India: First landmark ruling on Indian indirect transfer taxes!
09 September 2014
Posted by: Author: Shipra Padhi
Authors: Shipra Padhi and Shreya Rao (Nishith Desai Associates)
Delhi High Court restricts their applicability
- The Delhi High Court upholds the non-taxability of gains from sale of shares of overseas entities by the Copal Group to the Moody's Group.
- Interpretation of the indirect transfer tax provisions in a restrictive manner.
- 50% threshold for substantiality based on guidance by OECD/ UN material and Shome Committee Report and DTC, 2010.
Earlier this week, the Delhi High Court came out with the first High Court ruling on the indirect transfer tax provisions, in DIT v. Copal Research Mauritius Limited, Moody's Analytics, USA & Ors.1 These tax provisions have long plagued the international investor community, particularly cross border M&A, and it was hoped that they would be removed/ clarified by the Modi government's recent maiden budget.2
The Delhi High Court has stepped in to finish the task that the Finance Bill left undone, in a lucid and landmark judgment that upholds the non-taxability (in India) of gains from the sale of shares of overseas entities by the Copal Group to the Moody's group. The primary issue underlying the writ petition filed by the Indian tax department ("Revenue"), against the order of the Authority for Advance Rulings ("AAR")3, pertained to whether the taxpayer's transaction amounted to a prima facie avoidance of tax. However, in dismissing the writ, the High Court also goes on to lay down important judicial dicta on the scope and extent of applicability of the indirect transfer tax provisions.
A. Group Structure
Copal Partners Limited, Jersey ("Copal Jersey") had various subsidiaries across the globe (UK, Middle-East & Cyprus), including a wholly owned subsidiary in Mauritius, Copal Research Limited ("Copal Mauritius 1"). Copal Mauritius 1 further owns shares of various global subsidiaries, an Indian company, Copal Research India Private Limited ("Copal India"), and a Mauritius based subsidiary – Copal Market Research Limited ("Copal Mauritius 2"). Copal Mauritius 2 had an underlying Indian subsidiary, Exevo India Private Limited ("Exevo India")..
B. Description of the transaction:
The global acquisition of the Copal subsidiaries by Moody's group was carried out in the following order:
- Transaction 1: Transfer of shares of Copal India by Copal Mauritius 1 to Moody's Cyprus
- Transaction 2: Transfer of shares of Exevo Inc. (the US-based parent of Exevo India) by Copal Mauritius 2 to Moody's Inc.
- Transaction 3: Transfer of shares of individual shareholders (to the extent of 67% stake) in Copal Jersey to Moody's Inc. Importantly, there was no direct or indirect transfer of Indian assets in this stage.
Therefore, as a part of a global acquisition of Copal's subsidiaries by the Moody's group, two underlying Indian subsidiaries were transferred to the Moody's group. A diagrammatic representation of the transaction structure is contained below in Figure 1.
C. Relevant Provisions
The Revenue's main contention was that Transaction 1 and Transaction 2 were carried out for the purpose of avoidance of capital gains tax arising from the indirect transfer of underlying Indian assets. It was further contended that had the transfer of underlying Indian subsidiaries been effectuated through Transaction 3, there would have been a tax incidence in India.
Therefore, the Revenue's position was based on the assumption that the indirect transfer tax would be applicable to the acquisition of indirect control of Indian entities.
To give a background, these indirect transfer provisions, under section 9 read with Explanation 5 of the of the Income-tax Act, 1961 ("ITA"), prescribe that when a non-Indian company is transferred by a non-resident, Indian capital gains taxes may apply if the non-Indian company derives "substantial value" from assets situated in India.
The meaning, scope and extent of the term "substantially", as provided under Explanation 5 were not clarified in the letter of law, as the provisions were introduced by Finance Act, 2012 as a knee jerk reaction to the Supreme Court's verdict in Vodafone case. While there have been indications on this in the Direct Tax Code (DTC) Bill, the Shome Committee Report, etc these recommendations are yet to form part of the law and therefore limited clarity on the issue has plagued taxpayers.
The judgment goes on to provide some valuable insights on this ambiguous subject.
Analysis of Judgment
The judgment throws light on issue of whether the transaction structure results in prima facie avoidance of tax, and provides a detailed analysis of the applicability and scope of indirect transfer taxes.
A. Whether the acquisition was structured prima facie for avoidance of tax
The Revenue contended that Transaction 1 and Transaction 2 were carried out for the purpose of tax avoidance, and should thus be disregarded. The High Court dismissed this contention on finding adequate commercial rationale behind Transaction 1 and 2 which was as follows:
- Moody's group entities wanted to exercise 100% control over Exevo Inc. and Copal India while through Transaction 3, it would have been possible to gain control over only 67% of these entities and
- The fund flows involved a payment of dividends to certain banks and financial institutions which were shareholders in Copal Jersey. This would not have been possible without Transaction 1 and Transaction 2.
The above commercial objectives could not have been met if the acquisition was structured only through Transaction 3. Thus, it was held that the transactions were not structure prima facie for avoidance of tax. This also demonstrates the Delhi High Court's affirmation of the Mauritius route provided that there is sufficient commercial rationale.
B. Restrictive application of indirect transfer tax provisions
While the High Court dismissed the contentions of the Revenue on the issue of prima facie avoidance of tax, it went on to elaborate on the applicability of Indian tax implications on account of the Revenue's contentions on Indian taxability.
The High Court was of the opinion that indirect transfer tax provisions should not apply to Transaction 3 on the basis of the following:
- The High Court examined the consideration paid for all three transactions to come to the conclusion that, as USD 93.5 million was the consideration allocable to assets situated outside India and only USD 28.53 was allocable to the Indian assets, Copal Jersey cannot be said to derive substantial value from Indian assets.
- The High Court has also expanded on how the term "substantially" as used in Explanation 5 should be interpreted to mean "principally", "mainly" or at least "majority". It has stated that a restrictive approach should be employed while interpreting a legal fiction such as Explanation 5 and concluded that for the indirect transfer tax provisions to apply, the overseas company should derive at least 50% of its value from Indian assets.
- his is particularly significant considering the lower threshold of 20% recommended under the latest draft of the DTC. However, to reach this conclusion, the High Court relied on the following:
a) The object of section 9(1)(i) is to tax gains arising out of capital assets which are situated in India and thus, while interpreting Explanation 5, the scope of section 9(1)(i) should not be extended to tax income that has no nexus with India.
b) The Shome Committee Report and the Direct Tax Code Bill of 2010 both interpreted the term "substantially" to mean a threshold of 50% of the total value derived from Indian assets.
c) The OECD Model Tax Convention on Income and Capital as well as the UN Model Tax Convention provide that for the source country to exercise taxing rights over the disposal of shares of a company, the company should derive 50% or more of its value from immovable property situated in the source country.
On this basis, the High Court was of the opinion that there should be no Indian tax liability on Copal Group or withholding tax obligations on the Moody's group as a result of the acquisition.
This judgment provides much needed clarity to foreign investors on the applicability of indirect transfer tax provisions, as being one of the first judgments to have delved into the meaning, scope and extent of the term "substantially" in the context of indirect transfers. However, there are some key points on which we would need to continue to wait and watch.
What is substantial enough: By relying on the Shome Committee Report, OECD/ UN material and interpreting the statutory amendments in detail, the High Court has tied together several discussions on the indirect transfer provisions since they were first introduced in 2012. Unfortunately, while reliance was placed on the interpretation provided by the DTC Bill of 2010 which sets a 50% threshold, the latest draft of the DTC Bill was introduced by the previous government earlier this year lowering the threshold to 20%, has not been considered. On the basis of the High Court's reasoning, it is unlikely that the revised DTC Bill would have impacted the Court's decision – however, the point is now a subject of hypothesis.
How to value "substantial": The High Court has determined 'value' in terms of the share consideration paid for different legs of the transaction. However, there is currently no clarity on the manner in which 'value' of Indian subsidiaries may be determined i.e. whether it should be an asset value of the subsidiaries, revenue based value or some other value.
Impact on retrospective application – None: Importantly, the High Court did not (and was not required to) deal with the retrospective effect of the amendments to section 9. For this, one would need to wait for the matters pending at various High Courts challenging the constitutional validity of the retrospective amendments.
Interpretation of GAAR: While the Delhi High Court has confirmed that the commercial justification provided in the present case is sufficient to demonstrate prima facie avoidance of tax, one would need to wait and watch as to whether it would be sufficient to avoid the rigours of GAAR.
Overall, the tide seems to be shifting, slowly but steadily. This judgment is one of the several smaller changes being made towards improving the investor climate in India, by the regulatory authorities, Finance Minister or courts and has been much awaited for a while now.
1 W.P.(C) 2033/2013
2 For insights on Budget 2014-15
3 Moody's Analytics and Ors v. AAR, AAR No. 1186 of 2011, AAR No. 1187 of 2011, AAR No. 1188 of 2011 decision dated June 7, 2012.
This article first appeared on mondaq.com.