India clarifies indirect transfer tax for foreign private equity, venture capital funds

by Mansi Seth and Alaukik Singh, Nishith Desai Associates, New York

India’s Central Board of Direct Taxes (CBDT) on November 7 issued new clarifications on applicability of the indirect transfer tax provisions to foreign investors such as private equity and venture capital funds investing in India.

While the clarification is welcome, it is unfortunately limited in its scope, with the ambiguity continuing for certain classes of investments.

India and indirect transfer of shares

Under the Indian Income Tax Act, gains arising from transfer of shares of an offshore entity (i.e., entity incorporated outside India) can be taxable in India if the offshore entity’s shares derive their value ‘substantially’ from assets located in India.

Specifically, taxation applies when assets located in India exceed INR 100 (approx. USD 15 million) and represent at least 50% of the value of all the assets owned by the offshore entity whose shares are being transferred.

Last year the CBDT released rules for valuing indirect transfers of assets. (For further information on rules on valuation of assets, please refer to our earlier article.)

Since the introduction of these provisions, there have been several concerns raised and representations made by foreign investors, including private equity and venture capital funds investing in India.

In particular, concerns have been raised with respect to multiple levels of Indian taxation due to the indirect transfer provisions while upstreaming the same income (through redemptions or buy-backs).

The appeal from the foreign investment funds was to exclude the applicability of indirect transfer provisions to indirect investors, as the direct investor was anyways chargeable to tax.

Limited amendments were introduced earlier this year under Finance Act, 2017, exempting Category I and II, Foreign Portfolio investments from indirect transfer tax provisions.

However, clarifications assured by the Finance Minister in the budget speech this year for non-applicability of indirect transfer tax provisions in case of redemption of an interest outside subsequent to sale of direct investment in India were still under consideration at that time. These clarifications have now been announced through a CBDT circular.

CBDT circular

Appreciating the concerns raised by the foreign investors, the CBDT has clarified that indirect transfer provisions will not apply to the income accruing or arising to non-residents because of redemption or buybacks of shares held indirectly in the Indian investment funds, provided:

1. That such income should accrue or arise from or in consequence of transfer of shares or securities held in India by the Indian investment funds;
2. Such income is chargeable to tax in India; and
3. Proceeds of redemption or buyback tolthe non-residents should not exceed the pro-rata share of the non-resident in total consideration realized by the Indian investment funds from the transfer of shares and securities in India.

It is pertinent to note that the above exemption only relates to Indian venture capital funds and category I and II alternate investment funds registered with the Securities Exchange Board of India.

Limited scope

As such, while the clarification is helpful, it is limited in its scope. The lack of clarity with respect to the indirect transfer provisions still remains for category III foreign portfolio investors as well as the foreign funds investing directly (i.e., not through Indian funds) into Indian companies.

Further, it appears that only offshore redemptions subsequent to sale at the India level are exempt. In other words, offshore redemptions arising due to disposal of non-Indian investments or other commercial reasons, may still trigger the indirect transfer tax.

Moreover, the CBDT has not specified the effective date for implementing these clarifications. The expectation is that there may be further clarifications on some of these points, perhaps at the time of the release of the Finance Bill 2018.

–Mansi Seth is US practice leader at Nishith Desai Associates, New York.  Mansi can be reached at [email protected]

-Alaukik Singh is an associate at Nishith Desai Associates, based in the New York. Alaukik can be reached at [email protected]