Finance Bill, 2015 - Clarifications on Taxability of Indirect Transfer

WORLD cup fever is on and it was expected that Finance Minister would hit a massive six on the Budget Day. Till date,reactions to his first full year budget is a mixed one. But there is lot to cheer for foreign investors, be it indirect transfer, Minimum Alternate Tax on Foreign Institutional Investors or tax rate on royalties and fees for technical services. In subsequent paragraphs we are discussing budget proposals on provisions in respect of indirect transfers.

In the backdrop of the decision of the Supreme Court in the Vodafone case, Finance Act, 2012 enacted retrospective amendments whereby transfer of share or interest in a company or entity registered or incorporated outside India was fictionally considered to be taxable in India if such share or interest derives its value (directly or indirectly) substantially from assets located in India. The provision was construed to be draconian considering its wide scope and language as well as lack of clarity on what would be considered to be deriving value substantially from Indian assets. Further, the fact that such a substantive provision was implemented retrospectively raised several apprehensions in the minds of the foreign investors regarding stability and predictability of the tax regime in India.

In order to allay fears of foreign investors, an expert committee was formed under the chairmanship of Dr. Parthasarthy Shome (the Committee) to examine the provisions related to indirect transfer and provide its recommendations to the Government. The Committee published its draft report containing various recommendations relating to the provisions of indirect transfer in October 2012.

Finance Bill, 2015 (the Bill) has proposed certain amendments to the existing provisions related to indirect transfer based upon the recommendations of the Committee. The said amendments have been summarized hereunder:

1. Threshold for applicability of the fiction

A share or interest of a foreign company or entity shall be deemed to derive its value substantially from Indian assets (tangible or intangible) only if the value of Indian assets as on the specified date exceeds the amount of Rs. 10 Crores and represents at least 50% of the value of all the assets owned by the foreign company or entity. Accordingly, where the value of Indian assets are below Rs. 10 Crores or 50% of value of total assets of the foreign company or entity, transfer of shares of such company or interest in such entity should not be chargeable to tax in India.

For the purpose of computing the value of the asset, the Bill provides that the value of the asset would be determined without reduction of liabilities in such manner as may be prescribed. The memorandum to the Finance Bill explains that the value of an asset shall be its fair market value (FMV) and that the manner of determination of the FMV would be prescribed by rules. Further, the Finance Bill also defines the date having regard to which the value of the assets is to be considered for the purpose of applying the aforesaid threshold. These provisions would ensure that transactions where value of Indian assets are not substantial compared to the global assets of the foreign company are not charged to tax in India.

2. Exemption from applicability of the fiction in case of small holdings

Exemption from applicability of the aforesaid provision has been provided in the following situations

a. Where shares of Indian company are owned directly by the foreign company or entity whose shares are being transferred:

The transferor (individually or alongwith its associated enterprises) neither holds the right of management or control of such company or entity nor holds share capital or voting power exceeding 5% of the total share capital or voting power of the foreign company or entity owning shares of Indian company

b. Where the shares of Indian company are indirectly owned by the foreign company or entity whose shares are being transferred

The transferor (individually or alongwith its associated enterprises) neither holds the right of management or control of such foreign company or entity nor holds share capital or voting power exceeding 5% of the total share capital or voting power of the company that owns shares of Indian company

Accordingly, where the transferor of shares does not have right in the management or control of the foreign company or entity whose shares are being transferred and does not hold shares exceeding 5% of total share capital of the direct holding company owning shares of Indian company, no income arising on such transfer should be taxable in India.

3. Taxation of proportionate gains

The Finance Bill also provides that only that portion of income arising on transfer of share or interest of a foreign company as is reasonably attributable to assets located in India would be taxable in India. Taxation of gains arising on above envisaged transfers will be on proportionate basis, the manner of which will be proposed through rules. This definitely a step in right direction and will give much needed comfort to MNCs.

4. Exemption in case of tax neutral merger and de-merger

The Finance Bill provides that where in case of a merger or de-merger shares of foreign company or entity which derive their value substantially from Indian assets are transferred will not be regarded as transfer provided that:

- In case of merger, at least 25% of shareholders of the transferor company become shareholders of transferee company

- In case of de-merger, shareholders holding at least 75% in value of shares of transferor company become shareholders of transferee company

and the transaction is tax neutral in the country of origin of the transferor company.

This is a welcome step to ensure that corporate reorganizations of foreign companies do not lead to any adverse tax consequences in India.

5. Reporting obligation on the Indian concern and penalty for non-compliance

The Indian concern has been cast with an obligation to report any transaction in the prescribed manner having the effect of directly or indirectly altering the ownership structure or control of the said Indian concern. Further, penalty for non-compliance has been prescribed at two percent of the value of the transaction in respect of failure in case where transaction leads to transfer of management or control rights in such Indian concern (directly or indirectly). In respect of remaining cases not resulting in transfer of management or control rights in the Indian concern, penalty of Rs. 5 Lakhs is leviable.

In view of the substantial penalty proposed, it is critical to report all the transactions directly or indirectly altering the ownership of an Indian concern including those where the transfer of management or control rights in the Indian concern takes place.

6. Issues yet to be addressed

Following issues are still not addressed by the proposed amendments and hence may require to be ironed out:

- Calculation of cost of shares or interest - still a grey area

- Intra-group transfers other than amalgamation and demerger not covered

- No exemption granted in case of FIIs, PE Investors and listed foreign entities

- No clarification that the provisions shall be applied only to the taxpayer who earned capital gains from indirect transfer (and not to the transferee or its representative assessee)

Conclusion

The amendments proposed in the Finance Bill, 2015 provides substantial clarity on applicability of the provisions related to indirect transfer and the proposed provisions substantially rationalize the unreasonable impact of the retrospective amendment made by Finance Act, 2012. Further, there are certain aspects relating to computation of gains arising on taxable indirect transfer that would be clarified through the rules which read with the provisions proposed in the Bill would form a complete code on taxability of indirect transfer.