Introduction
The transfer of foreign assets often entails a complex interplay of international and domestic taxation principles. In India, the Income Tax Act, 1961 ("Income Tax Act") governs the taxation of such transactions. The Act provides a detailed framework for defining and taxing capital gains arising from the transfer of assets, including those involving foreign entities. This article delves into the tax implications of such transfers, focusing on treating shares that derive substantial value from Indian assets.
Understanding capital assets and their transfer
Under Section 2(14) of the Income Tax Act, "capital asset" encompasses all property, including rights related to Indian companies. Judicial precedents, such as the ruling of the Authority for Advance Rulings (Income-Tax), New Delhi in In re: Praxair Pacific Ltd.,1 affirm that shares held as investments qualify as capital assets.
Furthermore, the definition of "transfer" under Section 2(47) of the Income Tax Act extends to various modes of alienation, including direct or indirect transfers of rights in assets. Explanation 2 of this section ensures that even offshore transactions affecting Indian assets fall within the ambit of taxable transfers. Consequently, a foreign company's shares deriving significant value from Indian assets can also trigger tax liability in India.
The 'look at' and 'look through' approaches
The landmark Vodafone International Holdings BV v. Union of India case introduced the "look at" test, emphasising that tax authorities should consider the transaction's legal form rather than dissecting it for tax avoidance. Subsequent amendments to the Income Tax Act enabled authorities to "look through" transactions in cases involving indirect transfers of Indian assets. This shift underscores the legislature's intent to tax gains from such transfers, even if structured offshore.
Taxability under the scope of Section 9
Section 9(1)(i) of the Income Tax Act defines incomes deemed to accrue or arise in India, extending to transfers of capital assets located in the country. The accompanying explanations clarify that:
- Shares or interests in foreign entities substantially deriving value from Indian assets are deemed situated in India.
- The fair market value ("FMV") of such assets must exceed INR 10 crores and constitute at least 50% of the total asset value.
For example, if a foreign company's Indian assets fall short of the 50% threshold, as determined by accompanying Explanation 6(a), the indirect transfer provisions would not apply.
Fair market valuation and compliance
The determination of FMV is pivotal in assessing taxability. Section 9, as mentioned herein above, mandates valuation on the "specified date," typically the accounting year-end or the transfer date, whichever reflects higher asset values. If the Indian assets exceed the prescribed threshold, gains attributable to these assets become taxable in India, as per Explanation 7(b).
The tax calculation under Section 48 of the Income Tax Act considers the full value of consideration, acquisition cost, and improvements. Gains attributable to Indian assets are further taxed as per applicable slab rates under Section 115BAC of the Income Tax Act.
Practical application and implications
Case 1: Transfer of foreign shares not meeting the threshold
Where the Indian assets represent less than 50% of the foreign company's total assets, the indirect transfer provisions remain inapplicable. Such transactions escape tax liability under the Income Tax Act.
Case 2: Transfer meeting the substantial value criteria
If the Indian assets cross the 50% FMV threshold, the gains proportionate to these assets are taxed. For instance, in a hypothetical scenario involving a foreign entity holding shares in an Indian company, where FMV exceeds INR 10 crores, the indirect transfer provisions are triggered.
Conclusion
Typically, the tax liability regarding the transfer of an asset arises in the country where such transfer occurs. However, the Income Tax Act provides a framework for indirectly taxing offshore transactions having implications in India. Taxation of foreign asset transfers under Indian law reflects a robust framework designed to capture value attributable to domestic assets. Entities engaging in such transactions must carefully evaluate the deal structure to mitigate exposure to tax liabilities.
Footnote
1 [2010] 326, ITR 276
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