by Mansi Seth and Meyyappan Nagappan, Nishith Desai Associates
The Indian government has announced new rules for determining the fair market value of indirect transfer of assets for tax purposes. Unfortunately, though, the new provisions, adopted June 28, are overly complex and have imposed onerous obligations.
The question of indirect transfers being taxed in India arose with the Vodafone controversy. To briefly recap, the Supreme Court of India had ruled in Vodafone International Holdings BV v. Union of India (2012) 6 SCC 613, that the transfer of shares an offshore company, that in turn held shares in an Indian entity, would not be taxable in India since the shares of the offshore company were not located in India. In doing so, the Supreme Court dismissed arguments of the government that the transfer was in fact an indirect transfer of an asset in India that was subject to tax on the grounds that there were no express taxing provisions in the Indian Income Tax Act.
In a shocking move, with a view to bring indirect transfers into the tax net, the government added Explanations 5, 6 and 7 to Section 9(1)(i) of the Income Tax Act, to retrospectively clarify that indirect transfers had always been subject to capital gains tax.
These provisions state that if a share or interest in a foreign company or entity derived its value ‘substantially’ from assets located in India, then it would be deemed to be situated in India and its transfer would consequently be subject to Indian capital gains tax.
Given the uncertainty created for the taxpayer, thresholds as to what constitutes ‘substantial’ value were added through a subsequent amendment. The value of the foreign entity’s Indian assets must be in excess of INR 100 million (approx. USD 15 million) and must represent more than 50% of the total value of its global assets. For the purposes of determining “substantial value,” the value of Indian and global assets is equal to the fair market value (“FMV”) of the assets without reduction of liabilities. It is further provided that the FMV without reduction of liabilities is determined in the manner prescribed in the Income Tax Rules.
In its recent announcement, the government seeks to further prescribe the rules for determining the FMV, as provided for in the statute, through an amendment to the existing rules. As a general comment, a simpler way may have been to state that the aggregate asset value, as it appears in the balance sheet, would be taken into consideration for determining the FMV for this purpose. Instead, though, elaborate and inconsistent rules have been prescribed for the calculation of FMV for different kinds of assets, both Indian and global.
There are several issues which could be contentious and lead to protracted litigation in the absence of further clarifications.
Share transfers with control or management rights
While the transfer of listed shares is valued at the observable price on the market, a different formula has been set out when the shares are held as part of the shareholding which confers control or management rights. This ‘right of management or control’ has been given a wide and inclusive definition in the rules, and includes the right to, directly or indirectly, appoint majority directors or to control a policy decision. The definition creates uncertainty and will have taxpayers spending time and effort determining whether the shareholding in fact conferred the right of management or control, which could arise inter alia by virtue of shareholding, management rights, shareholder agreements, or voting agreements.
It should be noted that the 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, an Indian concern is required to fulfill its reporting obligations within 90 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.
Further, while the prescribed method for calculating the FMV of listed shares of an Indian company not conferring control or management rights is directly based only on the observable price of the shares on the stock exchange, with respect to any other asset, FMV is calculated in accordance with Explanation 6 to Section 9 of the ITA, by adding the liabilities of the company back to the market capitalization. Not only is this contrary to the mandate of the statutory provision, the rationale behind making such distinction is also unclear, especially considering that it could lead to an inconsistency in valuation of Indian shareholdings of FPIs and FIIs, which typically hold listed shares without having any right of control or management of the Indian company.
Timing of valuation of assets
The valuation of the assets being transferred must be valued on the “specified date,” which is not always the date of the transaction, according to the ITA. As per the indirect transfer provisions, the specified date would be the end of the accounting year of the foreign entity prior to the indirect transfer of the Indian assets.
In the event the value of the assets is more than 15% of its value as on the original specified date, then the specified date will be the date of the transaction. Further, if there is no balance sheet prepared on the specified date, an interim balance sheet approved by the Board of Directors shall be the basis for such valuation.
Indian entity reporting obligation
The requirement for the Indian concern to maintain for eight years the financial statements of the foreign company or entity with respect to the two years prior to the date of the relevant transfer 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. It may not be possible for the Indian concern to meet this requirement, or for foreign investors to share information with their portfolio companies.
Further, under India’s country-by-country reporting requirements, companies are required to provide detailed information with respect to each group entity only if the group revenue is above a certain threshold, to avoid placing such onerous obligations on smaller entities. However, neither are there any such similar thresholds prescribed for Indian concerns nor are any exceptions made for investments made by portfolio/private equity investors.
Withholding issues
When a transaction involving payment of consideration by any person to a non-resident is subject to tax in India, the foreign buyer company is obligated to withhold the requisite tax at the time of payment if the shares of the foreign target company derives its value substantially from assets located in India.
To this extent, the new valuation rules fail to provide any guidance on how the foreign buyer is to determine whether the shares of the target will meet the substantial assets test under Section 9. It also remains unclear whether revenue authorities will have the authority to proceed against a foreign buyer which has in good faith relied on accountant’s valuation 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 90 days from the date of the transaction in case of transfer of control or management, as the case may be. Such a reporting timeline does little to help the buyer to determine whether it has a withholding obligation at the time of the transaction itself. Therefore, it is impractical to expect the buyer to know or assess the proportion of the Indian assets vis-à-vis the global assets of the target company.
Effective date
The new rules do not indicate the date they become effective. It must be noted that these rules for taxing indirect transfers have been issued more than four years after the insertion of the retrospective provisions in the ITA and, as such, we do not expect these rules to be implement retrospectively to transactions, thereby unsettling past positions that have been taken. However, in the rare event of a retrospective application, these rules would affect investor sentiment, cause uncertainty, and lead to many rounds of litigation.
Since the final rules have been published after a draft was circulated for responses from the public, it is not anticipated that any further clarifications will be forthcoming from the government at this moment. However, these issues will need to be addressed, and we will have to look to the courts again for possible answers in these uncertain times ahead.
–Mansi Seth heads Nishith Desai Associates’ Indian practice in the US. Based in New York. She specializes in international taxation, funds, private equity investments, and mergers and acquisitions. Mansi has advised several GPs with respect to their India-focused funds, including devising onshore and offshore fund structures, investments, exits, and carried interest structuring.
–Meyyappan Nagappan is a Senior Member of the International Taxation team at Nishith Desai Associates, Mumbai. He has completed his Masters of Law (Commercial Laws) degree from the University of Cambridge. Prior to joining Nishith Desai Associates, he worked in the Chambers of Mr. Mohan Parasan, Solicitor General of India (2010-14); and was involved in some of the landmark cross-border international tax litigation in India during the time.
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