A Classic Case Of Double Taxation?
The Central Board of Direct Taxes in India issued Circular Number 41 on December 21, 2016 providing clarifications on applicability of ‘indirect transfer’ provisions under the Indian Income Tax Act, 1961 to investors of Foreign Portfolio Investors (FPIs) – earlier known as Foreign Institutional Investors (FIIs) in India.
The circular has considered the comments of the working group constituted by CBDT in June 2016, and provides clarifications to nineteen issues. A brief background of the issue and clarifications provided by CBDT is explained below.
In a typical structure where the FPI is predominantly an India-focused fund:
- Investors (say from U.S., U.K. or anywhere in the world) invest their money in a pooling vehicle in a tax and operationally efficient jurisdiction (say Mauritius).
- The Mauritius Fund (Z) then registers as an FPI in India for undertaking actual purchase and sale of Indian securities.
- The FPI Z complies with Indian tax laws (read with applicable tax treaty). The investors (A/B/C) do not undertake any direct registrations or transactions in India.
- Generally, at the time of exit from Z, the investor (A/B/C) places a redemption request with Z who in turn sells Indian securities to generate funds. However, sometimes Z may undertake purchase and sale of Indian securities on its own account to maximize returns of its investors. Accordingly, there may or may not be a direct co-relation between the entry/exit of the investor (A/B/C) with the purchase/sale of securities by Z in India.
The CBDT circular seeks to clarify the applicability of indirect transfer provisions to these investors of the FPI – as the gain made by them from the sale of units/shares/interest in Z mainly derives its value from the underlying Indian assets.
Overview Of Indirect Transfer Provisions In India
The indirect transfer provisions were introduced in 2012 (with retrospective effect from 1 April, 1962) after the Indian government lost the well-publicised battle against Vodafone.
In the case of Vodafone acquiring the India telecommunication business of Hutch via an offshore transaction the Supreme Court held that transfer of shares of an overseas company, even though deriving its value substantially from Indian assets, was not taxable in India.
Thereafter the government amended the law to state that gains arising from transfer of share/interest in a company/entity incorporated or registered outside India (overseas entity) will be taxable in India if such share/interest derives its value substantially from assets located in India.
In 2015, it was clarified, again by amending the law, that the value of the overseas company/entity will be deemed to derive its value substantially from assets located in India if on the specified date:
- value of Indian assets exceeds Rs 10 crore (approximately $1.47 million); and
- value of such assets represent 50 percent or more of value of all assets owned by the overseas entity.
If a transaction fit the criteria and met the definition of an ‘indirect transfer’, the following implications would arise:
- The non-resident transferor would have to obtain registration with Indian tax authorities, pay tax on capital gains in India (attributable to Indian assets) and file tax returns in India.
- Buyer would be required to undertake withholding tax registrations and compliances on payment of consideration to the transferor.
- Indian entity whose interest/shares are indirectly transferred would be required to report the transaction to the Indian tax authorities, failing which a penalty could be levied.
Exemption from these provisions was provided only to small shareholders. These are shareholders who do not hold any right of management or control in the overseas entity and hold 5 percent or less voting power or share capital or interest in the overseas entity directly owning assets in India (throughout 12 months preceding the date of transfer).
In the year 2016, final rules were prescribed for computation of fair market value of assets of the overseas entity and also taxable gain in India. Since the provisions have been developing over the years, from 2012 till 2016, there has been a lot of uncertainty among foreign investors, especially FPIs, on whether the indirect transfer provisions apply to their investors and hence they had made several representations to the government requesting clarifications.
Clarifications Provided In The CBDT Circular
The circular broadly seeks to make the following clarifications:
- Indirect transfer provisions would apply to investors of the FPI (Z in the illustration):
– on redemption of units or shares in the FPI.
– even in cases of master-feeder or nominee-distributor structures.
– even in case of merger/internal restructuring of the FPi; subject to exemption provided for small investors.
The circular also states that:
- The threshold of Rs 10 crore (approximately $1.47 million) of Indian assets is reasonable and does not need to be increased to Rs 100 crore (approximately $14.7 million).
- Exemption is not required for investors in a listed FPI since reasonable exemption has already been provided for small investors.
- Withholding tax and reporting compliances would apply.
- The argument of double taxation of same income (at fund and investor level) may not hold good since exemption has already been provided for small investors.
Impact On Investors Of FPIs
1. Pay Tax
In a nutshell, as per the circular, investors (non-small shareholders) of India focused FPIs (which derive their value substantially from Indian assets) would be required to pay tax in India on the gains made on redemption of units or shares in the FPI. However, since the CBDT circular is binding only on tax authorities and not taxpayers, it may be possible for FPIs and or their investors to challenge the same. They may however not get much support from the current wording of the indirect transfer provisions in the law.
Interestingly, the CBDT circular does not clarify on the taxation of investors using participatory notes (P-notes) for investments into FPIs. While the answer to this issue would depend on facts and structure of each case, it could be possible to argue that P-notes should not be covered under the indirect transfer provisions. This view is based on the argument that P-notes are contracts or agreements between the FPI and the investor and these do not provide any control or management or share to the investor and do not necessarily have any direct co-relation with the underlying securities of the FPI. However, there is no clarity on whether the CBDT will accept this view.
2. Tax Rate?
- Under the Income Tax Act, 1961
The rate of tax would depend on the characterization of the gain as business profit or capital gains. The law states that the gains of an FPI from securities in India would be classified as ‘capital gains’ only. However, whether the same position needs to be adopted by the investors in the FPI requires clarity. If the gains are treated as ‘capital gains’, the rate of tax would vary depending on the type of Indian security and classification of gain as short-term or long-term. Broadly, the tax rates could range from 10-40 percent which is substantial.
This could also be a classic case of double taxation where the investor may have already borne the impact of taxation when the FPI pays tax on the capital gains earned in India and yet, the investor could once again be required to pay tax on exit from the FPI/fund itself.
- Under the applicable tax treaty
If the investor is a tax resident of a country with which India has a tax treaty, then the possibility of exemption from tax can be explored under the applicable tax treaty.
The Andhra Pradesh High Court in the case Sanofi Pasteur Holding SA v. The Department of Revenue (this ruling has been challenged by the Indian tax authorities before the Supreme Court and the Supreme Court has admitted the appeal), held that the indirect transfer of shares of an Indian company was not taxable in India in the context of the India-France tax treaty.
Extending this rationale to other similarly worded treaties such as Belgium, Netherlands, Luxembourg, and others, it may be possible for investors of such countries to claim exemption from taxation of indirect transfers in India. However, investors from countries such as U..S., U.K., Canada, may not be able to obtain an exemption from such taxation under their tax treaties.
3. Withholding Tax
The FPI, in this illustration Z, would be expected to withhold tax when redeeming the units, failing which there could be tax and penal interest consequences on the purchaser (as was done in the case of Vodafone). But, in the case of a listed FPI or fund, there would be practical challenges in withholding tax from transactions over a stock exchange.
4. Tax Scrutiny
While cases prior to the amendment of the law in 2012 may not be selected for taxation, there is no clarity on whether cases falling in the intervening period 2012-2016 would be opened or selected for taxation. For ongoing and future assessment proceedings, the possibility of tax officers questioning around these issues and seeking to tax any qualifying indirect transfers cannot be ruled out. In fact, even a legal reprieve looks difficult as the government has indicated that they have merely stated and clarified the current provisions of the Act.
Impact On Indian Companies Receiving FPI Investment
Very importantly, Indian companies receiving FPI investment would be required to report such transfers to the income tax authorities, failing which, the Indian tax authorities could penalise the Indian company. Since the Indian company may practically not have such information on transfers overseas, the levy of penalty would be unfair. In fact, the CBDT has itself acknowledged in the circular that the practical application of the reporting requirement needs to be seen.
In our view, it would be desirable for the Government to rescind this circular and relax the applicability of indirect transfer provisions to the investors of FPIs. Also, the government should provide clarity on the availability of tax treaty benefits in case of indirect transfers and whether indirect transfer provisions would apply in case investors use P-Notes.