The Finance Minister, during his Budget speech, spoke about moving towards a tax regime which would be in consonance with global policy. In doing so, he has tried to address the concerns of investors by making significant changes to the indirect transfer tax provisions in the Income Tax Act (ITA). In the international context, capital gains tax is typically based on residence and not source and very few countries have provisions taxing indirect transfer of shares by offshore companies. However, by virtue of Section 9, the ITA taxes capital gains based on the source of the gains. Further, the indirect transfer tax provisions, as have been provided under the ITA, expand the existing source rules for capital gains. The indirect transfer tax provisions were introduced in the Finance Act, 2012 by way of Explanation 5 to Section 9(1)(i) of the 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.
On the basis of the recommendations provided by the Shome Committee appointed by the then Prime Minister, the Finance Bill (Bill) proposes to make various amendments to these provisions which are summarized below:
Threshold test on substantiality and valuation: The Bill provides that the share or interest of a foreign company or entity shall be deemed to derive its value substantially from the assets (whether tangible or intangible) located in India, if on the specified date, the value of Indian assets (i) exceeds the amount of INR 10 crores (INR 100 million); and (ii) represents at least fifty per cent of the value of all the assets owned by the company or entity. The value of the assets shall be the Fair Market Value (FMV) of such asset, without reduction of liabilities, if any, in respect of the asset. The manner of determination of the FMV of the assets has not been prescribed in the Bill and is to be provided for in the rules.
Date for determining valuation: Typically, the end of the accounting period preceding the date of transfer shall be the specified date of valuation. However, in a situation when the book value of the assets on the date of transfer exceeds by at least 15%. The book value of the assets as on the last balance sheet date preceding the date of transfer, then the specified date shall be the date of transfer. This results in ambiguity especially in cases where intangibles are being transferred.
Taxation of gains: The gains arising on transfer of a share or interest deriving, directly or indirectly, its value substantially from assets located in India will be taxed on a proportional basis based on the assets located in India vis-?-vis global assets. While the Bill does not provide for determination of proportionality, it is proposed to be provided in the rules. It would be necessary to ensure that only the value of the Indian assets is taxed in India. It is important to address the cost adjustment, if at a later point in time, the Indian assets are transferred. For example, if an offshore company derives substantial value from Indian company shares held by it, and tax is paid on transfer of the offshore company on account of the value derived from India, will there be a step up in cost basis if the shares of the Indian company are subsequently transferred?
Exemptions: The Bill also provides for situations when this provision shall not be applicable. These are:
Where the transferor of shares of or interest in a foreign entity, along with its related parties does not hold (i) the right of control or management; and (ii) the voting power or share capital or interest exceeding 5% of the total voting power or total share capital in the foreign company or entity directly holding the Indian assets (Holding Co).
In case the transfer is of shares or interest in a foreign entity which does not hold the Indian assets directly, then the exemption shall be available to the transferor if it along with related parties does not hold (i) the right of management or control in relation to such company or the entity; and (ii) any rights in such company which would entitle it to either exercise control or management of the Holding Co or entitle it to voting power exceeding 5% in the Holding Co.
Therefore, no clear exemption has been provided to portfolio investors as even the holding of more than 5% interest could trigger these provisions. This is a far cry from the 26% holding limit which was recommended by the Committee. Further, no exemption has been provided for listed companies, as was envisaged by the Committee. In case of business reorganization in the form of demergers and amalgamation, exemptions have been provided. The conditions for availing these exemptions are similar to the exemptions that are provided under the ITA to transactions of a similar nature.
Reporting Requirement: The Bill provides for a reporting obligation on the Indian entity through or in which the Indian assets are held by the foreign entity. The Indian entity has been obligated to furnish information relating to the off-shore transaction which will have the effect of directly or indirectly modifying the ownership structure or control of the Indian entity. In case of any failure on the part of Indian entity to furnish such information, a penalty has been proposed to be levied. The proposed penalty ranges from INR 500,000 to 2% of the value of the transaction. In this context, it should be pointed out that it may be difficult for the Indian entity to furnish information in case of an indirect change in ownership, especially in cases of listed companies. Further, there is minimum threshold beyond which the reporting requirement kicks in. This means that even in a case where one share is transferred, the Indian entity will need to report such change.
All in all, while these provisions will provide some relief to investors, a number of recommendations as provided by the Committee have not been considered by the Government. Some of these recommendations related to exemption to listed securities, P-Notes and availability of treaty benefits. Further, there are no provisions for grand fathering of existing investment made in the past and questions arise as to the tax treatment on transactions undertaken between 2012 and 2015 although in last year?s budget, the Finance Minister had clarified that assessing officers will not issue retrospective notices in relation to these provisions. Yet another issue that has not been considered is the potential double taxation that can happen, especially in multi-layered structures. Further, no changes have been proposed to the wide definition of ?transfer? which could potentially cover unintended activities like pledge/mortgage of property of the foreign company having assets located in India.
A fundamental question that ought to have been addressed is whether such tax policy is in consonance with global tax policies and the Finance Minister should have actually taken the bold step of scrapping the provisions from the ITA in entirety. In the current form, we can expect further litigation on various issues relating to the indirect transfer provisions for the foreseeable future.
About the author
This article is written by Nishith M. Desai