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Deals: India wants more taxes from cross-border M&A

KR Girish and Himanshu Patel, of KPMG, explain why high profile legal cases provoke a change in the law

Though mergers and acquisitions provide a substantial upside, shareholders will have to bear the brunt of the taxman. The revenue authorities are exploring the possibility of generating tax from cross-border M & A resulting in the transfer of beneficial interest of the Indian company. This is on the basis of substance theory that the country has a right to claim tax on the profit generated from the business carried out in India, which itself is a very debatable subject.

The concept of levy of tax on transfer of beneficial ownership in a cross-border transfer is not provided for in the current tax legislation. The Hutch-Vodafone and a spate of other overseas deals involve taxability of transfer of shares of a holding company (having an Indian operating subsidiary company) outside India. As per the press reports, this has lead the Central Board of Direct Taxes (CBDT) to propose an amendment in Section 9 of the Income-tax Act, 1961 (the Act) dealing with deemed accrual of profits and income of a foreign entity in India.

Before going into the specifics of the proposed amendment and its ramifications, let us understand the root cause behind the same.

Hutch – Vodafone deal

Hutchison International, a non-resident seller and parent company based in Hong Kong sold its stake in the foreign investment company CGP investments Holdings Ltd, registered in the Cayman Islands (which in turn held shares of Hutchison Essar - Indian operating company, through another Mauritius entity) to Vodafone, a Dutch non-resident buyer. The deal consummated for a total value of $11.2 billion, which comprised a majority stake in Hutchison Essar India.

In the light of this, the Revenue issued show-cause to Vodafone asking for an explanation as to why Vodafone Essar (which was formerly Hutchison Essar) should not be treated as an agent (representative assessee) of Hutchison International and asked Vodafone Essar to pay $1.7 billion as capital gains tax.

The whole controversy in the case of Vodafone is about the taxability of transfer of share capital of the Indian entity. Generally the transfer of shares of a non-resident company to another non-resident is not subject to tax in India. But the revenue department is of the view that this transfer represents transfer of beneficial interest of the shares of the Indian company and, hence, it will be subject to tax.

On the contrary, Vodafone’s argument is that there is no sale of shares of the Indian company and what it had acquired is a company incorporated in Cayman Islands which in turn holds the Indian entity. Hence the transaction is not subject to tax in India.

However, the revenue authorities are of the view that as the valuation for the transfer includes the valuation of the Indian entity also and as Vodafone has also approached the Foreign Investment Promotion Board (FIPB) for its approval for the deal, Vodafone has a business connection in India and, therefore, the transaction is subject to capital gains tax in India.

Following the notice, Vodafone Essar had approached the Bombay High Court in September 2007 challenging the department’s move to levy capital gains tax following the Vodafone-Hutch deal. The Bombay High Court has decided to admit the petition subject to maintainability.

The Genpact deal

Genpact originally was established in 1997 as GE Capital International Services, a captive subsidiary of GE Capital, to handle tasks such as credit card application processing, collections and accounting for GE's financial services businesses. At the end of 2004, GE divested 60 percent of the firm to US based private equity investors for $500 million dollars. GE did not pay any capital gains tax on such sale. The tax authorities have sent notices to Genpact asking for the details of the deal.



The Idea Cellular deal

AT & T sold its stake in Idea Cellular (an Indian company) to the TATAs. The tax authorities have issued a notice to TATA Industries for not withholding tax on purchase of AT&T stake.

Although AT&T had invested in Idea through Mauritius, the department believes it was a conduit company and effectively, AT&T US invested in India resulting in capital gains liability in India.

Based on the above, the CBDT has re-opened about 400 cases of large and mid-sized transactions that took place during the past six to seven years. Significantly, there were around 300 PE deals clocked in India in 2006 involving transaction value in excess of $5 billion.

Position under the law

The current legislation provides for taxation of gains arising out of transfer of the legal ownership of the capital asset in the form of sale, exchange, relinquishment or extinguishment of any rights therein or compulsory acquisition under any law. Section 9 of the Act deems gains arising from transfer of a capital asset situated in India to accrue or arise in India. In a cross-border transfer involving transfer of shares, normally the situs of the capital asset provides the safe guide to decide as to which of the contracting states has the power to tax such income subject to the relevant tax treaty.

As mentioned earlier, the concept of levy of tax on transfer of beneficial ownership in a cross-border transfer is not provided for in the current tax legislation. However, the revenue authorities are of the view that, in a cross-border transaction, the valuation for the transaction includes valuation for the Indian entity as well and, accordingly, the overseas entity has a business connection in India.

The Supreme Court, in R D Aggarwal & Company’s case, which was a case decided in as early as 1965, held that a business connection involves a relation between a business carried on by a non-resident which yields profits or gains and some activity in the taxable territories which contributes directly or indirectly to the earning of those profits or gains. It predicates an element of continuity between the business of the non-resident and the activity in the taxable territories.

Accordingly, the Revenue holds that, in a cross-border transaction, gains arising out of transfer of shares of overseas entity attributable to the operation of the Indian entity should be subject to tax in India, in view of the business connection of the overseas entity with the Indian entity.

The proposed amendment to section 9 of the Act is to give an authority of law to the aforesaid reasoning of the department. Given the re-opening of the past cases, and the retrospective amendment to section 9 of the Act brought by the Finance Act 2007 with effect from 1 June 2007 purportedly to overrule the decision of the Supreme Court in the case of Ishikawajma Harima Heavy Industries, it is likely that the proposed amendment to tax overseas M & A deals could also be retroactive.

Impact of the proposed amendment

The proposed amendment, if enacted in the Finance Act 2008, would have a major impact on transfer of shares overseas, especially in case where the seller of the shares is a tax resident of a country like Hong Kong, Cayman Islands or British Virgin Islands, with which India do not have double taxation avoidance agreement. In such cases, the seller would become liable to tax in India under the domestic law. Further, such companies would be required to file return of income in India and fulfil other compliances under the Act.

The amendment would also bring the investors from countries like the US and UK within the tax net in India, since India’s DTAA with such countries provides for taxation of capital gains in accordance with the domestic tax laws of India.

Investors who are tax residents of countries like Mauritius, Singapore, Cyprus, etc., would not be immediately impacted by the amendment, since India’s DTAA with these countries provides for exclusive taxation of capital gains in those resident countries. This is because Section 90 of the Act provides that the provisions of the Act, or the applicable DTAA, whichever is more beneficial, shall apply.

Further, certain DTAAs (for example, Kuwait) provides for taxation of capital gains in the country of which the company issuing the shares is a tax resident. In the case of overseas M & A deals, the company issuing the shares, typically, would not be a tax resident of India. Hence, the beneficial provisions of the DTAA could be availed for non-taxability in India.

Currently, a large chunk of the Foreign Direct Investments into India is coming from favourable offshore jurisdictions. The CBDT has to bear in mind the impact of the proposed amendment on the future flow of FDI into the country. Whether the Finance Minister would be able to perform a balancing act of moderating the capital flows into India, and at the same time take forward the growth trajectory, one has to wait and watch for the Budget on February 29.

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