In mid-2007, Vodafone acquired controlling interest in Hutchison Essar, one of India’s largest mobile telecoms operators, from Hutchison Telecoms International at a cost of nearly USD11 billion. In fact, the transaction entailed Vodafone’s Dutch subsidiary acquiring a majority stake in CGP Investments Ltd, a Cayman Islands registered company which through a maze of other subsidiaries held the Indian telecom assets of Hutchison. It is critical to note that no shares of any Indian company were transferred as part of this transaction. Despite this, the Indian tax authorities presented Vodafone with a demand for INR112 billion plus penalties (equivalent to around INR3 billion today).
Vodafone naturally appealed. Eventually, after an exhaustive series of court cases, India’s Supreme Court found in favor of Vodafone in January this year, confirming that the sale of offshore assets did not fall under the tax department’s jurisdiction.
But this was not the end of the story.
In March, the Indian government introduced a budget which included significant legislative changes impacting on international taxation and cross border transactions. In addition to the General Anti-Avoidance (GAAR) provisions, several retrospective amendments were proposed – overruling various previous judgments of the courts. In particular, the government sought to amend Section nine (which deems certain income as arising in India) of Income Tax Act 1961 retrospectively (from 1961) to make transactions such as the Vodafone purchase liable to Indian tax:
“Explanation 5. – For the removal of doubts, 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.”1
In effect, all indirect transfers of Indian assets are now caught by the tax system, and this is also retroactive.
In subsequent weeks, the international business community has woken up to the immense implications of the new regulations, which would have ramifications far wider than the Vodafone type of situation. They would potentially catch an enormous range of transactions around the world. For example, the sale and purchase of shares in an investment company with substantial Indian holdings could be caught, even though no controlling interest would change hands. Any investor selling shares in a company listed on an exchange in London or New York, but with assets in India, could be liable to Indian tax.
The new rules especially the proposed explanation four to section nine could also extend to the extensive market in participatory notes (P-Notes), derivative instruments used by many foreign investors or hedge funds that are not registered with the Securities & Exchange Board of India to seek exposure to Indian securities. The market is served by large multinational investment banks
Given the major, and still growing, global importance of India as an inward investment destination, it is unsurprising that these far-reaching new regulations should have excited extensive international concern and opposition. Following the budget, a group of seven international trade associations, ranging from Canada and the US to Britain and Asia, wrote to the Indian Prime Minister expressing their concern. In part, they said:
“There appears to be an assumption… that India’s ability to attract foreign investment is not affected by its taxation policies and practices. This simply is not the case…India will lose significant ground as a destination for international investment if it fails to align itself with policy and practice around the world and restore confidence in the relevance of the judiciary.”2
Similarly, a group of US trade associations is pressing US Treasury Secretary Tim Geithner to protest officially to the Indian government:
“We believe that the implementation of these provisions will have immediate and severe consequences for companies, affecting their willingness to commence or continue their operations in India.”3
The Indian business community is also increasingly concerned about the damage being caused to India’s reputation and the potential impact on the country’s continuing ability to attract foreign investment. The retrospective nature of the new legislation is especially damaging, since it makes the business environment inherently uncertain and implies that the government cannot be trusted.
The Indian regulators have recognized some of these challenges and decided to postpone the GAAR regulations by a year. However, no changes have been made to the retrospective amendments relating to indirect transfer of assets.
What to do?
With the continuing uncertainty, it would seem premature to take precipitate action. With respect to past transactions, there is little that can be done at this stage beyond identifying any which may fall into the net; it is useful to note that although the law is retrospective to 1962, the Indian authorities in practice only tend to act on tax due in the previous seven years. In relation to future transactions, the impact of this new measure per se may not be that decisive: since that companies will in any case derive less benefit from complex transaction structures designed to minimize tax liabilities, and will need to review their plans accordingly.
The best advice at present would seem to be – where possible to evaluate your structure and identify areas of change so as to deal effectively with the changes which the future holds.
KPMG in India
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1http://indiabudget.nic.in/ub2012-13/fb/bill31.pdf (PDF 177 KB)
2Financial Times 1 April 2012
3Quoted Financial Times, 18 April 2012