In its recent Budget, India introduced two major changes to its domestic tax law that look likely to have a significant impact on foreign investors investing into India. The changes mean that foreign investors may probably have to accept increased uncertainty and perhaps lower returns, and should re-examine their investment structures.
Firstly, the government plans to introduce General Anti-Avoidance Rules (GAAR), which target ‘impermissible avoidance arrangements’ and will take effect from the 2013-2014 financial year. Secondly, it announced retrospective taxation of offshore share transfers.
These Budget changes appear to affect all types of foreign investors - from Foreign Investment Institutions (FIIs) to private equity, hedge and infrastructure funds. Investments not satisfying the GAAR principles may not be entitled to tax treaty benefits and could be taxed at 10% on long-term gains from unlisted securities, at 40% for short term capital gains tax and15% in case of short-term gains on listed securities.
While the precise impact of GAAR will not be clear until underlying guidelines are finalised at the end of September, we believe that asset management companies need to review their holding structures and reassess their tax risks.
Under the new rules, the Indian Revenue Authorities (IRA) can declare an arrangement as ‘impermissible’ if its main purpose, or one of its main purposes, is to obtain a tax benefit and it:
While the IRA must prove an arrangement meets these criteria, once it has done so it has various powers including the right to disregard corporate structures, to re-characterise arrangements, to re-determine the place of residence or situs of an asset and to override treaty provisions.
Ahead of publication of the final guidelines that will detail the full impact of GAAR, the Central Board of Direct Taxes committee has recently issued a set of recommended draft guidelines for comments. From an asset manager’s point of view, the key highlights are:
While the illustrations do not specifically cover asset managers, the following key principles emerge from them and are relevant:
For asset managers, the two critical aspects are the ‘pooling’ jurisdiction and the jurisdiction of the ‘people’ performing the transaction. Typically, funds from investors are pooled in one jurisdiction, and might then be invested through a second jurisdiction, only for the asset management functions to be performed in a third. Based on the draft guideline’s illustrations, if there are no commercial or non-tax reasons for investing into India through the investing SPV in such a structure, the IRA could levy tax as if it did not exist. On the other hand, if the asset manager, pooling vehicle and investing vehicle were based in the same jurisdiction (with their own infrastructure), the illustrations’ principles suggest that the risk of GAAR being invoked might be limited. But few asset managers currently have this kind of structure.
So, while the recommendations don’t give any direct guidance to funds investing in India, you can test your existing structures against the principles emerging from them. You can then start to explore potential changes.
The retrospective taxation of offshore share transfers (with effect from April 1, 1962) seeks to tax any transfer of a share, or an interest in a foreign company or entity, if such share or interest derives, directly or indirectly, its value ‘substantially’ from assets located in India. As yet, the meaning of ‘substantial value’ has not been defined and no thresholds have been made public.
In the context of asset managers, while the Government might not intend this, a literal interpretation of the wordings may result in a potential India tax liability arising in the following scenarios (if benefit under the relevant tax treaty is not available):
Given that this provision lends itself to a very broad interpretation, there is a risk that redemptions from regulated or hedge funds may also be covered in some circumstances. Seeking more information, we have asked the Government for clarity about issues such as the taxability of an offshore fund buy-back, meaning of the term “substantially”, etc.
India’s Prime Minister recently set up a committee to finalise the GAAR guidelines by 30 September 2012. Including a senior economist, academic and a revenue official, the committee has a broad membership - so its perspectives will be interesting.
In the meantime, you would be wise to test your existing structures against the principles in the present set of recommendations.