Over the past decade the Indian economy has experienced a tremendous influx of foreign capital from private equity and hedge fund investors from across the globe. Such investment funds have typically used Singapore or Mauritius entities to invest in India because of their highly favorable Indian tax treatises. These treatises permit capital gains to be remitted with little, if any, tax. The Indian Government is now increasing their focus on these investment structures and they are making every effort to claim their share of tax they believe is due. They are challenging instances when intermediary entities are lacking substance, identifying permanent establishments, and reviewing the Indian sub-advisory roles; all in order to capture tax revenues distributed by capital gains delivered by the rich Indian economy.
Typically, investors enter Indian markets via "treaty platform" investment vehicles located in tax-favorable jurisdictions such as Singapore or Mauritius. Such treaty platform vehicles enable access to the Indian tax treaty network which provides for a 0percent capital gains tax on sale or direct or indirect transfer of investments in India. The validity of these treaty platforms is now being heavily scrutinized by the Indian Taxation Authorities (ITA). They believe they have been losing large amounts of revenue due to abusive tax structuring involving Mauritius and Singapore entities where the true beneficial owners have no substantial connection to either nation. Thus, over the past 3 years they have been reviewing hundreds of mergers and acquisition deals. In fact, the Indian income tax department has scrutinized more than 380 merger and acquisition deals from 2007 to 2008 and it is expected that many of these entities will be issued notices for tax totaling millions of US dollars.
One of the most highly publicized case is the Vodafone-Hutchinson tax dispute which is closely being followed by many investors in Indian markets. It is a landmark case that will severely impact the M&A landscape in India. In 2007 British Telecom giant Vodafone paid Hong Kong based Hutchison International over US$11 billion to buy Hutchison's 67percent stake in the Indian telecom company Hutchison Essar Limited (HEL). Vodafone indirectly acquired the 67percent interest in HEL an Indian telecom company, by purchasing the shares of a Cayman entity that held HEL.
Since the deal was offshore, and the shares of HEL did not change hands, neither Vodafone nor Hutchinson International considered it a taxable transaction in India. The Indian tax authorities disagreed. After review of the transaction the Indian tax authorities took the position that the intermediate entities between HEL and the ultimate foreign shareholder should be disregarded and the sale should be treated as a sale of HEL and should result in capital gains tax. Vodafone argued that the deal was not taxable in India as the funds were paid outside India for the purchase of shares in a non-Indian company. Vodafone also argues that if there were any tax liability resulting from the transaction then that the tax liability should be borne by Hutch because Vodafone was not liable to withhold tax as the withholding rule in India applied only to Indian residents. The ITA's argument was focused on proving that even though the Vodafone-Hutch deal was offshore, it was taxable as the underlying asset was in India and so it pointed out that the capital asset; that is the Hutch-Essar or now Vodafone-Essar joint venture is situated here and was central to the valuation of the offshore shares; that through the sale of offshore shares, Hutch had sold Vodafone valuable rights - in that the Indian asset including tag along rights, management rights and the right to do business in India and that the offshore transaction had resulted in Vodafone having operational control over that Indian asset. Currently Vodafone is contesting a 2.5billion tax bill in India over this deal and has appealed to the Supreme Court challenging a lower court order. In November the Supreme court asked Vodafone to deposit Rs2,500 billion crore and make a bank guarantee worth Rs8,500 crore as an interim arrangement. The appeal with the Supreme court is scheduled to be addressed in 2011 and will set the precedent of how future M&A deals will be scrutinized.
Permanent establishment issues are also coming under the scrutiny of India's taxation authorities. If a permanent establishment in India is made, the fund's investment manager and perhaps even the offshore fund itself could be subject to Indian tax. Some of the methods of developing a permanent establishment are when an Indian sub-advisor makes decisions on behalf of an offshore fund. It is extremely important that the Indian advisor limits its role to providing non binding advice. Another method is that of physical presence in India. If the fund manager employees spend significant time in India the fund manager has the burden of proving that the employees are merely performing an oversight function.
Factors that may establish a permanent establishment in India are:
- Investment manager employees spending a significant number of days in India.
- Investment manager employees representing themselves as part of the Indian sub-advisor.
- Investment manager employees signing deal-related documents while in India.
- The Indian sub-advisor representing to third parties that it has authority to bind the overseas management company or the fund.
- The Indian sub-advisor signing binding agreements on behalf of the overseas parent entity or on behalf of the fund.
There are no specific rules in India which determine what constitutes a permanent establishment but if a Indian sub-advisory entity were to make decisions on behalf of an offshore fund it may be considered as such. It is extremely important to review the role of Indian sub-advisors to determine if there may be permanent establishment issues. If a permanent establishment is determined to exist the fund manager, or even the funds will be subject to tax or tax filing obligations in India.
In addition to challenging the substance of M&A transaction structures the taxing authorities are also proposing a new taxation regime which allows for a "General Anti Avoidance Rule" (GAAR). This regime is included in the new Direct Taxes Code Bill 2010 (DTC) which is proposed to replace the existing direct tax laws in India and consolidate the direct tax laws into single legislation. This DTC is intended to be effective April 1st, 2012. Such a rule may enable authorities to treat related, accommodating or connected parties as one and the same person. Since these are expected to be very complex rules related to the treaty platforms it is crucial to exercise prudent due diligence prior to entry into India and continue to exercise the administrative and presence requirements needed to maintain the desired exit projections.
The DTC also proposes to expand the source of income rule to income that accrues, whether directly or indirectly, through or from the transfer, of a capital asset situated in India. Income from the transfer of share or interest in a foreign company by a non-resident outside of India will not be deemed to accrue in India if the fair market value of the assets owned (directly or indirectly) by the company does not exceed 50 percent of the fair market value of the total assets owned by that company. Further, it is provided that proportionate gains would be taxable in India where any income is deemed to accrue to a non-resident by way of a transfer of share or interest in a foreign company.
The aforementioned details of taxation in India are complex and the above provides a very brief summary of some of the significant items which are under scrutiny by Indian taxation authorities. The increased examinations by Indian taxation authorities should prompt investors to review current investment vehicle structures and ascertain whether such arrangements would withstand any regulatory scrutiny by India's tax authorities. We would be pleased to discuss planning opportunities or review your current structures in further detail. If you have any questions please get in touch with your KPMG tax or audit contact or the tax professionals noted below.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.