Indian Expert Committee publishes draft report on retroactive ...

17 October 2012
International
Tax Alert
<strong>Indian</strong> <strong>Expert</strong> <strong>Committee</strong>
<strong>publishes</strong> <strong>draft</strong> <strong>report</strong> on
retroactive amendments
to indirect transfer
Summary
In response to concerns and criticism of the retroactive effect of the
Finance Act 2012 (FA 2012), the scope of the <strong>Expert</strong> <strong>Committee</strong> (EC) to
handle General Anti-Avoidance Rules (GAAR) was expanded to include the
implications of the applicability of amendments relating to the taxation of
indirect transfers.
The EC acknowledged, after reviewing the provisions for indirect transfers,
global practices and recommendations of the Standing <strong>Committee</strong> of
Finance on the direct tax code provisions, and after having consultations
with a number of stakeholders, that the existing indirect transfer
provisions are complex and cannot be implemented without a number
of clarifications and exclusions. It recognizes the need for adequate
safeguards to avoid possible unintended consequences of the wide range
of the retroactive amendments. It also emphasizes that the retroactive
amendments should be carried out only in the rarest of cases and not for
expanding the tax base.
The EC has suggested that its recommendations be implemented through
an amendment to the income tax law (ITL), the Income-tax Rules or
through a circular, as may be appropriate.
Background
The FA 2012 enacted taxation of gain arising from an indirect transfer of
an asset or any share or interest in an entity organized outside India, if the
value of such share or interest derives, directly or indirectly, substantially
from assets located in India.

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The FA 2012 also made retroactive amendments to the definitions of
“capital asset,” “transfer,” etc.
The amendments were to overcome the Supreme Court (SC) judgment in
the Vodafone case in which the SC held for Vodafone, stating that gains
arising from a transfer of a foreign holding company shares was not
taxable in India.
Some of the consequences of the amendments are:
• Ambiguity of the scope of “substantial value” and the risk that a lower
threshold would be applicable to a determination of when a transaction
becomes subject to tax in India.
• Absence of a minimum threshold or extent of shareholding of the
transferor leading to a major concern for minority shareholders.
• Absence of computation mechanism and provision to limit taxation to
proportional <strong>Indian</strong> value.
• Taxation of overseas restructuring involving indirect transfer.
• Multilayer taxation of dividends paid by foreign companies.
• No provision for a basis step-up for subsequent transfer of shares.
• Taxation in multiple jurisdictions and possible denial of a foreign tax
credit.
Analysis of EC’s key recommendations
From a policy perspective, the EC classified retroactive amendments in the
following four categories and commented on each of them in the following
manner:
Serial number Type of retroactive
amendment
1 To correct apparent mistakes/
anomalies in the statute
2 To remove technical defects,
particularly in procedure, which had
vitiated the substantive law
3 To “protect” the tax base from
highly abusive tax planning
schemes that have the main
purpose of avoiding tax without
economic substance
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EC comments
Necessary
Necessary
Justified
4 To “expand” the tax base Unfair and against
basic principle of law
as it affects certainty
of law
The EC also commented that
retroactive amendments of a tax
law should only be in the rarest
of cases and cannot be made for
purposes of expanding the tax
base. Further, amendments should
be made only after exhaustive
and transparent consultation with
stakeholders who would be affected
by them.
On retroactive application of tax
on indirect transfer of assets
The amendments concerning
indirect transfers are not
clarifications as they, in effect,
widen the tax base. Such provisions
should therefore be applied
prospectively. This would align
with global practice, as well as
the principle of equity, and will
reflect integrity in the formulation
and implementation of commonly
recognized taxation principles.
Recommendations if retroactive
taxation of indirect transfers is
applied
• The provisions should be
applicable only to that taxpayer
who generated capital gains from
the indirect transfer.
• No person should be penalized
for failure to withhold tax on
payments to a nonresident person
or a representative as this would
impose obligations which was
not in the law in existence at the
time when the transaction was
executed.
• In all cases where tax is imposed
under the retroactive amendment
provision, no interest or penalty
should be assessed.

Recommendations regardless
of prospective or retroactive
application of taxation of indirect
transfers
Recommendations on meaning of
certain terms
• The phrase “share or interest in a
company or entity registered or
incorporated outside India” should
mean and include only such
share or interest which results
in participation in ownership,
capital, control or management.
Mere economic interest should be
excluded from the definition.
• The word “substantially” should
be set at 50% of the value of
assets in India.
• The phrase “directly or indirectly”
may be clarified to represent
a “look through approach”
to narrow its application by
disregarding values attached to
the intermediaries between the
foreign company and assets in
India.
• The term “value” should refer to a
fair market value computed under
a discounted cash flow method for
a service sector and a net asset
value method for non-service.
Implication of amendment to the
definition of “transfer” introduced
in the FA 2012
• As indirect transfer rules
specifically deal with a share
transfer of a foreign entity having
underlying assets in India, the
expanded definition of “transfer”
should be limited to the indirect
share transfer.
• Rights of management or control
or any other right in an entity
should not be considered as
property separate from shares,
unless such property has been
specifically identified as separate
property from shares. This aligns
with the principle that a specific
provision should override a
general provision.
Proportionality of taxation
• Only gain specifically attributable
to substantial underlying asset
value should be subject to tax.
Meaning of “an asset” or “a capital
asset”
• The presently enacted provision
in the ITL covers “an asset” or “a
capital asset” as being deemed to
be situated in India.
• As the objective of the indirect
transfer rules is to tax the indirect
transfer of capital assets, the term
“asset” within the scope of the
definition of deemed <strong>Indian</strong> asset
widens its application and leads
to ambiguity in interpretation.
Consequently, a recommendation
is to limit the taxation to the
indirect share transfer.
Certain exemptions from indirect
transfer rules
• Minority shareholders: Transfer
of a minority interest in a foreign
company should be excluded as
such transfer would not result in a
transfer of any controlling interest
in <strong>Indian</strong> assets. Accordingly, a
26% threshold is recommended.
• Listed foreign company:
Exemption may be provided to a
shareholder of a publicly traded
foreign company.
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• Overseas business
reorganization: Transfer of shares
or interests in a foreign entity under
intragroup restructuring 1 may be
exempt from taxation, provided
that such transfers are not taxable
in the jurisdiction where the foreign
entity is resident.
• Foreign Institutional Investor
(FII): An FII is typically a tiered
structure consisting of investors,
Promissory Notes holders, and
feeder units, with the main FII
registered in India and subject
to tax in India. A nonresident
investor making investments in
FIIs should not be subject to tax
where:
− A nonresident investor has made
any direct or indirect investment
in an FII; or
− Investment made by an FII in
India represents, directly or
indirectly, the underlying assets
of investment by a nonresident.
• Private equity (PE) investors:
PE investors should be outside the
coverage of indirect transfer, where
any of the following conditions is
satisfied:
− Investment by the nonresident
investor in a PE fund or a fundpooling
vehicle which does not
carry ownership rights as interest
similar to ownership rights, such
as share.
1 Intragroup restructuring is defined to
mean: (1) Amalgamation or demerger
as defined under the ITL, subject to
continuity of at least ¾ ownership; or
(2) any other form of restructuring
within the group (associated
enterprises), subject to continuity of
100% ownership.
3

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− Investor and its related parties
do not possess more than 26%
interest in voting shares of the
company.
− Investee entity does not have
assets in India that represents
more than 50% of its global
assets.
− Investee is a publicly traded
company.
− Transfer of share or interest
in a foreign entity is due to
reorganization within a group.
• Taxability of dividend paid by a
foreign company: Dividends paid
by a foreign company should not
be sourced in India to prevent
a cascading effect on dividend
taxation in multi-tier overseas
structures.
• Computation provisions of the
ITL: Existing ITL provisions do not
have a computation mechanism
for taxing indirect transfers.
Protection from foreign exchange
fluctuation presently available to
compute gain from direct transfer
should also be provided for
indirect transfer taxation.
• Interplay with tax treaties: India
will not have a right to tax gain,
unless:
− An income tax treaty grants a
right of taxation of capital gains
to India pursuant to India’s ITL.
− The tax treaty specifically
provides the right of taxation to
India on the transfer of shares
or interest of a foreign company
or entity.
Comments
The EC recommendations are truly
beneficial and align with norms of
certainty, predictability and stability
of the tax laws. The investor
For additional information with respect to this Alert, please contact the following:
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Ernst & Young LLP, <strong>Indian</strong> Tax Desk, San Jose
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• Jeff Hongo +1 212 773 6143 jeff.hongo@ey.com
International Tax Alert
community may further desire
that the EC restrict indirect
transfer taxation only to cases
of unproductive real estate
holdings or similar assets in India,
or may restrict such taxation to
abusive investment structures.
In addition, suitable basis stepup
will be necessary. While the
EC has recommended issuance
of administrative instruction by
the Central Board of Direct Taxes
proper statutory safeguards are
more desirable.
The EC has also made equally
strong recommendations on the
GAAR provisions; accordingly, the
expectations have turned to the
government of India to adopt and
implement these recommendations.

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