Tax Hotline May 14, 2012

Antidote for panic: FM announces delay of GAAR

On March 16, 2012, as he began to announce the tax proposals contained in the 2012 Budget, Pranab Mukherjee said: “the life of a Finance Minister is not easy”. Indeed, it has been a very difficult time for the Finance Minister since then, with the fall in stock-markets and backtracking by foreign investors, skepticism about India as an investment destination and world-wide criticism on the ‘reactive’ provisions. The proposals contained in the Finance Bill, 2012 (“Finance Bill”) were vague and extraterritorial and came as a rude shock to everyone. In fact, many proposals were retrospective from 1962! We had analyzed the proposals of the Finance Bill in our earlier hotline titled India Budget 2012: A Jolt to Foreign Investors.

Since the announcement of the Finance Bill, there have been numerous representations before the Finance Minister from all quarters. Such wide spread and negative criticism of some of the proposed changes forced the Finance Minister to make several public clarifications in these past two months and to reconsider some of the provisions. The Finance Bill which was introduced in the lower house of the Parliament on May 7, 2012 (“Amended Finance Bill”) contained changes brought about with the intention to calm the foreign investor community. The Amended Finance Bill has now been passed by the lower house and has been placed in the upper house for recommendations if any, within 14 days. The lower house has the discretion to accept or reject any recommendations of the upper house before finally passing this Amended Finance Bill.

We have provided below an analysis of the changes in the originally proposed provisions of the Finance Bill.

The Antidote: Amendments to the proposals in Finance Bill 2012

Implementation of GAAR delayed

The Finance Bill originally proposed to introduce comprehensive General Anti-Avoidance Rules (“GAAR”), effective from April 1, 2012.

To recap, GAAR seeks to provide wide powers to the revenue authorities in taxing ‘impermissible avoidance arrangements’ including the power to disregard entities in a structure, reallocate income and expenditure between parties to the arrangement, alter the tax residence of such entities and the legal situs of assets involved, treat debt as equity and vice versa, and the like. Such wide discretionary powers give much room for misuse and the use of ambiguous expressions in relation to defining an ‘impermissible avoidance arrangement’, such as misuse, abuse, bona fide purpose, substantial purpose and commercial substance result in subjective interpretation and implementation of the law. Thus, arose two main concerns - lack of clarity in applicability of these provisions and wide discretionary power conferred on the revenue authorities.

Under the shelter of GAAR, the revenue authorities had the power to deny tax benefits even if conferred under a tax treaty and the advance rulings on GAAR matters also seemed inaccessible due to limitations in the current statutory provisions. Add to that the fact that burden of proof lay on the tax payer to show that his arrangement has not been arrived at for obtaining a tax benefit.

These draconian provisions created much hue and cry and were criticized severely since there was no certainty at all for a foreign investor to plan his affairs. Hence, the Finance Minister’s announcement for deferring the implementation of GAAR by a year was very well received as it would enable tax payers to be prepared and adjust to the new system, more so in light of required documentation and proof that would have to be maintained by taxpayers to be able to demonstrate that their arrangement is not captured by GAAR.

The Finance Minister in his opening remarks on May 7, 2012, admitted that they had been unable to consider the report of the Parliamentary Standing Committee (“Committee”) and based on the Committee’s recommendations decided to make changes in the provisions. Thus, in addition to the deferral of imposition of GAAR to April 1, 2013, some of other safeguards included in the Amended Finance Bill are as follows:

§ The onus of proof for initiation of action under GAAR has been shifted from the taxpayer to the tax department;

§ In relation to determining whether an arrangement lacks commercial substance, the Budget, among others, proposed to deem that “the location of an asset or of a transaction or of the place of residence of any party which would not have been so located for any substantial commercial purpose other than obtaining a tax benefit” would satisfy the same. As against such an analysis on relative terms of whether such location would or would not have been so located for a substantial purpose, the Amended Finance Bill proposes to decrease the vagueness by referring only to situations where such location actually “is without” any substantial commercial purpose;

 

  • Originally, the revenue officer was required to make a reference to the Commissioner of Income Tax (“CIT”) for invoking GAAR and to contest the CIT’s decision the matter was to be referred to an Approval Panel comprising a minimum of 3 tax officials of the rank of CIT or above. The Amended Finance Bill proposes that the Approval Panel will consist of one officer from the Ministry of Law instead of all them being tax officials;
  • Taxpayers shall be allowed to approach the AAR for obtaining an advance ruling on whether their arrangement would amount to an “impermissible avoidance arrangement”;
  • A Committee, which has been constituted under the chairmanship of the Director General of Income Tax (International Taxation), is expected to give recommendations for formulating the rules and guidelines for implementation of GAAR by May 31, 2012.

 

The above proposals of the Amended Finance Bill, to some extent, help in regaining confidence of the foreign investors in the Indian system, which seemed to have vanished in past weeks. However, they yet do not take into consideration all the recommendations of the Committee. The hope now is to have unambiguous guidelines for both the revenue authorities and tax payers to operate in India. Unless and until the rules and guidelines define and to some extent limit the applicability of GAAR and are articulated rationally and comprehensively as opposed to being sketchily worded with room for varied interpretations, the uncertainty and skepticism of the foreign investors shall not evaporate.

No treaty override in indirect transfers

One of the original Budget proposals was to levy tax on indirect transfers of Indian entities by non-residents. The key changes proposed in the Act to tax such indirect transfers were: (i) change in the definition of ‘capital assets’ to include any rights whatsoever in (or in relation to) an Indian company, including the rights to manage and control it, (ii) change in definition of ‘transfer’ to include the creation or disposing of any interest in any asset in any manner whatsoever (i.e. directly, indirectly, absolutely, conditionally, voluntarily, involuntarily by way of an agreement entered into in India or outside India or otherwise), (iii) expanding the scope of ‘Income deemed to accrue / arise in India’ under section 9 of the Act, by creating a legal fiction to the effect that a (capital) asset being any share / interest in a company or entity registered or incorporated outside India shall be deemed to be situated in India if the share or interest derives (either directly or indirectly) its value substantially from the assets located in India. Dressed as ‘clarifications’, these amendments were proposed to take effect retrospectively from April 1, 1962.

These proposals gave birth to perplexing issues regarding principles of territoriality and nexus in taxing transfer of capital assets and applicability of treaties. It also remained uncertain whether the revenue authorities could or would reopen cases starting from 1962.

The Finance Minister has now confirmed that:

 

  • The amendments to section 9 of the Act seeking to tax indirect transfer abroad would not override the provisions of Double Taxation Avoidance Agreements (“DTAAs”) which India has with 82 countries;
  • These proposals would impact those cases where the transaction has been routed through low tax or no tax countries with whom India does not have a DTAA;
  • The retrospective clarificatory amendments would not be used to reopen any cases where assessment orders have already been finalized.

 

The Finance Minister also announced that the Central Board of Direct taxes has been directed to issue a policy circular to clearly state the above after the Budget proposals receive assent from both the Houses of the Parliament.

While the clarification has provided some comfort to the investors domiciled in treaty jurisdiction with respect to their Indian investments, the lack of clarity still remains. In the past two months, the Finance Minister has made several clarificatory statements which are not found in the Amended Finance Bill. For instance, he has clarified that holders of participatory notes and offshore derivative instruments shall not be taxed under these provisions; however the language used in the amendments is wide enough to apply to them. Similarly, there is no clarification that has been provided in relation to the application of these provisions which can arise in relation to overseas listed companies and small portfolio investments. The amendments proposed in the Amended Finance Bill, though positive, are inadequate at addressing the main issue which continues to be the significant expansion of the Indian tax jurisdiction (to even situations which the legislature doesn’t intend to capture for e.g. offshore derivative instruments). The question remains whether such expansion is reasonable, acceptable and constitutional.

Share premium from angel investors

One of the most unexpected proposals in the Budget was imposition of tax on the share premium paid by an Indian tax resident for subscription of an Indian company’s1 shares, to the extent it was in excess of the Fair Market Value (“FMV”)2 of such shares. The excess premium was proposed to be taxed in the company’s hands as “income from other sources”.

Consideration received by a venture capital undertaking for issuance of shares to a venture capital company or a venture capital fund was the only exclusion from the applicability of this section.

While intention to curb generation of unaccountable money is understandable, concerns were raised by this proposal; fear being that the premium in genuine commercial transactions would also be taxed by this provision. On May 8, 2012 the Finance Minister has acknowledged these concerns, specifically for angel investors which invest in start-up companies, and proposes to incorporate an enabling provision in the Act for exemption of a class of investors notified by the Central Government.

While this is definitely a welcome move creating room to excuse permitted class(es) of investors, it may be too early to comment on the groups that would be excluded as it is not clear how investors may be classified. Until notification by the Central Government, various genuine transactions may continue to be affected.

Foreign borrowings by Indian companies: Withholding tax reduced to 5% for all

In order to make long-term, low cost funds accessible to the stressed infrastructure sectors, the Budget had proposed a reduction in the withholding tax rate while making interest payments to non-residents from the current 20% to 5%. This provision was applicable, subject to certain conditions, to foreign borrowings made between July 1, 2012 and July 1, 2015 and was restricted to Indian companies engaged in specific infrastructure sectors namely power, airline, roads, bridges, affordable houses, fertilizer and dams.

To further facilitate access to foreign borrowings, the Budget proposals have been amended to extend the benefit of lower rate of withholding tax to all Indian companies, provided that the funds are either raised through long term infrastructure bonds or under a loan agreement, as approved by the Central Government.

Withholding on transfer of immovable property

The Budget had originally introduced withholding of tax on transfer of immovable property (other than agricultural land) to be imposed wherein every transferee, at the time of making payments or crediting the consideration for transfer of immovable property, was obliged to deduct tax at the rate of 1% of such sum, subject to de-minimus principles.

Due to the increases burden in compliance, the Amended Finance Bill proposes to withdraw the above-mentioned proposition of levy of 1% withholding tax on transfer of immovable property.

Booster Dose: New proposals added

Capital gains tax reduced for foreign investors

Currently, gains from transfer of unlisted securities by non-residents, if such securities are long terms capital assets3, are subject to capital gains tax at 20%. As opposed to this, Foreign Institutional Investors (“FIIs”) are subject to tax on long term capital gains from transfer of securities (carried out off the floor of the stock exchange) at 10%.

The Amended Finance Bill, after consideration of the representations made by several private equity foreign investors, proposes to bring all non-residents at par and reduces the tax rate for long term capital gains from sale of unlisted securities to 10%.

Further, currently, in determining the quantum of capital gains of a non-resident, in relation to shares and debentures, the transfer consideration and the cost of acquisition are taken to be the equivalent of that foreign currency in which they were purchased and the gain determined thereby is then converted into Indian currency. In relation to other securities, for non-residents, indexation is permitted in computing the cost of acquisition so as to offset the effect of inflation. However, these benefits shall no longer be available in relation to reduced tax rate of 10% for unlisted securities.

Capital gains on sale in Initial Public Offer not taxable

Currently, capital gains arising from the transfer of listed equity shares on the stock exchange, if held for at least 12 months, are exempt from tax4 and if held for less than 12 months, are subject to a reduced tax rate of 15%5, so long as the applicable securities transaction tax (“STT”) is paid on such transactions.

As a move to provide impetus to listing of companies, this benefit has been extended to sale of unlisted shares by existing shareholders in an initial public offer (“IPO”) too. Such sales would be subject to STT at 0.2% of the sale consideration payable by the seller. The obligation to collect the same has been imposed on the lead merchant banker appointed in relation to the IPO.

Incentive for Foreign Banks to convert Indian branch into subsidiary

The Reserve Bank of India (“RBI”) has been in strong support of the subsidiary-led model for foreign banks operating in India, instead of the existing branch mode of expansion. The intention is to incentivize foreign banks to open local subsidiaries in India in order to ring-fence domestic depositors from the adverse impact of their home markets. In January 2011, RBI had issued a discussion paper, which was in favour of introducing incentives, such as allowing the wholly-owned subsidiaries of foreign banks to raise rupee resources by issuing non-equity capital instruments in form of hybrid instruments and subordinate debt, to promote the subsidiary route.

In line with the above, the Finance Minister has proposed insertion of a new Chapter XII-BB in the Act. The chapter relates to conversion of Indian branch of a foreign bank into a subsidiary company. It is proposed that foreign banks, which seek to convert their Indian operations into subsidiaries, would not be required to pay taxes on the capital gains arising due to such conversion. This would operate as a one-time exemption and the subsidiaries shall function as normal taxpaying companies after the conversion.

Continuing Pains

Given the initial negative reaction towards the Finance Bill, the amendments did manage to lift up the spirits; however the issues are far from resolved. Many of the issues pointed out by us in our earlier hotline6 continue to remain unaddressed.

One of the most controversial points which remain unaddressed in the Amended Finance Bill is the taxation of Vodafone in India. From the amendments, it was evident that the Indian government believed that Vodafone is liable to pay tax in India and the ‘clarificatory’ amendments were a reaction to the Supreme Court’s decision7 and an attempt to override the decision which upheld the legitimacy of the Hutch structure in the Vodafone case. In spite of the international pressure, the Finance Minister, in the session of the lower house of the Parliament, with reference to Vodafone clearly stated that he would not allow a corporate to avoid paying tax in India by operating from a tax haven. The Indian government is staying firm in this regard, maintaining that they have a right to tax Vodafone and there would be no rethinking on this issue. The retrospective amendment to the law gives the revenue authorities the right to reopen this case and to pursue their claims against Vodafone. There is also a possibility that the revenue authorities may initiate penalty proceedings. The Indian government’s narrow and regressive approach will act a deterrent not only for Vodafone but for other foreign investors too.

On the other hand, Vodafone too is not sitting quiet – Vodafone has served the Indian government with a notice for violation of the international legal protections granted to Vodafone and other international investors in India. The notice is the first step towards international arbitration under the Bilateral Investment Treaty (“BIT”) between India and the Netherlands and an indication that this battle is far from being over anytime soon.


International Tax Team

You can direct your queries or comments to the authors


1 Applicable to a private limited company or unlisted public limited company (i.e. a company in which the public is not substantially interested)

2 “FMV” is deemed to be the higher of:

a) The amount, as may be substantiated by the company before the tax officer based on the value of its assets including intangible assets being goodwill, know-how, patents, copyrights, trademarks, licenses, franchises or any other business or commercial rights of similar nature; or

b) As maybe determined as the method prescribed under the relevant rules for calculation of FMV

3 In case shares, listed securities and certain other specified securities (Zero coupon bonds and units of a mutual fund or the Unit Trust of India), if held for at least 12 months and in case of other capital assets, if held for at least 36 months.

4 Section 10(38), ITA.

5 Section 111A, ITA.

6 India Budget 2012: A Jolt to Foreign Investors

7 2012 (1) SCALE 530


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