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Report of the Expert Committee on Retrospective Amendments made by the Finance Act, 2012 to Income-Tax Act, 1961 Relating to Taxation of Non- Residents on Indirect Transfer; Comments and Suggestions on the Draft Report to be submitted by 19th October, 2012

Executive Summary: Recommendations

Vide Finance Act, 2012, certain retrospective amendments were made in Income-tax Act, 1961 (hereinafter referred to as the Act), intended to clarify and restate the legislative intent of the source rule of taxation for non-residents in India. In particular, they addressed situations where transfers took place exclusively between such non-residents—hence indirectly—of underlying assets in India. The relevant section 9(1)(i) of the Act became effective retrospectively as of 01 April 1962.

The language and scope of the amendments led, however, to apprehensions about the certainty, predictability and stability of tax laws in India. The legislation with retrospective application in particular obviating an earlier Supreme Court decision on the matter of indirect transfer was not expected and thus perceived in negative light. The present Committee was mandated to analyze the amended provisions. Based on inputs received from various stakeholders and the Committee’s own analysis, the Committee is of the view that, as a matter of policy, Government should best avoid introducing fundamental changes in tax provisions without consultations and thus not anticipated by the taxpayer.

The adverse reactions to the amendments intermingled the two matters—retrospectivity in tax law, and indirect transfer—under the same rubric. This Report has attempted to untangle the two aspects. It addresses the issue of retrospectivity and prospectivity. It then proceeds to make a series of recommendations, including some that would apply if retrospectivity is opted for by Government, and others that would apply in either case.

The Committee concluded that retrospective application of tax law should occur in exceptional or rarest of rare cases, and with particular objectives: first, to correct apparent mistakes/anomalies in the statute; second, to apply to matters that are genuinely clarificatory in nature, i.e. to remove technical defects, particularly in procedure, which have vitiated the substantive law; or, third, to “protect” the tax base from highly abusive tax planning schemes that have the main purpose of avoiding tax, without economic substance, but not to “expand” the tax base. Moreover, retrospective application of a tax law should occur only after exhaustive and transparent consultations with stakeholders who would be affected(1).

Recommendations

(1) Reflecting that the provisions relating to taxation of indirect transfer as introduced by the Finance Act, 2012 are not clarificatory in nature and, instead, would tend to widen the tax base, the Committee recommends that these provisions, after introducing clear definitions as recommended in this Report, should be applied prospectively. This would better reflect the principles of equity and probity in the formulation and implementation of commonly recognized taxation principles.

The Committee has, however, taken due care to examine the ramifications of the possibility of Government proceeding with retrospective application, and makes the following two recommendations in case Government opts for retrospective taxation of indirect transfer –

(i) No person should be treated as an assessee in default under section 201 of the Act read with section 9(1)(i) of the Act as amended by the Finance Act, 2012, or as a representative assessee of a non-resident, in respect of a transaction of transfer of shares of a foreign company having underlying assets in India as this would amount to the imposition of a burden of impossibility of performance. This would imply that Government could apply the provisions only to the taxpayer who earned capital gains from indirect transfer.

(ii) In all cases where demand of tax is raised on account of the retrospective amendment relating to indirect transfer u/s 9(1)(i) of the Act, no interest under section 234A, 234B, 234C and 201(1A) of the Act should be charged in respect of that demand so that there is no undue hardship caused to the taxpayer. Moreover, in such cases, no penalty should be levied in respect of the income brought to tax on application of retrospective amendments under section 271(1)(c) (for concealment of income) and 271C (for failure to deduct tax at source) of the Act.

The following recommendations would apply whether indirect transfer provisions apply prospectively or retrospectively-

(2) Section 9(1)(i) of the Act is a general source rule for a non-resident. It provides, interalia, that any income accruing or arising, directly or indirectly, through transfer of a capital asset situated in India shall be deemed to accrue and arise in India and consequently be taxable. The words used in the clause, namely, “through”, “transfer”, “capital asset” and “situated in India” have been assigned additional meaning through insertion of Explanations vide Finance Act, 2012. As discussed in the Report, these Explanations need further clarifications as under –

(i) The phrase, “the share or interest in a company or entity registered or incorporated outside India,” in Explanation 5 to Section 9(1)(i) of the Act should mean and include only such share or interest which results in participation in ownership, capital, control or management. Therefore, all other types including mere economic interest should not be contemplated within the ambit of Explanation 5.
(ii) The word “substantially” used in Explanation 5 should be defined as a threshold of 50 per cent of the total value derived from assets of the company or entity, as proposed in DTC Bill 2010. In other words, a capital asset being any 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 from the assets located in India being more than 50% of the global assets of such company or entity.
(iii) The phrase “directly or indirectly” in Explanation 5 may be clarified to represent a “look through” approach which implies that, for the determination of value of a share of a foreign company, all intermediaries between the foreign company and assets in India may be ignored.
(iv) For the purposes of Explanation 5 –
(a) the value should refer to fair market value as may be prescribed(2);
(b) the value is to be ascertained based on net assets after taking into account liabilities as well;
(c) for determination of value, both tangible assets as well as intangible assets are to be considered; and
(d) the value is to be determined at the time of the last balance sheet date of the foreign company with appropriate adjustments made for significant disposal/acquisition, if any, between the last balance sheet date and the date of transfer.
(v) The phrase “an asset or” juxtaposed on the phrase “capital assets” in Explanation 5 to section 9(1)(i) of the Act appears to be an insertion to buttress the concept of capital assets. Since the objective is taxation of the transfer of capital assets alone, the phrase “an asset or” may be omitted. Indeed, it may lead to unintended consequences such as taxation of dividends paid by a foreign company.
(vi) As the provisions of section 9(1)(i) read with Explanation 5 of the Act specifically deals with transfer of shares of a foreign company having underlying assets in India, the general provisions of section 2(47) relating to transfer should not be applied on a stand alone basis.
(vii) The taxation of capital gains on indirect transfer should be restricted only to capital gains attributable to assets located in India. Thus capital gains should be taxed on a basis of proportionality between fair market value of the Indian assets and global assets of the foreign company, as proposed in DTC Bill 2010.
(3) In order to avoid undue hardship to small shareholders, it is recommended that, where shares or interest in a foreign company or entity derive, directly or indirectly, its value substantially from assets located in India, then the transfer of shares or interest in such company or entity outside India would not be subject to tax in India under section 9(1)(i) of the Act, if,
(a) in case such company or entity is the immediate holding company of the assets situated in India, the voting power or share capital of the transferor along with its associated enterprises in such
company or entity is less than 26%(3) of total voting power or share capital of the company or entity during the preceding 12 months; or
(b) in other cases, the voting power or share capital of the transferor in such company or entity along with its associated enterprises during the preceding 12 months does not exceed such percentage which results in 26% of total voting power or share capital of the immediate holding company of the assets situated in India.
(4) Exemption may be provided to a foreign company which is listed on a recognized stock exchange and its shares are frequently traded therein. The terms “frequently traded” and “recognized stock exchange” may be defined as in the SEBI guidelines and RBI regulation on overseas investments by residents respectively.
(5) Transfer of shares or interest in a foreign company or entity under intra group restructuring may be exempted from taxation subject to the condition that such transfers are not taxable in the jurisdiction where such company is resident.
For this purpose, intra group restructuring may be defined as
(a) amalgamation or demerger as defined under the Act subject to continuity of at least three fourth ownership; or
(b) any other form of restructuring within the group (associated enterprises) subject to continuity of 100% ownership.
(6) The investments made by a Foreign Institutional Investor (FII) as per regulation of SEBI are subject to tax in India in the hands of the FII. Taxation of non-resident investors {including Participatory Note (PN) holders} investing, directly or indirectly, in the FII may lead to double or multiple taxation. It may, therefore, be clarified that where

(i) a non-resident investor has made any investment, directly or indirectly, in an FII; or
(ii) the investment made by an FII in India represents, directly or indirectly, the underlying assets of investment by a non-resident,
then such non-resident will not be taxable in India on account of the provisions of section 9(1)(i) of the Act in relation to investments made by the FII in India.
(7) Private equity investors have expressed their concerns about likely taxation of gains arising to such investors outside India on account of redemption of their investments in the pooling vehicle or interse transfer amongst such investors. The recommendations suggested above in respect of “interest”, small shareholding, business reorganizations, listed companies etc. should, in totality, address such concerns of private equity investors. To reiterate, private equity investors would be outside the coverage of taxation of indirect transfer where –
(i) the investment by the non-resident investor in a PE fund is in the form of units which do not result in participation in control and management of the fund;
(ii) the investor along with its associates does not have more than 26% share in total capital or voting power of the company;
(iii) the investee company or entity does not have more than 50% assets in India as compared to its global assets;
(iv) the investee company is a listed company on a recognised overseas exchange and its shares are frequently traded,
(v) the transfer of share or interest in a foreign company or entity results due to reorganization within a group.
(8) As shares of a foreign company having underlying assets in India are deemed to be situated in India under Explanation 5 to section 9(1)(i) of the Act, this has led to an unintended consequence of taxation of income in the form of dividend arising from such shares. It may, therefore, be clarified that dividend paid by a foreign company shall not be deemed to accrue or arise in India under section 9(1)(i) read with Explanation 5.
(9) In order to provide certainty to foreign investors, it may be clarified that, where capital gains arising to a non-resident on account of transfer of shares or interest in a foreign company or entity are taxable under section 9(1)(i) of the Act and there is a DTAA with country of residence of the non-resident, then such capital gains shall not be taxable in India unless-
(i) the DTAA provides a right of taxation of capital gains to India based on its domestic law; or
(ii) the DTAA specifically provides right of taxation to India on transfer of shares or interest of a foreign company or entity.
The aforesaid recommendations may be carried out through amendment of the Income-tax Act, 1961 or Income-tax Rules, 1962 or by way of an explanatory circular, as appropriate in law. The explanatory circular may also include various observations and interpretations(4) made by the Committee while analyzing the retrospective amendments.

1 Indeed, reflecting the challenges behind just and correct application of retrospective application, there is a constitutional or statutory protection against it in several countries. Countries such as Brazil, Greece, Mexico, Mozambique, Paraguay, Peru, Venezuela, Romania, Russia, Slovenia and Sweden have prohibited retrospective taxation.
2 For this purpose, Discount Cash Flow (DCF) method in case of service sector and Net Asset Value (NAV) method for non-service sector may be used.
3 The criterion is based on provisions of the Indian Companies Act (although not applicable to a foreign company) which stipulates that a shareholder having voting power of 26% or more can block a special resolution.

(4) The Committee believes that such measures should allay the apprehensions of taxpayers and yet protect the tax base from erosion on account of indirect transfer of underlying assets in India.