Thursday, 1 June 2017

Indian Court upheld tax assessment on capital gains

In a decision issued on 9 March 2017, the Delhi Income Tax Appellate Tribunal (ITAT) upheld a tax assessment made by India’s tax authorities on capital gains arising from a transfer by a nonresident of shares of a foreign company that derived its value solely from assets located in India. Under India’s income tax law, which allows the taxation of indirect transfers of Indian assets by foreign companies, capital gains on such sales of foreign company shares are subject to Indian capital gains tax if the foreign company whose shares were sold derives 50% or more of its value from Indian assets. The indirect transfer rules introduced in 2012 (and that apply retroactively as from 1 April 1961) have
generated considerable controversy and criticism.
The taxpayer in the case was a UK company that, through a series of complex transactions during 2006, transferred its entire shareholding in its wholly owned subsidiary (Sub 1) to a new wholly owned Indian subsidiary (Sub 2). Sub 1, which was incorporated outside of India, was the sole owner of companies that had as their only significant assets oil and gas interests located in India. Subsequent to the transfer, Sub 2 undertook an initial public offering (IPO) whereby its shares became listed on various Indian stock exchanges. In return for the shares of Sub 1, Sub 2 transferred consideration to the taxpayer partly in the form of cash (from the proceeds it received in the IPO) and partly by
issuing its own shares.
Upon examination, the Indian tax authorities determined that the taxpayer’s transfer of the shares of Sub 1 to Sub 2 was a sale that yielded capital gain income that was chargeable to tax in India under the indirect transfer rules, because Sub 1 derived its value substantially from assets located in India. The tax authorities issued an assessment order to the taxpayer, and the taxpayer appealed the assessment order to the ITAT.
The ITAT ruled in favor of the tax authorities and upheld the authorities’ determination that the transfer of the shares of Sub 1 to Sub 2 resulted in capital gains that were subject to Indian tax. The ITAT rejected a series of arguments advanced by the taxpayer, including the following:

  • The transfer of the shares was not a sale but an internal reorganization of the group, and that the reorganization did not provide an increase in wealth to the taxpayer since the controlling interest of the group was held by the taxpayer both before and after the transaction;
  • No “real” income had accrued to the taxpayer as a result of the transfer of the shares to its subsidiary (however, upon reviewing the taxpayer’s financial statements, the ITAT found that the taxpayer did earn substantial gain from the transfer, including real value earned as a result of the gains not being chargeable to tax in its country of residence); and
  • India’s domestic law should be applied as it existed on the date the relevant tax treaty between India and the taxpayer’s country of residence was notified (i.e. the law that applied before the indirect transfer rules were enacted), so the capital gains tax should not apply.
  • Since there were series of transfers, the earlier transfers within the group also should be taxable. Taking this into account, the cost basis of the shares transferred by the taxpayer should be stepped up to their fair value at the time the shares were acquired, resulting in no capital gains in the hands of the taxpayer since the sale consideration should be equal to the cost of acquisition of the shares. (With respect to this argument, the ITAT held that Indian tax law does not address this situation.)

The taxpayer also challenged the tax authorities’ levy of interest on the resulting underpayment of advance tax for 2006. On this point, the ITAT agreed with the taxpayer and held that in the case of retroactive amendments, the taxpayer could not be expected to visualize its liability for payment of advance tax in the year of the transaction and, therefore, no interest should be payable.

Source: Deloitte