Research

(Temporarily) Avoiding the General Anti Avoidance Rule (“GAAR”)

The Bill has proposed that the implementation of GAAR be deferred by two years and GAAR provisions be made applicable to income arising on or after April 1, 2017.

Once effective, GAAR may be invoked by the Indian income tax authorities in cases where arrangements are found to be ‘impermissible avoidance arrangements’ i.e. an arrangement, the main purpose of which is to obtain a ‘tax benefit’, and, among other things, such arrangement ‘lacks’ or is ‘deemed to lack’ commercial substance in whole or in part. Further, where GAAR is invoked, the taxpayer would not have the option of being governed by the relevant tax treaty provisions.

It is however being proposed that investments made prior to April 1, 2017 will be grandfathered, and when implemented, GAAR would apply only prospectively to investments made on or after April 1, 2017. 

Pass through status to Category I and Category II Alternative Investment Funds (“AIFs”)

The Bill has proposed to provide a special tax regime for taxation of (i) Category-I AIFs1 and (ii) Category-II AIFs2 registered with the Securities and Exchange Board of India (“SEBI”).

1. Category-I AIFs are AIFs that invest in start-up or early stage ventures, social ventures, small and medium enterprises, infrastructure or other areas which the government or regulators consider as socially or economically desirable.
2. Category-II AIFs are funds (including PE or debt funds) which do not fall in Category-I or Category-III (use complex trading strategies and leverage such as hedge funds) and which do not leverage themselves other than for day to day operational requirements. Private equity funds and debt funds for which no specific incentives or concessions are given by the government or any other regulator fall under this category.

The special tax regime provides for a tax pass through to the specified AIFs in respect of all income, other than income chargeable under the head ‘Profits and gains of business and profession’ (“Business Income”), of the AIFs. Income (other than Business Income) payable to the unit holders will be subject to withholding tax at the rate of 10% (plus applicable surcharge and education cess). Business income of the AIFs shall be taxable in the hands of the AIFs at the applicable rates and shall be exempt in the hands of the unit holders.

Clarity relating to Indirect Transfer Provisions (the vexed ‘Vodafone’ issue):

The existing indirect transfer tax provisions were introduced in 2012 and provide that an offshore capital asset would be deemed to be situated in India, if the asset derives, directly or indirectly, its value substantially from assets located in India.

The Bill has proposed certain clarifications with respect to the threshold of value and the meaning of ‘substantially’. It is, inter alia, proposed that transfer of a share or interest in an offshore entity shall be taxable in India if on the specified date, the fair market value of Indian assets exceeds INR 100 million and represents at least 50% of the value of all the assets owned by such offshore entity. Further, specific exemptions are provided to small shareholders (no management and control and less than 5% shareholding / voting power) and in cases of offshore mergers and demergers subject to certain conditions.

The said changes are proposed to be applicable from tax year beginning April 01, 2015. Accordingly, while it appears that transactions completed prior to April 2015 will not fall within the ambit of these proposed amendments, the ambiguity on the tax treatment of these transactions continues to prevail. The Finance Minister does however seek to provide some comfort in his budget speech by stating that ordinarily retrospective tax provisions adversely impact the stability and predictability of the taxation regime and the resort to such provisions shall be avoided.

Relief from Minimum Alternate tax (“MAT”) on certain gains of Foreign Institutional Investors (“FIIs”) / Foreign Portfolio Investors (“FPIs”)

The concept of MAT was introduced in order to tax profitable companies which avoided tax by using exclusions, deductions and incentives. MAT is levied on the book profits of a company, where the overall tax paid is less than 18.5% of the book profits. Traditionally, MAT has not been levied on foreign companies except FPIs in certain cases.

The Bill has proposed that all long term capital gains and such short term capital gains which are subject to payment of securities transaction tax, derived by FIIs / FPIs, shall not be subject to MAT. These amendments will take effect from April 1, 2015.

Given that the Bill fails to explicitly exclude other categories of foreign companies from MAT, this proposal has given rise to a new uncertainty on the applicability of MAT to other categories of foreign companies. The effect of this would remain to be seen and a clarification from the Government in this regard would be welcome.

Conditions for determining residency status of foreign companies

It is proposed to provide that a foreign company would be deemed to be tax resident in India in any tax year, if its place of effective management, at any time in that year, is in India. Further, it is proposed to define the place of effective management to mean a place where key management and commercial decisions that are necessary for the conduct of the business of an entity as a whole are, in substance made. This amendment could potentially bring several offshore entities within the tax net in India and is likely to impact offshore structuring and investments by Indians abroad.

Presence of fund managers in India– Permanent Establishment Exemption

This change seeks to mitigate the risk faced by funds that may have a fund manager in India as being viewed as having a ‘permanent establishment’ in India, thereby exposing the fund to additional tax liability.

The Bill has proposed to provide a specific regime in the ITA in the case of certain offshore funds and fund managers which fulfill certain prescribed criteria. The proposed regime provides that the eligible offshore funds will not become taxable in India merely because the fund manager undertaking fund management activities on its behalf is located in India.

Some of key qualifying criteria for a fund are as follows: (i) that the fund is a tax resident of a treaty country, (ii) the fund must be subject to investor protection regulations in such country, (iii) Indian residents do not contribute more than 5% of the fund’s corpus, (iv) the fund must have at least 25 investors, (v) no individual investor can hold more than 10% in the fund, (vi) aggregate participation interest of 10 or less members and their connected persons must be less than 50% of the fund, (vii) the fund cannot invest more than 20% of its corpus in any entity, (viii) the fund cannot invest in an associate entity, (ix) the monthly average corpus of the fund cannot be lower than INR 1 billion, (x) the fund cannot carry on or control and manage any business in or from India, (xi) the fund does not undertake any other activity in India, which can result in a business connection, and (xii) the fund must remunerate the fund manager on an arm’s length basis.

Further, the key qualifying criteria for the fund manager are as follows: (i) the manager cannot be an employee or connected person of the fund, (ii) the manager is acting in 4 ordinary course of his business, (iii) the manager is not entitled to more than 20% profits earned by the fund from transactions carried out by the fund through the manager. In light of the aforesaid conditions, particularly conditions like the fund cannot carry on and manage any business in or from India, the practical ability of funds to actually have managers in India without being exposed to the ‘permanent establish risk’ seems low.

Extension of eligible period of concessional tax rate on interest payments made to FIIs / FPIs

The Bill has proposed to extend the eligibility period for concessional rate of 5% (plus applicable surcharge and education cess) withholding tax provided under the ITA on interest payment to FPIs with respect to INR denominated bonds of an Indian Company or government securities by 2 years. The benefit will now be available on interest payable up to June 30, 2017.

Taxation regime for Real Estate Investment Trusts (“REITs”) and Infrastructure Investment Trusts (“InvITs”)

The ITA provides limited pass through treatment to REITs and InvITs registered under the SEBI Act, 1992. The special provisions provide that the income of a REIT/ InvIT (except interest from a special purpose vehicle) shall be taxable in its hands at the applicable rates and such income, on distribution, shall be exempt from tax in the hands of the unit holders. The Bill has proposed certain changes to the taxation regime for REITs/ InvITs with effect from the tax year beginning April 1, 2015. The pass through treatment is proposed to be extended to rental income of REITs. Further, it is proposed that concessional capital gains tax regime shall be available to the sponsors on disposal of units of REITs/ InvITs which were acquired in consideration of transfer of shares of special purpose vehicles subject to levy of securities transaction tax. In addition to the proposed amendments to the Bill, the following issues were also addressed by the Finance Minister in his budget speech:

Consolidation of foreign investment caps

The Finance Minister mentioned in his budget speech that composite caps applicable to FDI and FPI investments would be notified. This is relevant in case of certain sectors which have separate caps for investments under the FDI route and investments under the FPI route. For example, in case of a commodity exchange, the overall cap is 49% and investments under the FPI route are limited to 23% and under the FDI route are limited to 26%. This change would provide more room and flexibility for structuring foreign investment.

Allowing foreign investments in AIFs

The Finance Minister also stated in his budget speech that the Government is proposing to allow foreign investments in AIFs. The Bill would be enacted into law once it is cleared by both the houses of the Indian Parliament and has received the assent of the President of India. Before the Bill is passed, the Government may make further proposals to amend the same. The Bill is likely to be enacted by the end of May 2015 and the various amended provisions will take effect from the date/s mentioned in the Bill as approved by the Parliament.

About the Author

Ravi Prakash is a Partner at AZB & Partners