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INDIA: Taxability of overseas share sale – India influences African Tax Administrations

Since the 2012 Union Budget specified that shares of a foreign company would be deemed to be situated in India if it derives its value “substantially” from assets located in India, there has been uncertainty over what this really means. A recent case clarifies the matter.
Delhi High Court clarifies taxability of overseas share sale

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Nikhil Rohera and Ravindra Agrawal
PwC India
Nikhil Rohera is an executive director and Ravindra Agrawal is an associate director at PricewaterhouseCoopers Pvt. Ltd, Mumbai, India
Corporates undertaking group reorganisations or share sale at overseas holding company levels have been facing uncertainty with regard to tax liability in India, owing to a specific provision which triggers Indian capital gains tax in certain situations. The Indian revenue authorities have been asserting capital gains tax where the ostensible objective was to transfer business in India.
Indian income tax law provides that any share or interest of a foreign company will be deemed to be situated in India if it derives directly or indirectly its value ‘substantially’ from assets located in India. In other words, once this deeming fiction is triggered, a foreign share is treated as an Indian share thereby triggering capital gains tax in India. However owing to the ambiguous nature of these provisions, uncertainties have arisen as to which transactions could get covered, what is threshold of assets in India, applicability of Tax Treaty provisions, etc.
Recently the Delhi High Court held, in a landmark judgment, the issue in favour of the taxpayer by prescribing a high benchmark of 50{780f53c297e2c008074d23b865a0ce0b35a4f08852d8e1e49466a5a902c4e44e} for triggering the capital gains tax in India.
In this case, Copal Group had undertaken a certain sale of shares of its group companies to Moody’s Group companies via a series of transactions. Earlier, the Authority for Advance Ruling (AAR) had decided this issue in favor of the taxpayer by pronouncing that no capital gain arises to Copal Group companies (Mauritius) from the transfer of their underlying shares / business in India to Moody’s Group companies outside India. The revenue appealed before the Delhi High Court against the AAR ruling. Their main plea was that the transaction of sale of shares by the Mauritius group companies was structured prima facie for avoidance of tax in India. They also argued 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 attracted capital gains tax in India.
The High Court has now upheld the AAR’s decision by observing that the sale of shares by Mauritius companies was a bona fide transaction, having strong commercial justification. It therefore came to a conclusion that the transaction was not designed for avoidance of any tax in India.
As part of its argument, the Revenue had also alleged that since the two Mauritius group companies were effectively managed by an individual resident of UK, the Mauritius Tax Treaty benefit should not be granted to them as their place of effective management was not situated in Mauritius. They further pleaded that the two Mauritius group companies should be treated as non-operative or shell companies as their only income was from rendering services to other group companies. The High Court disagreed with the Revenue and confirmed the AAR’s conclusion that in the absence of any material available to the contrary, the management of the two companies rested with their Board of Directors in Mauritius. The High Court also observed that the corporate veil of the Mauritius entities cannot be lifted simply because they were rendering services to group companies.
For the sake of completeness, the High Court also dealt with the other contention of the revenue regarding alleged taxability under the indirect transfer tax provisions although the transactions were anyway held as non-taxable under the Tax Treaty.
It will be recalled that after the Indian Supreme Court’s landmark decision in the Vodafone case in 2012, the then Indian Government had brought about a ‘clarificatory’ amendment to tax certain overseas share transfers. The retrospective amendment provided 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. The retrospective amendment not only virtually overruled the Supreme Court ruling but was also widely and ambiguously drafted leaving many questions unanswered including on the precise threshold for applicability of the provisions.
The Delhi High Court has now thrown light on the term ‘substantially’ for the purpose of triggering indirect transfer provisions in India. 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 in India must have territorial nexus with India.
The High Court observed that the intention of the amendment was not to extend the scope of deeming provisions to income which had no territorial nexus with India. It was not justifiable to tax overseas income which arises from transfer of assets outside India and which do not derive the’bulk’ of the value from assets in India. The High Court therefore held that that the term “substantially” would necessarily have to be read as synonymous to “principally”, “mainly” or at least “majority”.
Reference was also made to an earlier Report of a Parliamentary Committee which recommended that the term ‘substantially’ should be defined at a threshold of 50{780f53c297e2c008074d23b865a0ce0b35a4f08852d8e1e49466a5a902c4e44e} of the total value being derived from assets located in India. The High Court also referred to the OECD and UN Model Conventions, holding that these Conventions propose a regime which is generally accepted in respect of indirect transfers. Although not binding on Indian revenue authorities, the same would certainly have a persuasive value in interpreting the expression ‘substantially’ in a reasonable manner and in its contextual perspective. The High Court observed that the Capital Gains Articles in these Model Conventions provide a threshold of 50{780f53c297e2c008074d23b865a0ce0b35a4f08852d8e1e49466a5a902c4e44e} 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 given to the country where the underlying assets are situated only if more than 50{780f53c297e2c008074d23b865a0ce0b35a4f08852d8e1e49466a5a902c4e44e} of the value of such shares is derived from such property.
In the case before the Delhi High Court, the value of Indian assets appeared to be much less than 50{780f53c297e2c008074d23b865a0ce0b35a4f08852d8e1e49466a5a902c4e44e} of the total assets of the foreign company. The High Court thus held that gains arising from sale of shares of a foreign company which derives less than 50{780f53c297e2c008074d23b865a0ce0b35a4f08852d8e1e49466a5a902c4e44e} of its value from assets situated in India would be outside the purview of the Indian income tax laws.
It is worthwhile to note that the present Indian income tax law is proposed to be replaced by a new piece of legislation called the Direct Tax Code, which is currently at draft stage. In arriving at its conclusion, the High Court sought to draw analogy from the proposed Direct Tax Code draft of 2010 (which provided a similar threshold of 50{780f53c297e2c008074d23b865a0ce0b35a4f08852d8e1e49466a5a902c4e44e}); interestingly however it did not refer to the 2013 draft which now provides a lower threshold of 20{780f53c297e2c008074d23b865a0ce0b35a4f08852d8e1e49466a5a902c4e44e}.
To sum up, the decision of the High Court certainly is a welcome development, being the first Indian judgment which has provided much needed clarity with regard to the threshold for triggering indirect transfer provisions. The taxpaying community now hopes that the Indian Government will provide further clarity on other open issues concerning these far reaching provisions, so that disputes with the revenue authorities can be avoided.