Valuing indirect transfers: New rules introduced

By Ranjeet Mahtani and Hardik Choksi, Economic Laws Practice
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A US$11 billion deal between Vodafone and Hutchison Group brought the taxability of indirect transfers of Indian assets into the limelight. The Supreme Court of India in 2012 held that Hutchinson’s sale of shares of a Cayman Island company to Vodafone did not give rise to capital gains chargeable to tax in India. The Indian government then retrospectively amended the Income-tax Act, 1961 (ITA), to enable taxation of the transfer of a share/interest of a company or entity registered/incorporated outside India, if such share/interest derives substantial value from assets located in India.

Controversies arose as to the validity of the retrospective amendment to tax concluded transactions and interpretation of the term “substantial”, embodied in explanation 5 to section 9(1)(i) of the ITA.

Ranjeet Mahtani
Ranjeet Mahtani

Delhi High Court in 2014 analysed the term “substantial” and held that gains arising from sale of a share of a company incorporated overseas, which derives less than 50% of its value from assets situated in India, would not be taxable under the ITA. However, to resolve the uncertainty and ambiguity as regards interpretation of the term “substantial”, in 2015, provisions were incorporated in the ITA, to prescribe the threshold as being 50% in order to be “substantial”. Other amendments pertained to the proportionate basis of income attribution to the extent of value of Indian assets of the non-resident transferor, and certain reporting obligations relating to indirect transfers.

Under the amendment, the value of an asset which is the subject matter of a transfer must be determined on the basis of the fair market value (FMV) on a specified date, but the manner of determining the FMV was not notified. The Central Board of Direct Taxes (CBDT), through Notification 55 of 2016 on 28 June, notified the rules for determining FMV and income attributable to assets in India, thus amending the Income-tax Rules, 1962.

This column focuses on the recent rules introduced by CBDT and neither the position prior to introduction of these rules nor the matters in dispute.

The rules prescribe the valuation method for determination of FMV of Indian assets held directly or indirectly by a foreign company/entity and assets of a foreign company/entity. As regards FMV of Indian assets held by a foreign company/entity, the rules prescribe various valuation methodologies based on the nature of Indian assets transferred; whether shares are in a listed company with or without direct or indirect right of management or control or in an unlisted company, or the interest is in a partnership firm or association of persons, and lastly for any other assets. For assets owned by a foreign company/entity the valuation mechanism primarily depends on whether the transaction is between connected or unconnected persons, and the rules prescribe different methodologies for listed and unlisted companies.

The FMVs so determined are used for the “substantial” test and then used to determine income attributable to assets in India, which are subjected to transfer.

Hardik Choksi
Hardik Choksi

Since the Vodafone case and introduction of the retrospective provisions as to taxability, the Indian government has been taking incremental steps with respect to taxability of indirect transfer of Indian assets. The government has tried to resolve the controversy around the term “substantial” and income attribution in relation to indirect transfers. With the introduction of these valuation rules, the government has provided the specific methodologies for determination of FMV of the Indian assets being transferred and also of the assets of the transferor foreign company.

These rules have brought clarity and a few challenges. FMV, where required to be determined based on “internationally accepted valuation methodology” will pose a challenge as different valuation methods are used globally. Further, the subjective factors used in valuation may result in different FMVs.

The rules prescribe an extensive documentation to be maintained by Indian companies/entities. Tax officers have been empowered to determine the income from indirect transfer of Indian assets if the foreign transferor fails to provide the information required to compute FMV and income attribution.

As the obligation is on the Indian company/entity to maintain and furnish the information and documents, it will be critical for the foreign entity to make available to the Indian company/entity the requisite information and details of the transaction which the overseas parent company has undertaken outside India.

Indirect transfers involving Indian assets, taxability of which is to be determined as per the provisions of the ITA, will be subject to these rules, which if applied in their true spirit will provide clarity, certainty and ease doing business in India.

Ranjeet Mahtani is a partner and Hardik Choksi is a senior associate at Economic Laws Practice. This article is intended for informational purposes and does not constitute a legal opinion or advice.

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