The introduction of provisions to tax indirect transfer of shares of Indian entities, after the Supreme Court ruling on indirect transfer, has remained one of the most contentious changes in tax laws during the past four years.
Many concerns were raised in terms of its applicability to almost all transactions, irrespective of its size. Therefore, to avoid hardship to small shareholders, the law was amended to exclude taxation on account of indirect transfer wherein the transferor neither holds the right to management and control nor holds voting power exceeding 5% of the total voting power or share capital of a foreign company.
Subsequently, in a major relief, tax authorities provided another clarification where a transaction at the foreign company level will not be liable to be taxed in India unless the value from Indian assets is at least 50% of the fair market value of the total assets of the foreign company. Further, it was explained that the fair market value of such asset would be computed without the reduction of liabilities.
However, clarifications were still needed on a couple of major issues. How does one calculate the fair market value of Indian assets? And how does one attribute proportionate capital gains which are liable to be taxed in India?
Given the ambiguous language of the provisions, pending notification of the rules for valuation, the lack of jurisprudence around these interpretations, and the specific interpretation of the Indian tax authorities, remained untested. Therefore, pending these clarifications, it raised concerns on taxation in a number of global transactions having significant Indian assets and differing views between parties involved.
Any change in the holding of offshore funds may entail reporting requirements for all Indian investee companies, which is not feasible
In the backdrop of pending clarifications, the Central Board of Direct Taxes (CBDT) released Draft Rules on 23 May 2016, for the manner of determination of the fair market value and reporting requirements for transactions falling under indirect transfer provisions. The CBDT also invited comments and suggestions of stakeholders and general public on the Draft Rules.
Based on the feedback, the CBDT last week notified the final rules after making certain modifications to the Draft Rules. The Notified Rules primarily cover three facets—the manner of computation of the fair market value of assets, determination of income attributable to assets in India, and furnishing of documents and information by an Indian concern.
The manner of computation of the fair market value of assets provides that liabilities should be added to the value of assets to determine the fair market value. In the case of computation of the value of shares of a listed company, where the right of management or control is not conferred upon, the liabilities are not added. In the first place, the addition of liabilities is not in line with the valuation principles because shareholders can fetch value for their shares only after deducting the liabilities of the business. Additionally, where management control is not transferred, liabilities are not added back to fair value. The rationale behind such exclusion, however, remains unclear.
One also needs to factor that in many global transactions, the shares of holding companies are transferred, which may not necessarily have debt as often debt is at the operating company’s level. In such a situation, the comparison of the value of a holding company with the Indian operating company which may be highly leveraged, can lead to absurd results. Further, for calculating the book value of liabilities, although the Notified Rules provide exclusion for general reserves and surplus and security premium in addition to the equity capital as provided in the Draft Rules, it is pertinent to observe that Profit and Loss balance appears to form part of the book value of liabilities. Additionally, quasi-equity instruments such as convertible preference shares and convertible debentures—which economically may be on a par with equity—may be treated as a liability for this purpose.
Further, the Notified Rules define the observable price in respect of listed shares to be based on the average price for the period preceding the specified date. In case where there is no substantial increase in the book value of the assets on the date of transfer, the specified date would be the last date of the accounting period. More often, after the announcement of the transaction, the share price of a listed company moves towards the fair value attributable to the Indian entity. Therefore, ideally the fair value based on a period prior to the closing of transaction may be representative of the fair value of the Indian entity.
Additionally, there exists an obscurity in the determination of income attributable to assets in India. The Notified Rules provide that the income shall be determined in accordance with provisions of the Income Tax Act as if the share of the foreign company is located in India. To this extent, it may need to be clarified whether domestic provisions such as that of indexation benefit for computation would be available. Further, there is no clarity on the rates that would apply in such a case for the computation of capital gains. The Notified Rules also fail to provide any guidance on how the foreign transferee company is to determine whether the transferor will meet the substantial assets test and accordingly withhold tax, if any, at the time of payment.
The reporting and documentation requirements prescribed for the Indian concern are quite stringent. The Indian concern has to provide details in respect of overseas transferor company such as holding structure and financials. It may be practically difficult for the Indian concern to call for such detailed information from the foreign transferor entity.
In case of a foreign listed company, there could be instances of numerous transfers which may result in taxation in India. In such instances, it may be practically difficult for the Indian concern to keep track of such transfers and the foreign entity may get to know such a transaction post the transfer. Therefore, the information which the Indian entity needs to procure may not be feasible in every situation.
India-focused funds derive their substantial value from India. Therefore, any change in the holding of offshore funds, which hold multiple investments in different business groups in India, technically could entail reporting requirements for all Indian investee companies, unless they are part of the same group and one entity is nominated to report on behalf of others. Overall, the process of documentation appears to be challenging essentially in terms of collation and reporting for the Indian concern.
In recent times, the government has introduced various tax reforms such as clarifications on the capital gains regime, introduction of the Place of Effective Management, source-based taxation under the India-Mauritius treaty and grandfathering of past investments from applicability of General Anti Avoidance Rules (GAAR). The CBDT recently also invited public comments on the provisions of GAAR, which require clarity from an implementation perspective.
The Notified Rules show a step taken by the government to continue its vision to bring transparency in tax laws to reduce litigation. It would be worthwhile to relook at the areas highlighted above to make the rules workable in most situations in a logical manner.
Alok Mundra is partner, deal advisory M&A tax and private equity tax, and Amit Dhoot is an associate director, private equity tax, KPMG in India. Views are personal and do not necessarily represent the views of KPMG in India.
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