India
Rajendra Nayak
Ernst & Young
India
Companies need to keep in constant touch with a changing tax environment in India, points out Rajendra Nayak of Ernst & Young
With India inching towards double-digit growth and poised to be one of the biggest markets in the world by 2050, multinationals seeking long-term growth recognise that ramping up investment in the subcontinent is the key to realising this goal. However, the need to feed and sustain an ever growing economy has reflected in the government's efforts to bolster its tax revenue, sometimes though by its belligerence in contesting settled tax positions and inadvertently vexing the investment climate for multinationals.
While the promise and potential of India is palpable, a concomitant landscape fraught with tax uncertainty on cross-border transactions requires a ground-zero assessment of judicial developments on these.
The Mauritius structure under the taxman's microscope
Mauritius has been a traditional jurisdiction for routing investments into India primarily because of the favourable capital gains provision in the India-Mauritius Tax Treaty. It is one of the few treaties where India has foregone its taxing right on capital gains arising to a Mauritius resident on alienation of shares of an Indian company. Further, the absence of a limitation on benefits (LOB) clause in the treaty has been interpreted by India's Supreme Court (SC) in the Azadi Bachao case [263 ITR 706], as not prohibiting treaty shopping and that a taxpayer has the right to arrange its affairs in any legitimate manner within the framework of law, to mitigate tax. Despite the landmark ruling, there have been several attempts by the tax authority to deny the capital gains benefits arising to a Mauritius resident, possessing the mandatory Tax Residency Certificate.
In the case of E*Trade Mauritius [2010-TIOL-20-ARA-IT], the capital gains arising to a Mauritius company (taxpayer) was challenged by the tax authority on the grounds that the taxpayer was merely a smokescreen used to avoid capital gains tax, and that the real and beneficial owner of the capital gains is its US holding company. In this case, the taxpayer held shares in a listed Indian company which were sold to another Mauritius company, and the sale proceeds were remitted to its US holding company as dividends through a capital reduction process. The tax authority passed an order requiring that taxes be withheld on the payment, which was sustained by the Bombay High Court (HC), while it did not adjudicate on the technical merits of the case. Subsequently, the issue of taxability of sale of shares of the Indian company between the two Mauritius companies was adjudicated by the Authority for Advance Rulings (AAR).
The AAR placing reliance on the Azadi Bachao ruling and a favourable administrative circular, reaffirmed the position that gains arising to the taxpayer from sale of shares of an Indian company will not be taxable in India under the treaty. It observed that the motive behind setting up conduit companies in a third country and doing business through them in a country with beneficial treaty provisions cannot be material to judge the legality or validity of the transactions, under a treaty with no LOB clause. Anti-avoidance principles emerging from judicial decisions may be limited to sham arrangements, where the parties have a common intention that they are not to create the legal rights and obligations, which they have given the appearance of creating.
Further, because the US holding company exercises acts of control over its subsidiary-taxpayer does not, in the absence of compelling reasons, dilute the separate legal identity of the subsidiary. The source of funds for the purchase of shares being traceable to the holding company, or the holding company playing a role in suggesting or negotiating the sale, or the consideration received ultimately going to the parent company in the form of dividends or for the diminution of capital, does not lead to a legal inference that the holding company in reality owned the shares.
While the AAR has provided clarity on cross-border structures involving Mauritius, there is no closure on this as the tax authority has filed a special leave petition before the SC appealing the AAR's ruling.
More recent is the case of Aditya Birla Nuvo Ltd & Others [2011-TII-26-HC-MUM-INTL], where the Bombay HC has given an adverse ruling rendered in the context of the India-Mauritius Tax Treaty. The issue pertains to the sale of shares in an Indian joint venture company (Idea Cellular Ltd) registered in the name of a Mauritius company, being the wholly owned subsidiary of a US company. The HC observed that it was the US company that engaged in business in India and owned the equity in the joint venture through the Mauritius company because it did not have any right, nor did it act independently, to acquire the shares in the joint venture, even though the shares were registered in Mauritius company's name. The treaty applies only if the investments are made by the Mauritius entity, but not where Mauritius company is not the legal or beneficial owner of the shares in the joint venture. The Court therefore held that the gains arising from sale of shares in the joint venture by the Mauritius company would not be protected by the treaty.
More indirect transfers under scrutiny
Taxation of cross-border acquisitions involving indirect transfer of shares of an Indian company has gained infamy especially since the precedential Hutch-Vodafone deal in 2007.
The Indian tax law obligates any person who makes a payment to a non-resident, which is taxable in India, to withhold taxes. As a general principle, if an acquisition involves the transfer of shares of a foreign company, it should not result in a taxable event in India.
In the case of Vodafone, Vodafone NL, a Dutch entity acquired a Cayman Islands company (further held by the Hong Kong-based Hutchison group) for $11 billion, which indirectly held a controlling stake in an Indian telecom company, Hutch Essar Limited. While ruling on whether the Tax Authority has jurisdiction to tax such a transaction, the Bombay HC [2010-TII-13-HC-MUM-INTL] observed that the acquisition price and transaction documents factored in, and recognised independently, the entitlements and rights of the Indian entity (which were transferred to Vodafone NL). In view of the special characteristics of the transaction arrangement having an Indian nexus, the HC held that the Tax Authority has the jurisdiction to tax the transaction. The court also observed that a controlling interest in a company is a not a capital asset, independent of shares in the company, and that taxation of gains from share transfers would arise where the shares are located. This case is also pending before the SC.
Controversy on this subject-matter is not restricted to the Vodafone case. In another case of an indirect transfer of an Indian company between two non-residents, the Karnataka HC in the case of Richter Holding [199 Taxman 70] ordered the taxpayer to appear before the tax authority, which was directed to consider the case and pass appropriate orders in accordance with law. The court observed that it may be necessary for the tax authority to lift the corporate veil to look into the real nature of the transaction and determine whether the acquisition includes the indirect transfer of assets and interest in the Indian company.
While all these cases may be unique on a certain set of peculiar facts and circumstances, the trend of the tax authority over recent years has been to probe cross-border transactions involving countries where there are favourable tax treaty provisions with such countries or where certain tax structures are deemed suspect. While the SC's Vodafone ruling is keenly awaited, the present environment is likely to exacerbate the ambiguity that prevails on these matters and exasperate interested investors.
Subsidiary-Parent company nexus under PE
The question of whether a subsidiary or affiliate company, having separate legal personality, can create a permanent establishment (PE) for its foreign parent, has been a matter of dispute recently, especially with respect to outsourced activities undertaken by the subsidiary company. The Delhi Tribunal adjudicated on a similar matter in the case of eFunds Corporation and eFunds Solutions US [2010-TII-165-ITAT-DEL-INTL].
In this case, the taxpayers were provided certain outsourced services by their Indian subsidiary. The tribunal observed that the basic definition of the term PE is a fixed place of business through which the business of an enterprise is wholly or partly carried on. Through which must be given a wide meaning to apply to any situation where business activities are carried on at a particular location that is at the disposal of the enterprise for that purpose.
Even though the premises from which the outsourced services were provided were not owned, rented or under the possession of the taxpayers, the criterion will be satisfied. Thus, the subsidiary resulted in a PE of the taxpayers in India under an applicable India-US tax treaty. The court also held that as the subsidiary had not been remunerated on the arm's-length basis for its activities, further profits may be attributed to determine the taxable income of the PE.
While the tribunal ruled that the premises or facility of the Indian affiliate, which provides services to its foreign group company, would result in a PE, it did not throw much light on the factors that it considered decisive for determining that the place of business was regarded as being at the disposal of the foreign enterprise. With India being one of the primary locations for outsourcing of business processes or IT services, taxation aspects of similar business structures assumes significance.
Recent trends in transfer pricing audits
Ernst & Young's 2010 Global Transfer Pricing survey indicates that transfer pricing (TP) is the most important international tax issue that multinational companies face. In the Indian context, the tax authority has been increasingly focusing on TP audits and has been making substantial adjustments to the income of the taxpayer. One major area of concern has been on the TP aspects of intra-group services. The approach of the tax authority has been to make a detailed enquiry into the nature of the services, the organizational structure of the Indian entity, the value of the services, the determination of costs, the benefit received by the Indian affiliate, the allocation key adopted and the methodology chosen to defend the payment. Taxpayers are typically asked to describe the activities undertaken by the foreign affiliates and are also asked to quantify the time spent on India.
One case in point is the Bangalore Tribunal's decision on TP aspects of management service fee, in the case of Gemplus India Pvt. Ltd [2010-TII-55-ITAT-BANG-TP]. The tribunal, applying the Benefit Test (satisfied when the service provides any economic or commercial value to the recipient of service to enhance its commercial position), held that, the taxpayer had not proved commensurate benefits received for the service fees paid to the foreign affiliate. Hence, the payment of the management services was not justified under arm's length principles. The tribunal relied on the underlying documentation of the taxpayer before concluding that there were no details available on record with respect to the nature of services rendered to the taxpayer.
Another major area of concern is TP aspects of intangible property (IP). The issue may arise in several contexts, such as the appropriate royalty to be charged by a licensee of unique IP or the appropriate intercompany transfer price for goods manufactured and sold by a controlled distributor when the manufacturer owns the trademark for the finished goods. Here, the approach of the tax authority has been to make a detailed inquiry into the nature of the arrangements entered into by the taxpayer relating to transfer or use of the IP, request the taxpayer to demonstrate the benefits received from use of the IP and to seek justification that the payment is arm's-length in nature.
Absence of specific Indian TP rules and inherent documentation difficulties in these two categories, as compared to those in tangible goods transactions, is likely to put an onerous burden on most taxpayers.
Need for clarity
As India moves towards a more open economy and emerges as a key stakeholder in global trade and commerce, cross-border transactions will continue to grow. While, unfortunately, taxation continues to be a key determinant for investing into India, a credible and consistent tax environment shaped by a clear tax policy will go a long way in helping India achieve its himalayan potential. As the country is on the threshold of ushering in a new tax code, much activity and promise is expected in the tax space.
Rajendra Nayak (rajendra.nayak@in.ey.com) is a partner, international tax services with Ernst & Young in India