Mirrors Cause Hallucinations

Delhi HC joins dots on indirect transfer debate

In a ruling demonstrating wise judicial discipline, the Delhi High Court (HC) recently upheld non-taxability of sale of shares in an offshore company reasoning out that shares of target company didn’t derive substantial value from assets located in India.

The HC dismissing Revenue’s writs against rulings of the Authority for Advance Rulings (AAR), has upheld that share sale transaction between Copal Group shareholders (sellers) and Moody Analytics US, (buyer) were not designed to avoid tax.

A pleasing outcome of the ruling is the ‘obiter’ on ‘substantial value’ test as the court held that sale of shares of overseas holding company couldn’t be brought to tax in India, since shares derived less than 50 per cent of their value from assets located in India (i.e. shares of Copal India).

The HC verdict also underscored the important principle of ‘commercial rationale’ underlying a transaction while approving capital gains exemption for transfer or entities under the tax treaty. This will serve as reference, going forward for invoking treaty abuse provisions, in the absence of General Anti-Avoidance Rules.

The ruling entails the first-ever judicial analysis of ‘substantial value’ test in the domestic jurisprudence and assumes significance in the wake of the ongoing debate on Vodafone-controversy emerging from a favourable ruling of the apex court which led to the retrospective law change in 2012. Following amendments in Finance Act 2012, to section 9 of the Income Tax law, the tax administration has upped its ante on Vodafone-like transactions, often disregarding the most important trigger for taxability of such transaction, i.e. ‘substantial’ value test enshrined in Explanation 5 to section 9, ostensibly in the absence of definitive administrative guidance to enforce the draconian 2012 law.

The ratio of Copal ruling should please investors, as the HC didn’t hesitate from taking a bold view on definitional aspect of the statute, particularly when the lawmakers did not explicitly ascribe meaning to the term ‘substantial’ in the context of indirect transfer tax.
In doing so, the court has placed definitive reliance on the Direct Taxes Code (DTC) Bill, albeit of 2010 version, and recommendations of the Expert Committee Chaired by Dr Shome, both of whom had unequivocally advocated a 50 per cent asset value threshold. Supplementary interpretational aids drawn upon by the HC from international commentaries on tax treaties (under OECD and UN Model) is encouraging, as it reinforces the judiciary’s confidence in bilateral conventions, particularly in the matter of administering sophisticated portions of tax statutes dealing with cross- border matters.

What pleasantly surprises me is the short shrift accorded by the HC to the revised DTC Bill (of 2013) which prescribes a lower 20 per cent threshold for applying the ‘substantial value’ trigger. Now, an important question before the lawmakers is whether the court’s verdict (albeit an obiter), could assail against the lower threshold and prevail whilst the newly appointed special committee of the Central Board of Direct Taxes (CBDT) commences review of cases on taxability of indirect transfers, a step taken by the new government in 2014 budget to address the woes of foreign investors.

Legal effect of ‘obiter’
It is trite that a court judgment is a decision on the facts of the case, and would bind the parties on the principle of res judicata; however, insofar as the binding nature of any such verdict is concerned, what should bind the administration and subordinate courts is the ratio decidendi, ie the underlying legal principle pronounced by the court, and not the decision per se. Ordinarily, whilst there are certain judicial principles to suggest that an obiter dicta of the apex court ought to be binding on lower authorities /courts (though there are contrary rulings too), the same legal effect or precedence value may not be accorded to HC’s obiter. This however, does not preclude the administration from relying on the HC’s observations.

Taxability of indirect transfer hangs in balance
The hierarchy of courts’ judicial action and binding effect thereof could be a legal debate, what however intrigues me is the conundrum taxpayers will have to deal with for doing business in India in general, and for India to take the indirect transfer debate to its logical conclusion.

For one, the Revenue’s Special Leave Petition before the Supreme Court in Sanofi case is an outcome keenly anticipated by investors; on the other hand, multiple writs under Article 226 Bombay and Calcutta HC will only keep the investors conjecturing the constitutionality of retrospective amendments as much as the final contours of administrative guidance for interpreting the ‘substantial value’ test. Besides, the incumbent government’s abstinence in not withdrawing retrospective amendments and a move to address via administrative committee under the tax administration complicates matters for investors.

Since the FM in his 2014 Budget speech announced that he would instead await the judicial view on this debate, I wonder if this is his opportunity to pick cues from the logic espoused by the HC’s obiter on substantial value test, and carry out appropriate legislative amendment.

It would be certainly regressive for the administration to consider filing an appeal against the HC verdict on the pretext of the lower threshold test proposed by the DTC Bill of 2013. This is certainly an opportunity to join the dots and put a full stop to a debate which has attracted negative press for India in the past few years.

Source:http://www.business-standard.com/article/opinion/delhi-hc-joins-dots-on-indirect-transfer-debate-114090700750_1.html

Applicability of AS 30, 31 and 32

These standards are not mandatory but earlier adoption is encouraged. It may be mentioned that it has not been adopted by NACAS and thus in case of a company an earlier adoption of these standards might not comply with certain standards like AS-13 investment: A Company needs to consult accounting experts in such situation. Needless to mention that in case the company wishes to adopt the standard then it shall adopt the entire standard and not a part of it .

ICAI Clarification – Principle of Prudence

Under situation where an item of financial instrument is suffering from losses, than based on principle of prudence the entity shall provide for such losses through its profit and loss account.

Objectives and scope

Financial instruments are addressed in three standards: AS-31, which deals with distinguishing debt from equity and with netting; AS 30, which contains requirements for recognition and measurement; and AS-32, which deals with disclosures. The objective of the three standards is to establish requirements for all aspects of accounting for financial instruments, including distinguishing debt from equity, netting, recognition, derecognition, measurement, hedge accounting and disclosure. The scope of the standards is wide-ranging. The standards cover all types of financial instrument, including receivables, payables, investments in bonds and shares, borrowings and derivatives. They also apply to certain contracts to buy or sell non-financial assets (such as commodities) that can be net settled in cash or another financial instrument.

Nature and characteristics of financial instruments

Financial instruments include a wide range of assets and liabilities. They can mostly be exchanged for cash. They are recognised and measured according to AS-30 requirements and are disclosed in accordance with AS-32.

Financial instruments (FI) :

• represent contractual rights or obligations
• to receive or pay cash or other financial asset.

A financial asset:

• is cash;
• a contractual right to receive cash or another financial asset;
• a contractual right to exchange financial assets or liabilities with another entity under conditions that are potentially favourable; or
• an equity instrument of another entity.

A financial liability:

• is a contractual obligation to deliver cash or another financial asset or
• to exchange financial instruments with another entity under conditions that are potentially unfavourable.

An equity instrument is any contract that evidences a residual interest in the entity’s assets after deducting all its liabilities.

A derivative is a financial instrument that derives its value from an underlying price or index, requires little or no initial investment and is settled at a future date. In some cases contracts to receive or deliver a company’s own equity can also be derivatives.

They can be classified as:

• Futures
• Forwards
• Options ( Put and Call)

Embedded derivatives in host contracts

It means those derivatives which have features of more than one derivative attached to it. These instruments are required to be accounted on separate contract basis.

Host contract of liability                                ——-

Add: Advantages to holder of asset             ——-

(other party)

Less: Disadvantages to holder                    ——-

(other party)

Proceeds                                                     ——-

Advantages and disadvantages should be recorded as Equity Instruments.

Embedded derivatives that are not ‘closely related’ to the rest of the contract are separated and accounted for as if they were stand-alone derivatives (ie, measured at fair value, generally with changes in fair value recognised in profit or loss). An embedded derivative is not closely related if its economic characteristics and risks are different from those of the rest of the contract. AS-30 sets out examples to help determine when this test is (and is not) met. Analysing contracts for potential embedded derivatives and accounting for them is one of the more challenging aspects of AS-30.

Classification of financial instruments

The way that financial instruments are classified under AS-30 drives how they are subsequently measured and where changes in measurement are accounted for.

There are four classes of financial asset under AS-30A

Available for sale – those non – derivatives FAs which cannot be classified as held to maturity, loans and receivables and   fair value through profit and loss. They should be measured at fair value on the date of recognition plus directly attributable cost.

Held to maturity – these are non – derivative FAs with fixed or determinable payments and fixed maturity than an entity has positive intention and ability to hold till maturity.These are measured at fair value which means transaction cost plus directly attributable cost.

Loans and receivables – These are FAs which have fixed and determinable payments that are unquoted in active markets.Those which are short term are measured at acquisition price plus transaction cost.

Fair value through profit or loss – FAs which are

• held for trading
• acquired or incurred principally for the purpose of selling or repurchasing it in the near term,
• part of a portfolio,
• a Derivative (except for a derivative that is a Financial Guarantee Contract or an effective hedging instrument)

It should be measured at fair value on the date of acquisition which is the aquisition price plus directly attributable transaction cost which should be charged to Profit & Loss Account.

Financial liabilities are classified as fair value through profit or loss if they are so designated (subject to various conditions) or if they are held for trading. Otherwise they are classed as ‘ other liabilities’. Financial assets and liabilities are measured either at fair value or at amortised cost, depending on this classification. Changes are taken to either the income statement or directly to equity.

Financial liabilities and equity

The classification of a financial instrument by the issuer as either a liability (debt) or equity can have a significant impact on an entity’s reported earnings, its borrowing capacity,and debt-to-equity and other ratios that could affect the entity’s debt covenants. The substance of the contractual arrangements of a financial instrument, rather than its legal form, governs its classification. This means, for example, that since a preference share redeemable (puttable) by the holder is economically the same as a bond, it is accounted for in the same way as the bond. Therefore, the redeemable preference share is treated as a liability rather than equity, even though legally it is a share of the issuer. The critical feature of debt is that under the terms of the instrument the issuer is, or can be, required to deliver either cash or another financial asset to the holder and cannot avoid this obligation. For example, a debenture, under which the issuer is required to make interest payments and redeem the debenture for cash, is a financial liability. An instrument is classified as equity when it represents a residual interest in the issuer’s assets after deducting all its liabilities. Ordinary shares or common stock, where all the payments are at the discretion of the issuer, are examples of equity of the issuer. A special exception exists to the general principal of classification for certain subordinated redeemable (puttable) instruments that participate in the pro rata net assets of the entity. Where specific criteria are met such instruments would be classified as equity of the issuer. Some instruments contain features of both debt and equity. For these instruments, an analysis of the terms of each instrument in light of the detailed classification requirements will be necessary. Such instruments, such as bonds that are convertible into a fixed number of equity shares either mandatorily or at the holder’s option, must be split into debt and equity (being the option to convert) components. A financial instrument, including a derivative, is not an equity instrument solely because it may result in the receipt or delivery of the entity’s own equity instruments. The classification of contracts that will or may be settled in the entity’s own equity instruments is dependent on whether there is variability in either the number of own equity delivered and/or variability in the amount of cash or other financial assets received, or whether both are fixed. The treatment of interest, dividends, losses and gains in the income statement follows the classification of the related instrument. So, if a preference share is classified as debt, its coupon is shown as interest. But the dividend payments on an instrument that is treated as equity are shown as a distribution.

Recognition and derecognition

Recognition

Recognition issues for financial assets and financial liabilities tend to be straightforward.An entity recognises a financial asset or a financial liability at the time it becomes a party to a contract.

Derecognition

Derecognition is the term used for ceasing to recognise a financial asset or financial liability on an entity’s balance sheet. The rules here are more complex.

Assets

An entity that holds a financial asset may raise finance using the asset as security for the finance, or as the primary source of cash flows from which to repay the finance. The derecognition requirements of AS 30 determine whether the transaction is a sale of the financial assets (and, therefore, the entity ceases to recognise the assets) or whether finance secured on the assets has been raised (and the entity recognises a liability for any proceeds received). This evaluation might be straightforward. For example, it is clear with little or no analysis that a financial asset is derecognised in an unconditional transfer of it to an unconsolidated third party with no risks and rewards of the asset being retained. Conversely, it is clear that derecognition is not allowed where an asset has been transferred, but it is clear that substantially all the risks and rewards of the asset have been retained through the terms of the agreement. However, in many other cases, the analysis is more complex. Securitisation and debt factoring are examples of more complex transactions where derecognition will need careful consideration.

Liabilities

An entity may only cease to recognize (derecognise) a financial liability when it is extinguished — that is, when the obligation is discharged, cancelled or expired, or when the debtor is legally released from the liability by law or by the creditor agreeing to such a release.

Measurement of financial assets and liabilities

Under AS 30, all financial instruments are measured initially at fair value. The fair value of a financial instrument is normally the transaction price — that is, the amount of the consideration given or received. However, in some circumstances, the transaction price may not be indicative of fair value. In that situation, an appropriate fair value is determined using data from current observable transactions in the same instrument or based on a valuation technique whose variables include only data from observable markets.

The measurement of financial instruments after initial recognition depends on their initial classification. All financial assets are measured at fair value except for loans and receivables, held-to-maturity assets and, in rare circumstances, unquoted equity instruments whose fair values cannot be measured reliably or derivatives linked to and which must be settled by the delivery of such unquoted equity instruments that cannot be measured reliably. Loans and receivables and held-to-maturity financial assets are measured at amortised cost. The amortised cost of a financial asset or liability is measured using the ‘ effective interest method’. Available-for-sale financial assets are measured at fair value with changes in fair value recognised in equity. For available-for-sale debt securities, interest is recognised in income using the ‘ effective interest method’. Available-for-sale equity securities dividends are recognised in income as the holder becomes entitled to them. Derivatives (including separated embedded derivatives) are measured at fair value. All fair value gains and losses are recognised in profit or loss except where they qualify as hedging instruments in cash flow hedges. Financial liabilities are measured at amortised cost using the effective interest method unless they are measured at fair value through profit or loss. Financial assets and liabilities that are designated as hedged items may require further adjustments under the hedge accounting requirements. All financial assets, except those measured at fair value through profit or loss, are subject to review for impairment. Therefore, where there is objective evidence that such a financial asset may be impaired, the impairment loss is calculated and recognised in profit or loss.

Hedge accounting

‘Hedging’ is the process of using a financial instrument (usually a derivative) to mitigate all or some of the risk of a hedged item. ‘ Hedge accounting’ changes the timing of recognition of gains and losses on either the hedged item or the hedging instrument so that both are recognised in profit or loss in the same accounting period. To qualify for hedge accounting, an entity (a) at the inception of the hedge, formally designates and documents a hedge relationship between a qualifying hedging instrument and a qualifying hedged item; and

(b) both at inception and on an ongoing basis, demonstrates that the hedge is highly effective.

Hedging can be done through:

1. Currency Contracts
2. Interest rate swap

There are three types of hedge relationship

•  Fair value hedge: a hedge of the exposure to changes in the fair value of a recognised asset or liability, or a firm commitment.
•  Cash flow hedge: a hedge of the exposure to variability in cash flows of a recognised asset or liability, a firm commitment or a highly probable forecast transaction.
•  Net investment hedge: a hedge of the foreign currency risk on a net investment in a foreign operation.

A For a fair value hedge, the hedged item is adjusted for the gain or loss attributable to the hedged risk. That element is included in the income statement where it will offset the gain or loss on the hedging instrument.

For a cash flow hedge, gains and losses on the hedging instrument, to the extent it is an effective hedge, are initially included in equity.They are reclassified to the profit or loss when the hedged item affects the income statement. If the hedged item is the forecast acquisition of a non-financial asset or liability, the entity may choose an accounting policy of adjusting the carrying amount of the non-financial asset or liability for the hedging gain or loss at acquisition.

 Hedges of a net investment in a foreign operation are accounted for similarly to cash flow hedges.

Disclosure Requirements (AS 32):

1.  All financial assets and financial liabilities should be disclosed as a reconciliation statement.
2. If any financial asset has been furnished as a security to loan, the fact should be disclosed.
3. Following risks should be disclosed: 
   market risk – risk regarding changes in interest rate / discounting rate, liquidity risk – risk regarding late realisation of assets, credit risk – risk regarding non – realisation of assets.

4. Information should be given regarding hedging, hedged item, risk,% of effectiveness and hedge instrument.

5. Information should be given regarding Derivative risk, Derivative Instrument, purpose of Derivative, underlying derivative.

6. Information should be given regarding Securitisation, securitised asset, gain or loss on securitisation,yield rate applied for securitisation.

7. Accounting method followed for investment along with valuation basis. Trade date or settlement date accounting opted for Company’s investment should be disclosed.