Though M&A (mergers and acquisitions) provide a substantial upside, shareholders will have to bear the brunt of the taxman. Indias tax regime explores the possibility of generating tax from cross-border M&A resulting in the transfer of beneficial interest of the Indian company. This is on the basis of substance theory that the country has a right to claim tax on the profit generated from the business carried out in India.

The current legislation provides for taxation of gains arising out of transfer of the legal ownership of the capital asset in the form of sale, exchange, relinquishment or extinguishment of any rights therein or compulsory acquisition under any law.

Further, gains from transfer of a capital asset situated in India shall be deemed to accrue or arise in India. In a cross-border transfer involving transfer of shares, normally the situs of the capital asset provides the safe guide to decide as to which of the contracting states has the power to tax such income subject to the relevant tax treaty.

The concept of levy of tax on transfer of beneficial ownership in a cross-border transfer is not provided for in the current tax legislation. However, the revenue authorities are of the view that, in a cross-border transaction, the valuation for the transaction includes valuation for the Indian entity as well and, accordingly, the overseas entity has a business connection in India.

The apex court, in the Aggarwal & Company case, held that a business connection involves a relation between a business carried on by a non-resident which yields profits or gains and some activity in the taxable territories which contributes directly or indirectly to the earning of those profits or gains. It predicates an element of continuity between the business of the non-resident and the activity in the taxable territories.

Accordingly, the Revenue holds that, in a cross-border transaction, gains arising out of transfer of shares of overseas entity attributable to the operation of the Indian entity should be subject to tax in India, in view of the business connection of the overseas entity with the Indian entity.

In line with this approach, the Revenue recently issued notices with respect to two major deals Vodafone and Genpact. The broad details of the deals are as follows:

Hutchison International, a non-resident seller and parent company based in Hong Kong sold its stake in the foreign investment company CGP investments Holdings Ltd, registered in the Cayman Islands, which in turn held shares of Hutchison Essar (the Indian company) to Vodafone, a Dutch non-resident buyer. The deal consummated for a total value of $11.2 billion, which comprised a majority stake in Hutchison Essar India.

In the light of this, the Revenue issued show-cause to Vodafone asking for an explanation as to why Vodafone Essar (which was formerly Hutchison Essar) should not be treated as an agent (representative assessee) of Hutchison International and asked Vodafone Essar to pay $1.7 billion as capital gains tax.

The whole controversy in the case of Vodafone is about the taxability of transfer of share capital of the Indian entity. Generally the transfer of shares of a non-resident company to another non-resident is not subject to tax in India. But the revenue department is of the view that this transfer represents transfer of beneficial interest of the shares of the Indian company and, hence, it will be subject to tax.

On the contrary, Vodafones argument is that there is no sale of shares of the Indian company and what it had acquired is a company incorporated in Cayman Islands which in turn holds the Indian entity. Hence the transaction is not subject to tax in India.

However, the revenue authorities are of the view that as the valuation for the transfer includes the valuation of the Indian entity also and as Vodafone has also approached the Foreign Investment Promotion Board (FIPB) for its approval for the deal, Vodafone has a business connection in India and, therefore, the transaction is subject to capital gains tax in India.

Following the notice, Vodafone Essar had approached the Bombay High Court in September challenging the departments move to levy capital gains tax following the Vodafone-Hutch deal. In a relief to Vodafone, the court asked the revenue department not to pursue the notice issued to the cellular operator till the next hearing which is posted for December this year.

Incidentally, when GE partially divested its stake in Genpact (then Gecis), to a clutch of private equity funds, it did not pay any capital gains tax. The revenue department sent notices to Genpact asking for details of the $500 million deal in 2004, when GE sold off its 60 per cent stake in Genpact.