Tax Clarification That May Spook Foreign Investors And Result In Double Taxation

Indirect transfers provisions clarified but may not be to the liking of foreign investors.

A trader while working in a brokerage house in Mumbai, India. (Photographer: Prashanth Vishwanathan/Bloomberg News)
A trader while working in a brokerage house in Mumbai, India. (Photographer: Prashanth Vishwanathan/Bloomberg News)

Often in India answers to tax related questions generate more questions themselves. And that seems to be the case with the latest clarification issued by the tax department. The news is unlikely to please foreign portfolio investors in India.

On Wednesday December 21, a working group of the Central Board of Direct Taxes issued answers to 19 frequently asked questions on indirect transfer provisions contained in Section 9 of the Income Tax Act, 1961.

These provisions were first introduced in 2012, with retroactive effect, after the government failed in levying a tax on the British telecom giant Vodafone Group Plc’s purchase of Hutchison Whampoa Ltd.'s India telecommunications business.

Compliance Complexity And Double Taxation?

In the very first one the CBDT has clarified that if an investor or unit holder owning 5 percent or more in a fund registered as an FPI in India sells or redeems the shares or units, and the Fund has 50 percent or more of its money invested in India, then the investor will be liable to tax in India. Even though the Fund, when it buys and sells equity shares in India pays the relevant taxes.

Tax  Clarification That May Spook Foreign Investors And Result In Double Taxation

To be sure, the clarification sticks to a literal interpretation of the section, nothing more, but that’s exactly why it has come as a surprise says Punit Shah, partner at tax advisory firm Dhruva Advisors.

The current law provides that if any entity (fund/FPI) holds more than 50 percent of its assets in India AND an investor holds 5 percent or more interest in the Fund, then any gains earned by the investor on ‘transfer’ of units/shares in the Fund would be taxed in India.

Shah says the law was viewed as practically impossible to comply with, as all such overseas transfers would have to be tracked and reported in India. Hence representations were made to the CBDT to clarify that they should not be taxed in India. However, the December 21 circular clarifies that they will be taxable in India.

The implications are that (i) all such overseas transactions will be subject to withholding tax obligations and compliance in India, including all transactions on the overseas stock exchanges in case the fund is listed (ii) this would include redemption of units/shares by the FPIs ‎(considered as “transfer”) and would be taxable in India and subject to withholding tax, in spite of the fact that the FPI would have discharged its tax liability in India on the gains earned on the sale of shares in India (iii) Indian company, of which shares are held by the FPI, will have to track and report all such transactions to Indian tax authorities. This will considerably enhance the compliance burden on the FPIs and the Indian companies.
Punit Shah, Partner, Dhruva Advisors

It is this logistical difficulty that had prompted the need for a clarification by the CBDT. While FPIs are registered with SEBI and their transactions reported, to track their overseas unitholders and determine taxability and other details such as treaty coverage would be a mighty task.

Besides, as tax experts point out, the FPI already pays tax in India either as STT or capital gains if applicable. To also tax the unitholders amounts to double taxation of the same gains.
It could also hurt investor interest in India because had the overseas unitholder invested directly in India, it would have paid STT but could have availed of the long term capital gains tax exemption in case of an investment period longer than 12 months. But investing directly requires SEBI registration and many investors may not be keen on the paperwork. Hence they invest indirectly, except now that exposes them to tax in India.

Interestingly, so far no tax has been levied on such overseas transfers say tax experts, despite the law having changed 4 years ago and amended 2 years ago. So it’s not clear if this clarification will apply to past years’ transfers as well.

“Technical And Literal Interpretation”

Another question asks if tax is applicable in the case of an overseas fund transferring its units or shares in a sub-fund focused on India. The answer is yes.

Tax  Clarification That May Spook Foreign Investors And Result In Double Taxation

Pranav Sayta, tax partner at EY, rues the lack of relief from CBDT.

Far from providing any relief or comfort to taxpayers, the Circular seems to merely take a very technical and literal interpretation of the provisions without appreciating the need and expectation of taxpayers for a more pragmatic & fair application of the indirect transfer provisions.
Pranav Sayta, Partner, EY