An acquisition of business assets and liabilities in India would have to be undertaken by a company incorporated in India, since a foreign company cannot directly own assets and carry on a business in India, except through a branch office, a project office, liaison office or a wholly owned subsidiary in certain cases, subject to prescribed restrictions.
Where stock in a company is being acquired, it may be preferable for the acquisition company to be established outside India for the following reasons.
An Indian company is subject to corporate tax at the rate of 30 per cent (plus applicable surcharge and cess). In addition, the distribution of dividends is subject to DDT at the rate of 17.65 per cent (plus applicable surcharge and cess) in the hands of the company. Also, dividends paid and the DDT thereon is not tax-deductible. The gains arising from the sale of shares in an Indian company trigger capital gains tax implications in India. Further, India does not permit the consolidation of profits or losses for tax purposes for group companies.
Thus, in the case of an Indian acquisition company, repatriation of profits from the target company by way of distribution of dividends could be subject to two levels of DDT (first, when the target company distributes dividends to the Indian acquisition company, and second, when the Indian acquisition company distributes dividends to its foreign parent). This dual impact is, however, relaxed in cases where the Indian acquisition company holds more than 50 per cent of the equity share capital of the target company. In such a case, the dividends distributed by the target company on which the target company has paid DDT are allowed as a deduction in the hands of the Indian acquisition company, while computing its DDT liability in the same financial year. Upon the sale of stock of the target company by an Indian acquisition company, there would be two levels of tax: first, capital gains tax on the sale of shares, and second, DDT on the distribution of such gains as dividends. In addition, the distribution of dividends is subject to Indian corporate laws, which permit dividends to be paid only out of profits.
On the other hand, if the acquirer company is outside India, there would be one level of tax in India, in the case of distribution of profits by the target company in the form of dividends. Further, in the case of the sale of the shares in the target company, one level of capital gains tax would be triggered in India. The capital gains tax incidence could be mitigated if the acquisition was made from jurisdictions such as Cyprus, Mauritius, the Netherlands, Singapore, etc, by relying on the favourable tax treaties that India has with these countries, subject to the satisfaction of Limitation of Benefit (LOB) test and GAAR Regulations (discussed later). The substance test will vary from treaty to treaty and further upon terms of the covered tax agreements (CTAs) under multilateral instruments (MLIs). There has been significant debate in India on whether the benefits granted under the tax treaties are being abused by offshore companies resorting to treaty shopping, and the government has been engaging in a renegotiation of tax treaties with some countries. Tax treaties with Singapore, Cyprus and Mauritius have been negotiated and revised, as discussed later. The tax treaty with the Netherlands is under negotiation. While having a tax residency certificate (TRC) (disclosing prescribed particulars either in the TRC itself or in a separate prescribed form) from the revenue authorities of the home country is the basic and most essential requirement for claiming tax treaty benefits, the revenue authorities are also laying increased emphasis on the substance in the offshore holding companies set up in jurisdictions with favourable tax treaties. The substance test will vary from treaty to treaty and, in future, upon the terms of CTAs under MLIs.
The India-Mauritius tax treaty was amended in May 2016 to introduce a source-based taxation of the capital gains earned by a Mauritian resident on the transfer of shares in an Indian company. Pursuant to this amendment, capital gains arising from the sale of shares of Indian companies that are acquired and transferred between the period 1 April 2017 and 31 March 2019 are to be taxed at 50 per cent of the domestic tax rate (subject to satisfaction of certain LOB conditions), while capital gains arising on transfer of shares of Indian companies acquired after 1 April 2017 and sold after 31 March 2019 will be taxable at the full domestic tax rate. All investments made in shares of Indian companies before 1 April 2017 are grandfathered and will continue to enjoy exemption under the India-Mauritius tax treaty. The above-mentioned amendment does not apply to any asset other than shares in an Indian company (ie, gains arising from the transfer of any other securities issued by Indian companies will continue to be exempt from capital gains tax under the India-Mauritius tax treaty).
Aside from the above, the Financial Services Commission, Mauritius, has also notified requirements to be complied with by a Mauritius Global Business Licence Company - Category 1 (GBL-1) (which is the kind of company primarily used for Indian acquisitions) to be eligible for obtaining a TRC. These requirements essentially necessitate GBL-1 companies to have economic substance in Mauritius, such as having office premises in Mauritius, employing a full-time Mauritian resident at a technical or administrative level or have arbitration in Mauritius, etc.
Similar to the revision in the India-Mauritius tax treaty, the tax treaty with Singapore has undergone its third revision since its inception on 24 January 1994, wherein a protocol has been inserted providing for taxing the capital gains arising out of the sale of shares of an Indian resident company that were acquired on or after 1 April 2017 in India. However, shares acquired before 1 April 2017 shall be outside the scope of taxation in India and shall continue to enjoy the capital gains tax benefit in accordance with the erstwhile tax treaty provisions, subject to the fulfilment of revised LOB provisions. The erstwhile India-Singapore tax treaty provided for capital gains tax exemption in India in cases of transfer of shares of an Indian company, subject to the satisfaction of the LOB condition (ie, shares of the Singapore transferor company should be listed on a recognised stock exchange in Singapore or total annual expenditure on operations in Singapore should be equal to or more than S$200,000 in the immediately preceding period of 24 months from the date the gains arise).
Transitional provisions have also been notified wherein a relaxation of up to 50 per cent of capital gains tax has been provided to capital gains arising on the transfer of shares acquired after 1 April 2017 but before 31 March 2019 (the transition period), subject to revised LOB provisions. Under the revised LOB provisions, the expenditure threshold shall be applied during the period of 12 months immediately preceding the date of gain for cases falling within the transitional period.
The government classified Cyprus as a notified (uncooperative) jurisdiction in 2013. However, subsequent to the revision of the bilateral tax treaty on 18 November 2017, the government rescinded its notification. The amended India-Cyprus tax treaty provides for source-based taxation of capital gains arising from the sale of shares in the source country. Grandfathering provisions have been introduced pertaining to gains on the sale of share investments made prior to 1 April 2017, in respect of which capital gains will continue to be taxed in the country of residence of the taxpayer. No LOB clause has been notified in the revised tax treaty.
General Anti-Avoidance Rule (GAAR)
The Finance Act 2012 introduced the GAAR, which came into effect on 1 April 2018. GAAR provisions could apply if an arrangement is declared an ‘impermissible avoidance arrangement’; in other words, an arrangement for which the main purpose is to obtain a tax benefit, and that satisfies certain other tests. The GAAR provisions effectively empower the revenue authorities to deny the tax benefit that was being derived by virtue of an arrangement that has been termed ‘impermissible’.
Further, the GAAR provisions lay down certain scenarios in which an arrangement or transaction would be deemed to lack commercial substance, such as if the situs of an asset or a transaction, or one of the parties to the transaction, is located in a particular jurisdiction only for tax benefits. Thus, interposing special-purpose vehicles in a tax-friendly jurisdiction, devoid of any commercial substance or rationale, would be one practice that the revenue authorities would seek to challenge through the GAAR. As per the recent Central Board of Direct Taxes (CBDT) Circular No. 7 issued on 27 January 2017, where anti-avoidance rules (LOB) exist in a tax treaty, GAAR provisions should not be invoked in cases where such LOB provisions sufficiently address the tax-avoidance strategy of the taxpayer.
Recently, India has signed MLIs in support of the OECD’s BEPS Action Plan 15. India has opted for Simplified LOB (SLOB) and the Principle Purpose Test (PPT) for all its CTAs. The PPT is broader than Indian GAAR, since under the Indian GAAR provisions, one of the main purposes of an arrangement is tax benefits. In the PPT, ‘one of the main purposes’ of entering into an arrangement is to obtain treaty benefits, which is the decisive factor for identifying treaty abuse. Further, the PPT has a carve-out wherein a treaty benefit is granted to a transaction if such a benefit is in accordance with the object and purpose of the relevant tax treaty.
A notification has been issued by the government laying down certain exclusions from the scope of applicability of the GAAR provisions. The revenue authorities will not be empowered to invoke GAAR in cases of income arising to a person from the transfer of investments made before 1 April 2017. Further, the revenue authorities will not be empowered to invoke GAAR in cases where the tax benefit in a year arising to all parties to the arrangement (in aggregate) does not exceed 30 million rupees. GAAR will also not apply to:
- foreign institutional investors (subject to certain conditions) who have invested in listed or unlisted Indian securities and have not obtained any treaty benefits;
- non-residents, in respect of their investments in offshore derivative instruments; and
- investments made prior to 1 April 2017.
The Finance Act 2012 introduced a retrospective provision for Indian taxation on any gains from the transfer of shares (or interest) of an offshore company or entity that derives value substantially from assets located in India (indirect transfer provisions). The CBDT issued a clarification in May 2012 directing no reopening of cases on account of indirect transfer transaction where the tax assessment stands completed and no reassessment notice was issued before 1 April 2012. Further, on 28 August 2014, a committee was formed comprising senior officers of the CBDT, namely joint secretary (FT&TR-I), joint secretary (TPL-I) and commissioner of income tax (ITA), with the director (FT&TR-I) being the secretary of the committee. The tax officers need to seek a prior approval of the committee before initiating any action on the taxability of indirect transfers prior to April 2012. The Finance Act 2015 introduced further clarifications regarding the applicability of the indirect transfer provisions. Dual conditions are required to be fulfilled for the applicability of these provisions:
- the FMV of Indian assets exceeds 100 million rupees on the date on which the accounting period of the offshore entity (indirectly holding such assets) ends preceding the date of transfer; and
- the FMV of Indian assets represents at least 50 per cent of all the assets owned by the offshore entity.
In addition, to provide relief to minority shareholders, it has been provided that a transaction of an indirect transfer will not be subject to Indian tax if the transferor (along with its associated enterprises) does not hold, directly or indirectly, the right of control or management and voting rights, share capital or interest exceeding 5 per cent in the foreign entity at any time in the 12 months preceding the date of transfer. The indirect transfer of shares of an Indian company pursuant to amalgamation or demerger of foreign companies has also been exempted from Indian tax, subject to the fulfilment of specified conditions.
The CBDT has issued valuation rules with respect to the indirect transfer provisions. The rules prescribe:
- a methodology to calculate the FMV of the Indian assets based on the nature of the asset;
- a methodology to calculate the FMV of the total assets of the offshore entity whose shares are being transferred;
- a methodology to determine the income attributable to Indian assets that will be taxable in India; and
- compliances to be undertaken by the transferor to disclose the basis of arriving at the income attributable to Indian assets.
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