Direct Tax Alert - Long term capital loss from sale of shares at a price substantially lower than the price at which shares are acquired, not an artificial loss
29 July 2021
Insurance companies across the globe hold considerable stake in Indian insurance companies (life, general and insurance intermediaries). These investments are duly monitored and approved by the Insurance Regulatory and Development Authority of India (IRDAI) and other regulators like Reserve Bank of India (RBI).
The issue and sale price of shares for such investments in India has been a point of litigation between taxpayers and tax authorities [especially after introduction of Specific Anti-Avoidance Rules (SAAR) under section 56], despite the investment being monitored and complied with the requirements of various regulators in India. In this regard, recently, the Hon’ble Tax Tribunal1 of Mumbai had an occasion to examine whether loss incurred on sale of shares at a price lower than the cost at which such shares were acquired which has not been objected by IRDAI and is also compliant with FEMA2 regulations, is eligible to be carried forward and set-off against any subsequent gains.
We, at BDO in India, have summarised the ruling of Mumbai Tax Tribunal and provided our comments on the impact of this decision.
Facts of the case
- Swiss Reinsurance Company Limited (Swiss Re/ Taxpayer) a company incorporated in Switzerland and a tax resident of Switzerland is a global reinsurer and provides reinsurance services to various insurance companies including Indian insurance companies. Swiss Re held 26% stake In TTK Healthcare Services Pvt. Ltd. (TTK), an entity which provides Third Party Administrator (TPA) for health insurance companies. The 26% stake was acquired by Swiss Re in multiple tranches from 2007 to 2010 under the Foreign Direct Investment (FDI) route.
- The face value of shares of TTK was INR 10 and were issued to Swiss Re at a premium varying between INR 35 to INR 5,141.05 during the period 2007 to 2010. Since the entire investment was under the FDI route, Swiss Re had complied with the requirements prescribed under FEMA regulations. Moreover, TTK being an insurance intermediary i.e., a TPA, is regulated by IRDAI in India and hence investment in TTK was carried out with appropriate filings and intimations to IRDAI.
- During the Assessment Year (AY) 2014-15 Swiss Re sold the entire stake in TTK to Vidal Healthcare Services Pvt. Ltd. (Vidal) at an agreed price of INR 5 per share. The value per share as per Discount Cash Flow (DCF) was INR 7.19. The loss of INR 49.92 crores incurred on sale of shares of TTK was duly carried forward in the return of income by Swiss Re.
- The Tax Officer during assessment proceedings questioned Swiss Re to justify the loss incurred on sale of shares of TTK and also summoned Swiss Re to submit a valuation report under DCF method as well as under Rule 11UA of the Income-tax Rules, 1962 (IT Rules).
- In response to the details asked by the Tax Officer, Swiss Re submitted the valuation report as per DCF method and with regard to applicability of Rule 11UA of the IT Rules contested that the Swiss Re, being the seller the said Rule is not applicable.
- The Tax Officer disallowed the carry forward of loss as he was of the view that the shares were purchased at huge premium and sold at loss which does not reflect natural behaviour of a prudent businessman. Accordingly, the Tax Officer alleged that the loss had been artificially created to set-off against future gain. The taxpayer challenged the draft order passed by the Tax Oficer before the Dispute Resolution Panel (DRP). However, the DRP accepted the view taken by the Tax Officer and disallowed the loss considering it to be an artificial loss. Being aggrieved, the taxpayer preferred an appeal before the Tax Tribunal who disregarded the order of the Tax Officer and pronounced its judgment in favour of the taxpayer.
Tax Tribunal ruling
The Tax Tribunal considered the following points and ruled in favour of the taxpayer based on the following observations:
- The shares of TTK were purchased on different dates between 2007 and 2010 with a premium that was approved by regulators like IRDAI and RBI. Also, no doubt was raised by the departmental authorities either in case of the taxpayer or in case of TTK at the time of issuance of such shares.
- Further, ITAT observed that the taxpayer had duly submitted a valuation report determining the value of shares however, no valuation report was obtained by the departmental authorities to counter the valuation of the taxpayer.
- ITAT noted that it was a commercial decision of the taxpayer and was not in violation of any rules or regulation including FEMA regulations. Further, it was observed that the sale of shares by the taxpayer to Vidal at the agreed price of INR 5 per share has been approved and sanctioned by regulatory authorities like IRDAI. Accordingly, ITAT held that purchase and sale of shares TTK were within legal framework (since no adverse observation/ action was taken by IRDAI).
- Regarding the Tax Officer’s allegation that loss was artificially created to be set-off against gain arising in 2016-17, ITAT held that the Tax Officer’s reasoning is fallacious as at the time of purchase of shares and sale thereof, the taxpayer was not in a position to foresee or anticipate the future event of capital gain arising in AY 2016-17. Hence, the allegation based on which the Tax Officer denied the claim of long-term capital loss are either presumptive or irrelevant and without any basis.
Foreign investments in Indian entities are regulated and need to get the blessings of various regulators. The compliance requirements under these regulations are different i.e., the requirements/ conditions prescribed under a particular regulation may not suffice the requirements or conditions under other regulation. This leads to various compliances which need to be undertaken by the foreign investors who are keen on investing in Indian companies. With the Hon’ble Mumbai Tax Tribunal adjudicating the appeal in favour of the taxpayer by categorically emphasising that where a particular transaction has been carried out within the legal framework of regulators like IRDAI, RBI, etc. then the same cannot be considered to be arranged for creating artificial loss or for taking undue benefits. This decision also emphasises on the importance of compliance to the regulators and is expected to provide relief to genuine investments made in India by foreign investors.
1Swiss Reinsurance Company Ltd. [TS-588-ITAT-2021(Mum)]
2Foreign Exchange Management Act, 1999
In addition to above ground of considering the long term loss as artificial, the TAX OFFICER had also made an attribution of profits on account of the services rendered by a subsidiary in India to Swiss Re. However, the ITAT relied on the ruling of coordinate bench in Taxpayer’s own case and dismissed the ground by holding that the subsidiary is not a Permanent Establishment (PE) of the Taxpayer and hence the same is not liable for attribution.