Clarity and consistency in tax law and improving India's ranking in 'ease of doing business' are important elements in attracting foreign investment into the country. The indirect transfer tax provisions introduced retrospectively by the Finance Act 2012 after the Vodafone ruling by the Supreme Court seek to tax transfer of shares or interest in a foreign entity which derives its value substantially from Indian assets. The objective is to tax transfer of Indian assets transferred 'indirectly'. However, the wordings of these provisions unfortunately leave scope for unnecessary controversy or possible harsh implications, unless rationalised. Let us examine some such issues.
The indirect transfer tax applies if there is transfer of a foreign entity, if it derives its value "substantially" from Indian assets. However, the irony is that the term "substantially" has not been defined at all! Whether more than 20 per cent would be substantial, or more than 75 per cent, is open to interpretation. In fact, there is already litigation on this issue, and recently the Delhi High Court has ruled in the case of Copal Research that substantially should mean "more than 50 per cent".
Take a case of transfer of a foreign company which derives 60 per cent of its value from its Indian subsidiary and the remaining 40 per cent from, say, its Singapore subsidiary. Under the present provisions there can be a risk that gains from the entire 100 per cent of the value of the foreign company may be taxed in India, whereas only 60 per cent of the value would have got taxed if the Indian subsidiary was directly transferred. Further, there is no express clarity on how to determine 'value' for this purpose - in other words, whether it refers to book value or fair market value. Also, the provisions are silent on which valuation method has to be used - the discounted cash-flow method or net asset value?
In case of subsequent 'indirect' transfers of Indian assets, there is no clarity whether 'cost step-up' will be available. An example: suppose foreign company A owns foreign company B, which owns Indian company C. If shareholders of A transfer shares of foreign company A and get taxed in India on, say, $100 million, then, when A transfers shares of foreign company B, will company A get a deduction of $100 million as the cost of acquisition while computing capital gains?
Intra-group restructuring (in the form of foreign amalgamations, demergers, and so on) could lead to 'indirect transfer' of Indian assets within the same group. Such restructuring is presently not expressly made completely tax-neutral, unlike in the case of foreign mergers and so on, that involve 'direct transfers of Indian assets'. Further, technically, even if a small shareholder of a foreign company deriving its value 'substantially' from Indian assets transfers a single share (less than one per cent of the total shareholding) outside India on a foreign stock exchange, such a small shareholder may be taxable in India!
Also, when a foreign company derives its value 'substantially' from Indian assets and declares a dividend outside India to its foreign shareholders, there can be a controversy over whether such a dividend is taxable in India.
In fact, the expert committee constituted in 2012 under the chairmanship of Parthasarathi Shome had occasion to examine some of the above issues and had provided some recommendations which were well received globally. Maybe it is time to revisit the committee's recommendations.
The committee recommended that there should be tax incidence in India only where the value of India-centric assets is 50 per cent or more, as compared to the global assets. Further, the committee recommended that the capital gains on 'indirect transfers', if at all, be taxed only to the extent that the value of the share or interest is derived from Indian assets. For this purpose, the term 'value' should be interpreted as 'fair market value' as on the last balance sheet date of the foreign company, subject to adjustments. The committee recommended that the tax should not apply if the shareholding in the Indian company, or in the immediate holding company, is less than 26 per cent. The committee also recommended exemptions for frequently traded shares of a listed foreign company, for intra-group restructuring and for foreign dividends subject to conditions. However, unfortunately, none of these recommendations is yet enacted.
Rather than leaving it to the courts to decide after years of costly and painful litigation, investors will applaud if clarity is provided upfront. It is learnt that preparations for the 2015 Budget have already begun, or may soon begin. Considering the government's intention to end "tax terrorism" and provide a clear and predictable tax regime, it would be desirable that the above issues and the Shome Committee's recommendations are considered while framing the 2015 Budget.
The writer is a partner with Ernst & Young, India. These views are his own
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