Every emerging economy weighs the fiscal contribution with the growth in business and at times certain amendments / changes are essential to achieve this objective. Having stated that clearly businesses also do not frown upon changes in fiscal legislation or for that matter amendments introduced with an objective to widen the existing tax base but what is not looked upon favorably is the introduction of amendments which have an impact on past transactions. In the early part of the year the Finance Act, 2012 had introduced amendments to the Income-tax Act, 1961 (‘the Act’) for the purpose of expanding the scope of taxing indirect transfers in India with retrospective effect from April 1, 1962.
These retrospective amendments were essentially introduced to overcome the effect of the Supreme Court decision rendered in the case of Vodafone[1]. Whilst the retrospective application of the amendment definitely created uncertainty regarding the taxability and the possible interest and penalty consequences in respect of concluded transactions, it also had an impact on the inflow of foreign investments in India. Various concerns were raised by classes of foreign investors regarding the taxability of transactions involving transfer of assets by non-residents where the underlying asset is in India. The concerns were two fold one the widening of the tax base by introducing taxation of indirect transfer and the other was the introduction on a retrospective basis.
Dr Parthasarathi Shome Committee (‘Expert Committee’) which was appointed by the Prime Minister of India for the purposes of formulating guidelines for the General Anti Avoidance Rules (‘GAAR’) by adopting a consultative approach, was also mandated to examine the implications of the retrospective amendments introduced in the Act relating to the taxation of transfer of assets by non-residents where the underlying asset is in India, particularly in the context of the Foreign Institutional Investors (‘FIIs’)[2]. However, subsequently the scope for the Expert Committee was further expanded to examine the applicability of the retrospective amendments on taxation of transfer of assets by non-residents where the underlying asset is in India, in context of all non-resident taxpayers as against FIIs only[3].
As per the reference made, the Expert Committee first submitted its report to the Indian Government on August 31, 2012 focusing on GAAR issues (Click here to view BMR Edge on Expert Committee Report on GAAR). Thereafter, as per the additional reference made to it, the committee focused on the scope of ‘indirect transfers’ widened by the retrospective amendments introduced by the Finance Act, 2012 and has presented its draft report on retrospective amendments relating to indirect transfers (Click here to view the draft report).
Key recommendations
The Expert Committee report has recommended that retrospective amendments to tax law should occur in exceptional or rarest of rare cases. It has stated that in case the retrospective nature of the amendments is proceeded with, no burden ought to be fixed on the payer for not withholding taxes since the same would result in ‘impossibility of performance’. In any case, if the amendments are to be introduced, the taxpayers earning the capital gains should be made taxable on account of the retrospective amendments and no penalty and interest should be levied in respect of the income brought to tax on application of retrospective amendments.
The Expert Committee has recommended a threshold of 50 percent of the total value derived from assets of the foreign company or entity and has recommended major relief for foreign investors and intra-group restructuring abroad. As per the notification (Click here to view the notification), comments and suggestions on the draft report can be sent via email or post on the address specified therein by October 19, 2012.
This BMR Edge seeks to summarize the retrospective amendments introduced to tax indirect transfers in India and the notable recommendations made by the Expert Committee in respect of these amendments.
Amendments introduced by the Finance Act, 2012
In order to tax indirect transfers in India, the Finance Act, 2012 inserted the following ‘clarificatory explanations’ with retrospective effect from April 1, 1962 to various sections under the Act.
Explanation to the definition of ‘capital asset’ under Section 2(14) of the Act
The term ‘capital asset’ is defined to mean ‘property’ of any kind. The term ‘property’ as used in the definition of ‘capital asset’ was clarified to include any rights in or in relation to an Indian company, including rights of management or control or any other rights whatsoever.
Explanation to the definition of ‘transfer’ under Section 2(47) of the Act
The definition of ‘transfer’ was clarified to include besides its general meaning the following within its ambit -
a) Disposing or parting with an asset; or
b) Disposing or parting with an interest in an asset; or
c) Creating any interest in an asset.
Further, the above transactions was sought to be taxed irrespective of the activity that may be carried out in any manner whatsoever including –
a) Directly or indirectly; or
b) Absolutely or conditionally; or
c) Voluntarily or involuntarily; or
d) By way of an agreement (whether entered into in India and outside India) or otherwise.
Explanation of the term ‘through’ as appearing in Section 9 of the Act
Section 9 specifies cases of income which are deemed to accrue or arise in India for the purpose of taxation in the hands of non-resident tax payers. For this purpose, Section 9 inter alia provides the following income as accruing and arising in India in the hands of a non-resident for the purpose of taxation in India -
“All income accruing or arising, whether directly or indirectly, through or from any business connection in India, or through or from any property in India, or through or from any asset or source of income in India, or through the transfer of a capital asset situated in India”
The term through used in Section 9 as above was explained to mean and include 'by means of', 'in consequence of’ or 'by reason of’.
Explanation to the phrase ‘capital asset situated in India’ as appearing in Section 9
The phrase ‘capital asset situated in India’ as used in Section 9 was explained to include an asset or a capital asset being any share or interest in a company or entity registered or incorporated outside India, if such share or interest derives, directly or indirectly, its value substantially from the assets located in India.
Observations and recommendations of the Expert Committee
For this purpose, the Expert Committee referred to practices in several countries around taxation of capital gain in the hands of non-residents and treatment of indirect transfers for this purpose. The Expert Committee also referred to the model conventions and tax treaties entered into by India with various countries. It also received several representations from various stake holders. After reviewing all the available material, it summarized its observations and made certain recommendations in this regard.
The Expert Committee has also commented on situations when retrospective amendments should be made and when such amendments should not be made with retrospective effect. Purely from a policy perspective the Expert Committee observed that the retrospective amendments which expand the tax base lead to uncertainty and thus are against the basic principle of law. In the context of the subject retrospective amendments, the Expert Committee has categorically stated that these amendments intend to widen the tax base and thus are not clarificatory in nature. The Expert Committee has recommended prospective application of the amendments after inserting clear definitions as recommended in the report.
Recommendations where the amendments are continued to have retrospective effect
The Expert Committee noted that retrospective effect to such provisions could lead to few issues like ‘impossibility of performance’ where purchasers were required to withhold tax from the purchase consideration; payment of additional amounts towards tax, interest and penalty by purchasers where they have discharged full sale consideration and levy of interest and penalty in respect of such liability. Accordingly, while the Expert Committee recommended that these provisions relating to tax on indirect transfers should be made prospectively only, it has made the following recommendations in case the Indian Government decides to proceed with the retrospective application of the amendments –
· Retrospective amendment for taxing transactions pertaining to the transfer of shares of a foreign company having underlying assets in India should apply only to taxpayers who have earned capital gains from such transfers.
· The Expert Committee has recommended that no liability for the failure to withhold tax from the sale consideration should be fastened on the person responsible for the payment and that the purchaser should also not be treated as a ‘representative assessee’ in place of such transferors.
· In respect of the tax demands raised on account of retrospective amendments, the Expert Committee has recommended that no interest and penalty should be levied.
Recommendations made regardless of the date of applicability of these amendments
The Expert Committee noted that the current provisions are not entirely clear and could lead to different interpretations. Accordingly, irrespective of the retrospective or prospective application of the amendments, the Expert Committee has recommended the following changes either under the Act or the Income-tax Rules, 1962 or by way of an explanatory circular, as appropriate in law –
Recommendations for change in applicability and computation
Meaning of the phrase ‘share or interest in a company or entity registered or incorporated outside India’
· The term ‘share or interest in a company or entity registered or incorporated outside India’ has been used in newly introduced Explanation 5 to Section 9 of the Act. It expands the scope of phrase ‘capital assets situated in India’.
· The Expert Committee has recommended that the term ‘share or interest in a company or entity registered or incorporated outside India’ should mean and include only such share or interest which results in participation in ownership, capital, control or management and not merely economic interest. This recommendation was based on the analysis that the term interest has been used in respect of an entity like partnerships to cover rights like share in a company and thus the terms share and interest should be sue-generis in nature.
Definition of the word ‘substantially’
· As per the amendment to Section 9, income from the transfer of a share or interest in foreign company or an entity would be taxable in India if such share or interest derives it values substantially from the assets located in India. Unlike under the Direct Taxes Code, 2010 (‘DTC’), the term ‘substantial’ had not been defined or clarified.
· The Expert Committee has recommended that as proposed in the DTC, the word ‘substantially’ should be defined as a threshold of 50 percent of the total value derived from assets of the company or entity incorporated outside India. Accordingly, a capital asset being any share or interest in a company or entity registered or incorporated outside India would be deemed to be situated in India, if such share or interest derives, directly or indirectly, its value from the assets located in India being more than 50 percent of the global assets of such company or entity.
· It is recommended that for computing the 50 percent value, 100 percent global assets of Indian entities should be considered as against only Indian assets.
Meaning of the phrase ‘directly or indirectly’
· In respect of the phrase ‘directly or indirectly’ for the purposes of determining value of a share of a foreign company, a look through approach which ignores all intermediaries between the foreign company and assets in India has been recommended.
Meaning of the term ‘value’ and other related aspects
· In respect of the term value and the point of time for valuation, the following have been recommended –
· The term value should refer to fair market value (‘FMV’) as may be prescribed. For this purpose it has been advised that Discounted Cash Flow method in case of service sector and Net Asset Value method for non-service sector may be used.
· The value has to be ascertained based on the net assets of the company (after taking in account liabilities).
· For determining the value, both tangible and intangible assets should be considered.
· The value should be determined as on last balance sheet date of foreign company with appropriate adjustments made for significant disposal / acquisition, if any, between the last balance sheet date and the date of transfer.
· Further, as proposed in the DTC, it has been recommended that taxation should be restricted to capital gains attributable to assets located in India. Thus, capital gains would be taxed on a proportional basis between the FMV of Indian assets and global assets of the foreign company.
Deletion of the phrase ‘an asset or’ juxtaposed on the phrase ‘capital asset’
· Currently, Explanation 5 reads as ‘an asset or a capital asset being any share or interest...’. Given that the intention is to tax the transfer of capital assets alone, it has been recommended to delete the phrase ‘an asset or’ juxtaposed on the phrase ‘capital asset’. The Expert Committee has observed that the said phrase may lead to unintentional consequences such as taxation of dividends paid by a foreign company or income in the nature of business income regardless of existence of a business connection / permanent establishment in India.
Implications of amendment to the definition of ‘transfer’
· As discussed above, the definition of the term ‘transfer’ was significantly amended to widen its scope. Illustratively, transactions such as mortgaging or pledging of property or introduction of new partner in a partnership firm may be considered to be disposal of, or parting with, an interest in property or firm, as the case may be, and thus fall under the amended definition of transfer.
· As per the Expert Committee, the amendment to Section 9 and definition of the term ‘transfer’ has resulted in the taxation of transfer of shares of a foreign company having underlying assets in India in the following two ways
· To tax capital gains arising through indirect disposal of assets located in India; or
· To tax capital gains on the transfer of shares of a foreign company, where underlying assets of such foreign company are substantially in India, thereby implying that the situs of the shares of the foreign company is in India.
· The Expert Committee analyzed the amendment to definition of transfer and observed that such amendment would result in taxing transactions which were otherwise not taxable under Section 9 of the Act.
· Given that the intention of the amendment is to tax transfer of shares of a foreign company having underlying assets in India and the same has been specifically dealt with the amended Section 9, the Expert Committee has recommended that definition of transfer enshrined in Section 2(47) of the Act should not be read in isolation of Section 9.
Recommendations for exempting certain types of tax payers / transactions
Small shareholders
· Addressing the concerns of small shareholders in foreign companies, it has been recommended that transfer of shares or interest in a foreign company or an entity which has underlying assets in India would not be taxable if the following conditions are satisfied –
· In case the foreign company or the entity (of which the shareholder transfers shares) is the immediate holding company having underlying assets in India, the voting power or share capital of the transferor (ie small shareholder) along with its associated enterprises in such a foreign company or entity is less than 26 percent of the total voting power or share capital of the foreign company or the entity during the preceding 12 months; or
· In other cases, the voting power or share capital of the transferor (ie small shareholder) along with its associated enterprises in such a foreign company or entity during the preceding 12 months does not exceed such percentage which results in 26 percent of the total voting power or share capital of the immediate holding company having underlying assets in India.
Foreign company listed on a recognized stock exchange overseas
· It has been recommended to exempt foreign companies listed on recognized stock exchanges overseas whose shares are frequently traded from the purview of taxation of indirect transfers in India. It has been further recommended that the terms ‘frequently traded’ and ‘recognized stock exchange’ may be defined as per Securities and Exchange Board of India (‘SEBI’) guidelines and Reserve Bank of India (‘RBI’) regulations on overseas investments by residents.
· Here it is pertinent to note that, whilst the intension of the recommendation appears to be targeted to exempt capital gains arising to shareholders from the purview of taxation of indirect transfers in India, the recommendation articulates it differently.
Business reorganization abroad
· Given that the taxation of the transfer of shares of a foreign company was not anticipated in the past, the Expert Committee has duly considered the aspect of business reorganization by foreign companies abroad. The Expert Committee has recommended that since business reorganizations within the group do not result in any real income, such transfers whether in India or outside India should be excluded from the ambit of taxation of indirect transfers in India. This should however be subject to the condition that such transfer should not be taxable in the foreign jurisdiction and there exist sufficient safeguards to prevent misuse of such exemption by way of continuity of ownership.
· Further, the Expert Committee has recommended that intra group restructuring may be defined as -
· Amalgamation or demerger as defined under the Act subject to continuity of at least 75 percent ownership; or
· Any other form of restructuring within the group (associated enterprises) subject to continuity of 100 percent ownership.
FIIs
· Given that the investments made by the FIIs registered with the SEBI are subject to tax in India, in order to avoid the incidence of double or multiple taxation, it has been recommended that non-resident investors (including Participatory Note Holders) making investments, directly or indirectly, in an FII should not be taxable where –
· The non-resident investor has made any investment, directly or indirectly, in an FII; or
· The investment made by an FII in India represents, directly or indirectly, the underlying assets of investments by a non resident.
Private Equity Investors (‘PE Investors’)
· According to the Expert Committee, the concerns raised by the PE Investors regarding the taxation of gains arising to them on account of redemption of their investments in pooling vehicle or inter se transfer amongst such investors have been totally addressed by the recommendations suggested in respect of interest, small shareholders, business reorganization, listed companies etc. Accordingly, PE investors would be kept out of the coverage of taxation of indirect transfer where -
· The investment by the non-resident investor in a PE fund is in form of units which do not result in participation in control and management of the fund;
· The investor along with its associates does not have more than 26 percent share in total capital or voting power of the company;
· The investee company or entity does not have more than 50 percent assets in India as compared to its global assets;
· The investee company is a listed company on a recognized overseas exchange and its shares are frequently traded;
· The transfer of shares or interest is a result of reorganization within the group.
Conflicts with tax treaties of India
· Considering the conflicts that could arise in respect of taxation of gains arising from the alienation of shares in light of the tax treaties entered into by India with various countries, the Expert Committee has recommended that it may be clarified that the capital gains arising to non-residents which are taxable as indirect transfer and there exists a tax treaty would not be taxable in India unless –
· The tax treaty provides a right of taxation of capital gains to India as per its domestic law; or
· The tax treaty specifically provides right of taxation to India on transfer of shares or interest of foreign company or entity.
Cascading effect on dividend taxation in multi-tier structures abroad
· As per the amended provisions, besides capital gains on indirect transfers, even dividend income on shares of foreign company may be treated from a source (deemed) to be situated in India and thus taxable. Given that the apparent intention of the amendment was to tax any indirect transfer of a capital asset situated in India, it has been recommended that dividend paid by a foreign company should not be deemed to accrue or arise in India.
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