'Capital gains' used to be deeply antithetical to the British understanding of 'income' for the purpose of the charge of income tax. Income is supposed to be a periodical return that has been likened to the fruits of a tree whereas the tree is the capital. If the tree itself is felled or alienated, no income would conceivably accrue to be taxed. It is this world view that dominated the tax laws of the Anglo-Saxon world including in India. Then when the Brits left India, in the budget presented in 1947 by the interim government, a provision was introduced for charging capital gains to tax by introducing section 12B in the 1922 Act. What is interesting to note in the context of the present article is that section 12B provided for an exemption from the charge in case of transfer by a deed of gift or will or to an irrevocable trust. Although capital gains tax was retained in the first full budget passed after independence in 1948, it was abolished the very next year only to be reintroduced in 1956, following the recommendations of Prof. Nicholas Kaldor and has been a regular feature of the Indian tax system ever since. However, its administration has always posed a problem and there is hardly any year that some amendment or the other has not been passed relating to the provisions of taxation of capital gains. The exemption from the tax in case of gift, however, continues unamended in section 47(iii).

The innocuous provision that was introduced as an exception possibly considering the socio-economic realities and the state of the tax system in India in the early decades of independence, has now become a fertile playground for exploitation of a loophole by multinationals. It is fascinating to note the developments in this regard.

It all started with a ruling given by the Authority of Advance Ruling in the year 2009 in the case of an apparently bankrupt company called Dana Corporation, USA (DC) = 2009-TII-27-ARA-INTL. When the company filed for bankruptcy, It had three Indian subsidiaries. As part of the bankruptcy proceedings, a plan was submitted to the Bankruptcy Court in USA in terms of which a reorganisation plan was submitted. A new holding company (DHC) and a limited liability company (DCLLC) was formed as part of the plan. Thereafter, Dana Corporation transferred the equity shares held by it in two of the Indian Companies to Dana World Trade Corporation and the shares of the other Indian Company were transferred to Dana Global Products Inc. The transfer was without consideration in terms of the share transfer agreements. As a part of bankruptcy transfers, an independent private equity concern infused Capital into DHC in exchange for shares of DHC, additional shares of DHC were distributed as settlement for certain claims made against DC, DC transferred shares held in Dana World Trade Corporation and Dana Global Products Inc to DHC and finally, DC merged into DCLLC as per the Articles of Merger .

In the process what in effect happened was that the control over the Indian Companies was transferred to the newly formed holding company DHC. Undoubtedly, transfer of shares took place albeit outside India and hence an obvious question arose about the taxability of the capital gains in India. The long and short of the reconstruction plan form an Indian point of view was that shares of Indian subsidiaries were transferred and no capital gains accrued to the transferor. Under the India-US tax treaty, capital gains from alienation of shares in an Indian company would be taxable in India as per the domestic law of India and the company had also paid advance tax on the same. Thereafter it approached the AAR to give a ruling on the above issue. Although there was no pleading of exclusion of the resultant capital gains on the ground of the exclusion of such gains in terms of section 47(iii) (since the transfer was allegedly without consideration), the AAR laid down certain principles that were followed subsequently in other situations.

Relying on the old decision of the Supreme Court in the case of B.C. Srinivasa Setty = 2002-TIOL-587-SC-IT-LB that laid down the principle that where consideration is indeterminable, the computation provision in other sections of the chapter on capital gains fails, the taxpayer argued that the transfer of shares being without consideration, no consideration could be attributed to the transfer of shares and the computation provision in Section 48 fails and consequently, the charging provision under Section 45 cannot be invoked.

It was also argued that the fair market value of the shares in question could not be taken as representing the amount of consideration for the transfer of shares. Further, since there is no income chargeable under the Act, the transfer pricing provisions also cannot be made applicable.

The Revenue argued that that there was consideration for the transfer of shares as a part of reorganization scheme, and that it was immaterial that the consideration flowed from a third party. According to the revenue, the taking over of the liabilities by the newly formed holding company could be taken as the consideration for the transfer of shares and even if the consideration for transfer of shares was not identifiable or indeterminable, there was definitely an international transaction and the arm's length price of the same could be arrived at by resorting to the transfer pricing provisions and hence the computational provisions do not actually fail.

The AAR, however, brushed aside such argument and while reiterating the ratio of the SC decision in Setty's case, also observed that no profit or gain in the form of consideration for transfer can be inferred by a process of deeming or presumptive basis and that hypothetical profits cannot be taxed under section 45. The AAR also shot down the argument of the revenue that the fair market values of the assets could be taken as consideration for transfer observing that even if shares were valued for preparing financial statements , it cannot be said that the same represented the consideration. As for the argument that the computation provision does not fail because of the application of the transfer pricing provision , the AAR held that section 92 is not a charging section and to be applicable, some income must accrue; that section 92 is not intended to bring a new head of income or to charge to tax which is not otherwise chargeable under the Act .

These principles were then followed even in other cases where business reorganisation involving transfer of shares of Indian subsidiaries were cited by taxpayers as reason for such transfers without consideration. The net effect was that capital gains that were supposed to accrue to India escaped taxation.

Besides, gift tax having been abolished in 1998, there was scope of manipulation. In 2004, as an anti-abuse provision, section 56(2)(vii) was introduced that deemed any sum of money received above a certain limit as income from other sources in the hands of the recipient. The provision was made applicable in case of individuals/HUFs. But corporate transactions were out of its ambit. To plug, this loophole, a new provision in section 56(2)(viia) was subsequently introduced in 2010 to bring within the ambit of the deemed income provision, cases of transfer of unlisted shares without consideration or for inadequate consideration.

Then, in the much maligned 2012 amendments that have come to be associated with overturning the SC judgement in Vodafone, two relatively less discussed amendments were also made. These are introduction of a new section 50D and clarification of the scope of international transaction in section 92B.

Explaining the rationale of the introduction of section 50D, the Memorandum stated:

"Capital gains are calculated on transfer of a capital asset, as sale consideration minus cost of acquisition. In some recent rulings, it has been held that where the consideration in respect of transfer of an asset is not determinable under the existing provisions of the Income-tax Act, then, as the machinery provision fails, the gains arising from the transfer of such assets is not taxabl e. It is, therefore, proposed that where in the case of a transfer, consideration for the transfer of a capital asset(s) is not attributable or determinable then for purpose of computing income chargeable to tax as gains, the fair market value of the asset shall be taken to be the full market value of consideration.

Accordingly, it is proposed to insert a new provision (section 50D) in the Income-tax Act to provide that fair market value of the asset shall be deemed to be the full value of consideration if actual consideration is not attributable or determinable."

As for the relevant change in the Transfer pricing provision, it was mentioned:

Therefore, there is a need to amend the definition of international transaction in order to clarify the true scope of the meaning of the term "international transaction" (…). It is, therefore, proposed to amend section 92B of the Act, to provide for the explanation to clarify meaning of international transaction (…) 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." And since this was a clarificatory amendment, effect was given with retrospective effect from the date of the introduction of the TP provisions, 1.4.2002.

Shortly, thereafter, on the AAR gave a ruling in the case of Orient Green Power Pte Ltd (OGPL) = 2012-TII-35-ARA-INTL. In this case, a the Singapore based holding company had a fully owned subsidiary in India Orient Green Power Ltd (OGPL). It also held 49.75% shares of another Indian company, Bharat Wind Farm Ltd, (BWL), the balance being held by the Indian company. It was stated that the Singapore holding company decided to gift the shares of BWL to its subsidiary OGPL without consideration. In fact, the word "gift" was specifically mentioned. Apparently, the Board of Directors of the Singapore holding company apparently passed a resolution resolving that it had decided voluntarily to gift its shareholding in the Indian company to OGPL for no consideration, as it was supposedly in the interests of the company to make the gift. A memorandum of gift dated 30.1.2010 was drawn up stating that on 29.1.2010, a representative of the OGP had physically delivered to a representative of OGPL India, the share of BWFL together with appropriate share transfer forms by way of voluntary gift. The representative of OGPL had accepted the gift of the share for no consideration and thanked the OGP for the same and the transfer of the shares from OGP to OGPL India by way of gift was thereby completed. In other words, all the elements of a gift under the Transfer of Property Act were fulfilled on paper.

The taxpayer claimed that the gift having been made before 1.4.2010, it will not come within the purview of the recently introduced section 56(2)(via) and since there was no consideration for transfer, the machinery provisions for the computation of capital gains fail and no income could be charged to India. The Revenue in that case challenged the genuineness of the transaction. In that context the AAR observed: Without anything more, it is difficult to imagine the Articles of Association of a company providing for gifting away of the assets in the form of shares in another company by what is attempted to be described as oral gift. Though the AAR did not finally gave a ruling in the absence of adequate facts, the judge nevertheless observed:

"It appears to be proper to observe that in the context of section 47(i) and (iii ), this gift referred to therein, is a gift by an individual or a Joint Hindu Family or a Human Agency . Section 47(iii) speaks of ‘any transfer of a capital asset under a gift, or will or an irrecoverable trust'. Execution of a will involves a human agency. Cannot the expression gift take its colour from a will with which it is juxtaposed, especially in the background of clause (i) of section 47 and clause (ii) which earlier existed. A gift by a corporation to another corporation (though a subsidiary or an associate enterprise, which is always claimed to be independent for tax purposes) is a strange transaction . To postulate that a corporation can give away its assets free to another even orally can only be aiding dubious attempts at avoidance of tax payable under the Act. This is all the more so since section 47(iv) and section 47(v) specifically provide for covering cases of transfer of capital assets by the parent company to the subsidiary and by the subsidiary to the holding company and the other sub - clauses deal with amalgamation, demerger and reorganization of business and so on. As I see it, it is possible to say that a gift of shares held in a company by one company to another company would not fall under section 47(iii) of the Act…"

However, subsequently there were decisions of High Courts and Tribunals again reiterating the position that transfer of shares without consideration was a gift and there is no bar on such gifts. The Bombay High Court in the case of Asian Satellite Broadcast case = 2020-TIOL-1799-HC-MUM-IT, although in the context of a writ petition challenging the reopening of a completed assessment, agreed that it was evident that while any profits or gains arising out of transfer of a capital asset shall be deemed to be the income of the previous year in which the transfer took place chargeable to income tax under the head 'capital gains', section 47(iii) makes it very clear that any transfer of a capital asset under a gift or will or an irrevocable trust shall not be liable to income tax under the head 'capital gains. Thus, unless the genuineness of the transaction of such gift itself is validly controverted by the revenue, such intercorporate gifts involving transfer of shares will continue to escape taxation. Also, important to note in this connection is the fact that transactions involving corporate restructuring do enjoy tax free status but subject to fulfilment of various conditions.

In that connection, we may note a recent decision by the Madras High Court in the case of Redington India Ltd = 2020-TII-45-HC-MAD-TP. The main issue involved in this case was an adjustment made by the TPO to the long-term capital gains. The brief facts were that Redington India Ltd had a subsidiary RGF Gulf Ltd catering to its middle East and Africa business. In 2008, it set up a subsidiary in Mauritius, which in turn set up another subsidiary in the Cayman Islands. Within a short period, the taxpayer transferred its entire shareholding of the Gulf company to the Cayman company by way of gift. Within a week thereafter, a private equity firm acquired a 27.17% stake in the Cayman company for USD 65 million. The question arose whether there was any capital gains involved in the transaction involving gift of shares by which the gulf business of the taxpayer stood transferred to a company in a tax haven.

The tax department did a thorough enquiry and challenged the genuineness of the transaction relating to the alleged gift. Besides, the TPO found that there was no business rationale in setting up the subsidiaries except to frustrate the implementation of the provisions of section 47(v). A view was also taken that to be of the nature of gift there should be an element of love and affection that was lacking in the present case. More importantly, it was found that neither In the minutes of the Board meeting nor in the share transfer document was there any mention of any gift. In fact, it was the condition imposed by the Private equity investor that subsidiaries be formed in Mauritius and Caymans. The recorded statement of the CFO also showed that the transaction conferred commercial benefits to the taxpayer. It was therefore a case of restructuring that would be governed by sections 47(iv) or (v) and was not a gift contemplated in section 47(iii) And, as mentioned earlier, by virtue of the amendment on section 92B that retrospectively, transfer pricing provisions would apply to such restructuring.

In appeal, the tribunal decided against the department holding that there was no requirement of love and affection in the provision and that a company could make and receive gifts and therefore gift of shares in a subsidiary would be exempt u/s 47(iii) and not chargeable to capital gains tax.

In the department's appeal, the High Court held that In terms of Section 5 of the Transfer of Property Act, transfer of property means an act by which a living person conveys property in present or in future to one or more other living persons or to himself, or to himself and one or more other living persons and to transfer property is to perform such an act . It cannot be disputed by the Revenue that in Section 5, living person includes a company or association or body, individuals whether incorporated or not, but nothing contained in Section 5 shall affect in law for the time being in force relating to transfer of property to or by company's association or bodies of individuals. Thus, a company would be entitled to execute a gift in terms of Section 5 of the Act.

However, the High Court pointed out that having determined that a company can make a gift, he Tribunal had failed to examine as to whether the ingredients of Section 122 of the TP Act have been fulfilled to qualify as a valid gift. Section 122 of the TP Act defines "gift" to be transfer of certain existing movable or immovable property made voluntarily and without consideration by one person called the donor to another called the donee and accepted by or on behalf of the donee. The essential elements of gift are (i) absence of consideration; (ii) the donor; (iii) the donee; (iv) to be voluntary; (v) the subject matter; (vi) transfer; and (vii) the acceptance.

The High Court observed that revenue has consistently questioned the purpose of the transaction. In that context, the chain of events speak for themselves; the decision of the Board of the company in resolving to approve the transfer of shares with or without consideration is a clear indicator to show that the transaction is not voluntary. This is so because, within less than a week after effecting transfer, a private equity fund comes into the picture investing USD 65 million in the Cayman company for 27.17% stake. On the date when the company was incorporated, in July 2008 it had only a share capital of USD 10,400 and when the transfer took place in November, 2008, it had no other assets or income except the value of the shares in the gulf company. The explanation of the taxpayer was that it had decided to corporate re-structure in order to expand its business operation in the Middle East and Africa and other countries , they wanted their shares to be listed in Dubai Stock Exchanges and other overseas stock exchanges, therefore, they decided to bring in a third party investor so that they have a benchmark valuation. The facts as narrated by the taxpayer the TPO clearly demonstrates that much prior to effecting transfer, there were other transactions, which were in the pipeline. The sole intention of the taxpayer was for corporate re-structuring, which is stated to have identified a third party investor who holds the investment in Cayman Island. Therefore, the voluntariness in the transfer of shares stands excluded.

The High Court also referred to the finding of the TPO that the incorporation of the new entities abroad and transferring a revenue generating asset to such entities will essentially mean that in future the income from such asset will accrue directly to the non-resident and not to the Indian company. The TPO had also brought out how India had lost the potential revenue of at least of Rs.54.98 crores by way of tax on dividends relevant to AY 2011- 12 and AY 2012-13 alone. To that extent the shifting of profits outside the country had been established. Besides, if the Gulf entity was to be sold off in future, the gain would accrue to the Cayman Island company and not to the Indian company. Thus considering the uncontroverted factual matrix of the case, the High Court decided in favour of the revenue.

Although the decision of the High Court went in favour of the revenue, it is likely to be challenged and one is not clear as to whether other courts will follow the same. However, it is obvious that what was clearly meant to be excluded from the scope of capital gains taxation was gift by natural persons. The provision is now being abused by corporates particularly involving cross-border situations leading to loss of revenue to the coutry. It is high time to put an end to this controversy by making it clear in the section itself that the provision applies in case of individuals/HUFs alone.