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Good News For Indirect Transfers!

Published on Sat, Aug 23,2014 | 14:43, Updated at Sat, Aug 23 at 14:43Source : 

By: Nikhil Rohera, Executive Director, PwC

MNCs with business interests in India had been facing tax uncertainties while reorganising their India investments. The issue mainly revolves around the capital gains tax and consequent withholding tax obligation where certain shares are transferred overseas which results in indirect transfer of India business.

Recently the Delhi High Court in the landmark case of Copal / Moody’s has decided the issue in favour of the assessee by prescribing a high threshold of 50% before triggering any capital gains tax in India.

In this case Copal Group had undertaken certain sale of shares of its companies to the Moody’s Group via a series of transactions. The Authority for Advance Ruling (AAR) had earlier decided the issue in favour of the assessee by holding that capital gains arising to Copal Group companies (Mauritius) from transfer of their underlying shares in India to Moody’s Group companies outside India was not taxable in India. The main ground of the Revenue before the Delhi HC was that the transactions of sale of shares by the Mauritius companies were structured prima facie for avoidance of tax. It further contested that the real intention of the parties was to undertake a sale of shares at the ultimate parent level (in Jersey) which if done prior to the other sale transactions would have been taxable in India as capital gains.

The Court after examining the detailed factual matrix upheld the ruling of AAR by observing that the sale of shares by Mauritius companies was a bonafide transaction having strong commercial justification. It therefore held that the transactions were not designed for avoidance of any Indian income-tax.  

In addition, the Revenue contended that since the two Mauritius companies were effectively managed by an individual who was a UK resident, they should not be granted the Mauritius Treaty benefits as their place of effective management was not in Mauritius. It also argued that the two Mauritius companies were generating revenue from intra-group services and hence they should be treated as non-operative / shell companies. Here again, the HC upheld the AAR’s conclusion that the management of the two companies rests with their Board of Directors in Mauritius and in the absence of any material available to the contrary, the allegation of the Revenue was not tenable. It also observed that the corporate veil of a company cannot be lifted just because it was rendering services to its related enterprise.

Interestingly, even after holding the transactions to be bona fide commercially and therefore eligible to Treaty benefits, for the sake of completeness the HC went on to consider the other contention of the Revenue regarding alleged taxability under the domestic law.

It will be recalled that immediately after the Supreme Court’s decision in Vodafone’s case in 2012, the Government had brought about a ‘clarificatory’ amendment to tax certain overseas share transfers retrospectively. This retrospective amendment now provides that any share or interest of a foreign company is deemed to be situated in India if it derives directly or indirectly its value ‘substantially’ from assets located in India.     

This provision drew dissents from several stakeholders not only because of its unfair retrospectivity but also because of its ambiguous language and coverage. For example, the provision is silent on the precise threshold, valuation methodology, date of computation, etc.

The Delhi HC has now neatly analysed the meaning of the term ‘substantially’ for the purpose of trigger of indirect transfer provisions. It held that this issue can be addressed by reference to the express language of the provision as well as by applying the principle that income which is sought to be taxed must have territorial nexus with India.

The Court held that the object of the amendment was not to extend the scope of deeming provisions to income which had no territorial nexus with India. It held that there would be no justification to tax income which arises from transfer of assets overseas and which do not derive ‘bulk’ of the value from assets in India. The Court therefore held that that the term “substantially” would necessarily have to be read as synonymous to “principally”, “mainly” or at least “majority”. The amendment having been stated to be clarificatory must be read restrictively and at best to cover situations where in substance the assets in India are transacted by transacting in shares of overseas holding companies and not to transactions where assets situated overseas are transacted which also derive some value on account of assets situated in India.

The two Judge Bench also referred to the Shome Committee Report which recommended that the term ‘substantially’ should be defined at a threshold of 50% of the total value being derived from assets located in India. In addition to this, the Court held that the UN and OECD Model Conventions may also be referred since they propose a regime which is generally accepted in respect of indirect transfers. Although not binding on Indian authorities, the same would certainly have a persuasive value in interpreting the expression ‘substantially’ in a reasonable manner and in its contextual perspective. The Court observed that the Capital Gains Articles in these Model Conventions provide a threshold of 50% to determine if the share derives its value ‘principally’ from immovable property situated in India. In other words, the taxation rights in case of sale of shares are ceded to the country where the underlying assets are situated only if more than 50% of the value of such shares is derived from such property.

Based on the share transfer prices discussed in the judgment, it appears that the value of assets in India amounted to much less than 50% of the total assets of the foreign company. The HC thus concluded that gains arising from sale of a share of a foreign company which derives less than 50% of its value from assets situated in India would not be exigible to capital gains tax in India.

Interestingly, while the judgment does make a passing reference to the DTC draft of 2010 (which provided a similar threshold of 50%), it does not refer to the 2013 draft which now provides a lower threshold of 20%.

This is the first Court ruling in India which lays down a clear threshold for triggering capital gains tax on overseas share transfers. Taking cue from the ruling, it would be desirable if the Government can urgently consider the Shome Committee recommendations and provide clarity on all open issues concerning these far reaching provisions. This will provide certainty not only to the taxpayers but also to CBDT’s proposed High Level Committee which will then have some objective criteria to scrutinize all fresh cases involving indirect transfers.

( Ravindra Agrawal, Associate Director, PwC also contributed to this article).


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