India’s Budget potentially reduces investment returns

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.

Impermissible tax avoidance

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:

  • Creates rights or obligations which are not ordinarily created between persons dealing at arm’s length
  • Results, directly or indirectly, in the misuse or abuse of tax laws
  • Lacks or is deemed to lack commercial substance
  • Is not for bona fide purposes.

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:

  • GAAR will only apply to arrangements where the tax benefit exceeds a yet-to-be announced monetary threshold
  • Tax mitigation is outside GAAR’s scope but tax avoidance is impermissible
  • When acting under GAAR provisions, the IRA must observe specific time limits, forms and procedures
  • GAAR will not apply to FIIs if they subject themselves to domestic tax laws (i.e. without taking any treaty benefit); the Committee disregarded suggestions that FIIs should be exempt regardless
  • GAAR will not apply to investors in FIIs, irrespective of whether or not the FII chooses to take any treaty benefits
  • 21 illustrations have been provided to clarify the GAAR provisions.

While the illustrations do not specifically cover asset managers, the following key principles emerge from them and are relevant:

  • GAAR may not be invoked if a holding company is doing business in its country of incorporation and has substantial commercial substance in this country. The illustrations refer to Boards of Directors meeting in that country and the entity having adequate manpower, capital and infrastructure of its own.
  • GAAR may be invoked if the parent company is located in a non-treaty or unfavourable tax treaty jurisdiction and the investment is made through an intermediary holding company, and:
    • All rights of voting, management, right to sell, etc, are vested with the parent company; or
    • Funding can be traced back to the parent company; or
    • The holding company does not have substantial commercial substance in the low tax jurisdiction.
  • The recommendations state that where there is a Specific Anti-Avoidance Rule (SAAR) (there is a reference to the expenditure test, similar to the one present under the India - Singapore tax treaty), normally GAAR will not be invoked. But they also state that the IRA could invoke GAAR’s provisions in exceptional cases of abusive behaviour on the part of tax payer. The illustration around this clarifies that the IRA could, potentially, ignore an interest payment to a group concern, treating it as an impermissible expenditure.

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.

Treatment of offshore transfers

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):

  • When investors transfer or redeem shares / units in an offshore fund which invests predominantly in India
  • Where a fund redeems capital from an SPV which invests predominantly in India (at the time of exit)
  • When entities which hold substantial Indian investments distribute profits to investors/shareholders
  • When gains are passed through multiple levels of structuring, which might compound liabilities.

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.

Concluding remarks

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.