There are specific pricing provisions governing Indian companies and investors that require primary investments to be priced appropriately. From a target’s perspective, if shares are issued to resident investors at a price higher than the fair market value, as determined on the basis of specific formulae prescribed by tax laws, the target will be charged (subject to certain exceptions) to tax on the excess so received as income in its hands. Lately, Indian tax authorities have been examining share premium charged by Indian companies on the allotment of shares to non-residents also, and are attempting to tax Indian companies on excessive share premium. A valuation report from an independent reputed valuer supporting a share allotment and the premium charged is advisable.
Primary investments in closely held Indian companies are not taxable in the hands of investors, unless, in case of equity and preference shares, such shares have been acquired below fair market value. In such cases, the investor is taxed on the difference between the acquisition price and the fair market value of the shares, as the difference is treated as income in the hands of the investor. There was previously ambiguity on whether the conversion of convertible instruments into equity shares would be taxable in the hands of the instrument holder. Only the conversion of convertible debentures was specifically exempt under Indian tax laws. However, the Indian government introduced a specific provision to exempt the conversion of convertible preference shares into equity shares from capital gains tax under Indian tax laws from 1 April 2017 onwards.
A non-resident investor will be taxed in India, subject to relief as available under the relevant tax treaty between India and the country of residence of the investor.
Gains on transfers of shares are taxable at rates based on the period of holding, the type of holder, the type of company, and in the case of transfers of shares of listed companies, whether the shares are transferred on-market or off-market. Transfers include transactions such as share buybacks and redemptions. In unlisted companies, gains are treated as short-term if shares are held for a period of up to 24 months, and long-term if shares are held for a period of more than 24 months. For non-resident sellers (other than foreign portfolio investors (FPIs)), such short-term gains are taxable at 40 per cent in the case of corporate entities and 30 per cent in all other cases; and long-term gains are taxable at 10 per cent for all types of non-resident taxpayers. The 10 per cent concessionary tax rate for long-term capital gains on the transfer by non-resident taxpayers of shares of unlisted companies was introduced in the Finance Act 2016, pursuant to a clarification announced by the Indian government in the 2016-17 Union Budget. There was uncertainty about the effective date of the above amendment to Indian tax laws. However, the Indian government clarified in the 2017-18 Union Budget that the above concessionary tax rate would apply with retrospective effect from the 2012-13 financial year onwards. In listed companies, gains are treated as short-term if securities (including shares) are held for a period of up to 12 months and long-term if securities (including shares) are held for a period of more than 12 months. If the shares are sold on-market, such short-term gains are taxable at 15 per cent and long-term gains are tax-exempt (subject to certain conditions). The 2018-19 Union Budget has proposed to tax long-term gains in excess of 1 million rupees at 10 per cent, provided that securities transaction tax is paid at both the time of acquisition and disposal. On-market transfers are also subject to payment of securities transaction tax of 0.01 to 0.125 per cent, based on the type of on-market transaction. In off-market transfers, short-term gains are taxable at 40 per cent in the case of corporate entities, and 30 per cent in all other cases, and long-term gains are taxable at 10 per cent.
Note that all of the above capital gains tax rates are exclusive of applicable surcharges and education levies.
The Indian government has also introduced two anti-abuse measures on taxation of capital gains on the transfer of shares. First, long-term capital gains tax on the sale of equity shares acquired on or after 1 October 2004 will be exempt only if the acquisition of such shares was chargeable to securities transaction tax. The Indian government has notified certain transactions that are exempt from this requirement (such as the acquisition of shares under the FDI route, and the acquisition of shares pursuant to a court order, etc). Second, for the computation of capital gains on the transfer of shares of unlisted companies, if the consideration for such transfer is less than fair market value, as determined on the basis of specific formulae prescribed by tax laws, such fair market value shall be deemed to be the full value of consideration received for purposes of computing capital gains. A similar anti-abuse provision also applies to transfers of immovable property of a value less than the value determined for the computation of stamp duty.
Additionally, capital gains on the transfer of shares of a foreign company are subject to tax in India, subject to certain exemptions, if the shares of the target foreign company derive their ‘value substantially’ from Indian assets (ie, the value of such assets represents at least 50 per cent of the value of all the assets owned by the target foreign company and exceeds 100 million rupees). The value of such Indian assets as well as all the assets owned by the foreign company is determined on the basis of specific formulae prescribed by tax laws. Indian tax laws also prescribe additional disclosure requirements in multilevel holding structures to facilitate such determination.
Transfers by non-resident sellers to resident buyers or non-resident buyers are subject to withholding of the requisite amount of capital gains tax. Non-resident investors, other than registered FPIs, may also be subject to lower tax rates depending on their eligibility to claim benefits under the applicable tax treaty between India and their country of residence. Registered FPIs are subject to a special tax regime under Indian tax laws. Indian tax laws also prescribe additional disclosure requirements in multilevel holding structures to facilitate such determination. The above indirect transfer provisions do not apply to the transfer of investments made by a non-resident investor in shares of or interest in an entity registered as a Category-I or Category-II FPI (ie, a foreign institutional investor registered as a sovereign fund or an accredited private equity fund). The above exemption has provided foreign investors with much needed relief from indirect transfer taxes.
Non-resident sellers were historically exempt from paying capital gains tax if their investments were structured through jurisdictions having a favourable double taxation avoidance agreement with India. Mauritius, Singapore, Cyprus and the Netherlands were the most popular jurisdictions for PE investors to invest into Indian companies, as capital gains and dividends are not taxable and income tax rates are low. India has amended its double taxation avoidance agreements with Mauritius, Singapore and Cyprus to be able to tax capital gains arising out of direct disposal of Indian assets. These are key jurisdictions from which substantial foreign investment has been received in the last few years. Equity shares acquired prior to 1 April 2017 by PE investors based in Mauritius, Singapore and Cyprus will continue to be tax-exempt. Equity shares acquired by PE investors based in Mauritius and Singapore on or after 1 April 2017 but transferred prior to 1 April 2019 will be taxed in India at 50 per cent of the applicable domestic Indian capital gains tax; and on or after 1 April 2017 but transferred on or after 1 April 2019 will be taxed at full applicable domestic Indian capital gains tax. Equity shares acquired by PE investors based in Cyprus on or after 1 April 2017 will be taxed at applicable domestic Indian capital gains tax. Compulsory convertible debentures and non-convertible debentures are exempt from capital gains tax for investors based in Mauritius, Singapore and Cyprus.
The Indian government has introduced General Anti-Avoidance Rules (GAAR) from 1 April 2017. It is now imperative to demonstrate that there is a commercial reason, other than for obtaining a tax advantage, for structuring investments out of tax havens. GAAR can be used to challenge arrangements with the main purpose of obtaining a tax benefit and deny benefits otherwise available under a tax treaty. Income arising from the transfer of investments acquired before 1 April 2017 have been ‘grandfathered’ from the applicability of GAAR.
Further, a foreign company is to be treated as tax resident in India if its place of effective management (PoEM) is in India. PoEM is ‘a place where key management and commercial decisions that are necessary for the conduct of the business of an entity as a whole are in substance made’. If the foreign company becomes resident in India, it would be taxed at an effective rate of 41.2 to 43.26 per cent on its global income in India. Accordingly, PE investors must exercise caution while structuring their fund management structures, and in some cases their investments, in Indian companies.
Indian companies, irrespective of their ownership and control, continue to be taxed in India on their corporate income at a rate of 30 per cent (exclusive of applicable surcharges and levies). As an incentive to start-ups and medium scale companies, the Indian government announced in the 2017-18 Union Budget that the rate of income tax for companies with a turnover of up to 500 million rupees in the previous financial year will be 25 per cent instead of 30 per cent (in each case exclusive of applicable surcharges and levies). Dividend distribution tax (DDT) at an effective rate of 20.357 per cent (computed on a gross-up basis) is payable by Indian companies on the amount of profit distributed to its shareholders and no further tax is payable by the recipients of the dividend (subject to certain exceptions in the case of non-corporate resident taxpayers). DDT is payable by every company in India. Multilevel structures will result in DDT being payable by each company while upstreaming dividends to the ultimate parent company. An exemption from this cascading effect of DDT is available only if a parent company in the structure holds more than 50 per cent of its immediate subsidiary (the parent company may avail of the exemption regardless of the extent of shares held by its shareholders); and if dividends are distributed by such parent company from dividends received from its immediate subsidiary in the same financial year when they are received, provided the same amount of dividend shall not be taken into account for reduction more than once.
Indian companies are also required to pay minimum alternate tax (MAT) on the basis of profits disclosed in their financial statements. MAT is payable by companies based on their ‘book profits’, calculated in a prescribed manner, at an effective rate of between 19.06 and 21.34 per cent when the tax liability of the Indian company computed under normal provisions of Indian income tax laws is below 18.5 per cent. MAT is applicable to Indian companies and also to foreign companies in certain circumstances, subject to exemptions on certain specified streams of income for foreign companies. The applicability of MAT to foreign companies was controversial until a recent clarification in Indian tax laws, and judicial pronouncements clarified that foreign companies shall not be subject to MAT where:
- the country of residence of the foreign company has signed a double taxation avoidance agreement with India and such company does not have a permanent establishment in India under such agreement; or
- the country of residence of the foreign company has not entered into a double taxation avoidance agreement with India and such company is not required to seek registration in India under any applicable law.
Interest income on Indian rupee-denominated debt is subject to withholding tax at a rate of 40 per cent, unless the debt investment is structured through a tax-friendly jurisdiction and the borrowing is structured as a bond with an interest rate that is below a prescribed rate. In such cases, the withholding rate can be reduced to 5 per cent if such bonds are issued prior to 30 June 2020. Debt investments by PE investors through NCDs and ‘masala bonds’ are tax-friendly as a result. Interest income on foreign currency debt is subject to withholding tax at a rate of between 5 and 20 per cent, depending on several factors. As Indian laws do not permit PE investors to avail of domestic acquisition financing, PE investors are not ordinarily subject to withholding tax in India. With effect from 1 April 2017, NCDs issued to investors based in Mauritius will enjoy a 7.5 per cent withholding tax rate on interest income, as compared to 15 per cent for those based in Singapore and 10 per cent for those based in Cyprus.
Employees in India are subject to individual income tax at varied slabs. Indian income tax laws follow a progressive slab rate for individuals. The highest slab rate is 30 per cent (exclusive of applicable cess, surcharges and levies). Income received pursuant to the exercise of stock options, severance payments and golden parachutes are taxed as salaries. Indian tax laws do not permit parties to treat share purchase transactions as asset acquisitions.
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