On March 16, 2012, the Finance Minister of India presented the Finance Bill 2012. The Finance Bill contains a number of measures that, if enacted, would have significant impact on foreign investment in India, particularly from a tax perspective.
Retroactive Taxing of Offshore Transfers
One of the most controversial aspects of the Finance Bill is a
proposal to impose a retroactive tax on the indirect transfer of
capital assets. Until now, when corporate control passed because of
a transfer of shares, income was deemed to accrue in India only if
the sale of shares constituted a transfer of a capital asset
situated in India. In January 2012, the Indian Supreme Court
confirmed this rule in Vodafone International B.V. vs. Union of
India. There, the Court ruled that a controlling interest in
an Indian company is not a separate capital asset and, therefore,
the sale of a controlling interest in an offshore holding company
was not a transfer of the holding company's underlying capital
assets in India. The Finance Bill proposes to overrule
Vodafone by clarifying the Indian Income Tax Act's
("Tax Act") definitions of "capital assets,"
"transfer," and "through." As changed, the Tax
Act would deem any capital gains arising from the transfer of
shares or interest in an offshore company as a taxable transfer
within India if the shares or interest derived, directly or
indirectly, its value "substantially" from the assets
located in India. Moreover, because the Finance Bill purports to
simply "clarify" the meaning of terms that have been used
by the Tax Act all along since the Tax Act took effect on April 1,
1962, this new rule would operate retroactively, reaching back to
all transactions that have occurred in the past 50 years.
These proposed changes would effectively extend the scope of
India's source of income rules without any regard to tax
optimization structures. Such retroactive clarifications in the law
will generate tax uncertainty for foreign investors with plans to
invest into India, as well as those who have previously made
investments. The retroactive tax amendments have been strongly
criticized by the Indian and international business community
alike. The Finance Bill 2012 will become the Finance Act 2012 after
being approved by both houses of the Indian Parliament and
receiving the assent of the Indian President. The Indian Minister
of Parliamentary Affairs has recently announced that the Indian
parliament is likely to consider the Finance Bill 2012 on May 7,
2012.
General Anti-Avoidance Rules
The Finance Bill also attempts to codify the principle of
"substance over form" with new General Anti-Avoidance
Rules ("GAAR") scheduled to take effect on April 1, 2012,
once notified by the Indian government. The GAAR would give Indian
tax authorities new and sweeping powers to declare that a business
transaction is an impermissible arrangement for tax avoidance.
Among other things, this could deny businesses customary tax
benefits, including benefits under India's tax treaties with
other countries.
The proposed GAAR would permit the Indian tax authorities to
characterize a transaction as an impermissible tax avoidance
arrangement if one of its main purposes was to obtain a tax benefit
and it (i) creates rights and obligations not normally created
between parties dealing at arm's length; (ii) results, directly
or indirectly, in the misuse or abuse of provisions of the Tax Act;
(iii) is deemed to lack commercial substance; or (iv) was entered
into or carried out in a manner normally not employed for bona
fide purposes.
An arrangement is deemed to lack substance if, as a whole, it is
inconsistent with the form of its individual steps, or if it
involves round-trip financing, an accommodating party, elements
that offset each other, or disguises certain material elements of
the transaction.
The proposed GAAR erects a rebuttable presumption that an
arrangement's main purpose is to obtain tax benefit and places
upon the taxpayer the burden of proof to show the absence of a
motive of tax avoidance. In addition, the GAAR uses broad language
(such as "misuse or abuse of provisions of the Tax Act"
and "entered into or carried out in a manner, normally not
employed for bona fide purpose") that will make its actual
scope unclear. Under the Finance Bill, the Central Board of Direct
Taxes ("CBDT") will prescribe guidelines for the
GAAR's implementation, which may provide some insight on how
widely or narrowly the GAAR will be construed. The CBDT is expected
to submit draft guidelines to the Ministry of Finance by May
2012.
Already, the proposed GAAR seems to have had an effect upon Indian
taxation. On March 22, 2012, the Authority for Advance Ruling
("AAR")1upheld a tax demand on Otis Elevators
in India and denied capital gains tax benefits provided by the
India–Mauritius tax treaty. In this case, Otis India
bought shares from Otis Mauritius through a share buyback scheme
that resulted in capital gains tax for Otis Mauritius. Under the
India–Mauritius tax treaty, this should not have been
taxable in India. Nevertheless, the AAR upheld the Indian Income
Tax Department's submission that this structure was designed to
avoid tax in India and that the share buyback transaction was a
"colorable device." The Otis ruling follows the
principle of "substance over form" found in the proposed
GAAR, even though it makes no direct reference to it. In any event,
Otis gives an insight to the thinking of the AAR and the
intentions of the Indian Income Tax Department.
Withholding Tax Obligations for Nonresidents
Another retroactive provision in the Finance Bill is the
imposition of withholding tax obligations on nonresidents. The
amended tax provision would require all persons (both resident and
nonresident) who have made a payment to a nonresident person to
withhold taxes if that payment would be subject to tax in India.
This obligation would apply regardless of whether a nonresident
payer has a residence, place of business, business connection, or
any other presence in India and, like other provisions of the
Finance Bill, would apply retroactively to April 1, 1962.
Conclusion
The Finance Bill and provision of the GAAR threaten to have serious
effects upon companies that have invested in India or have plans to
do so. Unfortunately, they have adversely affected the outlook and
confidence of foreign investors in India at a time when India is
actively seeking increased levels of foreign direct investment. It
remains to be seen how the Indian tax authorities will implement
these provisions. However, it is clear that the amendments will be
challenged in the Indian courts. Recently, Vodafone served notice
to the Indian government under the India–Netherlands
Bilateral Investment Treaty challenging the proposed retroactive
tax amendments to the Tax Act. Until these legal issues are
resolved, it would be prudent to discuss with your tax and legal
advisors any potential impact that the Finance Bill's
retroactive amendments or the GAAR may have on any existing or
future investments in India.
Footnotes
1. The Authority for Advance Ruling is a quasi-judicial body incorporated under the (Indian) Income Tax Act 1961 that is primarily charged with the responsibility of deciding the income tax liability of a nonresident in cross-border deals. The AAR pronounces rulings on the applications submitted in the prescribed form under the tax legislation, and such rulings are binding both on the applicant and the Indian income tax authority.
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