International companies risk being entangled in India’s tax net, even if their investments have been structured offshore. Pranay Bhatia and Aditi Sharma examine the situation and reveal how the rules may be changing

International companies looking to invest in India often do so through mergers and acquisitions. Recently some of these acquisitions – like that by Vodafone of Hutchison’s telecom assets in India – have been caught up in tax controversies.

Choice of routes for transfer of shares

At the root of these controversies is the avenue taken by these companies. For while some international companies acquire shares within India, through an Indian subsidiary, others do so by buying into an offshore parent company or holding company that in turn owns shares within the country (see diagram A, page 44).

Diagram A

And it is the latter route that has run into controversies: India’s tax authorities claim that capital gains arising from offshore transactions are liable to be taxed in India.

Legality of taxing offshore transactions

The taxability by India of the transfer of such shares is debatable as the asset being transferred, i.e. the equity, is not located in India. The Income Tax Act, 1961, stipulates that income earned by a non-resident will be charged to tax in India if:

  • it is received or is deemed to be received in India; or
  • if it accrues or arises in India; or
  • if it is deemed to accrue or arise in India.

But a non-resident assessee, who resides in a country with which India has a double taxation avoidance agreement (DTAA), has the option to choose to be governed by the DTAA. In any case, if the transaction is subject to tax within India, section 195 of the Income Tax Act requires any person paying any amount to a non-resident or to a foreign company to deduct tax from what they pay.

The issue of withholding tax when remittances are made to non-residents was the subject of a recent Supreme Court judgment – GE India Technology Centre Private Limited v CIT (see page 15 for more on this case). In it the court held that the obligation to deduct tax at source in case of remittances to non-residents under section 195 arises only if the amount is chargeable to tax in India.

In light of the GE Technology decision the sale of shares of an offshore parent or holding company should be examined to determine if the income arising from the transfer of shares is “chargeable to tax” either under the provisions of the act or the DTAA. If so, the buyer of the shares would be obliged to withhold appropriate taxes.

Eyeing India from afar

What international businesses should know when investing in India through offshore holding companies

A holding company must have commercial substance and should not be construed as a mere shell or a conduit entity. It should also have its own independent management systems, i.e. office, directors, management officer, employees, etc. The company could carry out other business activities and should demonstrate that it is the beneficial owner of the income that it earns by applying its income.

The structure should be organized so that double taxation avoidance agreement protection is available. The entity holding the shares of the Indian company should preferably be in a jurisdiction that has a favourable tax treaty with India such as Mauritius, Singapore, Cyprus, or the Netherlands.

Where a company holding an Indian investment is only the holding company and does not have any other business activity, a multi-layer structure in a treaty favourable jurisdiction could be explored.

From a contractual perspective, the agreement for sale of shares should clearly outline that the valuation of shares of the holding company is derived based on its assets and its income earning capabilities. The intent of transferring the shares of the holding company should also be clearly spelled out.

The Direct Tax Code Bill, 2010 (DTC), which is currently before parliament, widens the scope of non-resident income that could be deemed to accrue or arise in India. Section 5 of the DTC, which, if enacted, will come into effect in April 2012, provides for taxation of income from the transfer of shares or interests of a foreign company, where the fair market value of its assets in India represents at least 50% of its total assets.

The inclusion of this particular section under the proposed DTC has drawn attention to the lack of such a provision in the Income Tax Act. This might imply that the ability of India’s tax authorities to tax the transfer of the shares of a holding or parent company under existing laws is questionable.

Evolving norms

Until recently, general principles suggested that when the shares of an offshore company are transferred, the gains made in the deal are taxable in the jurisdiction in which the company is incorporated. However, with tax departments in some other countries also beginning to change the rules, India’s tax authorities are not alone in demanding tax on “indirect transfer of Indian interest”.

The Chinese state administration of taxation issued circular number 698 in December 2009, which states China can tax a foreign company that indirectly transfers an equity interest in a subsidiary in China and plans the transfer through a special purpose vehicle located in a low tax jurisdiction. Similar anti-avoidance rules in both Korea and Hong Kong allow for the taxation of such indirect transfers of equity interest.

Indirect transfers of shareholdings in companies that own real estate interests in the US, Australia, Japan and Canada are taxed by these countries. In such cases there are thresholds for the quantity of shareholding and the value of land that is to be transferred.

Some of the DTAAs signed by India also allow for such provisions. Accordingly, the transfer of shares of a company that derives its value from immovable property is taxed in the state in which the property is situated.

This suggests that until now, the taxing of gains made on transfer of shares of an offshore company was envisaged only in real estate. Neither domestic laws nor treaty provisions had proposed extending such taxes to the transfer of business interest and shares of an offshore entity. This is just what happened in the recent headline-making Vodafone case.

Vodafone – aspects of the judgment

Vodafone Holdings acquired a single share of CGP Investment (CGP), a Cayman Island company, from the Hong Kong-based Hutchison Telecommunications International (HTIL) in February 2007. CGP, which belonged to HTIL, held a 67% stake in Hutchison Essar Limited (HEL) through various Mauritian companies. The transfer of the single share in CGP to Vodafone resulted in the transfer HTIL’s interests in HEL to Vodafone.

The Indian tax authorities were of the view that the transfer of shares of CGP is taxable in India. They asked Vodafone to show cause as to why the tax was not deducted while remitting the amount for the purchase of the share.

The question before Mumbai High Court was whether the gains arising from the transfer of assets between two offshore companies were taxable in India. Vodafone contended that the capital asset that was transferred was situated outside India and its transfer resulted in gains to a non-resident. As such the income cannot be held chargeable to tax in India and the tax authorities do not have the authority to issue a show cause notice.

However, the court proceeded on the premise that the offshore transfer of the single share had a significant nexus with India and in essence it resulted in a change in the controlling interest in HEL. Another key point made by the court was that the rights and entitlements that flow from the share could not be separated from the ownership of the share. Intrinsic to this transaction was the transfer of rights and entitlements and these rights in themselves constitute a capital asset. The court also observed that section 9 of the Income Tax Act is wide enough to cover the scope of the transaction.

Treaty v non-treaty jurisdictions

India does not have a DTAA with the Cayman Islands and so the taxability of the Vodafone transaction is examined only under the provisions of the Income Tax Act.

Vodafone argued that that if shares of HEL were sold by Mauritian companies, there would be no tax liability due to the provisions of the India-Mauritius Tax treaty. However, the court has not discussed this aspect further.

In this context it is important to note that the Indian courts distinguish between tax avoidance and tax planning and the mere structuring of an investment from a treaty favourable jurisdiction should not adversely affect the taxability of the investor.

In a recent decision in E*Trade Mauritius, the Authority for Advanced Rulings (AAR) of the Ministry of Finance, referring to the 2003 judgment in the Azadi Bachao Andolan case, explained: A legal transaction entered into by an entity set up in a tax friendly jurisdiction cannot be questioned merely on the grounds that the transaction was entered into to benefit from the provisions of a tax treaty.

As is to be expected, the scope of the tax treaties that India has entered into varies from country to country. Some, like that with the US, provide for the taxability of capital gains in accordance with the domestic laws of each country. However others, like the DTAA with Germany and South Africa, mandate that the gains arising on sale of shares is taxable in the country where the company whose shares have been transferred is resident.

Jurisdictions and possible taxation scenarios

Hence, if the gain is on account of the transfer of shares in a company that is resident in a treaty country, the gain should be taxable in the state in which the company is resident. However, if the gain arises through the transfer of shares of a company that is not in a treaty jurisdiction, the taxability of such gain may be open to challenge by the income tax authorities under the provisions of the Income Tax Act.

Treaty shopping: Vodafone’s tax liabilities fall under the Income Tax Act, since India does not have a DTAA with the Cayman Islands.
Treaty shopping: Vodafone’s tax liabilities fall under the Income Tax Act, since India does not have a DTAA with the Cayman Islands.

Such a transaction could happen in two possible scenarios: where the investment is made in a treaty country primarily to take advantage of a favourable tax treaty which India has signed; or where such a jurisdiction is the natural jurisdiction of the investing company.

In the first scenario, the investing entity could base its argument for not being taxable in India on the acceptability of treaty shopping and tax planning and the precedent set by earlier cases in terms as discussed above. In the second scenario, in addition to this argument, the company may contend that the choice of its country of residence followed quite naturally from the fact that it was incorporated there.

Apportioning income

Although the court left it to the assessing officer to work out the exact amount Vodafone owed in taxes, it applied the “principle of apportionment of income” while laying down guidelines on how it was to be decided. This may open up a fresh stream of disputes, especially now that the tax authorities have given the company a tax bill for Rs112 billion (US$2.5 billion).

Will this case lead to more certainty about the tax impact in India of offshore mergers and acquisitions? Only time, and the result of the pending appeal to the Supreme Court, will tell.

Pranay Bhatia is an associate partner and Aditi Sharma is an associate at Economic Laws Practice in Mumbai.