Tax Hotline May 27, 2016

Draft Rules on Capital Gains on Indirect Transfer of Assets Issued: Challenging Times for Global M&As

 

Explanations 5 and 6 to Section 9(1)(i) of the Income Tax Act, 1961 (“Indirect Transfer Provisions”) were first introduced as a knee-jerk reaction to the landmark ruling of the Supreme Court in Vodafone International Holdings BV v. Union of India1, where the Supreme Court held that the transfer of shares of a Cayman Islands company would not be subject to capital gains tax in India, since the shares of the Cayman Islands company were not located in India.

These Indirect Transfer Provisions are extremely relevant for global M&As where there are Indian operations.  The provisions were inserted in the Income Tax Act, 1961 (“ITA”) through the Finance Act, 2012, and provide that a share or interest in a foreign company or entity that derives its value ‘substantially’ from assets located in India would be deemed to be situated in India. As such, a completely offshore transfer of such foreign shares would be brought within the Indian tax net

The term “substantial value” was clarified in Finance Act, 2015 which stated that the share or interest of a foreign entity would derive its value substantially from Indian assets if the value of the foreign entity’s Indian assets (i) exceeds INR 100 million (approx. USD 15 million), and (ii) represents more than 50% of the total value of its global assets. It further provided that the value of Indian and global assets will be the fair market value (“FMV”) of the assets without reduction of liabilities as determined in the manner prescribed in the Income Tax Rules, 1962 (“Rules”). A requirement was also imposed on the Indian concern, through or in which the foreign company or entity holds the Indian assets, to furnish information and maintain supporting documentation.

In this regard, the CBDT has now issued draft rules (“Draft Rules”) prescribing the method of FMV computation and reporting requirements under the Indirect Transfer Provisions. These Draft Rules will be incorporated into the Rules and are open for comments from stakeholders or the general public till May 29, 2016.

Brief Summary of the Rules

A. FMV of Assets on the specified date2, in the following cases shall be:

India Level

Sr. No.

Nature of Asset

Method of Determining FMV

1.

Shares of a listed Indian company not conferring, directly or indirectly, any right of management or control in relation to the Indian company.

The observable price of such share on the stock market.

Observable price has been defined to mean the higher of the following:

  • The average weekly high and low of the closing prices of the shares quoted on the said exchange during the six months period preceding the specified date; or
  • The average of the weekly high and low of the closing price of the shares quoted on the said exchange during the two weeks preceding the specified date
 

2.

Shares of a listed Indian company, held as part of a shareholding which confers, directly or indirectly, any right of management or control in relation to the Indian company

FMV shall be the determined on the basis of the following formula:

(A+B)/C

Where,

A = the market cap of the company on the basis of the observable price of its shares;

B = the book value of liabilities of the company as on the specified date;

C = the total number of outstanding shares

Where the shares are listed on more than one stock exchange, FMV shall be determined with reference to the stock exchange which records the highest volume of trading in the share during the period which is considered for determining the price.

The “book value of liabilities” means the value of liabilities as shown in the balance sheet of the company or the entity as the case may be, excluding the paid-up capital in respect of equity shares/members’ interest.

3.

Shares of an unlisted Indian company

FMV shall be as determined by a merchant banker of accountant in accordance with any internationally accepted pricing methodology for valuation of shares on arm’s length basis and increased by the liability, if any, considered in such determination.

4.

Interest in a partnership, LLP or AOP

FMV shall be proportional to the enterprise value on the specified date, as determined by a merchant banker or accountant in accordance with any internationally accepted valuation methodology as increased by the liability, if any, considered in such determination.

5.

Any other asset

The price such asset would fetch if sold in the open market on the specified date as determined by a report from a merchant banker or an accountant as increased by the liability, if any, considered in such estimation.

Offshore Level

The FMV of all the assets of the foreign company or entity shall be determined in the following manner:

1.

Where the transfer of share of, or interest in, the foreign company or entity is between persons who are not associated person, and the consideration for transfer of share or interest is determined on the basis of a report prepared by an accountant or merchant banker of international repute

The FMV of all the assets of the foreign company or entity shall be the value determined in such report prepared by an accountant or merchant banker of international repute, as increased by the aggregate amount of liabilities, if any,that have been reduced for computing the value of assets for determination of such consideration.

2.

In any other case, where the shares of the foreign company or entity is listed on a stock exchange

The FMV of all the assets owned by the foreign company or entity shall be determined in accordance with the following formula, namely:-

FMV = A+B

Where,

A = Market capitalization of the company computed on the basis of the observable price on the stock exchange where the shares are listed

B = Book value of liabilities of the company or the entity as on the specified date

3.

In any other case, where the shares of the foreign company or entity are not listed on a stock exchange

FMV = A+B

Where,

A = FMV of the foreign company or the entity and its subsidiaries on a consolidated basis as determined by a merchant banker or an accountant as per the most appropriate internationally accepted valuation methodology

B = Book value of liabilities of the company or the entity as on the specified date

 

B. Determination of Income Attributable to assets in India

When the Indirect Transfer Provisions are triggered, the income attributable to assets located in India, shall be determined based on the FMV of Indian assets in proportion to the FMV of the entity’s global assets.

The transferor of the share of, or interest in, a company or entity that substantially derives its value from assets located in India, is required to obtain and furnish a report verified by an accountant as prescribed in the Draft Rules along with the income tax return. The report should certify that the apportionment has been correctly computed based on the FMV of the Indian assets in proportion to the FMV of the global assets. Failure to provide the information required to compute the attributable income will result in the entire income, from the transfer of the share or interest in the foreign company or entity, being deemed to be attributable to assets located in India and be taxed accordingly.

C. Reporting Requirements of the Indian concern

The Indian concern to which the transaction relates is required furnish details of the transaction within 90 days from the end of the financial year in which the transaction took place. However, where the transaction results in the transfer, directly or indirectly, of the right of management or control in relation to the Indian concern, the information is to be furnished within 30 days from the end of the transaction.

The details which are to be maintained by the Indian concern are onerous and inter alia include the following:

  1. Details of the immediate holding company, intermediate holding company(ies) and ultimate holding company;

  2. Details of group entities in India;

  3. Holding structure of the shares of, or interest in, the foreign company or entity before and after the transfer;

  4. Any transfer contract or agreement entered into in respect of the share of, or interest in, any foreign company or entity that holds any asset in India through or in the Indian concern;

  5. Financial and accounting statements of the foreign company or the entity which directly or indirectly holds assets through or in the Indian concern, for two years prior to the date of transfer of the share or interest;

  6. Information relating to the decision or implementation process of the overall arrangement of the transfer;

  7. Information relating to:

    • Business operations

    • Personnel;

    • Finance and properties;

    • Internal and external audit/valuation report, forming the basis of the consideration for the share or interest;

    of the foreign company or entity being transferred and its subsidiaries, which directly or indirectly hold the assets located in India through or in the Indian concern;

  8. The asset valuation report and other supporting evidence to determine the place of location of the share or interest being transferred;

  9. The details of payment of tax outside India, which related to the transfer of the share or interest;

  10. Valuation report in respect of Indian assets and total assets duly certified by a merchant banker or accountant with supporting evidence

  11. Documents which are issued in connection with transactions under the accounting practice followed.

Complexity Analysis and Impact

At the outset, it must be noted that these Draft Rules for taxing indirect transfers have come in more than four years after the insertion of the retrospective provisions in the ITA. Considering that the method of determining the charge of tax, particularly the manner and timing of its application, is still in its draft form and yet to be notified as law, the question that arises is “how can a tax liability be fastened for assessment years in the past, in the absence of such law crystallizing the tax liability”. It is time that the Government took a step to reconsider the levy of such tax till such time the final rules are notified.

Further, while the Draft Rules seek to provide some clarity on the circumstances when the Indirect Transfer Provisions actually apply, there are still many contradictions and ambiguities that need to be addressed. A few of these are set out below:

  1. Inconsistency in addition of liabilities: The manner for determining the FMV of shares of an Indian company listed on a stock exchange (not conferring right of management or control) has been prescribed without adding liabilities of the company to the observable price of the shares on the stock exchange. This is inconsistent with the valuation method prescribed in all other cases where liabilities are required to be added to the market capitalization or observable price, as the case may be. The rationale behind making such distinction is unclear, especially considering that it could lead to an inconsistency in valuation of Indian assets vis-à-vis total assets of a FPI or FII holding listed shares of an Indian company without having any right of control or management of the Indian company.

  2. Different treatment for shares with ‘control and management’: The Revenue has not provided a definition as to what constitutes management and control for the purposes of determining whether shares confer such rights. For example, it is unclear whether granting affirmative voting or board seat rights would be sufficient to qualify shares as conferring management and control rights. This becomes significant in two instances. First, the Draft Rules provide a different valuation formula depending on whether the shares in question confer control and management rights. As mentioned above, in the absence of right of control and management rights, shares of an Indian listed company are to be valued based only on observable price on the stock exchange. However, shares conferring such rights are to be valued using a formula based on market capitalization increased by liabilities of the company. Second, reporting obligations are also different based on whether shares confer control and management rights. In respect to a transaction involving shares which provide such rights, and Indian concern is required to fulfill its reporting obligations within 30 days of the transaction. However, when the transaction does not involve such shares, the Indian concern is permitted to fulfill its reporting obligations within 90 days from the end of the financial year in which the transfer takes place.

  3. Ambiguity in addition of ‘the liability’: In respect of (i) shares of an unlisted Indian company, (ii) interest in a partnership, LLP or AOP, and (iii) any other Indian asset, the valuation is to be “increased by the liability”. However, the Draft Rules fail to clarify what exactly constitutes “the liability” for the purpose of valuing the aforesaid assets. This is in contrast with the requirement for adding “aggregate amount of liabilities” when valuing FMV for the total assets of the foreign company or entity. The intention behind using the different language may be to limit the addition of liabilities in respect of the Indian assets only to the extent they relate to the assets held by the foreign company or entity, as opposed to the aggregate liabilities of the Indian concern. However, this intention is not clear from the express language of the Draft Rules, and could give rise to confusion in valuation.

  4. Reliance on unqualified international standards: The Draft Rules provide some comfort to investors by limiting the discretion of Revenue authorities to challenge FMV valuations of unlisted shares calculated by merchant bankers and accountants in accordance with internationally accepted pricing methodology. However, the Draft Rules also provide that in instances where there is a transfer of shares between non-associated persons, and the consideration for such transfer is based on a report prepared by an accountant or merchant banker of international repute, then the FMV for all the assets of the foreign company shall be the value as determined pursuant to such report (increased by aggregate liability, if any). Unfortunately, the Draft Rules remain silent on what criteria should be used when determining whether a particular pricing methodology is international accepted or whether an accountant or merchant banker qualifies as having international repute. These ambiguities with respect to international methods and classifications may leave otherwise accurate FMV determinations, open to litigation.

  5. Burdensome withholding obligation on transferee: Under Indian income tax law, when a transaction involving payment of consideration by any person to a non-resident is subject to tax in India, such person is obligated to withhold the requisite tax at the time of payment. As such, a foreign company transferee will be subject to withholding obligations in the event that the transferor company qualifies under section 9 as a foreign company deriving its value substantially from assets located in India. To this extent, the Draft Rules fail to provide any guidance on how the foreign transferee company is to determine whether the transferor will meet the substantial assets test under Section 9. It also remains unclear whether Revenue authorities will have the authority to proceed against a transferee company which has in good faith relied on accountant reports to determine that there is no withholding liability in a particular transaction. Further, the reporting provisions only require the Indian concern to obtain the relevant financial information and furnish the same to Income Tax authorities within 90 days from the end of the financial year in which the transactions took place or 30 days from the date of the transaction, as the case may be. Such a reporting timeline does little to help the transferee company determine whether it has a withholding obligation at the time of the transaction itself.

  6. Onerous reporting requirements: The requirement for the Indian concern to maintain financial statements for the past two years of the foreign company or entity is onerous and impractical especially in cases of multi-layered structures. Even in simple transactions, requiring the Indian concern to obtain financial information from its investors may deter foreign investors who want to maintain confidentiality, particularly with respect to private equity investors and other portfolio investors who typically only hold minority stakes. Simply put, this is one of the most regressive moves that could have been made by the Revenue authorities and unheard of in most jurisdictions. The ability for either the Indian concern to meet this requirement or for foreign investors (especially portfolio investors) to share information with their portfolio companies is highly questionable.

    Further, most of the reporting requirements under the Draft Rules are similar to the requirements under Country-by-Country (“CbC”) reporting which was introduced by Finance Act, 2016. CbC reporting is in line with the OECD Action Plan on Base Erosion and Profit Shifting and has been prescribed in respect of multi-national group companies. Under the CbC reporting requirements, companies are required to provide detailed information with respect to each foreign company of a group having consolidated revenue above a certain threshold. Placing similar requirements on the Indian concern under the Indirect Transfer Provisions is extremely onerous, especially without providing a similar threshold or making exceptions for investments made by portfolio / private equity investors.

It is hoped that Revenue authorities take note of these discrepancies and remedy them before finalizing the Draft Rules. Further, it is imperative that appropriate safe harbours are also set out to ensure that foreign investors are not entirely deterred by the expansive provisions and onerous compliance requirements envisioned under these Draft Rules.

- International Tax Team

You can direct your queries or comments to the authors


1 (2012) 6 SCC 613

2 “Specified date” has been defined in the Indirect Transfer Provisions as follows:

i. The date on which the accounting period of the foreign company or entity ends preceding the date of transfer of the share or interest, or

ii. The date of transfer, if the book value of the assets of the company on that date exceeds the book value on the date described in (i) by 15%

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