Indirect transfers in the context of capital gain covers the transfer of shares of an Indian entity/assets situated in India, where the transaction occurs outside India among the foreign entities . Since India has source based taxation, i.e. any income accruing or arising, or deemed to accrue or arise, in India to a non – resident is taxable in India. In case of sale of shares of an Indian company, the situs of shares is in India. Hence, income accrues and arises in India.
The Finance Act, 2012, introduced tax on indirect transfers with retrospective effect from 1962.
The Income Tax Act, 1961 (the Act) was accordingly amended to provide that transfer of shares or interest in a company or entity registered/incorporated outside India shall be chargeable to tax in India if the value of such shares is substantially derived from assets located in India. Though an amendment was made to the Act, still there were a number of practical issues in interpretation of the same. The word ‘substantially’ which was the benchmark for deciding the taxability had not been defined. This not only created uncertainty in its interpretation but also resulted in challenges in global restructurings . Thus the finance bill left two pivotal questions unanswered:
- What is considered ‘substantial’
- How this ‘substantial value’ is to be calculated for tax purposes .
Clarification proposed in Budget 2015
To avoid ambiguity on such an important concept and based upon the
Exemption available on transfer of shares in case of merger and de-merger subject to fulfilment of certain conditions
Recommendations of the committee and the concerns raised by various stake holders , the Finance Bill, 2015 has proposed certain amendments to the existing provisions related to indirect transfer, namely:
1. Defining Substantial Value
Share of foreign company shall be deemed to derive substantial value from Indian assets if on the specified date, the fair value of the Indian assets
- Exceed INR 10 crores ; and
- Represents at least 50% of the value of all the assets owned by the company or entity
2. Manner of computing the value
- Value of an asset shall mean the fair market value of such asset without reduction of liabilities , if any, in respect of the asset.
- The manner of determination of fair market value of the Indian assets vis -a vis global assets of the foreign company shall be prescribed by the rules .
- The specified date of valuation shall be the date on which the accounting period of the company or entity, as the case may be, ends preceding the date of transfer.
- However, if the book value of the assets of the company on the date of transfer exceeds by at least 15% of the book value of the assets as on the last balance sheet date preceding the date of transfer, then instead of the date mentioned as above, the date of transfer shall be the specified date of valuation.
3. Taxation
It has been specified that only the proportionate value of assets linked to India would be subject to tax. The computation mechanism for determining the proportionality will be prescribed in the tax rules to be notified subsequently.
4. Exemptions
Certain exceptions have been carved out to provide relief to small transfers , like in the case of a transfer by a non -resident outside India of any shares in a foreign company that directly owns the assets situated in India or indirectly owns the assets situated in India and where the non -resident neither holds the right of management or control nor holds voting power or share capital or interest exceeding 5% in such foreign company.
Further, in case of a merger or de-merger, where shares of foreign company or entity which derive their value substantially from Indian assets are transferred will not be regarded as transfer provided that:
In case of merger, at least 25% of shareholders of the transferor company become shareholders of transferee company
- In case of de-merger, shareholders holding at least 75% in value of shares of transferor company become shareholders of transferee company and
- The transaction is tax neutral in the country of origin of the transferor company.
5. Reporting requirements
The Indian entity shall be obligated to furnish information relating to the off -shore transaction having the effect of directly or indirectly modifying the ownership structure or control of the Indian company or entity. In case of any failure on the part of Indian concern in this regard a penalty shall be leviable. The proposed penalty shall be:
- A sum equal to 2% of the transaction value where such transaction had the effect of directly or Indirectly transferring the right of management and control in relation to the Indian concern.
- A sum of INR 500,000 in any other case
Parting Thoughts
This is a very positive move by the Hon’ble Finance Minister as this will provide greater clarity to investors on the taxability of merger and acquisition transactions in India where shares are transferred outside the country, though the underlying asset is within the country. Foreign investors should be pleased with the budget as it tries to address many of their concerns and looks to alleviate their concerns . Further, this amendment is in line with the judgment of Delhi High Court in the case of DIT v. Copal Research Ltd., Mauritius in which it was held that the gains arising from sale of a shares of a company incorporated overseas , which derive less than 50 per cent of its value from assets situated in India would not be taxable under section 9(1)(i) read with Explanation 5 thereto.
However as a budget critic, I still have few unanswered questions from this introduction, namely on the following points , firstly since this is a prospective clarification it leaves doubts about open cases Secondly, the CBDT has not come out with rules to determine the valuation of shares which is of great essence in this . Lastly it will be interesting to see what rules are prescribed by CBDT regarding the reporting of transactions and whether they would have any inherent practical challenges .