THE DEBATE OVER TAXABILITY OF HOLDING CONTROLLING EQUITY INTEREST IN A SUBSIDIARY

INTRODUCTION:

India Inc has witnessed a great transformative fiscal journey since the transition was made from the erstwhile legacy indirect tax regime to the new GST Regime in 2017. Litigations on GST have gradually started kicking from both a factual and legislative perspective. The most astounding and puzzling litigation of them all, has to be the recent set of notices received by various corporate taxpayers of India Inc, on the proposed levy of GST at the rate of 18% on the so-called ‘service’ rendered by a holding company to an Indian Subsidiary company on account of merely holding equity shares in the subsidiary that bestow a controlling interest.

ISSUE AT HAND:

Notices have been received by taxpayers on account of explanatory notes to the Scheme of Classification of Services (hereinafter referred to as SAC) issued by the CBIC for SAC  99717 containing ‘Services of holding financial assets’ . 

Specifically, SAC 997171 covers ‘Services of holding equity of subsidiary companies’. It states that the service code includes, services provided by holding companies, i.e. holding securities of (or other equity interests in) companies and enterprises for the purpose of owning a controlling interest.

As a result of existence of the above classification, demand notices have been proposed to:

1. Indian Holding Companies holding equity in their Indian Subsidiary under forward charge mechanism.
2. Indian Subsidiary companies that have foreign holding companies under Reverse Charge Mechanism on account of import of services.

Some of the the notices have been apparently issued on the basis of annexure to Notification No. 11/2017 – Central Tax (Rate) which reads out as follows-

‘In exercise of powers conferred by subsection (1) , sub-section (3) and sub-section (4) of Section 9, sub-section(1) of Section 11, sub-section(5) of Section 15, sub-section (1) of Section 16, and Section 148 of the CGST Act of 2017.

To arrive at the taxable value, proper officers are using the following methods:

• Adopting Profit after Tax earnings per share (hereinafter referred to as ‘EPS’) as taxable value of each share or are resorting
• Adopting a % of the share capital as taxable value as per Rule 32(2)(b)(i) by equating the transaction to ‘Service of purchase and sale of Foreign Currency including money changing’.
• Adopting 5% of the amount held as equity throughout the year (5% being the risk free return on investment in Govt Bonds) and proposed year on year.

It is also pertinent to note that the extended period of limitation has been invoked.

In order to decipher the Department’s intent behind taxing investments in equity of subsidiaries, let us first understand the relevant legal provisions pertaining to supply and a few other definitions.

RELEVANT LEGAL PROVISIONS:

1. Definition of Supply:

The provisions of Section 7 (1) of the CGST Act has been laid down as follows:

“Supply includes

1. All forms of supply of goods or services or both such as sale, transfer, barter, exchange, license, rental, lease or disposal made or agreed to be made for a consideration by a person in the course or furtherance of business,
2. Importation of services, for a consideration whether or not in the furtherance of business, and
3. The activities specified in Schedule I, made or agreed to be made without a consideration.”

For an activity to be considered as supply in terms of section 7, there has to be 3 parameters:

1. Supply should be of goods or services. Supply of anything other than goods or services like money, securities, etc does not attract GST.
2. Supply should be made for a consideration.
3. Supply should be made in the course or furtherance of business.

There are a few exceptions to the 2^nd  parameter. Few exceptions to the second parameter have been carved out where a transaction is deemed to be a supply even without consideration (contained in Schedule I). In this context, it is relevant to quote Para No.2  and Para No.4 of Schedule 1 of the CGST Act (Activities to be treated as supply even if made without consideration) which reads as follows –

“Supply of goods or services or both between related persons or between distinct persons as specified in Section 25, when made in the course or furtherance of business” (Para 2).

“Import of services by a person from a related person or from any of his other establishments outside India, in the course or furtherance of business”

It is very important that the concept of consideration is embedded as part of the mandate for a supply to be made exigible to GST unless as mandated above in law so as to attract GST

Similarly, the condition of supply to be made in the course or furtherance of business has been relaxed in case of import of services.

1. Definition of Consideration:

The concept of consideration has been defined in section 2(31) of the CGST Act of 2017, which reads out as follows:

“Consideration in relation to supply of goods or services or both includes:

1. any payment made or to be made, whether in money or otherwise, in respect of, in response to, or for the inducement of, the supply of goods or services or both, whether by the recipient or by any other person but shall not include any subsidy given by the Central Govt or a State Govt.
2. the monetary value of any act or forbearance, in respect of, in response to, or for the inducement of, the supply of goods or services or both, whether by the recipient or by any other person but shall not include any subsidy given by the Central Govt or State Govt.

iii. Definition of Related Person:

Under GST Law, various categories of related persons have been specified. The term ‘related person’ has been defined in explanation to Section 15. In this context, it is relevant to lay down that persons including legal persons are deemed as related persons if –

1. a) One of them controls (directly/indirectly) the other.

While the definition of control or controlling interest is not laid down in the GST Act, in common parlance, control refers to having at least a 50% of the outstanding shares or 2 rights of a company.

Now that we have the relevant legal provisions laid down above, let’s try and analyse the different legal and logical angles, that negate the premise taken by the Department to bring investment in equity of Indian subsidiary leading to controlling interest, under the tax net.

DIFFERENT ANGLES TO BE EXPLORED

1. a) Whether the act of infusion of capital constitutes an underlying activity for Supply?

There has to be an underlying activity for a supply to be considered as a supply. The underlying activity has to be an affirmative supply and cannot be assumed so as a supply even amongst deemed distinct persons or related parties. This emerges from even a cursory reading of the provisions contained in Section 7 of the CGST Act.  It can be clearly understood that the mere act of holding equity does not constitute an activity that can give birth to a supply. There is only a creation of a security which by itself is neither considered as goods or services.

What is afterall  “Securities” which is out of the GST purview per se

Securities as per Companies Act?

Under section 2(h) of SCRA, the term ‘securities’ include the following: Shares, scrips, stocks, bonds, debentures, debenture stocks etc. in or of any incorporated company or another body corporate. Derivatives. Units issued by any Collective Investment Scheme to the investors in such scheme.

Goods as well as services have been defined in the GST Law. “Goods” has been defined as every kind of movable property other than money and securities but includes actionable claim, growing crops, grass and things attached to or forming part of the land which are agreed to be severed before supply or under a contract of supply.

 “Services” means anything other than goods, money and securities but includes activities relating to the use of money or its conversion by cash or by any other mode, from one form, currency or denomination, to another form, currency or denomination for which a separate consideration is charged.

The expression “services” includes facilitating or arranging transactions in securities. Thus, securities are excluded from the definition of goods as well as that of services. Money is also excluded from the definition of goods as well as services. However, activities relating to use of money or its conversion by cash or by any other mode, from one form, currency or denomination, to another form, currency or denomination for which a separate consideration is charged are included in services.

Therefore from the above, it is clear that equity that is held as Securities is excluded from the purview of GST exigibility and it is only the supply of facilitating the transaction of such securities are subject to GST.

 The investor is merely performing an automatic and inuilt function to protect their own interest and ensuring it’s value is protected by participating in meetings, having a say in the election/nomination of the board of directors, influencing the strategic direction that the company pursues. There is no economic benefit that an Indian subsidiary receives when a security is merely held by an investor. If none of the above are to be considered, even considering the subsidiary as an establishment on its own makes the whole process of setting up a company redundant in India.

Infusion of capital is merely considered as a capital receipt and is not recognised as income in neither financial or direct tax lingo.

1. b) Can Issue of Equity Shares qualify as consideration when there is no activity?

The issuance of equity for receipt of capital cannot be considered as consideration as it’s not a payment made in response to, or for the inducement of, the supply of goods or services. Though there is monetary value to equity, issuing equity is neither an act or forbearance, in respect of, in response to, or for the inducement of, the supply of goods or services or both. The concept of quid-pro-quo does not apply for issuance of equity in exchange for infusion of capital.            As seen above, since the legislation of GST ecosystem itself holds that equity is part of “securities “ and that other than facilitation fee if any for transaction in equity which is a security cannot be subjected to GST,

1. c) Whether there is a affirmative supply of service?

There is no supply of service either by the holding company to the subsidiary or vice versa when capital is infused into the subsidiary in exchange for equity. Even from a regulatory perspective, the receipt of say such amounts towards equity from the cross border company is scheduled to be that of “capital receipt” in the FIRC/e-BRC and not mentioned as towards services rendered per se.

If the act of holding one’s own asset is interpreted as a service to someone else, such interpretation can only be called absurd.

Further as per Section 2(102) of CGST Act of 2017 , “services” means anything other than goods, money and securities but includes activities relating to the use of money or its conversion by cash or by any other mode, from one form, currency or denomination, to another form, currency or denomination for which a separate consideration is charged.

As specified in the above definition, securities such as equity shares cannot be considered as services.

Further the act of investing in equity shares cannot be considered as activities relating to the use of money or its conversion by cash.

There has to be an affirmative approach to taxability under GST especially when it relates to transaction relating to Money or Securities. It has been laid down clearly in the law that the arrangement or the facilitation of the transaction in money or securities is subjected to GST to the extent of the facilitation fees or by whatever terminology the same is called.

For instance, if a company is seek a loan, the amount of the loan which is lent is treated as a transaction in money and the same does not fall within the purview of the GST at all. However if there is a transaction fee or facilitation fee or processing charges, then the same is subjected to GST.

Similarly in the case of Securities as well, this has been specifically set out. The Explanation to Section 2(102) inserted vide Central Goods and Tax (Amendment) Act, 2018 set out  “facilitating or arranging transactions in securities” is covered within the meaning of ‘service’.

While the above has been held and assumed to be one of providing a service, it was still set out specifically and explicitly to avoid the confusion in public interest. It is very apparent from the above, that while the Securities by itself is out of the purview of the GST exigibility, the facilitation or arranging the transaction in securities will be subject to GST.

However the concept of holding the equity per cannot be subjected to GST

A service can be rendered only if there’s a service provider and a service recipient, both of which is absent in this case.

The following are pertinent to be mentioned

While it is seen that facilitating the transaction in Securities has been subjected to GST, the very concept of Securities have been kept out of the GST exigibility.

There is no rate of tax that has been prescribed. It is also important to note that on specific services without consideration finds a mention specifically in the GST ecosystem as exigibile to GST.

It is equally important to note that the detailed valuation set of rules which set out the different parameters as applicable to goods as well as services in various contexts are absolutely silent about any applicable rule to the so called provision of holding equity in a subsidiary. This also clearly brings out the fact that there was absolutely no intention to subject the same to GST more so as it is kept out of the GST purview as much as a transaction in money is kept out of the GST purview.

From the above it is clear that none of legislative provision from which power is drawn to subject a supply of service to tax is in existence.

1. d) Whether a taxable event even arises in the case of holding equity in a subsidiary?

A taxable event is any transaction or occurrence that results in a tax consequence. Before levying tax, taxable event needs to be ascertained. It is the foundation stone of any taxation system and it determines the point at which tax should be levied. In GST, the taxable event is indeed a supply of goods or services. The infusion of capital in exchange for equity of a subsidiary doesn’t trigger an iota of a taxable event that’s needed for a tax to be levied. Clearly as the equity is considered as part of “Securities” which is kept out of the purview of the GST itself, the same cannot be the basis of triggering a taxable event.

1. e) Whether there is a transaction in securities?

As per Section 17(2) & 17(3) of the CGST Act, when goods or services or both are used partly for the purpose of effecting taxable supplies and partly for effecting exempt supplies, the amount of credit shall be restricted and allowed only for the input tax that is attributable to the taxable supplies. Also, the ITC proportionate to the exempt supply shall be reversed. This applies in the case of transaction in securities. It can be argued that there in no transaction in securities as well in the case of parent company holding equity in a subsidiary company

There is no act of private placement involved in issuing shares to a parent, neither there’s any trading in securities. Equity is merely being created by the subsidiary and hence there is no transaction in securities. Therefore, there are strong grounds for the taxpayers to not even reverse input tax credit in proportion to the value of supply relating to sale of securities (being 1% of Sale value of securities as per Explanation 2(b) of Chapter V of the CGST Rules). 

1. f) Whether there is a tangible activity for consideration?

As mentioned in point c) above, even if issuance of equity shares is considered as consideration, it is not in response to or for the purpose inducing an activity leading to supply of goods or services. Further there is no evidence in the form of a document such as a tax invoice that’s generally considered as a proof of taxable supply of goods or services. Hence the act of infusion of capital is not even a tangible activity.

1. g) Whether there is an affirmative action of supply?

The holding company when it sets up a subsidiary company would prefer to equity in the subsidiary company for various sets of reasons. The very fact that a subsidiary company is being set up would mean that it would need financing in the form of equity to start with to set up the company in terms of regulatory perspective. Be it cross border or even within the territorial contours of India. This does not automatically mean that there is an affirmative supply of services as a result of equity being picked up by the parent company. The very thought of trying to propose a levy of GST on the same is beyond logical comprehension and is akin to levy of GST on a loan being taken from a bank or a loan taken as a External commercial borrowing.

If in the event of providing services by the subsidiary to the parent or otherwise, there is going to be an invoice raised for the same and the same will be subjected to a GST if applicable.

1. h) Whether there is an economic benefit received by the subsidiary company?

On the strength of the recently pronounced judgement of the Supreme Court in the case of  CCE Vs Northern Operating Systems Pvt Ltd – 2022-TIOL-48-SC-ST-LB dated 19.05.2022 which used the ‘substance over form’ doctrine for the purpose of determining the liability of service tax on reverse charge mechanism, there cannot be any case of trigger of an indirect tax on the basis of economic benefits of a transaction accruing to the recipient in this case, as there’s no economic benefit that accrues to the subsidiary company when a holding company merely holds equity in the subsidiary company.

The investor is merely performing a stewardship function to protect it’s own interest and ensuring it’s value is protected by participating in meetings, having a say in the election/nomination of the board of directors, influencing the strategic direction that the company pursues. There is no economic benefit that an Indian subsidiary receives when a security is merely held by an investor or when capital is infused by the investor.

1. h) If there is no consideration, whether it qualifies as a supply as per Schedule I (Activities considered as supply when there’s no consideration)?

As set out in earlier para the GST ecosystem also seeks to cover under exigibility concept any services imported by a taxable person from a related person outside of India. This is applicable even when there is no consideration towards the import of the said service. The same figures as an item in Entry 4 of Schedule I of the CGST Act.

It is very important to note here that even in the said entry what is of paramount importance is a supply of service whether with or without consideration per se. unless there is a evidence of supply the same cannot be subjected to a GST at all. And more so specifically when it is understood that equity is part of “Securities” which is kept out of GST net, it is beyond logical comprehension that authorities are mechanically issuing Show Cause  Notices.

1. j) Whether a case for valuation can be made when there is no supply

There is no case of valuation when there is no occurrence of a taxable event, being a supply of goods or service. Securities can neither be considered as goods or as a service as is evident in the definition. Even if we consider the act of holding equity as a supply,  valuation adopted on the basis of EPS or at the rate 5% (risk-free rate) of holdings throughout the year is not a prescribed method of valuation as per the CGST Rules. 

Also, the act of valuing equity holdings in a subsidiary on the basis of EPS distribution to the holding company for the purpose of levying GST, is an even more absurd method of levying indirect tax, as a tax on profits usually falls under the domain of direct taxes. Rule 32(2)(b)(i) has been quoted as the section on the strength of which this EPS based valuation has been deployed. Rule 32(2)(b)(i) can only be used when there is a service of purchase and sale of Foreign Currency including money changing. This means that the said rule can be applied only when there’s a service that facilitates money changing and not the infusion of money itself.

1. k) Whether the activity of infusion of capital in exchange for equity triggers a levy of tax?

Section 9 of the CGST Act of 2017 provides for levy of GST on intra-state supplies of goods or services or both. As there is no supply, nor is there any goods or services that are supplied, the taxable event, being supply of goods or services does not even arise.

1. l) Does the Burden of Proof to prove that a particular activity/transaction is not liable to GST, rest on the taxpayer?

It is well settled position of law that burden of proof towards taxability of a transaction is always on the Revenue and the Revenue must explain and prove that a particular transaction on which tax is being demanded is taxable in the manner claimed by them. The notices issued by the Department to taxpayers in various states does not elucidate how the act of holding equity is covered within the meaning of supply.

With this argument, a mere mention in the scheme of classification per se doesn’t lead to a conclusion or assertion that there is a supply of service. Hence mere reference to an entry in the scheme of classification doesn’t discharge the revenue from it’s burden of proof towards taxability.

1. m) Can a mere mention of holding security in the HSN entry by itself make it mandatory for being Exiigble to GST

The concept of classification of a supply of goods or services at that can happen for the purpose of levy of GST only and only if there is a supply of goods or services that are subjected to the levy itself.

Just the very presence of a classification by itself cannot create a levy of GST per se more so in the present case, the very concept of “Securities” is kept out of the exigibility of GST.

CONCLUSION:

The arrangement of holding shares in a subsidiary company is a regular business phenomenon. It is widely practiced by all foreign companies investing in India. The Department’s misplaced executive intent (without a legislative backing) to tax investment in equity shares will make it condition impossible for an Indirect tax to remain as an Indirect tax.

It may also be a counter-productive move from an FDI perspective as foreign companies may reduce investments in Indian Inc to avoid a GST liability since their Indian counterpart shall have to discharge GST under Reverse Charge Mechanism leading to working capital issues. The Indian Rupee shall also weaken as a result of Foreign Companies wishing to move to greener pastures. It has to be borne in mind that any attempt to wilfully misuse a subordinate legislation to by pass the legislative intent to impose a GST on holding equity will make “Ease of doing business in India” a redundant concept.

It is to be kept in mind by the Revenue authorities as well, that GST is a taxation system which is supposed to render a business look at Business based Strategic decisions to do business rather than tax based decisions.

Also a point to be noted is that it shall also lead to the Central Govt and the State Govt themselves being taxed for holding controlling stakes in many subsidiary companies, PSUs, etc. And anyone issuing an IPO will be subjected to pay GST and within India will it be a case of Domestic Reverse Charge Mechanism as well since the investors will be primarily retail individuals as well.

The Government through the CBIC should issue a Circular  urgently and give clarity on this issue so that a closure is brought about rather than making the genuine tax payers to run to the various judicial for a leading unnecessary litigation with huge costs involved both in terms of financial costs as well as loss of face for India fiscal system.