The Indian economy is booming and foreign direct investment in India is on the rise once again. Savvy foreign investors, however, are watching two recent developments in India that could make their lives more complicated: a proposed new tax code and a decision in the landmark Vodafone case.
Before understanding the impact of these developments, it is helpful to understand the India-Mauritius tax treaty, formally known as the Double Taxation Avoidance Agreement of 1983 (the "DTAA"). The DTAA generally provides that a Mauritius resident that sells shares of an Indian company (assuming holding periods are satisfied) is not subject to capital gains tax in India, but is subject to tax in Mauritius. (Mauritius does not tax capital gains, while India taxes long-term capital gains at a rate of approximately 20%.) Under the DTAA and a 2003 decision by the Supreme Court of India, the treaty applies to any person or entity that holds a duly issued Mauritius tax residency certificate, whether or not that person or entity actually has any substance in Mauritius, so long as it does not have a permanent establishment in India. This means that in most cases a foreign private equity investor can set up a Mauritius investment vehicle with nothing more than a contract with a service provider in Mauritius, obtain a tax residency certificate and effectively avoid paying capital gains tax in India for gains on sales of shares of Indian companies. The Indian tax authorities view this result as permitting tax avoidance by non-Mauritius investors.
A proposed new tax code and a decision in the landmark Vodafone case have received much notice and are discussed in further detail below.
Direct Tax Code
On August 30, 2010, the Indian government introduced the Direct Tax Code of 2010 (the "DTC"). Among other provisions of the DTC, which if adopted would go into effect on April 1, 2012, are the following:
- Companies Resident in India. Indian companies and companies resident in India will be subject to taxation in India. A company will be resident in India if its place of effective management is in India. The definition of place of effective management has been codified and expanded from the current guidance to include any place where (i) the board or directors or executive directors make decisions, or (ii) the executive directors or officers perform their functions in such cases where the board routinely approves the decisions taken by them.
- Controlled Foreign Company. Income of a controlled foreign company ("CFC") will be attributable to the Indian resident(s) in control of the CFC and will be subject to taxation in India. The residency test along with the CFC rules should cause many Indian resident investors to review their current strategies for deferring or mitigating taxation in India through offshore holding companies.
- Anti-Avoidance. Under the General Anti-Avoidance Rules (commonly referred to as "GAAR"), the Indian tax authorities will have broad discretion to look through many commonly utilized structures for foreign direct investment into India. Accordingly, the Indian tax authorities could use the GAAR to deny the benefits of the DTAA to a private investment fund or vehicle organized in Mauritius and holding a Mauritius tax residency certificate if the beneficial owners of that fund or vehicle are mostly U.S., European or other non-Mauritius investors.
- Treaty Override. While the DTC recognizes the preferential status of international treaties, including the DTAA, as noted above the tax department may override such treaties if the GAAR or CFC provisions are invoked.
- Capital Gains Exemption for On Market Transactions. While the GAAR and CFC provisions may have the effect of imposing capital gains tax for transactions in Indian shares, the DTC did retain an important benefit for transactions in listed securities made on the market. Such transactions will generally remain exempt from capital gains tax in India so long as the transactions are made on a recognized stock exchange, the securities are held for at least one year and the seller has paid a nominal securities transaction tax.
The Vodafone Case
On September 8, 2010, the Bombay High Court surprised many observers and sided with the tax department's decision to impose a US$2 billion tax obligation on Vodafone for a transaction between two non-Indian companies.
For those not familiar with the Vodafone case, in 2007 Vodafone and Hong Kong based Hutchison Group entered into an agreement for the sale by Hutchison of the Indian mobile carrier Hutchison Essar Limited to Vodafone for a total purchase price of approximately US$11 billion. The transaction was structured as a sale by a Cayman Islands subsidiary of Hutchison of the shares of another Cayman Islands subsidiary (which itself held the shares of certain Mauritius subsidiaries which, in turn, held shares of Hutchison Essar) to a subsidiary of Vodafone organized in the Netherlands.
The Indian tax authorities claimed that the transaction was subject to taxation in India in the amount of approximately US$2 billion, and that Vodafone should have withheld the amount of the tax from the purchase price paid to Hutchison and remitted the same to the Indian tax authorities. Much has been written about the competing claims of the tax authorities and Vodafone, and the case is not yet final because Vodafone has announced its intention to appeal the matter to the Supreme Court of India. Some practitioners have even suggested that had the Mauritius subsidiaries of Hutchison sold the shares of Hutchison Essar, the Indian company, to another Mauritius company controlled by Vodafone, the gain on the sale would not have been subject to taxation in India under the DTAA.
The DTC and the Vodafone decision are clear warnings to private equity and other foreign investors in India that they should be extremely careful in structuring their activities and investments in India. Investors should consult with experts to determine whether there are steps that could mitigate the effect of the potential new legal landscape. These steps could involve using multi-tiered investment structures so as to increase the likelihood of the applicability of one or more tax treaties and incorporating strategies to step up the basis of unlisted shares so as to minimize any capital gains tax in India, if applicable. Additionally, investors should consider whether at the time of purchase they should seek an advance ruling regarding the applicability of any withholding tax obligation, withhold and remit any capital gains tax or get adequate assurances from the seller that the investor will not bear any liability for the tax if imposed.
As a general matter, investors should (i) avoid the creation of a permanent establishment in India, which would subject the organization to taxation there, (ii) build substance in any treaty jurisdiction utilized for Indian investments, and (iii) undergo internal reviews to ensure strict compliance with the applicable tax rules.
- Avoiding a Permanent Establishment. With regard to the review of activities in India to avoid the creation of a permanent establishment in India, investments should be negotiated and contracts should be signed outside India by non-Indian residents. Indian residents should be employed by a separate Indian advisory company subject to tax in India. The advisory company may advise on transactions but should not be involved in negotiating transactions. This is often difficult for firms who employ investment professionals in India.
- Building Substance in a Treaty Jurisdiction. Firms should review the various countries that have favorable tax treaties with India. Mauritius is the most widely used, while Singapore, Cyprus and the Netherlands also have beneficial treaties. Whichever jurisdiction is selected, if the GAAR rules are adopted it will be essential to build substance in that jurisdiction. There is broad consensus among India tax practitioners that the Indian authorities will continue to challenge the applicability of treaty benefits to companies in Mauritius (or any other treaty jurisdiction) that lack substance in that country. Already there has been a trend among foreign investors to take separate office space and hire staff on the ground in the applicable treaty jurisdiction. Firms that lack such substance take on additional tax risk in India.
- Reviewing Activities for Compliance. In connection with a tax audit, the Indian tax authorities will review all activities and documents and will do so with 20-20 hindsight. They will review minutes of investment committee meetings, deal approval memos, emails and other correspondence and written materials to determine whether any investment activities may have taken place in India. In addition, they will also review websites, press announcements and marketing materials. Therefore, firms should carefully document their compliance with applicable rules, maintain appropriate policies on retention of materials, and take extreme care in the preparation of websites, announcements and marketing materials.
While investing in India can at times seem complicated and cumbersome, with proper advice and attention, investors can do so successfully.
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