Indirect Transfers Continues To Create Controversy

“Indirect transfers” has garnered worldwide attention in the recent past.  The controversy which begun during the year 2007, continues to be the most talked about corporate income tax controversy.  This article briefly touches upon this issue, given a recent judgment of the High Court of Delhi in Copal Research Ltd and the legislative amendments. 
 
Taxation of transfer of indirect interest held by a foreign entity in India begun with the case of Vodafone International Holdings BV and Hutchison Telecommunications International Limited, which eventually after much litigation, the matter finally reached the Hon’ble Supreme Court of India. 
 
The Apex Court held that the transfer of shares of a foreign entity, is not liable to tax in India and accordingly, the Buyer was not obligated to withhold taxes.  The controversy, though favourably decided with the Apex Court’s judgement, was re-initiated by the Indian Legislators by introducing with retrospective effect provisions to tax indirect transfers.  Explanation 5 to Section 9 of the Income-tax Act, 1961 (“ITA”) as amended is as follows:
 
“It is hereby clarified that an asset or a capital asset being any share or interest in a company or entity registered or incorporated outside India shall be deemed to be and shall always be deemed to have been situated in India, if the share or interest derives, directly or indirectly, its value substantially from the assets located in India”
 
Owning to this provision, if there is a transfer of shares of a foreign company and such foreign company derives value substantially from the assets located in India, in such cases, the seller of the shares of the foreign company shall be liable to tax in India, and the buyer of the shares of the foreign company is required to withhold tax at the time of payment of the purchase consideration. 
 
The provision created quite a stir and has since been watched by investors and tax departments across globe.  It was contemplated that the Government of India will withdraw the retrospective application of the provision on the back of the recommendations of the Expert Committee headed by Dr. Parthasarathi Shome.  However, the Indian Government has not withdrawn the retrospective operation of the provision and in the Union Budget 2014 said that the pending cases will reach their logical conclusion.  Any new cases, wherein income accrue or arise before 1 April 2012, which come to the notice to the Assessing Officer, will be referred to the Committee which has been constituted (though with no definitive guidelines being issued). 
 
The confused signals belie the Government’s policy of clarity and certainty; however, it is appeared to be driven by the revenues involved.  As the provision now reads, there remains ambiguity even in respect of the scope and ambit of the expression “value substantially”. 
 
The terms which need definitive guidelines are “substantial” and “value”.  The term “substantial” has been defined by the Expert Committee (appointed by the Government of India) at a threshold of 50% of the total value of the assets of the company or entity.  Further, “value” it has been clarified needs to be determined based on the fair market value. 
 
In relation to the term “substantial”, recently, the High Court of Delhi has defined the term to mean a threshold of 50% in the case of Copal Research Ltd.  The judgement is discussed below. 
 
Three transactions were undertaken between Copal Group and Moody Group, which are as follows:
 
1. Transaction I: Shares of COPAL Research India Private Limited were sold by COPAL Research Limited, Mauritius to Moody’s Group Cyprus Ltd on 03.11.2011. 
2. Transaction II: Shares of Exevo Inc, USA were sold by Copal Market Research Limited, Mauritius to Moody’s Analytical, USA on 03.11.2011
3. Transaction III: 67% Shares of COPAL Partners Limited, Jersey (“Copal Jersey”) were sold by individual shareholders to Moody’s Group UK Ltd on 04.11.2011. 
 
Transaction I and II involved direct and indirect transfers, which were held not to be subject to capital gains tax by the Authority for Advance Ruling (“AAR”) and consequentially there was no withholding tax obligation on the Moody Group entities.  No application was filed before the AAR in respect of Transaction III, as this was entered into after Transaction I and II were entered into and consequently not involving any indirect transfer of shares of an Indian entity.  The Revenue filed an appeal before the High Court of Delhi basically contending that the three transactions have been entered for avoidance of tax, as Transaction III would have been taxable in India, in the absence of Transaction I and II. 
 
The High Court analysed the whole transaction structure and concluded that the Transactions as undertaken, had commercial substance and cannot be said to have been entered for avoidance of tax.  The Court went ahead to analyse the taxation of Transaction III assuming that Transaction I and II had not been undertaken.
 
The Court held that Transaction III also involved indirect transfer of shares; however such indirect transfer of shares could not be taxed in India pursuant to Explanation 5 to Section 9 of the ITA, as the value derived from assets situated in India by the foreign entity was only a fraction of the total value of the assets of the foreign entity situated across the world.  This conclusion was arrived at after analysing the meaning of the term “substantial”.  The Court referred to the meaning provided by the Direct Taxes Code Bill, 2010, Report of the Expert Committee, United Nations Model Double Taxation Convention between Developed and Developing Countries (“UN Model”) and OECD Model Tax Convention on Income and Capital (“OECD Model”), to arrive at a conclusion that transfer of shares of a foreign company will be taxable in India only if the foreign company derives 50% or more value from the assets situated in India.  This test not being met by Transaction III (it was 23%), the same was held not to be taxable in India.
 
This judgement is the first judgement which has dealt with the meaning of the term “substantial” and held it to be at a threshold of 50%.  The judgement attempts to bring about certain clarity on the term “substantial”, which is required at this point of time, especially when the law is silent on this aspect.  In the absence of clarity, there is a possibility for the tax officers to apply varied interpretations, leading to further litigation.  It is therefore, critical for the Government of India to bring about definitive guidelines in this regard.  The present controversy does not end with the judgment of the High Court, as the current draft of Direct Taxes Code, which has been placed for public comments, provides for a threshold of 20%, indicating the intention of the Legislature - the logic in this behalf is that the threshold of 50% is too high.  Such a low threshold will render a lot of transactions liable to tax in India.  The Expert Committee, UN Model and OECD Model have uniformly set the threshold at 50%.  The Government should usher in clarity at the earliest, whilst heeding these views to fix the threshold at or above 50%. 
 
Disclaimer:
 
This article has been authored by Ranjeet Mahtani, who is an Associate Partner and Vidushi Maheshwari, who is an Associate Manager at Economic Laws Practice (ELP), Advocates & Solicitors.  They can be reached at ranjeetmahtani@elp-in.com or vidushimaheshwari@elp-in.com for any comment or query.  The information provided in the article is intended for informational purposes only and does not constitute legal opinion or advice.  Readers are requested to seek formal legal advice prior to acting upon any of the information provided herein.
 
Economic Laws Practice is a leading full-service Indian law firm established in the year 2001 by eminent lawyers from diverse fields.  The firm has a unique positioning from the perspective of offering comprehensive services across both indirect and direct taxes (including transfer pricing) covering the entire spectrum of transactional, advisory and litigation work.  ELP is the firm of choice for its clients due to its commitment to deliver excellence and has won several awards including Taxation Firm of the Year inIndia Business Law Journal’s Indian Law Firm Awards consistently for the past 5 years and Best Tax Firm of the Year in LegalEra Awards 2014.