It’s been almost six years since the provisions regarding indirect transfers have been introduced to plug the taxation rights on transactions where the situs of assets are out of India but primarily derives value from India. As the provisions were new, they led to some practical issues in compliance and interpretations. In order to obviate those concerns, the Central Board of Direct Taxes (CBDT) has issued a circular in December 2016.
However, instead of resolving the concerns, it led to further concerns around the interpretation of various aspects of these provisions and therefore it was decided to keep the circular in abeyance. It is important to note that even though the circular has been suspended, the provisions in the law are yet to be amended to resolve some of those concerns. It will be worthwhile for the government to address some of the following issues arising out of these provisions.
Currently an exemption on upstreaming of income from India is provided to category I and II Foreign Portfolio Investment (FPI). This exemption was further extended by CBDT to specified funds which include AIF, REIT and InVit. In his budget speech of 2017, the Finance Minister indicated that indirect transfer should not apply to redemption of share or interest outside India arising out of proceeds of redemption or sale of investments in India. However, currently this does not apply to FDI vehicles which constitute a large component of investments in India and therefore would lead to a cascading effect of tax on account of the multi-tier structure.
Currently overseas corporate reorganisation such as mergers or demergers between two foreign companies enjoy exemptions subject to the satisfaction of conditions provided in the income tax Act, 1961 (the Act). However, a similar exemption from indirect transfer is not provided to the shareholders of such foreign companies and therefore even though no real transaction with the third party has happened on account of such reorganisation, shareholders of such entities could end up paying taxes in India.
In many cases, regional fund or regional companies have made multiple investments in companies located in different jurisdictions. Therefore the divestment of investment outside India which is further up streamed by such entity to its shareholders other than by way of dividend should not be taxed in India as the source of income itself is not in India. However if that entity derives its substantial value from India then even income sourced from outside India could fall into the category of indirect transfer. This anomaly needs to be addressed.
The rules for the substantial value tests also need re-consideration. Currently, the valuation rules seek to compare enterprise value of the Indian company and the Foreign Company rather than the equity value i.e. the liabilities are added back to the equity value for the purpose of valuation. This could have unintended consequences. For example, say a Foreign Company holds investment in Indian Company and also holds investments in other countries and equity value of these investments are INR40 and INR60 respectively and the Foreign Company does not have any debt so enterprise value is INR100. Say, the Indian Company has operating level debt and therefore its enterprise value is INR60. The indirect transfer rules will compare the enterprise value of Indian Company of INR 60 with enterprise value of Foreign Company of INR100 and the substantial value test will be regarded to be met although on equity value basis the Foreign Company does not satisfy the substantial value test. Further, the foreign investments in the Indian Company are often made in the form of compulsorily convertible preference shares or debentures. The current definition of liabilities only excludes equity paid-up capital and therefore compulsorily convertible instruments were also added as a part of liabilities increasing the enterprise value of Indian Company, when actually these instruments are equity instruments. Also there is lack of clarity about whether the value of liabilities needs to be considered from consolidated financial statements or stand-alone financial statements.
The concept of the valuation being conducted on a ‘specified date’ also may pose challenges in certain scenarios. The rules require that substantial value tests be undertaken on the specified date i.e. date on which accounting year of the Foreign Company ends preceding the date of transaction unless book value of assets of Foreign Company on date of transaction exceeds by more than 15 per cent. Thus, the specified date and transaction date may not necessarily coincide. As a result, there may arise a scenario that fair market value of Indian asset is more on the specified date than the date of transaction and consequently higher proportion of capital gains is attributed to India. There may also arise a scenario where a substantial value test is met on the specified date but is not met on a transaction date but since the test needs to be undertaken on specified date the indirect transfer tax is triggered even though substantial value is not derived on the transaction date. Hence, the CBDT may want to re-look the valuation rules and the specified date principles to address these anomalies.
The indirect transfer reporting obligations are also cumbersome and complicated. Firstly, there is ambiguity as to when does the reporting obligation arise. On harmonious reading of section 285A and the prescribed rules, it appears that reporting obligations will only be triggered when substantial value test is met. Having said this, the form 49D prescribed for reporting purpose includes a question whether substantial value test is met which creates ambiguity whether reporting is required in all case of indirect transfers. The interpretation assumes importance because the penalties for non-reporting could be substantial (2 per cent of transaction value in case the indirect transfer results in a change of control or management and INR5 lakhs in other cases)
The rules require the Indian concern to maintain a lengthy list of information such as corporate structure of the foreign shareholder effecting the indirect transfer, valuation reports, transaction documents, details relating to operations, personnel, properties of the foreign transferor, etc. These requirements can be very onerous and practically not possible to obtain in cases where the foreign company is holding a minority stake in the Indian company.
Further, these reporting norms are difficult to comply with in cases where foreign companies are listed and a constant change in shareholding takes place. This also deters foreign investors who may not be comfortable disclosing such detailed information and wish to maintain confidentiality. Form 49D itself also needs to be simplified as it currently requires certain information which does not bear relevance to substantial value test or taxability. CBDT may want to re-look and rationalise the reporting obligations.