Today, a stable, predictable tax and regulatory regime is a sine qua non for creating a conducive climate for foreign portfolio investors (FPI). Investors wishing to invest in India will, for a very long time, see the Vodafone ruling as an indication of an unstable tax regime.
In an attempt to overrule the Supreme Court’s judgment in the landmark Vodafone ruling, in 2012, the then finance minister amended Section 9 of the Income Tax Act with retrospective effect from April 1, 1962. An Explanation was introduced into the Act that clarified that an asset or capital asset, being any share or interest in a company or entity registered or incorporated outside India, shall be deemed to be situated in India if the share or interest derives its value, directly or indirectly, substantially from assets located in India.
The provision was construed to be draconian, considering its wide scope and language, as well as the lack of clarity regarding what would be considered to be deriving value ‘substantially’ from Indian assets. The fact that such a substantive provision was implemented retrospectively raised several concerns in the minds of foreign investors, including FPI, regarding the stability and predictability of the tax regime in India. The intention of the government was to target transactions where the entire Indian business was indirectly transferred from one foreign entity to another entity without discharging any tax thereon. The amendment created quite an uproar in the media, and in the foreign investor space. The government set up an expert committee under the chairmanship of Parthasarthy Shome, to examine the provisions related to indirect transfer and to provide its recommendations to the government. The committee published its draft report, containing various recommendations relating to the provisions of indirect transfer, in October 2012.
In order to give effect to the recommendations and provide further clarity regarding the provisions of indirect transfer, the government made certain amendments to the Act vide the Finance Act, 2015, by providing quantitative criteria for the applicability of the legal fiction. A marginal exemption was also provided for transfer of shares or interest by minority shareholders holding less than 5% voting power and interest in the overseas entity that owns the shares of the Indian company. Though some recommendations of the expert committee were considered by the government, a few important ones were ignored, like an exemption for transfer of shares or interest in listed foreign entities, investment through FPI route and providing double taxation avoidance agreement (DTAA) benefits.
Since no exemption is provided to investments in India through the FPI route, and considering the quantitative criteria set for the applicability of these provisions, India-focused funds would face the greatest impact since these funds are most likely to meet the criteria of holding more than 50% of their assets in India and of their assets located here exceeding the absolute value of R10 crore. This would prove to be disadvantageous to a single country fund manager. A fund which solely invests in India will be in a disadvantageous position compared to a global fund which makes a small allocation to India. Multi-layered structures will also face taxation at multiple layers as upstreaming of cash by way of redemption of preferred stock will also fall foul of these provisions.
India is one of the most favoured investment destination within the BRICS (Brazil, Russia, India, China, South Africa) nations for foreign investors. India-focused funds have been very popular not only amongst non-resident Indians but also amongst other foreign investors looking for high growth, returns and safety of investments. These groups of investors could be hit hard if they were taxed on the capital gains they earn from redemptions/sale of holdings in these FPIs. Tax rates could range anywhere between 20% and 40%, depending upon the category to which the investor belongs, in addition to tax already discharged by the FPI. Not only would it reduce the return to the ultimate beneficial owners, but it also could lead to an increase in compliance and litigation.
Looking at the current wave of optimism in the country, which has attracted investors worldwide, investors need to be assured that a predictable, stable and non-adversarial tax regime is ensured to investors before they commit to investment invitations.
Co-authored by Shahin Badsha, director (Tax & Regulatory), PwC India
The author is partner
(Tax & Regulatory), PwC India. Views are personal