The single-mindedness with which the Direct Taxes Code has been designed to enhance revenue productivity would have been praiseworthy but for the fact that the Code avowedly goes against many time-hallowed and basic concepts on the specious ground that some assumptions which have held the ground for many years have been discarded.

To give just two examples: first, the Code has more or less ignored the basic concept that there is a difference between a revenue receipt and a capital receipt and secondly, that a later provision in the domestic act will override Double Taxation Avoidance Agreements (DTAA).

It is, therefore, heartening to see Chairman CBDT state that the proposal in the Code, which virtually gives supremacy to the Indian tax laws over DTAAs with other countries, needs to be reviewed because such a proposal would not be internationally acceptable. He also said that an internal task force is reviewing the Code and taxpayers could expect major conceptual changes in all other proposals in the Code over which they have raised concern.

One of the issues which needs to be resolved immediately to obviate endless litigation in future is the provision contained in Section 5(1) of the Code regarding income deemed to accrue in India which reads as follows: The Income shall be deemed to accrue in India, if it accrues, whether directly or indirectly, through or from:
(a)a business connection in India;

(b)a property in India;

(c ) an asset or source of income in India; or

(d ) the transfer, directly or indirectly, of a capital asset situated in India.

The difference from the current provisions of Income Tax Act, 1961 is the insertion of the word indirectly in Section 5(1) (d). As the word indirectly which appears in the opening sentence of Section 5(1) refers to income, this is obviously a new attempt to catch the indirect transfer of a capital asset situated in India.

However, as the ensuing discussion in this article will show, it seems to be extremely doubtful whether the insertion of the word indirectly in Section 5(1) of the Code would eventually be found to serve its supposed purpose.

There are some who hold the view that it is unfair that transactions, which occur overseas but arguably derive their value from assets situated in India are not taxed in India. The purpose of this article is not to debate whether such a position is unfair but to clarify that, if a decision is made to tax such transactions, clear and effective legislation must be enacted on a prospective basis. Tweaking the current provisions of the Act or enacting the proposed Section 5(1)(d) of the Code to plug the lacunae in the Act is not the correct way to proceed.

Let us take a simple but common corporate holding structure:
(a)Company A incorporated in Germany has a wholly owned subsidiary in Singapore, S1

(b)S1 has a wholly owned subsidiary in Mauritius, S2

(c)S2 holds 51% shares in an Indian Company X, the remaining shares of X are held by two Indian companies

(d)Company X has a number of wholly-owned subsidiaries in India.

Now let us assume that Company A sells shares in S1 at a profit to another German Company B. This scenario raises three important issues from a tax perspective, namely:
(i) Chargeability of capital gains;

(ii) Computation of capital gains; and

(iii) Collection of tax on capital gains.

The first problem in our example is identification of the assets situated in India, i.e. is it the shares of Company X, the assets of Company X or the assets of the subsidiaries of Company X, that are being transferred? It is a settled law that a shareholder of a company has no rights over the assets of the company. There are good reasons for this position, not the least that the rules for determining the cost, and therefore the profit on a sale, of shares are quite different than those for physical assets.

Secondly, is it fair that an attempt is made to tax Company A (or indeed seek withholding tax from Company B), whereas if S2 had transferred its 51% in Company X, capital gains tax would not be payable in view of the DTAA between India and Mauritius. The Treaty position was recently confirmed by the Authority for Advance Rulings in the case of E-Trade by following the decision of the Supreme Court in the Azadi Bachao Andolan case.

Thirdly, Section 5(1) (d) of the Code raises the prospect that the corporate veil will have to be lifted at each level from the subsidiaries of Company X to Company A. I am extremely doubtful if the corporate veil can be lifted as per the existing law. Case law allows for the lifting of the corporate veil in only limited circumstances.

Unless the structure is a sham, the veil cannot be lifted and without proof to the contrary the use of holding companies does not establish a sham (this position was recently upheld in the Authority for Advance Ruling decision of KSPG Netherlands Holding B.V.).

Lastly, as per the decision of the Supreme Court of India in its famous decision in CIT v. B.C.Srinivasa Setty 128 ITR 294 no capital gains tax is exigible unless capital gains are capable of being computed. The Code does not provide any guidance on how the gain on indirect transfers should be computed, in particular there is no mechanism for determining the cost of the asset or deeming provision as to the profit that is taxable. The problem with this omission becomes apparent if in our example, S2 also held shares in companies incorporated in countries other than India and the purchase price did not, as one would expect, allocate a value to each entity.

On the assumption that the capital gains are taxable in India in the hands of Company A, the next question which arises for the Revenue is how to collect the said tax from Company A. If Company A does not have any assets in India, Revenue will not be able to collect the tax from Company A and nor can it collect the tax from Company X in the absence of any provisions in this regard in the Act. Accordingly, the only avenue that would be open to the Revenue is to proceed against Company B u/s 201 of the Act for failure to deduct tax while making payments to Company A and hold it to be an assessee deemed in default. This would also not be easy where Company B does not have any assets in India. It is not a simple matter to just attach the shares that S2 holds in Company X or the dividends declared by Company X to S2, because this involves lifting the corporate veil. If S2 was not a wholly owned subsidiary of S1 but a joint venture between third parties, I am sure those third parties would object to any such actions!

The provisions of Section 5(1) (d) of the Code are unclear and I have touched only on some of the tricky issues involved in the proposed provisions. On the other hand, there can be no doubt that it would have a lot of deleterious effect on the flow of foreign investment in India. Can we, therefore, learn from the efforts of some other countries in this direction?

Indonesia has recently introduced a law to tax capital gains arising from the sale of shares in a foreign tax haven country which holds shares in an Indonesian company by specifically providing that such a sale will be deemed as a sale/transfer of shares in an Indonesian Company and that the capital gains will be deemed to be 25% of the selling price. The withholding tax will be 20% or in other words 5% of the selling price.

The ambit of the recent Indonesian legislation in this regard is prospective and clearly defined and it does not apply to foreign companies resident in countries with which Indonesia has DTAAs but merely applies to sale of shares of the company in the tax haven country.

A comprehensive relook on the issue is, therefore, required keeping a balance between the desire of the Revenue authorities in India to tax the transactions under consideration on one hand and the international practices including the economic aspects on the other hand. If India wishes to remain an attractive destination for foreign investment, it must ensure its tax laws are crystal clear and do not lead to protracted disputes between vendors, acquirers and the Tax Authorities.