Taxation of Indirect Transfer

The Honorable Finance Minister, during his Budget speech, spoke about moving towards a non adversarial tax regime which would be in consonance with global policy. In doing so, he has tried to address the concerns of foreign investors by making significant changes to the indirect transfer tax provisions under the Income Tax Act, 1961 (Act).

Taxation on indirect transfer
The existing provisions of section 9 of the Act deals with cases of income which are deemed to accrue or arise in India. Sub-section (1) of the said section creates a legal fiction that certain incomes shall be deemed to accrue or arise in India. Clause (i) of said sub-section (1) provides a set of circumstances in which income accruing or arising, directly or indirectly, is taxable in India. The said clause provides that all income accruing or arising, whether directly or indirectly, through or from any business connection in India, or through or from any property in India, or through or from any asset or source of income in India, or through the transfer of a capital asset situated in India shall be deemed to accrue or arise in India.
In the backdrop of the decision of the Supreme Court in the Vodafone case, the Finance Act 2012, had amended Section 9 of the Act, with a retrospective applicability from April 1, 1962 through introduction of Explanation 5 to section 9(1)(i) of the Act. The Explanation 5 clarified that an asset or capital asset, being any share or 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, directly or indirectly, its value substantially from the assets located in India. The provision was construed to be draconian considering its wide scope and language as well as lack of clarity on what would be considered to be deriving value substantially from Indian assets. Further, the fact that such a substantive provision was implemented retrospectively raised several apprehensions in the minds of the foreign investors regarding stability and predictability of the tax regime in India.
In order to allay fears of foreign investors, an expert committee was formed under the chairmanship of Dr. Parthasarthy Shome (the committee) to examine the provisions related to indirect transfer and provide its recommendations to the Government. The committee published its draft report containing various recommendations relating to the provisions of indirect transfer in October, 2012.
The recommendations of the Expert Committee were considered and a number of recommendations (either in full or with partial modifications) have been accepted for implementation either by way of an amendment of the Act or by way of issuance of a clarificatory circular in due course. In order to give effect to the recommendations, the Finance Act, 2015 has made the following amendments relating to indirect transfer, which is applicable from 1st day of April, 2016:

Amendments made under section 9
Threshold for applicability of the legal fiction

The share or interest of a foreign company or entity shall be deemed to derive its value substantially from Indian assets (tangible or intangible) only if the value of Indian assets as on the specified date exceedsthe amount of-

10 Crores and
represents at least 50% of the value of all the assets owned by the foreign company or entity.

Accordingly, where the value of Indian assets are below Rs. 10 Crores or 50% of value of total assets of the foreign company or entity, transfer of shares of such company or interest in such entity should not be chargeable to tax in India.

For the purpose of determining the value of the asset, the Act provides that the value of the asset shall be the fair market value as on the specified date without reduction of liabilities, if any, in respect of the assets, determined in such manner as may be prescribed.
Further, the Act also defines the date having regard to which the value of the assets is to be considered for the purpose of applying the aforesaid threshold.
These provisions would ensure that transactions where value of Indian assets are not substantial compared to the global assets of the foreign company are not charged to tax in India.

Exemption from applicability of the legal fiction

♠ Exemption from applicability of the aforesaid provision has been provided in the following situations

Where shares of Indian company are owned directlyby the foreign company or entity whose shares are being transferred:

Where the shares of Indian company are indirectlyowned by the foreign company or entity whose shares are being transferred:

The transferor (individually or alongwith its associated enterprises), at any time in the twelve months preceding the date of transfer, neither holds the right of management or control of such foreign company or entity nor holds share capital or voting power exceeding 5% of the total share capital or voting power of the company that owns shares of Indian company.
♠ Accordingly, where the transferor of shares does not have right in the management or control of the foreign company or entity whose shares are being transferred and does not hold shares exceeding 5% of total share capital of the direct holding company owning shares of Indian company, no income arising on such transfer should be taxable in India.

Taxation of proportionate gains

The Act also provides that only that portion of income arising on transfer of share or interest of a foreign company as is reasonably attributable to assets located in India would be taxable in India. Taxation of gains arising on above envisaged transfers will be on proportionate basis, the manner of which will be computed through rules.

Amendments made under section 47
Exemption in case of amalgamation and de-merger

♠ The Act provides that where in case of amalgamation or de-merger, shares of foreign company or entity which derive their value substantially from Indian assets are transferred will not be regarded as transfer provided that:

In case of amalgamation, at least 25% of shareholders of the amalgamating foreign company become shareholders of amalgamated foreign company and the transaction is tax neutral in the country of origin of the amalgamating company.
In case of de-merger, shareholders holding at least 75% in value of shares of demerged foreign company become shareholders of resulting foreign company and the transaction is tax neutral in the country of origin of the demerged foreign company.

Amendments made under section 285A and 271GA
Reporting obligation on the Indian concern and penalty for non Compliance

The Indian concerns have to report any transaction in the prescribed manner having the effect of directly or indirectly altering the ownership structure or control of the said Indian concerns.

Further, penalty for non-compliance has been prescribed at 2% of the value of the transactions in respect of failure in case where transaction leads to transfer of management or control rights in such Indian concern (directly or indirectly). In respect of remaining cases not resulting in transfer of management or control rights in the Indian concern, penalty of Rs. 5 Lakhs is leviable.
Taxation on foreign dividend
The extended application of provisions of the Explanation also seemed to widen the tax net, not just to include the income arising out of indirect transfer of shares but also, income accruing or arising from any shares / interest in a foreign company deriving substantial value from assets located in India thereby extending the contours of indirect transfer taxation framework to foreign dividends. This may cause unintended double taxation and would be contrary to the generally accepted principles of source rule as well as the object and purpose of the amendment made by the Finance Act, 2012.
The Board has clarified the issue vide its circular no. 04/2015 dated 26th March, 2015, which is extracted as under:-
“Declaration of dividend by such a foreign company outside India does not have the effect of transfer of any underlying assets located in India. It is therefore, clarified that the dividends declared and paid by a foreign company outside India in respect of shares which derive their value substantially from assets situated in India would not be deemed to be income accruing or arising in India by virtue of the provisions of Explanation 5 to section 9 (1 ) (i) of the Act.”
Conclusion
The amendments proposed in the Finance Bill and circular issued thereafter provides substantial clarity on applicability of the provisions related to indirect transfer including foreign dividend income and the proposed provisions substantially rationalize the unreasonable impact of the retrospective amendment made by Finance Act, 2012.