Clarifications on Indirect transfer provisions under the Incometax Act, 1961

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1 22 December mber 2012 EY Tax Alert Clarifications on Indirect transfer provisions under the Incometax Act, 1961 Executive summary Tax Alerts cover significant tax news, developments and changes in legislation that affect Indian businesses. They act as technical summaries to keep you on top of the latest tax issues. For more information, please contact your Ernst & Young advisor Subsequent to the decision of the Supreme Court of India in the case of Vodafone International Holdings BV vs Union of India, the Government of India vide the Finance Act, 2012 introduced indirect transfer provisions by amending section 9(1)(i) of the Income-tax Act, 1961 with retrospective effect from 1 April These provisions sought to tax indirect transfer of an Indian asset by providing that a share or interest in a company or entity registered or incorporated outside India shall be deemed to have been situated in India, if the share or interest derives, directly or indirectly, its value substantially from assets located in India. Pursuant to the amendment made to section 9(1)(i) of the Act, representations were made by several stakeholders seeking clarification on various aspects of indirect transfer provisions. Following the representations made, the Finance Act, 2015 further amended section 9(1)(i) of the Act. In this regard, the Central Board of Direct Taxes has issued Circular No 41 of 2016 (Circular) clarifying certain aspects on the indirect transfer provisions in a Frequently Asked Question format. This alert summarizes the key features of the Circular.

2 Background Section 9(1)(i) of the Income-tax Act, 1961 (Act) provides that income accruing or arising, whether directly or indirectly, inter-alia, through the transfer of a capital asset situated in India, shall be deemed to accrue or arise in India. The Supreme Court of India in the case of Vodafone International Holdings BV vs Union of India 1 (Vodafone) held that gains arising to a foreign company from transfer of shares of a foreign holding company, which indirectly held equity interest in an Indian operating company would not be taxable in India. Post the above decision, the Hon ble Government of India (GoI) vide the Finance Act, 2012 introduced indirect transfer provisions by amending section 9(1)(i) of the Act with retrospective effect from 1 April These provisions sought to tax the indirect transfer of an Indian asset by providing that a share or interest in a company or entity registered or incorporated outside India shall be deemed to be situated in India, if the share or interest derives, directly or indirectly, its value substantially from assets located in India. Pursuant to the amendment made to section 9(1)(i) of the Act, representations were made by several stakeholders seeking clarification on various aspects of indirect transfer provisions. Following the representations made, the Finance Act, 2015 further amended section 9(1)(i) of the Act. The key highlights of the amendments made by Finance Act, 2015 have been provided below: The share or interest shall be deemed to derive its value substantially from assets (tangible or intangible) located in India, if on a specified date, the value of Indian assets: - exceeds INR 100 million; and - represents at least 50% of the value of all assets owned by the company or entity An exemption is also provided from the trigger of indirect transfer provisions to small shareholders who would mean: - If transfer is of share/ interest in a foreign company which directly owns Indian assets, the transferor [individually or with Associated Enterprises (AEs) 2 ]: Does not hold right of control or management in the foreign company; and Does not hold voting power/ share capital/ interest > 5% of total voting power/ share capital/ interest of the foreign company. - If transfer is of share/ interest in a foreign company, which indirectly owns Indian assets, the transferor (either individually or with AEs): Does not have right of control or management in relation to the foreign company; ITR 1 2 The term Associated Enterprise has been defined to mean entities which would be treated as associated from an Indian transfer pricing perspective.

3 Does not hold any rights in/ in relation to the foreign company which entitles the transferor to exercise control or management on the company/ entity which directly holds Indian assets; and Does not hold voting power/ share capital/ interest in the foreign company which results in the transferor holding voting power/ share capital/ interest > 5% of total voting power/ share capital/ interest in the company which directly owns Indian assets. Indian concerns are obligated to report cases (in a prescribed format) where a foreign entity transfers shares deriving substantial value from Indian assets. Additionally, the Central Board of Direct Taxes (CBDT) 3 had also issued the following guidelines in relation to indirect transfer provisions: Circular 4 of 2015 dated 26 March 2015, clarifying that the declaration of dividend outside India by a foreign company would not be taxable in India under the indirect transfer provisions. Indirect transfer Rules issued vide Notification 55/2016 dated 28 June 2016, which provides for valuation mechanism, determination of proportionate income, form for reporting compliance and details of documents to be maintained in relation to the indirect transfer provisions. Further, the CBDT has now additionally released Circular No 41 of 2016 (Circular). In this regard, the Circular refers to constitution of a Working Group on 15 June 2016 by the CBDT to examine the issues raised. Subsequent to the comments provided by the Working Group, the CBDT has issued the Circular clarifying certain aspects on the indirect transfer provisions in a Frequently Asked Question (FAQ) format. This alert summarises the key clarifications provided in the context of specific factual scenarios outlined in the Circular. 3 The Apex tax administrative body.

4 Scenario Structure Facts Clarification by the Circular A Fund is a pooling vehicle registered as a Foreign Investors Various Jurisdictions Portfolio Investor (FPI) in a favourable jurisdiction for investing in India The Fund may/ may not be listed in the offshore jurisdiction The Circular clarifies that transfer/ redemption of units by investors will be covered by the indirect transfer provisions. However, investors qualifying as small shareholders shall be exempt from taxation under the said provision. Fund (FPI) Offshore jurisdiction Value of India assets of the Fund constitutes more than 50% of its total assets and exceeds INR 100 million Securities India Unitholder/ investors in the Fund may transfer/ redeem their units/ shares in the Fund from time to time

5 Scenario Structure Facts Clarification by the Circular B Feeder Fund I and Feeder Fund Feeder Fund I (Country X) Investors Master Fund FPI (Country X) Various jurisdictions Feeder Fund II (Country Y) II are pooling vehicles in Country X and Country Y, respectively Monies pooled by the Feeder Funds are invested by the Master Fund, located in Country X, in Indian securities under the FPI route Investors of the Feeder Funds qualify to be small shareholders and a declaration to this effect is furnished by the Feeder Funds to the Master Fund Given that the unitholders/ investors in the Feeder Funds qualify to be small shareholders, transfer/ redemption of units by such unitholders/ investors will not be covered by the indirect transfer provisions 4. Indian Securities India Value of India assets of the Master Fund constitutes more than 50% of its total assets and exceeds INR 100 million Unitholders/ investors in the Feeder Funds may transfer/ redeem their units/ shares in the Feeder Funds from time to time 4 Thus it may be inferred that where the unitholders/ investors in the Feeder Funds do not qualify to be small shareholders, transfer/ redemption of units by such unitholders/ investors will be covered by the indirect transfer provisions.

6 Scenario Structure Facts Clarification by the Circular C Fund X, set-up in Country A is a Various pooling vehicle and makes Jurisdictions Investors portfolio investment in Asia India focused Fund (FPI) Fund X (Country A) Offshore jurisdiction 90% of the corpus of Fund X is invested in securities of companies of Country B. 10% of the corpus has been allocated for India investments Fund X has set-up an India focussed Fund for making investments in India under the FPI route Indirect transfer provisions will be applicable in the case of Fund X since the value of shares/ units held by it in the India focussed Fund derives its value substantially from assets located in India 5 India Country B Unitholders/ investors in Fund X qualify to be small investors Securities Securities 5 The Circular clarifies that the transfer/ redemption of shares/ other interest in the FPI will fall within the purview of the indirect transfer provisions.

7 Scenario Structure Facts Clarification by the Circular D Various Jurisdictions Fund A and Fund B are set-up in Country A as corporate/ noncorporate Investors Investors entities Fund A Fund (FPI) Securities Pre-amalgamation Amalgamation with Fund B Fund B Post-amalgamation Offshore jurisdiction India Value of India assets of Fund A constitutes more than 50% of its total assets and exceeds INR 100 million Fund A is merged with Fund B and such transfer is tax neutral in Country A Investors of Fund A become investors of Fund B subsequent to the merger Where Fund A and Fund B qualify to be corporate entities, indirect transfer provisions will not be applicable to Fund A since the transaction of merger with Fund B is specifically exempt under the domestic tax law [section 47(viab) of the Act 6 ] Where Fund A and Fund B qualify to be non-corporate entities, indirect transfer provisions will be applicable to Fund A in absence of a specific exemption being present in the Act In both scenarios, investors of Fund A will be taxable under the indirect transfer provisions in absence of any exemption being granted to them other than the small shareholder exemption 6 Section 47(viab) of the Act contain two conditions which need to be fulfilled for the transaction to be exempt from tax. The same being that a) at least 25% of the shareholders of the amalgamating foreign company continue to remain shareholders of the amalgamated foreign company and b) such transfer does not attract capital gains in the country in which the amalgamating company is incorporated

8 Other issues clarified by the Circular The Circular has also sought to provide clarifications on certain other aspects relating to indirect transfer provisions such as: Specified date - valuation of the asset deriving its value substantially from assets based in India will have to be determined on the specified date. The term specified date has been defined in the Act 7. Valuation methodology method for determining value of assets has been prescribed in Rule 11UB and Rule 11UC of the Income-tax Rules, Withholding tax requirements - where indirect transfer provisions are triggered, payers of income (including FPIs) will be required to comply with withholding tax requirements as specified in the Act. As per the withholding tax provisions, any person who is responsible for paying to a non-resident, any sum which is chargeable to tax under the provisions of the Act, will be required to withhold taxes at the appropriate rate prior to making payment to the non-resident. Failure to do so shall result in interest and penal consequences. Overall Perspective The clarificatory amendments made to section 9(1)(i) of the Act followed the Supreme Court decision in the case of Vodafone. This lead to a general belief amongst foreign investors in the Indian capital markets that the apparent intent of the amendment was to bring within the purview of Indian tax, transfers of substantial interests in Indian operations; ostensibly through the transfer of shares in offshore investment holding companies. However, given the wide purview of the language of the clarificatory amendments introduced, there has been on going and significant representation by various industry bodies seeking clarifications supporting the above belief and granting relief to this effect; either through further amendments in the law or by ways of issuance of Circulars. A number of representations before the GoI were made by various stakeholders on the indirect transfer provisions. Considering the concerns raised by various stakeholders regarding the scope and impact of the amendment an Expert Committee under the Chairmanship of Dr Parthasarathi Shome was constituted by the then presiding GoI to go into the various aspects relating to the amendments made by Finance Act, The Expert Committee had made various recommendations to the GoI. The Committee submitted its draft report to the GoI on 1 October 2012 which was 7 Specified date has been defined to mean a) date on which the accounting period of the company/ entity ends preceding the date of transfer of the share or interest; or b) date of transfer, if the book value of assets of the company/ entity on the date of transfer exceeds the book value of assets as on the date referred to in sub-clause (a), by 15%.

9 published by GoI on 9 October 2012 for public consultation. The Committee inter alia recommended that FPI investment into India should be excluded from the ambit of the indirect transfer provisions. The recommendations of the Expert Committee were considered several recommendations were incorporated vide amendments proposed to the Act by the Finance Act, In addition, the CBDT also issued the following guidelines in relation to indirect transfer provisions: Circular 4 of 2015 dated 26 March 2015 clarifying that the declaration of dividend outside India by a foreign company would not be taxable in India under the indirect transfer provisions. Indirect transfer Rules issued vide Notification 55/2016 dated 28 June 2016 which provides for valuation mechanism, determination of proportionate income, form for reporting compliance and details of documents to be maintained in relation to the indirect transfer provisions. However, despite the above amendments and Circulars, inter alia the following concerns remained significantly unaddressed : While specific recommendations on the non-applicability/ exclusion of the indirect transfer rules to FPIs were made by the Expert Committee, no specific exemptions were provided from indirect transfer provisions to an FPI investing in the Indian capital markets. No provision was specifically made in the language of the law, to exclude transactions where the income/ gains on the underlying transaction had already been subjected to tax in India, in the hands of a foreign entity which directly owns the assets situated in India and then subsequently distributed to its shareholders (other than by way of dividends). The present Circular has now dealt with the above mentioned areas. The Circular is clear in strictly interpreting the language of the law as it stands to the above situations and has made clear that the same would apply in the context of the various scenarios discussed in FAQ format in the Circular [It is to be noted that a Circular issued by the CBDT is binding on the Indian tax authorities]. However, the same should be read in conjunction with applicable treaty provisions and relief, if any, provided by a tax treaty should be available to taxpayers. The Circular is likely to have a far reaching impact on funds investing into Indian capital markets/ Indian companies; including specifically funds having a multi-tiered investment structure. It is now incumbent on the Fund industry and foreign investors investing into Indian assets to quickly assess the impact of the Circular on their Indian investments and their investors.

10 Comments The FAQs primarily seeks to provide clarity on applicability or otherwise of indirect transfer provisions in the hands of FPI and its investors. They also deal with certain issues on which representations were made for amendment to the law governing taxability of indirect transfers. The clarifications while provided in the context of FPI investments into India would equally apply to other foreign investments into Indian companies with similar fact pattern.

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