Flip-flop on taxing indirect transfers

Tax experts expect significant clarifications in the Budget to address double-taxation concerns

On December 21, the Central Board of Direct Taxes (CBDT) issued a circular clarifying that offshore vehicles, including foreign portfolio investors (FPIs), were subject to indirect transfer provisions. The move set alarm bells ringing in fund houses from Hong Kong to London and New York.
 
Effectively, the indirect transfer provisions imposes taxes on offshore transactions if the value of Indian assets represent 50 per cent or more of the value of all assets owned by the FPIs.
 
The circular contained responses to queries on the indirect transfer provisions in a number of different contexts, such as redemptions by offshore funds registered as FPIs, master-feeder structures, and corporate reorganisations. “While the expectation was that the circular would examine the practical problems being faced by stakeholders and propose rectifications to the indirect transfer provisions or, at least, relax the rigours arising from a mechanical application of the existing provisions, the circular instead confined itself to an excessively literal interpretation and provided little guidance to stakeholders,” a note by Mumbai-based law firm Nishith Desai Associates said.
 
Following representations from individual funds, including FPIs, venture capital funds and industry bodies such as the Asia Security Industries & Financial Markets Association (Asifma), the government decided to keep the operation of this circular in abeyance. While the move has come as a temporary relief, foreign investors still see the sword of double-taxation hanging above their hard-earned returns. They expect the upcoming Budget to take significant steps to address the issue in a wholesome manner.
 
Tax more than gains
 
Some officials say the funds and consultants brought it upon themselves by bombarding the government with queries on how the law would apply in different situations.  On June 15, the CBDT had constituted a working group to examine the issues raised by stakeholders with respect to the indirect transfer provisions added in the Indian tax rules in 2012. After considering the comments of the working group, the CBDT, through the December circular, issued clarifications on the concerns raised in the format of answers to frequently asked questions. As many as 19 situations were addressed in the circular.  
 

The original purpose of the legislation was to target foreign investors holding a significant stake in an Indian company that rather than selling the shares of the Indian company sold the offshore holding company and avoided Indian tax. The legislation followed the Supreme Court ruling in the Vodafone case. Shefali Garodia, partner,  BMR & Associates LLP, said, “The law on indirect transfers was brought in to tax Vodafone-type cases, where instead of selling Indian shares, foreign holding companies are sold. There is no merit in extending this law to offshore funds, where the funds and investors in the funds both will pay tax.”
 
The provisions will have a significant negative impact on investing in India, say foreign funds.  “It results in multiple layers of taxation because an FPI could already be paying tax on its direct trading of Indian securities and then – now under the indirect transfer provision -- taxed again when it distributes the gains up through its holding structure via redemptions or when investors in the FPI transfer their interests in the FPI.  The situation is compounded if the FPI is part of a multi-tier fund structure. The total tax can be greater than the actual gain,” said a note prepared by foreign funds.
 
According to the clarifications, FPIs are required to report, withhold, and pay the taxes on gains derived by their investors.  “This is an overwhelming compliance burden, and may be practically impossible to comply with for widely held or listed funds,” the investors added.  And, since the ‘clarification’ is effective from 1961, it is a retroactive tax and retroactive burden.
 
The move also is contradictory to the government’s efforts to encourage funds to invest in India and develop the onshore fund management business. Funds with a focus on India will be adversely affected as they are more likely to hit the 50 per cent threshold. The move also went against the government’s own verbal assurances that the provisions were not intended to apply to these situations.
 
Suresh Swamy, partner, financial services tax, PwC, said, “Currently, the circular is merely kept in abeyance. The government should consider withdrawing the circular altogether, and also simultaneously amending the tax law to exclude investors in the FPI from the applicability of overseas transfer provisions. Care has to be taken to ensure that the exemption is provided with retrospective effect rather than merely making it prospective.”
 
Relief in Budget
 
India is an outlier on this. No other jurisdiction imposes such indirect transfer tax on widely held funds.  Goradia of BMR added, “Many countries do not tax non-residents on sale of shares even where there is a direct transfer. Some countries in Asia and BRICS do tax non-residents on sale of shares, including on indirect transfers.  Notably China and Israel have such a provision.  Australia has such a rule for real estate holding companies. I am not aware of any country which has a law that taxes the same income at multiple levels.”
 
Swamy of PWC said, “Other economies apply overseas transfer provisions very differently and do not apply them to portfolio investors in general.” Foreign investors will mostly look for amendments to safeguard against double taxation, Goradia feels.  “The Shome committee has already given its recommendation on limiting the scope of indirect transfer tax, by exempting intra-group transfers, foreign-listed companies and for investors in offshore funds. The government should fully adopt these recommendations so that there is no ambiguity while applying the law.”
 
Nishith Desai Associates expected that a definitive step will be taken towards resolution of the issues in the Budget itself. “It is possible that such resolution may also be in the form of amendments to the Income Tax Act through the Budget, with the Budget speech scheduled to be delivered soon on February 1, 2017. Accordingly, the CBDT might modify the circular and operationalise it with a suitably amended scope and application,” the note said.

Where foreign investors fear to tread

• Indirect transfer provisions taxes offshore transactions if the value of Indian assets represented 50 per cent or more of the value of all assets owned by the FPIs
• No other jurisdiction imposes such indirect transfer tax on widely held funds
• Despite a temporary relief, foreign investors still see the sword of double-taxation hanging above their hard earned returns