Recently on 2nd Jan 2013 ITAT held that, Transfer of shares by assessee & LTIL to its AE group “at same price” attracts transfer pricing. ITAT bench also rejects assessee use of CCI valuation to justify share transfer price.
Assessee is a subsidiary of an international company called ALIL which in turn is a wholly owned subsidiary of AL Singapore. Assessee is engaged in real estate business by way of building and leasing out techno-park and software parks. Assessee had in 2002 entered into a joint venture agreement with one M/s. L&T Infocity Limited (LTIL) for developing, owning and managing Information Technology Parks in India. For the purpose of enabling the joint venture business, assessee alongwith LTIL incorporated a company called LTIAL (L&T Infocity Asendas Ltd.) on 30.5.2002. Assessee and M/s. LTIL each held 25,000 equity shares of F.10/- each and 9.88 lakhs preferential shares of F.100/- each in LTIAL. LTIAL thereafter pursued the business of developing informationtechnology parks. On November 1 2006, an agreement was entered by Assessee and LTIL with one M/s. Ascendas Property Fund India (APFI) selling their respective holdings in LTIAL to M/s.APFI. At this juncture itshould be noted that Assessee and APFI were Associated Enterprises as defined in Chapter X of the Income Tax Act, 1961. Consideration received from M/s. APFI on sale of the shares, coming to F.79 crores was split between Assessee and LTIL equally.
Assessee had also incorporated another company called AITPL on 3.11.2003 along with Tamilnadu Industrial Development Corporation Ltd. (TIDCO). Assessee had 84.97% shares in the said company whereas TIDCO had 11%. Ascendas Property Management Services (India) Private Limited, another company falling within the group of Assessee held 4.02%. M/s. AITPL was also into development of IT parks and buildings. Said company was doing some projects of this nature. On 30.3.2007, an agreement was entered by Assessee with M/s.APFI to sell its share holdings in AITPL to M/s. APFI and the same was effected in two stages. First tranche of the share transfer happened in March 2007 which fell within the relevant previous year.
While filing return for the impugned Asst. Year, Assessee had justified the price at which it had sold the shares in LTIAL and AITPL to M/s.APFI. According to it the sale price of shares in LTIAL were perfectly comparable and in accordance with rules for determining ALP. Sale price of Rs. 26.07 per share in AITPL was supported by a “valuation certificate” determining the enterprise value of AITPL prepared by a Chartered Accountant in accordance with Controller of Capital Issues (CCI) Valuation guide lines. CCI guidelines were as per Foreign Exchange Management (Transfer or Issue of security by a personnel resident outside India) Regulations 2000.Such valuation of the enterprise was made considering average of net asset value and yield. The price at which shares of AITPL was sold to APFI at Rs. 26.07 per share was much higher than the value of Rs. 3.07 per share arrived by the Chartered Accountant based on CCI guideline.
AO referred the issue of determination of ALP to the TPO. TPO was of the opinion that transfer of shares in LTIAL by LTIL to APFI could not be considered as an uncontrolled comparable transaction. According to her, the relationship of Assessee with M/s. LTIL which was through common participation in LTIAL, automatically resulted in LTIL and assessee becoming Associated Enterprises. Further, according to her, sale of shares effected by LTIL to APFI was intimately connected to the sale of shares by assessee to APFI.
The TPO was of the opinion that share price as valued by the CA on CCI valuation guidelines, could not be accepted. As per the TPO the price of Rs. 26.07 per share received by Assessee for selling the shares was computed based on a single year data. Again as per the TPO, the guidelines and rules for valuation of shares for CCI, were not relevant for the purpose of ascertaining the ALP under the Transfer Pricing Rules. The purpose of CCI valuation guidelines were entirely different and in any case according to the TPO, the said guidelines were replaced by SEBI guidelines with effect from April 2010 and the replaced guidelines recommended adoption of Discounted Cash Flow (DCF) method for valuation of an enterprise.
Assessee argued that most appropriate method for the purpose of arriving at ALP of shares in LTIAL was the CUP method, especially since all the conditions specified in Rule 10B(2), however, this was not accepted by the TPO. As per the TPO, the valuation and data used by Assessee in computing ALP were neither reliable nor correct.
Relying on the decision reported in (2008) TaxCorp (TP) 2392 (HC-P&H), the TPO held that the value computed for M/s. LTIAL based on the alleged CUP method and for AITPL based on CCI Guidelines were not reliable basis for determining the ALP of the share prices.
After correcting some of the mistakes pointed out by Assessee, TPO arrived at an ALP of F.70.52 per share for AITPL and F.26,655/- per share for LTIAL, based on DCF applied on future cash flows. Accordingly, adjustments were carried out on the value of international transactions viz. sale of shares by Assessee toM/s.APFI. This resulted in an upward adjustment of F.239,82,91,448/- being recommended by the TPO. Draft assessment order was issued by the AO in accordance with the report of the TPO, and forwarded to the assessee.
Before DRP assessee again contended that shares in the same company were also transferred by LTIL, which was not at all an AE and, therefore, CUP method which was adopted by Assessee was unjustly rejected. As per the DRP, there was no need to interfere with the values arrived at by the TPO. DRP also rejected the objections taken by the Assessee on the project life of 20 years considered by the TPO for working out the future cash flows.
Before ITAT bench on behalf of assessee CA Shri Kanchan Kaushal contended strongly assailing the orders of the lower authorities, has preferred two different lines of arguments. First set of arguments are relevant for transfer of shares by LTIAL and second set of arguments are relevant for transfer of shares of both AITPL as well as LTIAL. Adverting to the first line of argument, AR submitted that CUP method was most appropriate one since LTIL was not an interested party nor an AEs. According to him, there was no common share holding between LTIL and APFI. LTIL had independently transferred shares which were held by it in LTIAL to APFI. Provisions of Rule 10B(2) were satisfied fully. Hence, according to him, lower authorities erred in rejecting the CUP method and foisting a different method based on Discounted Cash Flow, for arriving at the ALP of the shares.
The first is whether we can consider the sale of shares by LTIL to APFI to be uncontrolled, observed and held that every clause in the said agreement applies to both Assessee and LTIL. Even the consideration of Rs. 79 crores mentioned at clause No.3 of the said agreement is a consolidated one. Thus, the price for which shares of LTIAL were transferred was based on a single agreement and, therefore, to say that one part of that agreement would be an uncontrolled transaction, for comparing it with the other part, would, in our opinion, be unacceptable. The agreement has to be taken as a whole and it is clear that the transactions between Assessee and LTIL with regard to the sale of shares of LTIAL, was not an independently entered one but a joint effort. In such circumstances, Assessee’s contention that the sale of shares of LTIAL by LTIL to APFI has to be taken as an comparable uncontrolled transaction, falls flat.
The the second question as to whether it would be possible to apply any one of the methods, out of those prescribed in sec.92C(1) of the Act. No doubt the said section uses the term “shall”.
ITAT observed that for the purpose of enactment of Chapter X, is to benchmark an international transaction with the Fair Market Value of such transaction, so as to ensure that there are no profit transfers between parties in different jurisdictions effectually circumventing axes. Thus, purpose of transfer pricing rules, is to verify whether the prices at which an international transaction has been carried out is comparable with the market value of the underlying asset or commodity or service. It may be true that difficulties might arise in ascertaining the fair market value, but such difficulties should not be a reason for not adapting the rules and methods prescribed in this regard. This might require some subtle adjustments in the methodology prescribed for evaluation of an international transaction. A water-tight attitude of interpretation of the prescribed methods will defeat the very purpose of enactment of transfer pricing rules and regulations and also detrimentally affect the effective and
fair administration of an international tax regime. That interpretation of the word ‘shall’ need not always be mandatory and could also be read as “may”, is a rule laid down by the Hon'ble High court in the case of CIT v. Gujarat Oil & Allied Industries. This is more or less the same view taken by the Hon'ble Apex Court in the case of Director of Inspection of Income Tax (Investigation) v. Pooran Mal & Sons and in the case of AIR 1961 SC 1480. Hence, while finding the most appropriate method it is not that modern valuation methods fitting the type of underlying service or commodities have to be ignored.
As observed that in the case reported in (2008) TaxCorp (TP) 2392 (HC-P&H), Hon’ble high court , specifically held that “price fixed by RBI under FERA cannot apply to provisions of the Act which provide for a particular methodology for computation of income with regard to ALP of ‘International Transaction’ ”. No doubt, Rule 11 U and 11UA prescribe a method for determination of fair market value of a property other than immovable property for the purpose of sec.56 of the Act. But these rules have been inserted by IT(Second Amendment) Rules, 2010 with effect from 01.10.2009 and cannot be taken as a basis for valuation in a transfer pricing matter.
ITAT also noted that Ld.Counsel for the Assessee, did submit that if the CUP method and CCI guidelines method suggested by the assessee were not acceptable, DCF method could be adopted but with certain riders. His objections were with regard to the factors considered by the TPO for the DCF analysis. Discounted Cash Flow for valuation is an accepted international methodology for valuing an enterprises and for determining the value of the holding of an investor. Investors are interested in ascertaining the present value of their investments, considering the future earning potential of the underlying asset. In our opinion, ascertaining net present value of future earnings is all the more appropriate where market value of an investment is not readily ascertainable by conventional methods. In assessee’s case both the companies whose shares were sold were private limited companies which had no ready market for its equity shares due to various constraints for transfer of its shares. However, the sale of shares were effected to its own AE, and for verifying the fairness of the prices, value of such shares which discloses its true market potentials has to be considered. The value of an equity can be obtained in two methods even under the Discounted Cash Flow method. First one is to discount the cash flow expected from the equity investment and the second is to ascertain the value of the enterprise by applying DCF on its future earnings and then dividing it with the number of shares. Both the TPO and assessee in its reply to the TPO, had used the second method whereby the companies concerned were valued by discounting their future cash flows over a period of 20 years and thereafter dividing such value by the total number of shares.
Most important aspect in the application of DCF is the discounting factor used for working out the net present value (NPV). The Discounting factor generally used is the Weighted Average Cost of capital and It is obvious that difficult parts are (i) determining the future cash flows, (ii) determining the cost of equity, (iii) determining the cost of debt and (iv) determining the period of discounting. Here both parties have agreed that 20 years is an appropriate one and hence last mentioned difficulty is not there. Future cash in-flow also can be reasonably ascertained since major part of the earnings of the assessee are rental or lease income and these are predictable with reasonable accuracy. Similarly, cash out-flow also can be reasonably ascertained by virtue of the very nature of the business of Assessee. Problem is with regard to determination of cost of equity and debt. TPO had adopted 7.5% as the cost of debt whereas as per Assessee it was 11.5%. TPO had determined the cost of equity at 11.5% on AITPL and 10% on LTIAL, for which he has taken cue from agreement that assessee had with M/s TIDCO. But in our opinion cost of equity will always be higher than the risk free interest rate in the market. When risk free interest rate is adjusted with the risk premium the resulting figure will be cost of equity. It is a basic principle of economics that risk and returns go together. Greater the risk, the higher is the possibility of return and vice-versa. A person who places his money in a Fixed Deposit with a Bank will be satisfied with a lower rate of interest than the returns he would expect, had he placed his money in equity shares. Risk of investment in equity shares is higher since returns are not assured. Therefore, cost of equity will always be higher than the cost of debt.
If the ALP of the shares are worked out without considering a reasonable value for the enterprise, it will result in injustice. We are, therefore, of the opinion that the issue of working out of value of the companies so as to ascertain the ALP of the shares requires a re-look by the AO and TPO.
With regard to the argument of the Ld. AR that a discount for illiquidity of shares should be given, this cannot be accepted for the reason that when weighted average cost of capital is worked out and discounting factor is applied for ascertaining the net present value of the future cash flows, such discounting rate would take into account all associated risks. When value of an enterprise is fixed based on present value of its future earnings there is no scope for any further allowance for any perceived risk factor
ITAT while holding that discounted cash flow method was appropriate to determine the ALP of the international transaction, we set aside the issue to the file of AO for re-working the value afresh in accordance with standard practices adopted for such valuation.
Assessee is a subsidiary of an international company called ALIL which in turn is a wholly owned subsidiary of AL Singapore. Assessee is engaged in real estate business by way of building and leasing out techno-park and software parks. Assessee had in 2002 entered into a joint venture agreement with one M/s. L&T Infocity Limited (LTIL) for developing, owning and managing Information Technology Parks in India. For the purpose of enabling the joint venture business, assessee alongwith LTIL incorporated a company called LTIAL (L&T Infocity Asendas Ltd.) on 30.5.2002. Assessee and M/s. LTIL each held 25,000 equity shares of F.10/- each and 9.88 lakhs preferential shares of F.100/- each in LTIAL. LTIAL thereafter pursued the business of developing informationtechnology parks. On November 1 2006, an agreement was entered by Assessee and LTIL with one M/s. Ascendas Property Fund India (APFI) selling their respective holdings in LTIAL to M/s.APFI. At this juncture itshould be noted that Assessee and APFI were Associated Enterprises as defined in Chapter X of the Income Tax Act, 1961. Consideration received from M/s. APFI on sale of the shares, coming to F.79 crores was split between Assessee and LTIL equally.
Assessee had also incorporated another company called AITPL on 3.11.2003 along with Tamilnadu Industrial Development Corporation Ltd. (TIDCO). Assessee had 84.97% shares in the said company whereas TIDCO had 11%. Ascendas Property Management Services (India) Private Limited, another company falling within the group of Assessee held 4.02%. M/s. AITPL was also into development of IT parks and buildings. Said company was doing some projects of this nature. On 30.3.2007, an agreement was entered by Assessee with M/s.APFI to sell its share holdings in AITPL to M/s. APFI and the same was effected in two stages. First tranche of the share transfer happened in March 2007 which fell within the relevant previous year.
While filing return for the impugned Asst. Year, Assessee had justified the price at which it had sold the shares in LTIAL and AITPL to M/s.APFI. According to it the sale price of shares in LTIAL were perfectly comparable and in accordance with rules for determining ALP. Sale price of Rs. 26.07 per share in AITPL was supported by a “valuation certificate” determining the enterprise value of AITPL prepared by a Chartered Accountant in accordance with Controller of Capital Issues (CCI) Valuation guide lines. CCI guidelines were as per Foreign Exchange Management (Transfer or Issue of security by a personnel resident outside India) Regulations 2000.Such valuation of the enterprise was made considering average of net asset value and yield. The price at which shares of AITPL was sold to APFI at Rs. 26.07 per share was much higher than the value of Rs. 3.07 per share arrived by the Chartered Accountant based on CCI guideline.
AO referred the issue of determination of ALP to the TPO. TPO was of the opinion that transfer of shares in LTIAL by LTIL to APFI could not be considered as an uncontrolled comparable transaction. According to her, the relationship of Assessee with M/s. LTIL which was through common participation in LTIAL, automatically resulted in LTIL and assessee becoming Associated Enterprises. Further, according to her, sale of shares effected by LTIL to APFI was intimately connected to the sale of shares by assessee to APFI.
The TPO was of the opinion that share price as valued by the CA on CCI valuation guidelines, could not be accepted. As per the TPO the price of Rs. 26.07 per share received by Assessee for selling the shares was computed based on a single year data. Again as per the TPO, the guidelines and rules for valuation of shares for CCI, were not relevant for the purpose of ascertaining the ALP under the Transfer Pricing Rules. The purpose of CCI valuation guidelines were entirely different and in any case according to the TPO, the said guidelines were replaced by SEBI guidelines with effect from April 2010 and the replaced guidelines recommended adoption of Discounted Cash Flow (DCF) method for valuation of an enterprise.
Assessee argued that most appropriate method for the purpose of arriving at ALP of shares in LTIAL was the CUP method, especially since all the conditions specified in Rule 10B(2), however, this was not accepted by the TPO. As per the TPO, the valuation and data used by Assessee in computing ALP were neither reliable nor correct.
Relying on the decision reported in (2008) TaxCorp (TP) 2392 (HC-P&H), the TPO held that the value computed for M/s. LTIAL based on the alleged CUP method and for AITPL based on CCI Guidelines were not reliable basis for determining the ALP of the share prices.
After correcting some of the mistakes pointed out by Assessee, TPO arrived at an ALP of F.70.52 per share for AITPL and F.26,655/- per share for LTIAL, based on DCF applied on future cash flows. Accordingly, adjustments were carried out on the value of international transactions viz. sale of shares by Assessee toM/s.APFI. This resulted in an upward adjustment of F.239,82,91,448/- being recommended by the TPO. Draft assessment order was issued by the AO in accordance with the report of the TPO, and forwarded to the assessee.
Before DRP assessee again contended that shares in the same company were also transferred by LTIL, which was not at all an AE and, therefore, CUP method which was adopted by Assessee was unjustly rejected. As per the DRP, there was no need to interfere with the values arrived at by the TPO. DRP also rejected the objections taken by the Assessee on the project life of 20 years considered by the TPO for working out the future cash flows.
Before ITAT bench on behalf of assessee CA Shri Kanchan Kaushal contended strongly assailing the orders of the lower authorities, has preferred two different lines of arguments. First set of arguments are relevant for transfer of shares by LTIAL and second set of arguments are relevant for transfer of shares of both AITPL as well as LTIAL. Adverting to the first line of argument, AR submitted that CUP method was most appropriate one since LTIL was not an interested party nor an AEs. According to him, there was no common share holding between LTIL and APFI. LTIL had independently transferred shares which were held by it in LTIAL to APFI. Provisions of Rule 10B(2) were satisfied fully. Hence, according to him, lower authorities erred in rejecting the CUP method and foisting a different method based on Discounted Cash Flow, for arriving at the ALP of the shares.
The first is whether we can consider the sale of shares by LTIL to APFI to be uncontrolled, observed and held that every clause in the said agreement applies to both Assessee and LTIL. Even the consideration of Rs. 79 crores mentioned at clause No.3 of the said agreement is a consolidated one. Thus, the price for which shares of LTIAL were transferred was based on a single agreement and, therefore, to say that one part of that agreement would be an uncontrolled transaction, for comparing it with the other part, would, in our opinion, be unacceptable. The agreement has to be taken as a whole and it is clear that the transactions between Assessee and LTIL with regard to the sale of shares of LTIAL, was not an independently entered one but a joint effort. In such circumstances, Assessee’s contention that the sale of shares of LTIAL by LTIL to APFI has to be taken as an comparable uncontrolled transaction, falls flat.
The the second question as to whether it would be possible to apply any one of the methods, out of those prescribed in sec.92C(1) of the Act. No doubt the said section uses the term “shall”.
ITAT observed that for the purpose of enactment of Chapter X, is to benchmark an international transaction with the Fair Market Value of such transaction, so as to ensure that there are no profit transfers between parties in different jurisdictions effectually circumventing axes. Thus, purpose of transfer pricing rules, is to verify whether the prices at which an international transaction has been carried out is comparable with the market value of the underlying asset or commodity or service. It may be true that difficulties might arise in ascertaining the fair market value, but such difficulties should not be a reason for not adapting the rules and methods prescribed in this regard. This might require some subtle adjustments in the methodology prescribed for evaluation of an international transaction. A water-tight attitude of interpretation of the prescribed methods will defeat the very purpose of enactment of transfer pricing rules and regulations and also detrimentally affect the effective and
fair administration of an international tax regime. That interpretation of the word ‘shall’ need not always be mandatory and could also be read as “may”, is a rule laid down by the Hon'ble High court in the case of CIT v. Gujarat Oil & Allied Industries. This is more or less the same view taken by the Hon'ble Apex Court in the case of Director of Inspection of Income Tax (Investigation) v. Pooran Mal & Sons and in the case of AIR 1961 SC 1480. Hence, while finding the most appropriate method it is not that modern valuation methods fitting the type of underlying service or commodities have to be ignored.
As observed that in the case reported in (2008) TaxCorp (TP) 2392 (HC-P&H), Hon’ble high court , specifically held that “price fixed by RBI under FERA cannot apply to provisions of the Act which provide for a particular methodology for computation of income with regard to ALP of ‘International Transaction’ ”. No doubt, Rule 11 U and 11UA prescribe a method for determination of fair market value of a property other than immovable property for the purpose of sec.56 of the Act. But these rules have been inserted by IT(Second Amendment) Rules, 2010 with effect from 01.10.2009 and cannot be taken as a basis for valuation in a transfer pricing matter.
ITAT also noted that Ld.Counsel for the Assessee, did submit that if the CUP method and CCI guidelines method suggested by the assessee were not acceptable, DCF method could be adopted but with certain riders. His objections were with regard to the factors considered by the TPO for the DCF analysis. Discounted Cash Flow for valuation is an accepted international methodology for valuing an enterprises and for determining the value of the holding of an investor. Investors are interested in ascertaining the present value of their investments, considering the future earning potential of the underlying asset. In our opinion, ascertaining net present value of future earnings is all the more appropriate where market value of an investment is not readily ascertainable by conventional methods. In assessee’s case both the companies whose shares were sold were private limited companies which had no ready market for its equity shares due to various constraints for transfer of its shares. However, the sale of shares were effected to its own AE, and for verifying the fairness of the prices, value of such shares which discloses its true market potentials has to be considered. The value of an equity can be obtained in two methods even under the Discounted Cash Flow method. First one is to discount the cash flow expected from the equity investment and the second is to ascertain the value of the enterprise by applying DCF on its future earnings and then dividing it with the number of shares. Both the TPO and assessee in its reply to the TPO, had used the second method whereby the companies concerned were valued by discounting their future cash flows over a period of 20 years and thereafter dividing such value by the total number of shares.
Most important aspect in the application of DCF is the discounting factor used for working out the net present value (NPV). The Discounting factor generally used is the Weighted Average Cost of capital and It is obvious that difficult parts are (i) determining the future cash flows, (ii) determining the cost of equity, (iii) determining the cost of debt and (iv) determining the period of discounting. Here both parties have agreed that 20 years is an appropriate one and hence last mentioned difficulty is not there. Future cash in-flow also can be reasonably ascertained since major part of the earnings of the assessee are rental or lease income and these are predictable with reasonable accuracy. Similarly, cash out-flow also can be reasonably ascertained by virtue of the very nature of the business of Assessee. Problem is with regard to determination of cost of equity and debt. TPO had adopted 7.5% as the cost of debt whereas as per Assessee it was 11.5%. TPO had determined the cost of equity at 11.5% on AITPL and 10% on LTIAL, for which he has taken cue from agreement that assessee had with M/s TIDCO. But in our opinion cost of equity will always be higher than the risk free interest rate in the market. When risk free interest rate is adjusted with the risk premium the resulting figure will be cost of equity. It is a basic principle of economics that risk and returns go together. Greater the risk, the higher is the possibility of return and vice-versa. A person who places his money in a Fixed Deposit with a Bank will be satisfied with a lower rate of interest than the returns he would expect, had he placed his money in equity shares. Risk of investment in equity shares is higher since returns are not assured. Therefore, cost of equity will always be higher than the cost of debt.
If the ALP of the shares are worked out without considering a reasonable value for the enterprise, it will result in injustice. We are, therefore, of the opinion that the issue of working out of value of the companies so as to ascertain the ALP of the shares requires a re-look by the AO and TPO.
With regard to the argument of the Ld. AR that a discount for illiquidity of shares should be given, this cannot be accepted for the reason that when weighted average cost of capital is worked out and discounting factor is applied for ascertaining the net present value of the future cash flows, such discounting rate would take into account all associated risks. When value of an enterprise is fixed based on present value of its future earnings there is no scope for any further allowance for any perceived risk factor
ITAT while holding that discounted cash flow method was appropriate to determine the ALP of the international transaction, we set aside the issue to the file of AO for re-working the value afresh in accordance with standard practices adopted for such valuation.
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