Many foreign investors consciously design a second option for selling their emerging market investments: i.e. the ability to sell an offshore holding company (OHC) that holds the shares of the investee company. OHCs are always single asset owning companies. On very rare occasions, when the idea is to list the OHC and not the operating company, investors share ownership in OHC. Otherwise, OHCs are almost always Single Owner Single Asset (SOSA) companies. The Amendment on Indirect Transfers (AIT) that was passed in the Finance Bill of 2012 was intended to target indirect transfers of SOSA companies that are designed to mask a direct transfer of an Indian company.
Issues with the AIT
Nobody can disagree with the idea that tax authorities need to have the right to tax indirect transfers in:
A: Situations where transferors deliberately choose indirect transfer as a ruse to mask an underlying “taxable” direct transfer (i.e. sale of a SOSA company).
The legislative intent for the AIT was to draft a “clarifying amendment” that can see through such ruses and tax avoidance devices. (The motivation was to classify the Vodafone-Hutch deal as a taxable transaction.) Unfortunately, the broad language that was used went far beyond legislative intent and covered several situations such as:
B: Situations where Indian transfers are part of global transfers (i.e. as a consequence of a global M&A transaction, control of an Indian company is transferred but is not subject to tax in India. Even though tax avoidance in India is not a consideration in global transactions, Indian taxation is perpetually postponed, as direct transfers are never contemplated).
C: Trading of minority interests in listed or unlisted global businesses with an India presence;
D: Trading of interests in listed or unlisted Offshore Funds that invest all or part of their capital in listed or unlisted Indian companies (minority or majority or control is irrelevant in a fund, where investors have no management rights).
Investors’ concerns on the AIT were three fold:
- The AIT was imposing a new tax regime (for eg in situation B above) making it a substantive amendment, which should not be enforced on a retrospective basis;
- Transactions that fall in situation B are legitimate targets for taxation but the AIT should be narrowed to avoid extra-territorial taxation of genuine business activity (for eg situations C and D above).
- The AIT should be limited to indirect transfers where the underlying direct transfer was taxable. The AIT should not be used as a ruse to tax direct transactions that would be eligible for treaty benefits.
Recommendations of the Dr Shome Committee
Given the extra-ordinary broad language, it is obvious that the AIT was imposing a new tax regime for global M&As involving Indian assets and for trading of interests in offshore funds operating in India. The Expert Committee (EC) headed by Dr Shome is correct in assessing that, in its current form, the AIT is a substantive amendment that can only be enforced prospectively. However, after determining against retrospective enforcement, the EC has missed the woods for the trees on everything else.
In its interim report, the EC has made suggestions that can be classified into two groups. In the first group of flawless suggestions, the EC has recommended the following:
- Not for profit intra group transactions/reorganisations be exempted;
- Trading of minority interests in overseas listed companies be exempted.
In the second group of suggestions, the EC has recommended the following:
1. Only transactions where Indian assets comprise more than 50% of overall transaction value be covered by the AIT;
2. Only transferors who own 26% “see through” economic ownership in an OHC that is one level above the Indian asset (hereinafter referred to as “Level 1 OHC”) be covered by the AIT;
3. Trading of interests in Offshore Funds that invest in India through the FII route be exempted from the AIT.
As per recommendation 1 above, global M&As will be exempt from Indian taxation unless the value of the Indian assets comprises of 50% or more of overall transaction value. It will be interesting to know the standards in other countries because the EC recommendation appears to be an unnecessarily generous carve-out. Effectively, a global M&A transaction valued at $ 25 billion where control of an Indian asset valued as high as $ 12 billion is transferred would be tax-exempt whereas a global M&A transaction valued at $10 million with Indian assets as small as $ 5.2 million would be subject to pro-rata Indian taxation.
In recommendation 2, the EC has mistakenly used the 26 per cent shareholding threshold that provides negative rights under Indian company law as a guiding principle. Unfortunately the 26 per cent shareholding is irrelevant in most overseas jurisdictions and does not provide a shareholder with the ability to “design an indirect transfer as a ruse to mask a direct transfer”.
Logically, the EC should have recommended that the scope of AIT be reduced to situation A only i.e. to cover indirect transfers of Indian assets that are a ruse to avoid a taxable direct transfer. Even at this late stage, if the government chooses to reduce the scope of the AIT, it can acquire some legitimacy to argue that the AIT is a clarifying amendment, while pursuing Vodafone or more logically Hutch, for collecting disputed taxes!
The government can then introduce new substantive and prospective amendments to tax transactions in situation B above to widen the tax base and raise revenue. For these amendments, the government should consider an alternative definition of seeking to tax transactions where a controlling interest of an Indian company being sold as a consequence of an overseas control transaction in an OHC or a global M&A transaction. Such a definition would sensibly expand the number of transactions that can be taxed in India. As neither the EC nor CBDT has suggested an exemption where the underlying Indian company is listed, one has to presume that the intention is to tax sale of controlling interests in Indian listed companies as well. But surely, a provision to tax direct transfers of controlling interests in Indian listed companies would have to be made first, before the government can target such transactions under the indirect transfer provisions.
Finally suggestion 3 of the EC demonstrates the clout of the FIIs, rather than the merit in exemptions for trading in fund interests! Even though the EC concedes that trading in other offshore funds such as PE and VC funds needs to be exempt, it has suggested that normal provisions should suffice and a special carve out similar to the FIIs is not needed. The suggestion that investors who have no involvement in the management of the fund should be exempt will hopefully satisfy PE investors. However, it is possible for the government to improve on the EC’s suggestion.
Offshore funds would typically be Multi Owner, Multi Asset (MOMA) vehicles that can be easily distinguished from logical targets for indirect tax provisions i.e. SOSA companies and single asset OHCs. Instead of just exempting FIIs, the government can consider exempting offshore MOMA vehicles (whether they are partnerships, unit trusts and companies or whether they operate in India through the FII, FVCI or FDI route) from the AIT or any new tax amendments on indirect transfers.
(The author is a private equity professional).
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