Tax Hotline August 13, 2009

New Indian Direct Tax Code to adversely impact cross-border M&A

The new Direct Tax Code has finally arrived! It is a comprehensive legislation that consolidates the entire law relating to direct taxes (income-tax, dividend distribution tax, fringe benefit tax and wealth-tax) in India. The draft Code released by the Finance Minister, Pranab Mukherjee, is now open for public comments, and is intended to be tabled before the Parliament in the coming winter session. Once enacted, the provisions of the Code would be effective from the financial year 2011.

The Code signifies a strategic shift in the government’s fiscal agenda and seeks to achieve three policy objectives: (i) minimize tax exemptions; (ii) remove ambiguities; and (iii) curb tax evasion. According to the Finance Minister, the Code is designed to provide stability in the tax regime as it is based on well accepted principles of taxation and international best practices.

While it is true that the Code has introduced a number of constructive measures including a reduction in tax rates, these have been overshadowed by the negative ramifications of certain provisions. Some of these changes will have an adverse effect on both Indian and offshore M&As involving Indian subsidiaries. The Code has incorporated the much feared general anti-avoidance rules (GAAR) which codify the economic substance doctrine and reject long-settled jurisprudence confirming the validity of form over substance in India. The provisions seem to provide unfettered authority to the Indian tax authorities (Commissioner of Income Tax) to (i) disregard specific legal entities or individual steps in a series of transactions; (ii) re-characterize and re-allocate income between parties: and (iii) re-characterize legal instruments used in transactions.

It has been indicated that the GAAR provisions even permit the tax authorities to disregard provisions of a double taxation avoidance treaty between Indian and any other country! The Code also adopts the later-in-time doctrine implying that the provisions of the new 2011 law could override every tax treaty that India has entered into in the past!

The Code seeks to tax every offshore transaction resulting in an indirect transfer of a capital asset situate in India. It seems that the object behind this provision is to specifically target foreign M&As having underlying Indian subsidiaries or interests. One may recollect that the Indian tax authorities have already taken such aggressive positions in a number of recent cases such as Vodafone, E*Trade, GE and Aditya Birla Nuvo.

Currently, subject to certain conditions, the transfer of shares of an Indian company pursuant to an offshore merger of two foreign companies is tax exempt. Due to a possible drafting error, such transfer of shares would not qualify for the tax exemption under the Code. Further no provision has been made to cover outbound mergers of Indian companies.

Adding to the various woes of investors in general, profits from a slump sale (sale of an undertaking for a lump sum consideration) would be taxed as business profits rather than capital gains.

The Code seems to equate legitimate tax planning with tax evasion. The changes brought about will seriously impact consummation of M&A transactions and many of the current structures will be brought within the tax net. The wide discretion provided to the Indian tax authorities would create complete uncertainty making it a challenge to structure future M&As.

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