India is one of the largest and fastest growing economies in the world. It harbours enormous opportunities for domestic and foreign investments because of its highly skilled manpower, huge domestic market and natural resources. Foreign investors have found India to be a very attractive investment destination, leading to enormous growth in the economy.
Significant and expanding cross-border trade has led to the Indian government increasing its efforts in providing an investor friendly tax regime, without losing major revenue. As a result, India has signed agreements with a large number of countries for the avoidance of double taxation (DTAs). Besides preventing income from being taxed twice, the treaties also promote trade and commerce.
However, in certain cases, effective DTAs have also resulted in double non-taxation. This has led to a large number of investors routing their investments through jurisdictions that have a favourable DTA with India, such as Mauritius, Singapore, and to a certain extent, the Netherlands and Cyprus.
While the DTA provisions allowed investments to be steered into India from a tax efficient intermediate jurisdiction, the issue has also led to an increased amount of litigation because of ‘treaty shopping’, among other issues. Time and time again, the legislature made attempts to eliminate grey areas and doubts over the application of DTA provisions, while the judiciary made substantial developments with landmark judgments.
An example of this is the case of the Union of India v Azadi Bachao Andolan (2003) 263 ITR 706 (SC). In this case, the Supreme Court of India (SC) said the Indian government had power under Section 90 of the Income-tax Act (IT Act) to enter into an agreement to avoid potential double taxation by demarcating the respective areas of each jurisdiction’s taxation – even if no tax is presently levied in the other country. It also upheld the validity of Circular No. 789, which stated that the tax residency certificate issued by Mauritian tax authorities is enough proof of residency.
In a step towards substance-based taxation, the Indian tax laws have undergone some significant changes that have inter alia directly impacted the conventional ways in which foreign investments are structured.
To name a few, these changes include:
- The taxation of offshore indirect transfers of Indian assets;
- The notification of Cyprus as a non-cooperative jurisdiction (see below);
- The recent amendments to the India-Mauritius DTA and the consequential impact it has on the India-Singapore DTA;
- The introduction of the General Anti Avoidance Rules (GAAR);
- The change in corporate residency tests that are now based on the place of effective management of a foreign company; and
- The mandatory disclosures of foreign assets, including offshore trusts.
Some of these changes are discussed below, followed by how the amendments are making some conventional structures outdated.
Cyprus was originally one of the preferred jurisdictions for routing investments into India.
Its low tax regime for offshore and resident companies, as well as its identity protection for investors was highly sought after by institutions.
However, Cyprus failed to share information on tax avoiders and the Indian government declared Cyprus as a non-cooperative jurisdiction in November 2013 and imposed a 30% withholding tax on any payment to a Cyprus entity by Indian residents — effectively suspending the tax benefits otherwise available under the India-Cyprus DTA.
A recent press release issued by the Indian Ministry of Finance said the notification may be withdrawn following negotiations between the two countries. The press release also stated that India and Cyprus may soon sign a revised DTA under which, among other changes, the capital gains will be taxable at source, rather than on a residence basis (the latter resulting in a double non-taxation of capital gains where a Cypriot resident sells shares of an Indian company).
Amendment to India-Mauritius DTA
Under the India-Mauritius DTA, capital gains were exempt from tax in India and could be taxed only in Mauritius. However, Mauritian tax laws meant capital gains were not taxable in Mauritius either. This double non-taxation made Mauritius a favourite jurisdiction for foreign investors to route their investments into India.
Due to this provision, the government lost a substantial amount of tax revenue, resulting in India renegotiating some terms of the DTA with Mauritius. A protocol signed by the authorities on May 10 2016 plugged the double non-taxation loophole.
Under the revised DTA, capital gains tax will be charged on the sale of shares of Indian companies from April 1 2017.
However, the protocol provides a grandfathering period for investments made in Indian companies before April 1 2017.
Impact on India-Singapore DTA
Like the original India-Mauritius DTA, India’s DTA with Singapore provides a similar capital gains tax exemption on alienation of shares in an Indian company by a Singapore resident.
The revised measures in the India–Mauritius DTA will impact this exemption in the India-Singapore DTA. The protocol to the India–Singapore DTA provides that the said exemption will remain in force so long as the DTA between India and Mauritius provides exemption from capital gains tax in the source state in case the sale of shares of a company (for instance, in India when the shares of an Indian company are sold by a Mauritian resident). There is lack of clarity on aspects such as:
a) Whether the protocol to the India–Mauritius DTA would automatically result in the withdrawal of the exemption or would require re-negotiation of the India–Singapore tax treaty itself;
b) Whether there would be any grandfathering provision; and
c) Whether the exemption under the India–Singapore DTA would only be withdrawn for equity instruments and not for debt, among other instruments. Finance Minister Arun Jaitley has confirmed that India will renegotiate the DTA with Singapore soon.
Indirect transfer of assets
The tax landscape of indirect asset transfers has also changed in recent years.
In 2012, the Indian legislator introduced a provision to levy tax on capital gains earned by a non-resident’s transfer of shares or interest into a foreign company that derived “substantial value” from underlying Indian assets. The SC ruling in the Vodafone dispute case had been sought to be overruled by the retrospective amendment.
In 2015, a number of important amendments were made to the criteria, including the definition of “substantial value” for taxing income attributable to Indian assets. The changes also introduced a reporting requirement for Indian entities.
In June 2016, the government released rules relating to the method of computing the fair market value of Indian and global assets and other compliances. The underlying Indian entities, as part of their reporting obligation, must maintain extensive information regarding multi-level and multi-jurisdictional structures.
Introduction of GAAR
The Indian government’s primary focus has been to revise its laws to eliminate double non-taxation and discourage illegitimate tax planning. As part of this plan, GAAR will enter into effect from the next financial year, commencing on April 1 2017.
The rule will empower the Indian tax authorities to scrutinise investment structures and other transactions that have been made only to achieve a tax benefit and do not have any commercial substance. Hence, investments made in India through a third country may need to pass the test of GAAR before receiving a tax benefit under a DTA.
The principle of substance over form
Looking at the recent changes made by the Indian government in its taxation policies and the decisions made by the Indian judiciary, it is evident that the tax authorities will look into the ‘commercial substance’ of an arrangement rather than the ‘form’.
Tax authorities will scrutinise transactions and will deny tax benefits to any such transaction or arrangement that could be a tool to evade tax or that is lacking any commercial substance.
Even in the amended India-Mauritius DTA, a Limitation of Benefits (LoB) clause has been introduced. The provision, which is similar to the LoB clause in the India-Singapore DTA, does not allow a shell company in Mauritius to be entitled to claim benefits of the reduced tax of half the applicable rate during the two year transition period between April 2017 and March 2019.
India has adopted Place of Effective Management (POEM) as the basis for determining corporate residency of a foreign company.
POEM means a place where key management and commercial decisions that are necessary for the conduct of business of an entity as a whole are made.
Accordingly, a foreign company could be considered an Indian tax resident if its POEM is for the relevant year is considered to be in India.
On December 23 2015, the government issued draft guiding principles for the determination of the POEM of a company (POEM Guidelines). These guidelines emphasise that:
(a) The determination of POEM is based on all relevant facts related to the management and control of the company;
(b) The POEM concept is one of substance over form; and
(c) The POEM determination is an annual exercise, i.e. the POEM of a company is to be determined on a year to year basis.
Once the POEM of a foreign company for a particular financial year is in India, its global income for that particular financial year is exposed to Indian taxation unless the applicable DTA resolves the tax residence of the taxpayer in favour of the other jurisdiction.
These changes have led multinational enterprises and the investor community to re-think their methods for investing in India or divesting from their existing Indian investments.
Traditional structures becoming outdated
Given the more evolved tax law in India, below we briefly discuss some of the conventional structures for investing in India that may no longer be used.
SPV structures that use an intermediary holding company in a tax friendly or tax neutral jurisdiction for routing investment to India would be exposed to a greater level of scrutiny under GAAR when the rule enters into effect. With the recent DTA amendments influencing the attractiveness of Cyprus, Mauritius and Singapore (for the time being), investors may have a limited choice in how they structure investments into India from the perspective of achieving a tax efficient exit.
With the indirect transfer tax provisions being part of law, using an intermediary entity to indirectly transfer underlying Indian assets/ business would be subject to tax in India. Also, the Indian tax law has strict disclosure requirements on the Indian companies to disclose such offshore transactions. The obligations ensure the Indian tax authorities are aware of such offshore transactions.
Tightening of disclosures of foreign assets, including offshore bank accounts and trusts, discourages the use of structures set up to accumulate the wealth of Indian residents outside India to avoid residence-based taxation, as well as those structures where Indian funds are routed back into India through structures, which are able to achieve a no tax outcome. Tougher disclosure rules also give the tax authorities more tools to track down such structures.
Based on the POEM, a foreign company that has its intelligence in India would be considered to be an Indian resident. While POEM based taxation would be more relevant for outbound investment structures, it may potentially also impact fund structures where the fund managers or advisers are in India and are providing advice regarding the Indian investment market on which investment vehicles are being used to invest into the country. In such structures, factors such as independent decision making of the investment vehicle, substance in the investment vehicle in terms of its ‘head and brain’, location of the real decision makers and the nature of advice provided by the Indian teams, both on paper and in conduct, would be critical. Note that the POEM Guidelines do recognise the electronic/ virtual modes of attending meetings and thus, use of technology to flout rules may not be an option for taxpayers.
ALL is not lost
Given all these recent significant developments concerning taxation in India, the ‘substance’ in structuring is going to be critical and that will be the biggest challenge in terms of structuring foreign investments into India in a tax efficient manner.
This may require a change in mind set from the first step. The structuring exercise would need to consider and build a commercial and non-tax justification supported by the underlying documents and actual conduct.
Investments made prior to April 1 2017 will be grandfathered from a GAAR perspective whereby taxability of income from the transfer of such investments will not be tested under GAAR.
Similarly, April 1 2017 is a critical date for investments from Mauritius. The amendments to the India-Mauritius DTA only shuts the equity investment route as the capital gains arising from the sale of shares would no longer be exempt from Indian taxes. However, capital gains from the transfer of other capital assets situated in India, such as units, non-convertible debentures, debt securities, etc. will continue to enjoy exemption from capital gain taxes under the amended India-Mauritius DTA, but they may be susceptible to GAAR. Therefore, the debt route may still be tax efficient under the amended India-Mauritius DTA with a 7.5% withholding tax rate on interest arising to a Mauritian beneficial owner of such debt from India. Thus, going forward, Mauritius could be the most preferred jurisdiction for debt investments into India.
Furthermore, based on this changed scenario, the Netherlands could be an interesting jurisdiction worth exploring for the purposes of investing into India. Under the India-Netherlands DTA, when a resident of the Netherlands transfers its investments in an Indian company to another foreign/non-resident buyer, its capital gains would be exempt from tax in India.
Also, in relation to indirect transfer taxation, the transferor’s jurisdiction of tax residence and the applicable tax treaty with India are also relevant as there are several tax treaties under which there is a favourable provision in this regard whereby only the residence country gets the right to tax the transaction.
Thus, all is not lost and there are structuring opportunities which could be considered while ensuring that the structures have adequate substance.
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