Ascendas (India) Private Ltd. v. Dy. CIT

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The Tax PublishersITA No. 1736/Mds/2011 2013 TaxPub(DT) 0661 (Chen-Trib) : (2013) 152 TTJ 0057 : (2013) 082 DTR 0218 : (2013) 021 ITR (Trib) 0665 INCOME TAX ACT, 1961 --Transfer pricing--Computation of ALP Adjustment for valuation of sale of shareholding--Assessee was a subsidiary of an international company called ALI Ltd., which, in turn, was a wholly-owned subsidiary of AL, Singapore. Assessee was engaged in real estate business by way of building and leasing out techno-park and softwarepark. Assessee had in year 2002 entered into a joint venture agreement with one LTIL for developing, owning and managing Information Technology Park in India. For purpose of enabling joint venture business, assessee along with LTIL incorporated a company called LTIAL. Assessee and LTIL each had 25,000 equity shares of Rs. 10 each and 9.88 lakhs of preferential shares of Rs. 100 each in LTIAL. LTIAL thereafter pursued business of developing information technology park. On 1-11-2006, an agreement was entered into by assessee and lTIL with one M/s APFI selling their respective shareholding in LTIAL to APFI. It was to be noted that assessee and APFI were Associated Enterprises. Consideration received from APFI on sale of shares, coming to Rs. 79 crores was split between assessee and LTIL equally. Assessee had also incorporated another company called AITPL on 3-11-2003 along with TIDCO. Assessee had 84.97 per cent shares in said company, whereas TIDCO had 11 per cent APMS (P) Ltd., another company, falling within group of assessee held 4.02 per cent shares. M/s. AITPL was also in the business development of IT Parks and buildings. On 30-3-2007, an agreement was entered into by assessee with APFI to sell its shareholding in AITPL to APFI and same was effected in two stages. First tranche of share transfer happened in March 2007 which fell within the relevant previous year. In the return of income, assessee stated that price at which LTIL sold their shareholding in LTIAL to APFI on basis of comparable uncontrolled price (CUP). The price at which shares of AITPL was sold to APFI at Rs. 26.07 per share was much higher than value of Rs. 3.07 per share arrived at by Chartered Accountant based on CCI Guidelines. However, TPO/DRP adopted Discounted Cash Flow (DCF) Method for valuation. *Held:* Not proper. There was no dispute with regard to cash inflows and cash out flow, only dispute was with regard to weighted average cost of capital (WACC) and figures adopted for the same by TPO, hence, issue is remanded back to TPO to work out value of companies so as to ascertain ALP of shares. Even if Tribunal accepts the stand of assessee, CUP method could at the best be adopted, for the sale of shares in LTIAL only and not for that of AITPL. No doubt, in LTIAL, assessee and LTIL were holding equal shares. Argument of assessee that LTIAL was not an Associated Enterprise of assessee is without doubt technically true. Hence, its contention that the price at which LTIL sold the shares to APFI is a perfectly comparable uncontrolled price does appear at the first look very attractive. However, it is, in fact, not so. Sub-section (2) of section 92C mandates application of an appropriate method for determining ALP from those prescribed in Sub-section (1). All these methods are prescribed with the intention of arriving at the possible transaction value, had the parties been unrelated or at Arm's Length. The question here is whether Tribunal can consider the sale of shares by LTIL to APFI to be uncontrolled. For answering this, Tribunal has to look at the agreement entered between the assessee, LTIL, LTIAL & APFI placed at P.34 to 91 of the Paper Book. At one end of this agreement is LTIL and assessee together, and on the other end APFI. The sellers are assessee and LTIL. Sellers joined together and sold the shares held by them in LTIAL to APFI. Had these been independent transactions entered into by two different parties, the sale would not have been ordinarily effected through one agreement. APFI was interested in purchasing the shares of LTIAL, only if both assessee and LTIL sold their respective holdings at a single price. 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, 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 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. [Para 16] It appears that following one of the methods mentioned in (a) to (f) of sub-section (1) to (sic-of) section 92C are mandatory. However, 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 taxes. 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'. 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. Fixing enterprise value based on discounted value of future profits or cash flow, is a method used worldwide. Endeavour is only to arrive at a value which would give a comparable uncontrolled price for the shares sold. If viewed from this angle, one cannot say that the discounted cash flow method adopted by the TPO was not in accordance with section 92C(1). [Para 17] As to the argument of the Authorised Representative that TPO was bound by the value fixed by the Chartered Accountant in accordance with CCI guidelines. This in cannot be accepted for the simple reason that CCI guidelines were for a totally different purpose and could not be transported into a pricing methodology prescribed for fixing ALP. [Para 18] It is to be noted that 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. 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. 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. [Para 19] 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. [Para 20] 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 per cent as the cost of debt whereas, as per assessee it was 11.5 per cent. TPO had determined the cost of equity at 11.5 per cent on AITPL and 10 per cent on LTIAL, for which he has taken cue from agreement that assessee had with M/s TIDCO. But 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. [Para 21] In working out the WACC the assessing officer considered only equity and debt of Phase 1. Nevertheless in the Denominator he took the aggregate of equity share application money, debt of phase 1 and debt of phase 2. This is an obvious mistake in the working out done by the TPO. As pointed out by assessee, PV factor also is to be spread starting with the year in which the transaction took place. For a valuation to have some amount of objectivity, it is imperative that errors in calculations are avoided and variables are considered within a reasonable limit so that acceptable values can be arrived at. Even a slight change in the discounting ratio will result in substantial change in the valuation of the company. If the ALP of the shares are (sic-is) worked out without considering a reasonable value for the enterprise, it will result in injustice. As already noted here, there is no dispute with regard to cash inflows and cash out-flows. Only dispute is only with regard to weighted average cost of capital and the figures adopted for working out the same. Might be, it is true that there were other mistakes also in the working out of the TPO. Therefore, 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 assessing officer and TPO. [Para 22] With regard to the argument of the Authorised Representative 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. [Para 23] While holding that discounted cash flow method was appropriate to determine the ALP of the international transaction, is set aside the issue is set aside to the file of assessing officer for re-working the value afresh in accordance with standard practices adopted for such valuation. Assessee shall be given an opportunity for giving its work-out and this shall be duly considered by the TPO and the assessing officer. [Para 24] SUBSCRIBE FOR FULL CONTENT

The Tax PublishersITA No. 1736/Mds/2011
2013 TaxPub(DT) 0661 (Chen-Trib) : (2013) 152 TTJ 0057 : (2013) 082 DTR 0218 : (2013) 021 ITR (Trib) 0665

INCOME TAX ACT, 1961

--Transfer pricing--Computation of ALP Adjustment for valuation of sale of shareholding--Assessee was a subsidiary of an international company called ALI Ltd., which, in turn, was a wholly-owned subsidiary of AL, Singapore. Assessee was engaged in real estate business by way of building and leasing out techno-park and softwarepark. Assessee had in year 2002 entered into a joint venture agreement with one LTIL for developing, owning and managing Information Technology Park in India. For purpose of enabling joint venture business, assessee along with LTIL incorporated a company called LTIAL. Assessee and LTIL each had 25,000 equity shares of Rs. 10 each and 9.88 lakhs of preferential shares of Rs. 100 each in LTIAL. LTIAL thereafter pursued business of developing information technology park. On 1-11-2006, an agreement was entered into by assessee and lTIL with one M/s APFI selling their respective shareholding in LTIAL to APFI. It was to be noted that assessee and APFI were Associated Enterprises. Consideration received from APFI on sale of shares, coming to Rs. 79 crores was split between assessee and LTIL equally. Assessee had also incorporated another company called AITPL on 3-11-2003 along with TIDCO. Assessee had 84.97 per cent shares in said company, whereas TIDCO had 11 per cent APMS (P) Ltd., another company, falling within group of assessee held 4.02 per cent shares. M/s. AITPL was also in the business development of IT Parks and buildings. On 30-3-2007, an agreement was entered into by assessee with APFI to sell its shareholding in AITPL to APFI and same was effected in two stages. First tranche of share transfer happened in March 2007 which fell within the relevant previous year. In the return of income, assessee stated that price at which LTIL sold their shareholding in LTIAL to APFI on basis of comparable uncontrolled price (CUP). The price at which shares of AITPL was sold to APFI at Rs. 26.07 per share was much higher than value of Rs. 3.07 per share arrived at by Chartered Accountant based on CCI Guidelines. However, TPO/DRP adopted Discounted Cash Flow (DCF) Method for valuation. Held: Not proper. There was no dispute with regard to cash inflows and cash out flow, only dispute was with regard to weighted average cost of capital (WACC) and figures adopted for the same by TPO, hence, issue is remanded back to TPO to work out value of companies so as to ascertain ALP of shares.

Even if Tribunal accepts the stand of assessee, CUP method could at the best be adopted, for the sale of shares in LTIAL only and not for that of AITPL. No doubt, in LTIAL, assessee and LTIL were holding equal shares. Argument of assessee that LTIAL was not an Associated Enterprise of assessee is without doubt technically true. Hence, its contention that the price at which LTIL sold the shares to APFI is a perfectly comparable uncontrolled price does appear at the first look very attractive. However, it is, in fact, not so. Sub-section (2) of section 92C mandates application of an appropriate method for determining ALP from those prescribed in Sub-section (1). All these methods are prescribed with the intention of arriving at the possible transaction value, had the parties been unrelated or at Arm's Length. The question here is whether Tribunal can consider the sale of shares by LTIL to APFI to be uncontrolled. For answering this, Tribunal has to look at the agreement entered between the assessee, LTIL, LTIAL & APFI placed at P.34 to 91 of the Paper Book. At one end of this agreement is LTIL and assessee together, and on the other end APFI. The sellers are assessee and LTIL. Sellers joined together and sold the shares held by them in LTIAL to APFI. Had these been independent transactions entered into by two different parties, the sale would not have been ordinarily effected through one agreement. APFI was interested in purchasing the shares of LTIAL, only if both assessee and LTIL sold their respective holdings at a single price. 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, 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 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. [Para 16] It appears that following one of the methods mentioned in (a) to (f) of sub-section (1) to (sic-of) section 92C are mandatory. However, 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 taxes. 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'. 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. Fixing enterprise value based on discounted value of future profits or cash flow, is a method used worldwide. Endeavour is only to arrive at a value which would give a comparable uncontrolled price for the shares sold. If viewed from this angle, one cannot say that the discounted cash flow method adopted by the TPO was not in accordance with section 92C(1). [Para 17] As to the argument of the Authorised Representative that TPO was bound by the value fixed by the Chartered Accountant in accordance with CCI guidelines. This in cannot be accepted for the simple reason that CCI guidelines were for a totally different purpose and could not be transported into a pricing methodology prescribed for fixing ALP. [Para 18] It is to be noted that 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. 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. 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. [Para 19] 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. [Para 20] 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 per cent as the cost of debt whereas, as per assessee it was 11.5 per cent. TPO had determined the cost of equity at 11.5 per cent on AITPL and 10 per cent on LTIAL, for which he has taken cue from agreement that assessee had with M/s TIDCO. But 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. [Para 21] In working out the WACC the assessing officer considered only equity and debt of Phase 1. Nevertheless in the Denominator he took the aggregate of equity share application money, debt of phase 1 and debt of phase 2. This is an obvious mistake in the working out done by the TPO. As pointed out by assessee, PV factor also is to be spread starting with the year in which the transaction took place. For a valuation to have some amount of objectivity, it is imperative that errors in calculations are avoided and variables are considered within a reasonable limit so that acceptable values can be arrived at. Even a slight change in the discounting ratio will result in substantial change in the valuation of the company. If the ALP of the shares are (sic-is) worked out without considering a reasonable value for the enterprise, it will result in injustice. As already noted here, there is no dispute with regard to cash inflows and cash out-flows. Only dispute is only with regard to weighted average cost of capital and the figures adopted for working out the same. Might be, it is true that there were other mistakes also in the working out of the TPO. Therefore, 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 assessing officer and TPO. [Para 22] With regard to the argument of the Authorised Representative 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. [Para 23] While holding that discounted cash flow method was appropriate to determine the ALP of the international transaction, is set aside the issue is set aside to the file of assessing officer for re-working the value afresh in accordance with standard practices adopted for such valuation. Assessee shall be given an opportunity for giving its work-out and this shall be duly considered by the TPO and the assessing officer. [Para 24]