Taxation of Capital Gains including Indirect Transfers December 20, 2014

Workshop on Taxation of Foreign Remittances

S. R. Patnaik Partner

Amarchand & Mangaldas & Suresh A. Shroff & Co. Peninsula Chambers, Peninsula Corporate Park, Ganpatrao Kadam Marg, Lower Parel, Mumbai - 400 013 Tel: (91-22) 2496-4455 Fax:(91-22) 2496-3666 Email: [email protected]

Outline of the Presentation  Taxability of Capital Gains under the IT Act  Taxability of Capital Gains under the DTAA  Salient Features of some DTAAs signed by India  Taxability of indirect transfers under the DTAAs  Withholding tax obligations  Purchase of capital assets from an NRI  Case Studies

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Taxability of Capital Gains under the IT Act

Taxability of Capital Gains under the IT Act  Every person is liable to pay tax annually on its total income computed in accordance of the provisions of the IT Act [Section 4]  Non residents are taxable in India on income that accrues or arises, or is deemed to accrue or arise or is received or is deemed to be received in India. [Section 5 ]  As per Section 9(1)(i) of the IT Act, the following income is deemed to accrue or arise in India: “all income accruing or arising, whether directly or indirectly, …....through the transfer of a capital asset situated in India”

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Meaning of terms used in Section 9(1)(i)  ‘Capital asset’ means property of any kind held by a taxpayer whether or not connected with his business or profession subject to certain specific exemptions [Section 2(14)]  ‘Transfer’ is defined to include inter alia sale, exchange, relinquishment of assets, the extinguishment of any right therein and compulsory acquisition under law [Section 2(47)]  ‘Property’ includes any rights in or in relation to an Indian company, including rights of management or control or any other rights whatsoever [Explanation to section 2(14)]  ‘Through’ means and include ‘by means of’, ‘in consequence of’ or ‘by reason of’[Explanation 4 to section 9(1)(i)]  ‘Capital asset situated in India’ would include any share or interest in a foreign company or entity, if such share or interest derives, directly or indirectly, its value substantially from the assets located in India 5

Indirect Transfer – An Illustration  Facts

US Co French Co Mauritius Co

• US Co holds 50% shares of Mauritius Co • Mauritius Co holds 100% shares of Indian Co • Mauritius Co has no other significant assets or business operations • US Co wants an exit from its investment in Indian Co. For this purpose the US Co transfer its shares in Mauritius Co to a French Co

 Tax Implications

Indian Co

• Shares of Mauritius Co will be deemed to be situated in India • Capital gains arising to US Co on transfer of shares of Mauritius Co will be taxable in India 6

Issues In Indirect Transfer  Meaning of the term ‘substantial’ • Term not defined in the IT Act for the purpose of indirect transfer • Other sections of the IT Act prescribes a threshold in the range of 20% to 50% • Shome Committee Report prescribed a threshold of 50% • DTC 2010 had prescribed a threshold of 50%. DTC 2013 brought down the threshold to 20% • Timing of determination of substantial

• Delhi HC in 2014 in the Copal case prescribed a threshold of 50%

 ‘Shareholding threshold’ in the intermediate company • No threshold under the IT Act • Shome Committee Report has prescribed a threshold of 26% of voting power and share capital in the intermediate company • DTC 2013 has prescribed a threshold based on the control and management and effective holding of 5% of voting share capital in the Indian Co 7

Issues In Indirect Transfer  Quantum of tax liability in India • No mechanism to compute the proportionate tax liability in India • In fact, section 9(1)(i) seems to suggest that the entire gains arising from transfer of shares of foreign company may be taxable in India • LTCG / STCG could be determined based on the period of holding of the shares of the intermediate company • What if a significant business of the Indian entity was bought recently? • Indexation benefit may be available  Rate of tax • Short term capital gains at the rate of 40% • Long term capital gains at the rate of 20%/ 10% - debatable

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Taxability of Capital Gains under the DTAA

Overview of Capital Gains Article  Taxability of capital gains - Article 13 of OECD MC and UN MC  Taxability of capital gains derived on alienation of properties is dependent on the nature of asset alienated

 ‘may be taxable’ - Articles 13(1), 13(2), 13(4) and 13(5) v. ‘shall be taxable only’ [Articles 13(3) and 13(6)]  No distinction is drawn between Long Term and Short Term Capital Gains

 The mode of computation is not provided in the DTAA. Accordingly, provisions of IT Act dealing with sale consideration, cost of acquisition, period of holding , rate of tax would be applicable

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Meaning of certain terms  Capital Gains not defined under the DTAA – to be interpreted as per IT Act [Section 2(14)]  Meaning of the term ‘alienation’ • Not defined in most DTAAs

• Commentary to UN MC (2011) defines ‘alienation’ to include sale or exchange of property and also partial alienation, expropriation, transfer to a company in exchange for stock, sale of a right, gift and passing of property on death • India–Mauritius DTAA and India- Sri Lanka DTAA defines ‘alienation’ to include sale, exchange, transfer, or relinquishment of property or the extinguishment of any rights therein or compulsory acquisition under law • The definition of ‘transfer’ as used under the IT Act cannot be used to interpret the term alienation [Sanofi Pasteur Holding SA, [2013]30 taxmann.com 222 (Andhra Pradesh)] • Protocol to India-Canada DTAA specifically provides that the term ‘alienation’ includes ‘transfer’ within the meaning of the IT Act 11

Article 13(1) – Immovable Property  Article 13(1) of UN MC “Gains derived by a resident of a Contracting State from the alienation of immovable property referred to in Article 6 and situated in the other Contracting State may be taxed in that other State”  Article 13(1) of OECD MC is pari materia to Article 13(1) of UN MC  Immovable property would inter alia include • property accessory to immovable property; • livestock and equipment used in agriculture and forestry; • usufruct of immovable property

 Situs of immovable property • Immovable property should be situated in the source state • Article 13(1) would not apply if immovable property is situated in the state of residence or in a third State

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Article 13(2) - Movable property of a PE  Article 13(2) of UN MC “Gains from the alienation of movable property forming part of the business property of a permanent establishment which an enterprise of a Contracting State has in the other Contracting State or of movable property pertaining to a fixed base available to a resident of a Contracting State in the other Contracting State for the purpose of performing independent personal services, including such gains from the alienation of such a permanent establishment (alone or with the whole enterprise) or of such fixed base, may be taxed in that other State.”  Article 13(2) of OECD MC is similar to Article 13(1) of UN MC  The term ‘movable property’ is not defined in UN MC • IT Act also does not define movable property • Indian General Clauses Act, 1897 defines movable property to mean all property other than ‘immovable property’ • Includes intangible property [Vikas Sales Corporation v. CCT (1996) 4 SCC 433 (SC)] 13

Article 13(2) - Movable property of a PE  Article 13(2) may apply to gains derived on alienation of the PE or the fixed base itself . (e.g. sale of Indian branch)  Article 13(2) may apply even if the movable property is sold after PE ceases to exist [Cartier Shipping Co. Ltd. v. DDIT (2010) 131 TTJ 129 (Mum)]  In the following decisions it has been held that Article 13(2) may not apply on return of movable property by PE to HO: • Van Oord Dredging and Marine Contracts BV v. ADIT (2011 –TII-111-ITATMumbai) • Cartier Shipping Co. Ltd. v. DDIT (2010) 131 TTJ 129 (Mum)

 Irrelevant Factors • Location of movable property whether within or outside the source state • Sale of movable property whether within or outside the source state 14

Article 13(3) – Ships, aircrafts, boats etc  Article 13(3) of the UN MC “Gains from the alienation of ships or aircraft operated in international traffic, boats engaged in inland waterways transport or movable property pertaining to the operation of such ships, aircraft or boats, shall be taxable only in the Contracting State in which the place of effective management of the enterprise is situated.”

 Article 13(3) of OECD MC is identical to Article 13(3) of UN MC  Applies only when the alienator itself operates the ships etc or leases it on time charter basis and not if it is leased on bare boat charter basis [Para 28.1 of Commentary to UN MC]  Most Indian DTAAs, however, tax such gains in the State in which the enterprise owning such ships, aircrafts and boat is a resident  Since Article 13(3) is a special article, it would override Article 13(2)  However, Article 13(3) does not override Article 13(1) as it does not apply to immovable property 15

Article 13(4) – Shares of Real Estate Companies  Article 13(4) of the UN MC “Gains from the alienation of shares of the capital stock of a company, or of an interest in a partnership, trust or estate, the property of which consists directly or indirectly principally of immovable property situated in a Contracting State may be taxed in that State…..”  It also provides specific exemption from application of Article 13(4) to entities engaged in the business of management of immovable property  To meet the threshold of ‘principally’, value of immovable property should be >50 % of the aggregate value of all assets  Differences between OECD MC and UN MC • OECD MC does not cover alienation of interest in partnership, trust or estate

• OECD MC does not exclude companies which is engaged in the business of management of immovable property

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Article 13(4) – Shares of Real Estate Companies  Article 13(4) permits taxation of entire gains (not the proportion attributable to immovable property) arising from transfer of shares of company in State S  “Directly or indirectly”- Also covers transfer of shares which indirectly holds immovable property through multi-tier structure  Ratio of values to be determined based on the value of all assets without considering debts or other liabilities  Irrelevant Factors • Type of shares, i.e. equity or preference • Percentage of participation in investee entities • Whether investee is a resident of State S or resident of a third state

 Some Indian treaties do not cover alienation of interest in partnership, trust or estate (e.g. India- UAE, India- France etc)

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Article 13(5) – Shares of Companies  Article 13(5) of UN MC “Gains, other than those to which paragraph 4 applies, derived by a resident of a Contracting State from the alienation of shares of a company which is a resident of the other Contracting State, may be taxed in that other State if the alienator, at any time during the 12 month period preceding such alienation, held directly or indirectly at least ___ per cent (the percentage is to be established through bilateral negotiations) of the capital of that company”

 Article 13(5) of UN MC is not present in OECD MC  Most Indian DTAAs provide taxing rights to the state where the company is a resident, irrespective of the percentage of holding in the capital of such company.

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Article 13(6) – Residuary Provision  Article 13(6) of UN MC “Gains from the alienation of any property other than that referred to in paragraphs 1, 2, 3, 4 and 5 shall be taxable only in the Contracting State of which the alienator is a resident.”

 Article 13(5) of OECD MC is similar to Article 13(6) of UN MC  Article 13(6) would, inter alia, cover gains from • Bonds, debentures and units • Index futures, index options, stock options and stock futures (exchange traded derivatives) • Intangibles such as trademark and technology

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Salient features of some DTAAs signed by India

Salient features of some DTAAs signed by India  Some of the peculiar characteristics found in the DTAAs signed by India have been illustrated below: • No right to tax capital gains arising from transfer of shares of an Indian company (India-Singapore, India-Mauritius, etc.) • Right to tax capital gains on transfer of shares of Indian companies if such shares represent participation of at least 10% (e.g. India- France ) • Right to tax capital gains from alienation of any shares of Indian companies (Most Indian Treaties including India – Singapore, India – UAE, India – Sri Lanka) • Right to tax all types of capital gains to be determined as per the respective domestic laws (e.g. India-US, India-UK, India-Canada)

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Salient features of some DTAAs signed by India  India - Singapore DTAA • Capital Gains from alienation of shares of an Indian company is exempt from tax in India and taxable only in Singapore • Such exemption is subject to the Limitation of Benefit clause which provides that the exemption will not be available if − Affairs are arranged with the primary objective of taking advantage of the benefits of capital gains exemption − Entity which claims to be a resident of Singapore is a shell / conduit. A Singapore resident is deemed not to be a shell/conduit company if a. its total annual expenditure on operations in Singapore is not less than S$200,000, in the immediately preceding period of 24 months from the date the gains arise, or

b. it is listed on a recognized stock exchange of Singapore

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Salient features of some DTAAs signed by India  India - Switzerland DTAA • Capital gains arising to a Swiss resident on transfer of shares of an Indian company is taxable in Switzerland. However, India also has a right to tax such gains; • However, capital gains arising to an Indian resident on transfer of shares of a Swiss company is taxable only in India.

 India - Netherlands DTAA • Capital gains arising on transfer of shares of a company is taxable only in that state in which the alienator is a resident. However, gains arising from alienation of shares of a company which is resident of a State which represents at least 10% participation may be taxed in that State if the shares are alienated to a resident of such State. Thus, − If holding in Indian shares < 10% – not taxable in India − If holding in Indian shares ≥10% and shares are sold to a non-resident – not taxable in India − If holding in Indian shares ≥ 10% and shares are sold to a resident in India – taxable in India 23

Salient features of some DTAAs signed by India  India - Malaysia DTAA • No Article on capital gains • Article 23 on income from other sources will apply – taxable in India if it ‘arises’ in India

 India - Libya DTAA • No Article on capital gains • No Article on income from other sources also • Capital gains may be taxed based on their domestic tax laws - Debatable

 India - Ukraine DTAA • Gains from alienation of properties covered by Article 13(6), i.e. residuary provision is taxable only in the state where alienator is resident provided that the gains is subject to tax in that state. 24

Taxability of indirect transfers under the DTAAs

Taxability of indirect transfers under the DTAAs  As per IT Act, where indirect transfer provisions apply, shares of foreign company is deemed to be situated in India and accordingly taxed in India  Tax on indirect transfer would be subject to the benefits available under DTAA [Sanofi Pasteur Holding SA, [2013] 30 taxmann.com 222 (Andhra Pradesh)]  As per Article 13 of the UN MC, shares of foreign company will be covered under Article 13(6) as • • • •

Article 13(1) Article 13(2) Article 13(3) Article13(4)

– – – –

• Article 13(5) – • Article 13(6) –

Shares are not an immovable property Such shares may not be a movable property of a PE Shares are not ships, aircrafts, boats etc Such shares may / may not be share of a company whose value consist of principally immovable property in India Such shares are not shares of an Indian company Shares of foreign company would, thus, fall within the ambit of residuary provisions and hence would be taxable only in the state of which the alienator is a resident 26

Taxability of indirect transfers under the DTAAs  India – US DTAA (Article 13) Capital gains is taxable in both the contracting states in accordance with the provisions of their domestic law. Thus, India has the right to tax indirect transfers under India-US DTAA

 India – France DTAA (Article 14) • Gains from alienation of shares representing a participation of at least 10 per cent in an Indian company would be taxable in India • Gains from alienation of all other shares would be taxable only in France • India would not have the right to tax indirect transfers under India-France DTAA

 India – Singapore DTAA (Article 13) Gains from alienation of all shares is taxable only in the state in which the alienator is a resident. Thus, India would not have the right to tax indirect transfers under India- Singapore DTAA

 India – Bangladesh (Article 14) Gains from alienation of any shares of a company is taxable only in the state where the company is incorporated. Thus, India would not have the right to tax indirect transfers under India- Bangladesh DTAA 27

Withholding tax obligations

Withholding tax obligations  Withholding tax obligation on Purchasers • A Purchaser is required to withhold tax u/s 195 of the IT Act on capital gains arising to a non-resident seller, if such gains are taxable in India; • To determine whether the sum is taxable in India, beneficial provisions of DTAA shall have to be taken into consideration

 Risk Mitigation measures • Seller may obtain a certificate u/s 197 from the tax authorities • Purchaser may obtain a certificate u/s 195 from the tax authorities • AAR ruling may be obtained • Funds may be retained in an Escrow account to cover tax, interest and penalties • Appropriate tax indemnities may be negotiated from the Seller • Tax Insurances may be obtained 29

Purchase of Capital Assets from an NRI

Purchase of Capital Assets from an NRI  Purchase of shares and property from non resident individuals (NRIs) has become a common phenomenon  Payments made to NRIs is also subject to TDS u/s 195 irrespective of when, where or in which currency it is made.  Residential status of the payee − Residential address in the sale deed [(Meena S. Patil v. ACIT (2008) 114 ITD 181 (Bangalore) Syed Aslam Hashami v. ITO (2012) 55 SOT 441 (Bangalore )] − If one of the co-owners is non-resident [R. Prakash v. ITO (2013) 38 taxman.com 123] − Where in doubt a representation may be obtained from the Seller

 NRI sellers may claim that they are entitled to exemption from capital gains u/s 54, 54EC, 54F, 54GB  The Purchaser will be required to comply with certain procedural requirements i.e. obtaining TAN, depositing taxes, filing of TDS return, issuance of TDS certificates, etc. 31

Case Studies

Copal Research Mauritius Limited, Moody’s Analytics, USA & Ors.  Facts •

Copal Ltd., Jersey was an offshore entity which had various subsidies including Copal Mauritius 1

•

Copal Mauritius 1 further owned shares of Copal India and Copal Mauritius 2

•

Copal Mauritius 2 had another underlying subsidiary, Exevo India

 Transactions: (in chronological order) •

Sale of 100% shares of Copal India by Copal Mauritius 1 to Moody Cyprus

•

Sale of 100% Exevo US by Copal Mauritius 2 to Moody US

•

Sale of 67% of Copal Jersey shares held by its shareholders to Moody UK

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Issues before Delhi HC  Tax Avoidance • Whether Transactions 1 and 2 were put in place prima facie for the avoidance of income tax under the IT Act?

 Indirect Transfer • Whether, if a single transaction (i.e. Transaction 3) had been undertaken, it would fall within the ambit of indirect transfer under section 9(1)(i) of the IT Act and hence gains derived there from would have been taxable in India?

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Delhi HC Judgment  On the issue of tax avoidance • The Delhi HC held that the set of transactions undertaken was not to avoid tax but to achieve specific commercial results; • Effecting the Transactions 1, 2 and 3 by way of a single transaction (Transaction 3) would not achieve the same commercial result as three separate transactions would since: − Transaction 3 would only entitle the Moody Group to an indirect 67% economic interest in Copal India & Exevo US as opposed to 100% direct control by way of Transactions 1 and 2 − Sale consideration received by Copal Mauritius 1 and Copal Mauritius 2, were ultimately distributed to the shareholders of Copal Jersey, including banks and financial institutions. This would not have been possible had the transaction been structured only in the form of Transaction 3

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Delhi HC Judgment  On issue of indirect transfer • The term ‘substantially’ was read by the Delhi HC to be synonymous with ‘principally’, ‘mainly’ or ‘majority’ • The Delhi HC interpreted ‘substantially’ to mean that the shares of the overseas which is being sold, must derive more than 50% of their value from assets situated in India • Relied on − Shome Committee Report − Direct Taxes Code Bill, 2010 − OECD MC and UN MC

• Since shares of Copal Jersey derived less than 50% of their value from the underlying assets in India, even if the entire transaction was structured using only Transaction 3, it would not have be taxable under section 9(1)(i) of the IT Act 36

Sanofi Pasteur Holding SA  Facts • SBL was an Indian company 79% of whose shares were held by ShanH, a French Company

• Shares of ShanH were in turn held by two French companies – 80% by MA and 20% by GIMD • MA and GIMD transferred their shares in ShanH to Sanofi, another France company

 Issue Whether retrospective amendments in law would impact the provisions of the DTAA and/or otherwise render the transaction liable to tax under the provisions of the IT Act? 37

Andhra Pradesh HC Judgment  Retrospective amendments to the provisions of the IT Act per se cannot operate to deflect, modify, or subject DTAA provisions to the provisions of the IT Act  The retrospective amendments to section 9(1) of the IT Act cannot override the provisions of the DTAA  There is no ambiguity in Article 14(5) about the meaning of ‘alienation’ or ‘participation’ and since these terms are neither employed nor defined in the IT Act, provisions of Article 3(2) of the India-France DTAA cannot be invoked  Corporate veil of ShanH would not be pierced, considering that ShanH was an independent entity that had commercial substance and business purpose  As MA and GIMD had transferred shares of ShanH (a French company), taxation of capital gains arising on transfer is allocated exclusively to France under Article 13(5) of the India - France DTAA 38

Zaheer Mauritius  Facts Zaheer Mauritius

• JV Co, an Indian company was a wholly owned subsidiary of Vatika, another Indian company. Mauritius

Vatika

• Zaheer Mauritius subscribed to equity shares and CCDs of JV Co and thereafter, Zaheer Mauritius and Vatika became JV partners of the JV Co • Vatika exercised the call option under the SHA and purchased all the CCD’s and some of the shares held by Zaheer Mauritius

JV Co India 39

Issues before Delhi HC  Whether the gains arising on transfer of equity shares and CCDs by Zaheer Mauritius to Vatika is taxable as capital gains or interest income?  Whether the transaction between Zaheer Mauritius and Vatika was a sham and was essentially a transaction of loan to Vatika camouflaged as an investment in shares and CCDs of the JV Co?

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Delhi HC Judgment  On characterisation of income • The relevant factors for determining whether income on sale of CCD is capital gains or not is whether the CCD’s are held as capital assets by its holder • For such determination, it is immaterial whether a CCD is a loan simplicitor or in the nature of equity

 On issue of tax avoidance • It is a common practice to have covenants for buying each others' stakes to enable JV partners to exit from JV Co

• This does not convert CCDs into fixed return instruments, as the option to continue with its investment as an equity shareholder continues to exist • On review of the clauses of SHA, it held that on lifting the corporate veil, it was found that Vatika and the JV Co were not the same entity

• Issue of CCD cannot be regarded as designed solely for the purposes of avoiding tax.

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Vanenburg Facilities BV  Facts Vanenburg NL Ascendas

Netherlands

Singapore

• Vanenburg NL, a company incorporated in the Netherlands has a wholly owned subsidiary, namely VITPL, in India. • VITPL is engaged in the business of developing, operating and maintaining infrastructure facilities in India. • Vanenburg sold 100% shares of VITPL to Ascendas, a Singapore based company

 Issue VITPL India

Whether the gains arising on transfer of shares of VITPL to Ascendas is taxable as capital gains in India? 42

Hyderabad Tribunal Judgment  Shares in a company owning immovable property cannot itself be considered as immovable property  Thus , Article 13(1) of the India- NL DTAA would not apply as Vanenburg NL did not transfer any immovable property or any rights directly attached to an immovable property  Article 13(4) of the India- NL DTAA would also not apply as although the infrastructure facilities held by VIPTL would qualify as immovable property, the business of VIPTL was carried on through such assets;  Thus the capital gains on sale of shares of VIPTL falls within the ambit of Article 13(5) being the residual provisions.  Since shares of VIPTL are sold to Ascendas, not being a resident of India, capital gains would be taxable only in NL.

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Disclaimer The opinions expressed in this presentation are solely those of the presenter and not necessarily those of Amarchand & Mangaldas & Suresh A. Shroff & Co. The objective of this presentation is to provide general information about the topics being discussed and not meant to be tax advice. Anybody acting on the basis of this presentation is advised to obtain specific tax advice beforehand.

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