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October
15, 2012
No Retro-tax on offshore M&A,
recommends Shome Com
Relief for
Vodafone, Safe Harbors for PE and Foreign Listed Cos et al
Last week, the
Ministry of Finance released the much awaited report on retroactive
amendments relating to taxation of indirect transfer of shares / assets in
India (“Report”). Prepared by an Expert Committee appointed by the
Prime Minister of India and chaired by Dr. Parthasarathi Shome (“Committee”),
this Report follows close on the heels of an earlier report on the Indian
general anti-avoidance rule (“GAAR”), which recommended the deferral
of GAAR by 3 years (Read our hotline on the GAAR report here).
Both these reports,
along with the recent announcements on liberalization of foreign investment
into the multi-brand retail1, insurance and
aviation sectors, may be seen as part of a coordinated effort to assuage
foreign investors’ concerns with India’s uncertain regulatory and tax
environment.
The Report makes
important recommendations in aid of rendering the indirect transfer
provisions fair and workable and inter alia recommends that the indirect
transfer provisions should only be applied prospectively. Safe harbours are
also suggested for portfolio investments, PE investors, foreign listed
companies and group restructuring.
Background
To rewind to the
origins of the controversy preceding the Report, the Indian revenue
authorities had initiated high profile litigation against Vodafone in
relation to the purchase by Vodafone of an offshore company which indirectly
held assets in India. Claims were initiated on the basis that Vodafone had
failed to withhold Indian taxes on payments made to the selling Hutch entity.
The Supreme Court
of India delivered a judgment in favour of Vodafone2
in January this year, stating inter alia that no Indian tax was required to be
withheld on a transfer of offshore assets between two non-residents.
Shortly thereafter,
the Finance Act, 2012 introduced Explanation 5 to Section 9(1)(i) of the
Income Tax Act, 19613 (“ITA”),
“clarifying” that an offshore capital asset would be considered to have a
situs in India if it substantially derived its value (directly or indirectly)
from assets situated in India. The amendment is currently retroactively
applicable from 1961. Several other “clarificatory” amendments were also
introduced to the definitions of “capital asset”, “transfer” and the
withholding tax provision, to bring offshore indirect transfers within the
Indian tax net. However, important issues were left unconsidered including
questions relating to the applicability of indirect transfer provisions to
listed companies, issues on the attribution of value, adjustment of cost of
acquisition, availability of treaty benefits and foreign tax credits, etc.
Considering the
sharp decline in foreign direct investment (almost 65% in the April – June
2012-134), largely attributable to the unstable
legal and tax regime in India, the Prime Minister set up the Committee to
engage with stakeholders and examine the implications of the new rule to tax
indirect share transfers. The Committee recommended significant dilution of
the scope of the provisions with a view to make it less burdensome on
investors.
Key Recommendations
- Retrospective applicability: Contrary to
the position taken by the Government, the Report states that the
provisions relating to indirect transfer are not clarificatory in nature
and hence should be applied in a prospective manner. The Committee has
also set out guiding principles in respect of retrospective amendments,
which the Government will be well served to follow. The Committee has
stated that retrospective amendments should not be made to expand the
tax base as that would affect certainty and rule of law. Further, it has
been suggested that retrospective application of tax law should not
occur as a matter of practice, but only in rarest of rare cases after
the exhaustive and transparent consultation with stakeholders who would
be affected.
- Withholding tax obligations: The
Committee has recommended that where the tax is sought to be
retrospectively applied, the withholding tax obligation should not be
retrospectively applied for payments that have already been made. It has
further been recommended that such a payer of previous payments should
not be treated as a representative assessee, nor should interest or
penalty be leviable on such previously made payments. This, if
implemented, would specifically impact taxpayers such as Vodafone who
were potentially covered by the retrospective amendments.
- What constitutes an indirect transfer: The Committee
has recommended some measures to fine tune the application of the
indirect transfer provisions, where such provisions are applied on a
prospective basis. The Committee has noted that the amendments
potentially cover indirect transfers in two ways – first, by relocating
the situs of the offshore asset to India under section 9(1)(i), and
second, by the amendment to the definition of transfer and capital
asset, which includes indirect transfer of an interest in a capital
asset. It has been recommended that the two should not be parallelly
applied. Other recommendations:
i. Transfer of
“interest”
It has been stated that the expression “share or interest in a company or
entity registered or incorporated outside India” should mean to include
only shares or interest which result in ownership, capital, control or
management but should exclude mere economic interest in the share. Further,
the term ‘interest’ has been clarified to have a meaning similar to a share i.e.
having ownership, control or management rights. This clarification is to
ensure that situations such as subscription to units of a mutual fund set up
abroad or interest of a lender are not considered to be brought within the
ambit of the amendment. This should also address concerns of the PE industry
where limited partners may hold an economic interest but not have control or
management rights in the underlying property. What continues to be left open
is the question of what should constitute “capital”, “control” or
“management”, as separate from “ownership”, and what degree of control or
management would be required to result in the share or interest being
considered to have a situs in India.
ii. Meaning of
“transfer”:
Another important clarification is in the context of the term “transfer”. The
amendment to the indirect transfer provisions had sought to widen the meaning
of the term “transfer” to include creation of an interest. In this
regard, the Committee has in its Report stated that the widening of the
definition may potentially cover unintended activities like pledge/mortgage
of property of the foreign company having assets located in India. It has
therefore recommended that the widened definition of “transfer” should be
read in the context of other relevant provisions rather than on a stand-alone
basis.
- Threshold test on substantiality and valuation: The
Committee while looking at the words ‘substantially’ and ‘assets
located in India’ has firstly recommended ‘substantially’ to
mean a 50% test whereby at least 50% of the total value should be
derived from assets located in India. Further, to this extent, the value
of the shares of the Indian company (and not the assets of the Indian
company) should be taken into consideration to determine whether the 50%
test has been met. This would imply that in a situation where the Indian
company has assets situated outside India, even that would be taken into
consideration since it will be included within the value of the shares
of the Indian company.
- Separate tests have been prescribed for service
based companies (the discounted cash flow valuation) and other companies
(which would be valued on the basis of net asset value). It is also
stated that such value should be determined at the time of the last
balance sheet date with appropriate adjustments made for significant
disposal/acquisition, if any, between the last balance sheet date and
the date of transfer. How this would apply in practice may still require
some consideration. For example, what weightage would be accorded to the
customer contracts / IP at the parent company level which may be loss
generating, even though the Indian subsidiary may be remunerated on a
cost plus basis?
- Look through approach: In
determining the meaning of the phrase, “directly or indirectly”,
the Committee has recommended a “look through” approach. This
essentially means that the intermediaries between the foreign company
and assets in India should be ignored for the purpose of valuation of
shares of the foreign company.
- Attribution of value: The
Committee has recommended that a proportional basis of taxation should
be adopted for the purpose of calculation of the tax liability of the
transfer of shares of a foreign company (covered by the amendment) in
India. Thus, in this regard the Committee recommended that only that portion
of the gains should be taxable in India which is proportional to the
total gains which the Indian assets bear to the global assets.
Key Exemptions
- Threshold Exemption: The
amendment in its current form could attract potential taxation of shares
of a foreign company having its substantial assets in India even to the
extent of transfer of a single share. The Committee has recommended that
persons holding less than a specified percentage (of 26% ownership of
voting power / share capital) should be excluded from the purview of the
indirect transfer tax. To this extent, the indirect transfer provision
would apply in cases where the transferor has a direct / indirect voting
power or share capital in the immediate holding company (that holds the
shares of the Indian company) of more than 26% during the preceding 12
month period. The rationale for the 26% threshold stems from Indian
corporate law provisions which allow a 26% shareholder to block special
resolutions and is in the nature of negative control. It is also
pertinent to note that the 26% threshold computation also includes
holdings by associated enterprises (related parties) and to this extent
there is an aggregation that is set out.
- Listed securities exemption: The Committee
has recommended, in line with the recommendations for listed securities
in the GAAR Report, that income arising from sale of listed securities
should not be subject to capital gains tax provided that the following
two conditions are fulfilled:
i. The foreign company
is listed on a ‘recognized foreign exchange’; and
ii. The shares of the
foreign company are ‘frequently traded shares’5
- Business reorganizations exemption: In case of
business reorganizations in the form of demergers and amalgamations, the
Committee has recommended that intra-group restructuring involving the
transfer of an asset in India should not be taxed in India provided that
such transfers are not taxable in the jurisdiction where such company is
resident.
For this purpose,
the Committee has recommended that intra group restructuring be:
i. A merger or a
demerger as defined under the ITA where there is continuity of at least 3/4th
shareholder.
ii. Any other form of
re-structuring within the group (associated enterprises) subject to 100%
shareholder continuity.
The rationale
behind this is that, any foreign business restructuring does not intend to
have a significant impact on the ownership of the company and related
enterprises and thus, no additional tax burden should be placed on the
business in such a scenario. This is in line with the realization principle
that unless there is an actual realization of capital gains, the same should
not be subject to taxation.
- Exemption for P-Notes: The Committee
has recognized the issues in indirect transfer taxation on Foreign
Institutional Investors (“FIIs”) as FIIs are multi-tier
structures that may make either direct or synthetic investments (P-Notes
and offshore derivative instruments). Applying the indirect tax
provisions in its current form, in case of such investments, tax may be
levied at multiple levels. Further, the frequency of the transfers or
redemptions are also fairly high. Thus, the Committee has recommended
that a circular may be issued in this regard, clarifying that
investments made by FIIs into India shall be taxed only at the hands of
the FIIs along with a specific exception for the case of P-note holders.
- Treaty benefits in context of indirect transfer
tax on non-residents: The Committee has also recommended
that, in cases where capital gains arise to a non-resident on account of
transfer of shares or interest in a foreign company, and if such
non-resident is from a jurisdiction which has a Double Taxation
Avoidance Agreement (“Tax Treaty”) with India, then no tax should
be applicable in India. The exceptions to this are that the Tax Treaty
(i) provides a right of taxation of capital gains to India based on its
domestic law; or (ii) the Tax Treaty specifically provides right of
taxation to India on transfer of shares or interest of a foreign company
or entity. Therefore, the treaty benefits that would apply in case of
investors from certain jurisdictions such as Singapore or Mauritius
would apply even in an indirect transfer context.
Some Thoughts
In spite of being a
largely laudable analysis, the Report continues to leave open some open
points:
- Rethink indirect transfer rule.
Several
prominent jurisdictions such as the United States, United Kingdom, New
Zealand, Australia and Singapore do not ordinarily tax transfer of
shares of domestic companies by foreign investors. Most countries do not
tax foreign investors on transfer of shares of a foreign company. China
and Brazil which are the few exceptions may tax such transactions only
in cases of abuse. It is therefore necessary for India to reconsider whether
it is appropriate to tax offshore share transfers, especially
considering the difficulties in compliance and enforcement.
- Adjustment of basis/ cost of acquisition: The
mechanics for adjustment of cost price continues to be an open issue.
For example, if an offshore company derives substantial value from an
Indian entity, and tax is paid on transfer of the offshore company on
account of the value derived from India, what should be the treatment in
India when it is the Indian company which is subsequently transferred?
While this adjustment is likely to require a legislative amendment to be
put in place, the question is unaddressed under the current Report.
- Cascading taxes in multi-layered structures: An
additional issue that has not been considered by the Committee is the
potential double taxation that can happen, especially in multi-layered
structures. In this regard, the Committee has failed to provide for
provisions dealing with adjustment of basis or cost of acquisition in
certain cases. For example, if Company A holds the shares of Company B
which holds the shares of India Co., in this case if there is a transfer
of shares of Company A, the same will be subject to tax on the full
value of gains and if immediately thereon Company B sells the shares of India
Co., there is another layer of double taxation that is imposed on what
can potentially be the same gains. The computation mechanism based on
the principle of proportionality as discussed in the Report does not
address such issues.
- Foreign Tax Credit: Although the
Committee has considered the impact of triangular situations and stated
that India should allow Tax Treaty benefits to non-residents from treaty
countries in indirect transfer situations, it does not adequately
consider that India would not be a party and may have no role to play in
a treaty involving the disposition of a non-Indian asset by a
non-resident. The availability of foreign tax credits for Indian
indirect taxes is questionable. In fact, countries such as the United
States have specifically stated that they will not grant credit for such
taxes as they do not believe them to be rightfully levied. This would be
a significant impediment for foreign investors who may not obtain a
credit for taxes paid in India due to the amendment as it seeks to erode
the tax base of the foreign country where the foreign company / investor
is located and most countries may not provide a credit for such taxes
paid in India. This may effectively increase the cost of doing business
for a foreign investor and may deter them from investing in India.
- Valuation Issues: While the Report does take
steps to provide clarity on the manner in which valuation should take
place, it is open ended in setting forth certain parameters and does not
deliberate much on the methods of calculation that should be adopted
with respect to such valuation. This is likely to be the cause of some
controversy. In addition, as discussed above, the question of
attribution does not appear to have been adequately dealt with, as there
may be situations where the offshore transferred entity is in fact a
loss generating entity, although the Indian company may be profitable.
- Enforceability of indirect transfer provisions: It would
have been helpful if the Report examined the extent of enforceability of
the indirect transfer provisions, considering that this has been one of
the most significant difficulties and criticisms of these provisions in
a rapidly globalizing world that continues to work within the
traditional limits of enforcement jurisdiction prescribed by
international law.
As outlined above,
there may still be implementation issues with the said provisions. Further,
the view that indirect transfers can be taxed if more than 50% of the assets
are located in India is at divergence with established practices in most
countries (which restrict such provisions to transfer of immovable property).
At a time when India is looking to increase foreign investment, questions
need to be asked as to whether this would tantamount to best practice. The
Committee has, no doubt, cleared the air by providing additional clarity and
diluting the indirect transfer rule. However, it is probably necessary for
India to fundamentally reconsider, in light of international best practices,
whether transfer of foreign shares should be ever be taxable.
_______________________
1 Read our Hotline on
liberalization of foreign investment into the multi-brand retail here
2 Read our Hotline on the Supreme
Court judgment of the Vodafone case here
3 Explanation 5.—For
the removal of doubts, it is hereby clarified that an asset or a capital
asset being any share or interest in a company or entity registered or
incorporated outside India shall be deemed to be and shall always be deemed
to have been situated in India, if the share or interest derives, directly or
indirectly, its value substantially from the assets located in India;
4
http://rbidocs.rbi.org.in/rdocs/Bulletin/PDFs/40T_BUL101012F.pdf
5 Regulation 2(j) of
Securities And Exchange Board Of India (Substantial Acquisition Of Shares And
Takeovers) Regulations, 2011 provides “frequently traded shares” as shares of
a target company, in which the traded turnover on any stock exchange during
the twelve calendar months preceding the calendar month in which the public
announcement is made, is at least ten per cent of the total number of shares
of such class of the target company:
Provided that where
the share capital of a particular class of shares of the target company is
not identical throughout such period, the weighted average number of total
shares of such class of the target company shall represent the total number
of shares;
The International Tax Team
You can direct your
queries or comments to the authors
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