, such international transaction
needs to be benchmarked having regard to the arm‘s length principles. In light of above, it
36 Logix Micro Systems Ltd. v. ACIT TS-49-ITAT-2010(Bang).

37 Perot Systems TSI (India) Limited v. DCIT [2010] 130 TTJ (Delhi) 685.
can be said that the short receipt of share premium amount is a furtherance of loan and hence
an international transaction. It is pertinent to note that the Hon‘ble Mumbai Tribunal in, the
recent case of Medusind Solutions India Pvt. Ltd. v ACIT38 has remanded back the matter
relating to outstanding receivable being treated as an international transaction in light of the
new clarification to Section 92B.
In a very recent case of Bharti Airtel Limited v ACIT39, the Delhi ITAT held as follows:
―No doubt, if these transactions are treated as in the nature of lending or borrowing,
the transactions can be subjected to ALP adjustments, and the ALP so computed can be the
basis of computing taxable business profits of the assessee, but the core issue before us is
whether such a deeming fiction is envisaged under the scheme of the transfer pricing
legislation or on the facts of this case. We do not find so. We do not find any provision in law
enabling such deeming fiction. What is before us is a transaction of capital subscription, its
character as such is not in dispute and yet it has been treated as partly of the nature of
interest free loan on the ground that there has been a delay in allotment of shares. On facts of
this case also, there is no finding about what is the reasonable and permissible time period
for allotment of shares, and even if one was to assume that there was an unreasonable delay
in allotment of shares, the capital contribution could have, at best, been treated as an interest
free loan for such a period of ‗inordinate delay‘ and not the entire period between the date of
making the payment and date of allotment of shares. Even if ALP determination was to be
done in respect of such deemed interest free loan on allotment of shares under the CUP
method, as has been claimed to have been done in this case, it was to be done on the basis as
to what would have been interest payable to an unrelated share applicant if, despite having
made the payment of share application money, the applicant is not allotted the shares. That
aspect of the matter is determined by the relevant statute. This situation is not in pari materia
with an interest free loan on commercial basis between the share applicant and the company
to which capital contribution is being made. On these facts, it was unreasonable and
inappropriate to treat the transaction as partly in the nature of interest free loan to the AE.
Since the TPO has not brought on record anything to show that an unrelated share applicant
was to be paid any interest for the period between making the share application payment and
38 Medusind Solutions India Pvt. Ltd. v. ACIT, [2013] 56 SOT 177 (Mum).
39 Bharti Airtel Limited v. ACIT, TS-76-ITAT-2014(DEL)-TP.
allotment of shares, the very foundation of impugned ALP adjustment is devoid of legally
sustainable merits.‖
A similar finding has been given by Hon‘ble Mumbai ITAT in the case of Parle
Biscuits Pvt Ltd v DCIT.40
5. THE ISSUE AT THE INTERNATIONAL LEVEL
Article 9 of tax treaties does not cover any such secondary adjustment. The OECD
has clarified in its commentary on Article 9 of the model treaty convention that sovereign
countries can opt for secondary adjustments, if permissible by their domestic laws. Some of
the countries have adopted the practice to apply secondary adjustments, on the backing of
express provisions in their respective domestic tax laws, namely:41
CANADA
Canada‘s Income Tax Act, empowers the Revenue to treat an upward TP adjustment
as deemed dividend. However, no deemed dividend would arise if the non-resident is a
controlled foreign affiliate for Canadian tax purposes. The provisions for the same are
covered under Section 247(2) of the Income Tax Act. The Canada Revenue Agency generally
treats the amount of the primary adjustment, i.e., the disallowed portion of the price paid to
the non-arm‘s length non-resident, as a shareholder benefit under subsection 15(1) of
Canada‘s Income Tax Act which is deemed to be a dividend subject to withholding tax under
paragraph 214(3)(a). Prior to the Budget 2012 amendments to Canada‘s Income Tax Act,
secondary adjustments were raised using traditional benefit conferral provisions (i.e. sections
15, 214 etc). The amendments of 2012 added provisions dealing specifically with secondary
adjustments. Under the new provisions, notably subsection 247(12), the amount of the
primary adjustment results in a deemed dividend to the non-resident party, thereby invoking
Part XIII withholding tax. The amendments provide42:
40 Parle Biscuits Pvt Ltd v. DCIT, TS-127-ITAT-2014(MUM)-TP.

41 Rahul Mitra, Undervaluation Of Shares – Do Indian TP Provisions Support Adjustment?,
TAXSUTRA.COM, (April 1, 2013) http://www.tp.taxsutra.com/experts/column?sid=101#content-bottom
(June 10, 2014, 11.00AM).
42 Miller Thomson LLP, Toronto, Transfer Pricing Secondary Adjustments (April 2, 2012),
http://www.martindale.com/corporate-law/article_Miller-Thomson-LLP_1490240.htm (June 10, 2014,
11.00AM).
Amount:
The amount subject to withholding tax is the sum of the Canadian corporation‘s
income and capital transfer pricing adjustments under section 247, but with the capital
adjustments determined on a gross basis. And, this amount is determined as if the Canadian
corporation had undertaken no transactions other than those transactions in which the
particular non-arm‘s length non-resident participated.
Reduction:
The amount subject to withholding tax is reduced by transfer pricing adjustments in the
Canadian taxpayer‘s favour.
Deemed Dividend:
The excess amount is treated as a deemed dividend for withholding tax purposes.
Therefore, the withholding tax rate under any applicable tax treaty will be the rate for
dividends. Nothing is said about when such deemed dividends will qualify for the lower
dividend withholding tax rate available under many treaties where the shareholding meets a
specified minimum threshold.
Timing:
The deemed dividend is deemed to be paid at the end of the taxation year in which the
relevant transactions occurred.
CFA Exception:
There is an exception for a transaction with a non-resident that is a controlled foreign

affiliate (hereinafter ‗CFA‘) under subsection 17(15) of the Tax Act. A primary transfer
pricing adjustment in relation to a transaction with this type of CFA will not give rise to a
deemed dividend subject to withholding tax. Excess payments by the Canadian corporation to
such a CFA are considered to be equivalent to downstream capital contributions to the
foreign affiliate rather than upstream distributions of surplus to foreign shareholders.
Therefore, a withholding tax assessment is not appropriate. A subsection 17(15) CFA is
generally a CFA controlled by the taxpayer and/or Canadian residents with whom the
Canadian corporation does not deal at arm‘s length. The non-resident must qualify as this
type of CFA throughout the period during which the subject transaction or series of
transactions occurred.
The Canada Revenue Agency‘s (hereinafter ‗CRA‘) policy with respect to assessing
withholding tax for such secondary adjustments is set out in paragraph 211 of CRA
Information Circular 87 - 2R on International Transfer Pricing. As per the circular, a relief
may be provided if the following conditions are met43:
1. The Canadian taxpayer agrees in writing to the proposed transfer pricing

adjustments (such an agreement does not restrict the Canadian taxpayer or the non-
arm's length party from seeking relief under the Mutual Agreement Procedure article
of Canada's tax treaties)
2. The adjustments did not arise from a transaction that may be considered
abusive; and
3. The foreign corporation repatriates the funds equivalent to the gross amount
arising from the transfer pricing adjustment immediately or agrees in writing to
repatriate such amount within a reasonable time
EUROPEAN UNION
As per a report issued by the European Union Joint Transfer Pricing Forum (hereinafter
‗EUJTPF‘) dated 18th October, 2013 on "secondary adjustments" in TP, one notes that out of
the twenty seven EU Member States, nine countries have legislation on "secondary
adjustments", namely Austria; Bulgaria; Denmark; Germany; France; Luxemburg;
Netherlands; Slovenia; and Spain. 44 EUJTPF has also provided for certain recommendations
around secondary adjustments in the sense that Member States should refrain from inflicting
upon "secondary adjustments", when they lead to double taxation. Where secondary
adjustments are compulsory under the legislation of a Member State, it is recommended that
Member States provide for ways and means to avoid double taxation (e.g. by endeavouring to
solve it through a MAP, or by allowing the repatriation of funds at an early stage, where
possible).
43 International Transfer Pricing, Circular No. 87-2R of September 27, 1999, CANADA REVENUE AGENCY,
GOVT. OF CANADA, http://www.cra-arc.gc.ca/E/pub/tp/ic87-2r/ic87-2r-e.html#P918_102991 (June 10,
2014, 11.00AM).
44 EU JOINT TRANSFER PRICING FORUM‘S Final Report on Secondary Adjustments, EUROPEAN
COMMISSION, BRUSSELS, Doc. No. JTPF/017/FINAL/2012/EN dated 18th January 2013
http://ec.europa.eu/taxation_customs/resources/documents/taxation/company_tax/transfer_pricing/forum/
final_report_secondary_adjustments_en.pdf (June 10, 2014, 11.40AM).
Furthermore, with a view to avoid complications it has been recommended that within
the EU Member States characterise secondary adjustments as constructive dividends or
constructive capital contributions rather than as constructive loans, as long as there is no
repatriation. The EUJTPF is of the view that penalties should only relate to the transfer
pricing adjustment itself, i.e. the primary adjustment and not to the secondary adjustment.
Hence it has recommended that when a secondary adjustment is required, Member States
should refrain from imposing a penalty with respect to the secondary adjustment.
The aforesaid elucidations clearly demonstrate that even globally, sovereign countries
resort to carrying out of "secondary adjustments" in TP, only if there is an express & specific
mandate provided in their respective domestic legislation. Countries do not undertake
"secondary adjustments" in TP as a matter of practice, without the express blessing of their
respective domestic legislation
As far as applicability of TP regulations on subscription of shares is concerned, such a

position is unprecedented globally. In the case of Lowry (Inspector of Taxes) v. Consolidated
African Selection Trust Ltd.45 It was held that amounts related to issue of shares are obviously
not profits or gains of the trade, and they are not liable to be brought into the accounts for
income-tax. The sum which the company might hypothetically have received for premiums
was not an item in its profits and gains. The above observation been relied upon by the
Calcutta Bench of the Hon‘ble Tribunal in case of Asiatic Oxygen Ltd. v DCIT.46
Also it is worthwhile to pay attention to the following observations made in context of

applicability of TP regulations in the English case of Ametalco UK v IRC:47
―transactions involving money which are not naturally described as ‗the giving of
business facilities‘ are not within the scope of the relevant statutory provisions and that a
subscription for ordinary shares in an associated company is not naturally so described and
is not within the statutory net, but that is not, they say, a reason for excluding transactions
which can naturally be so described (such as an advance on a loan) although the purely
economic purpose of such a loan may be similar to a subscription for shares.‖
45 Lowry (Inspector of Taxes) v. Consolidated African Selection Trust Ltd., [1940] 8 ITR (Supp.) 88 (HL).
46 Asiatic Oxygen Ltd. v. DCIT., [1994] 49 ITD 355 (Cal).
47 Ametalco UK v. IRC, [1996] STC (SCD) 399.
6. CONCLUSION
Clarity of law and consistency in approach is the bedrock of a good tax administration
and better tax collection. In the words of former Chief Justice of India, Shri S.H. Kapadia,
―FDI flows towards location with a strong governance infrastructure which includes
enactment of laws and how well the legal system works. Certainty is integral to rule of law.
Certainty and stability form the basic foundation of any fiscal system. Tax policy certainty is
crucial for taxpayers (including foreign investors) to make rational economic choices in the
most efficient manner. …. It is for the Government of the day to have them incorporated in
the Treaties and in the laws so as to avoid conflicting views. Investors should know where
they stand. It also helps the tax administration in enforcing the provisions of the taxing
laws.‖48 In wake of numerous ongoing transfer pricing related litigation pertaining to share
subscription, a proper guidance is required from the tax department. The well settled
principal that emerges from the above discussion is that in absence of a legislative mandate
TP provisions are not applicable on transactions which are capital in nature. ‗Income‘ has to
be present in order to compute the ALP. And such income should necessarily be ‗real‘
income and not ‗notional‘ in nature. Furthermore, secondary adjustments also require a
legislative backing. In absence of the same, the stand taken by the department seems to be
weak. On the fundamental jurisdictional issue, the Bombay High Court 49 has held that it
should be dealt with before determination of ALP, or else the entire exercise of determining
ALP becomes academic, and therefore redundant. When the tax department is trying to levy
income tax even on share capital, this is an extremely reassuring and positive comment made
by the judiciary. The amendment brought in by the Finance Act, 2012 has laid down a new
law in this regard. Hence the same is substantive in nature. By this very nature, it should not
have been made retrospective. The stand taken by the tax department in the present case
seems to be very desperate and aggressive in nature. When on one hand excess security
premium is not being charged to tax, then taxing under receipt of the same seems to be a
farfetched idea.
That being said, going forward, in the interest of the tax administration and to instil
confidence in foreign investors as well as taxpayers that we must remember the following
words written by Nani Palkhivala:
48 Vodafone International Holdings B.V. v Union of India, 341 ITR 1(SC).

49 Vodafone India Services Pvt. Ltd. v. Union of India [2013] 39 taxmann.com 201 [Bombay].
―Every government has a right to levy taxes. But no government has the right, in the
process of extracting tax, to cause misery and harassment to the taxpayer and the gnawing
feeling that he is made the victim of palpable injustice.‖
The ghost of the great Vodafone saga is yet to be buried and enough bridges have been
burnt in the process. It is hoped that in such cases the courts deal with them in a rational
manner rather than by extending the concept of ―income‖ beyond its natural and sensible
bounds. This will help in solving not only the interpretation issue but also allay the fears that
the foreign investors are experiencing off late.
II
INDIAN JOURNAL OF TAX LAW
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INDIAN JOURNAL OF TAX LAW

Missing the Woods for the Trees: Ishikawajima v.

Theoretical Issues in the Management of Property

Taxation of the Income of Investment Funds:

Royalty Taxation in India Post Reliance Infocom:

Indian GAAR: Is Uncertainty Causing a Setback to

Subscription of Shares vis-à-vis Transfer Pricing and

Indian Journal of Tax Law

Organisation of the students of National Law University Odisha, Cuttack.

Price: Rs. 250 or $ 10

Mode of Citation: 1 IJTL (2014)

Missing the Woods for the Trees: Ishikawajima v.

Theoretical Issues in the Management of Property Rates

Taxation of the Income of Investment Funds: Applying the

Royalty Taxation in India Post Reliance Infocom: Setting a

Indian GAAR: Is Uncertainty Causing a Setback to

Subscription of Shares vis-à-vis Transfer Pricing and

Recently when Delhi High Court in Linde AG reaffirmed application of

 Assistant Professor of Law, NALSAR University of Law, Hyderabad; E-mail: nehapathakji@gmail.com

PART I INTRODUCING THE CONTROVERSY

Contemporary times have witnessed proliferation of turnkey contracts and consortium

Consequent to Vodafone judgement it was opined by several rulings of Authority for

4 Alstom Transport v. DIT, (2012) 349 ITR 292 (AAR).

PART II FOUNDATION PILLARS OF DISSECTED APPROACH AND LOOK

Ishikawajima is considered to be foundation pillar of dissecting approach to turnkey

PART III OSCILLATING DECISIONS POST VODAFONE

A quick survey of rulings delivered post-Vodafone, provides fair amount of

In Re: Roxar Maximum Reservoir Performance WLL15where ONGC floated a tender

Alstom Transport v. DIT16went on to hold that the approach adopted in Ishikawajima

14 Hyosung Corporation v. DIT,(2009) 314 ITR 343 (AAR)

In DIT v. Nokia Networks OY 19 , the assessee (Nokia Networks) was a Finnish

The aforementioned discussion demonstrates how turnkey contracts were subject to

PART IV TWO DETERMINANT TESTS

1) Where equipments and materials are manufactured by a non-resident outside

2) Where equipments and materials are manufactured by a non-resident, procured

3) Where offshore services are provided as a part of a composite contract

4) Where it cannot be sufficiently provide that the offshore services formed an

Thus what is enumerated above is possible tax implication of a transaction. Situation

PURPOSE AND OBJECT OF CONTRACT TEST

SOURCE OF RECEIPT TEST

The Supreme Court in Ishikawajima, however accorded prominence to source of

21 A.A.R. No. 618 of 2003.

Insofar as application of Vodafone is concerned it needs to be carefully examined that

A classic instance of matters where Vodafone decision has application is found in

2. PROPERTY RATES TAX EXPLAINED

20 The Local Government (Rating) Act No. 8, 2005, §37 cl. 2.

3. THEORIES IN ADMINISTRATION OF PROPERTY RATES TAX AND

3.1 PRINCIPAL-AGENT THEORY

However, what makes the principal-agent model distinctive is the additional

The principal-agent framework is not only of interest in understanding the relation

The principal-agent framework can also be used to understand relationship between

3.2 GAME THEORY

30 M. D. DAVIS, GAME THEORY: A NON TECHNICAL INTRODUCTION, xiv (1983).

Furthermore, a tax compliance game indicates existence of both competitive and

The primary objective of KCCA in imposing property rates tax on individuals is to

3.3 NOZICK’S STATE OF NATURE THEORY

33 R. Nozick, Anarchy, State, and Utopia 10 (1974 Basic Books).

3.4 THE THEORY OF UTILITARIANISM

Utilitarianism is grounded on a vision of equality in that no one person should be

47 J. BENTHAM, THE THEORY OF LEGISLATION 2 (1931 C.K. Ogden Ed.).

53 The Local Government (Rating) Act, section 37 (2).

2. INDICATORS FOR CHARACTERIZING INCOME

 Student of Law, National University of Advanced Legal Studies, Kochi; E-mail: