After the recent worldwide implementation of OECD’s recommendations to prevent Base Erosion and Profit Shifting (BEPS), another forum (The Platform for Collaboration on Tax) has released a discussion draft on “The Taxation of Offshore Indirect Transfers – A toolkit” (hereafter, referred as “the toolkit”) for public comments on 1 August, 2017.
The Platform recognizes that offshore indirect transfers (OITs) have emerged as a significant issue in many developing countries and this issue was not addressed under the OECD’s BEPS project. The toolkit is designed to help developing countries tackle the complexities of taxing OITs of assets. It indicates that a more uniform approach is necessary for taxation of OITs, with several countries resorting to unilateral measures (for example, India retrospectively introduced indirect transfer provision under its domestic law vide the Finance Act, 2012).
Key focus areas in the toolkit
The toolkit favors allocating taxing rights with respect to capital gains associated with transfers of immovable assets to the country in which the assets are located, regardless of whether the transferor is resident there or has a taxable presence there. The toolkit takes cognizance of the already existing principle in Article 13(4) of the Model Tax conventions that suggests a similar principle: capital gains taxation of OITs of “immovable” assets be primarily allocated to the location country. Nonetheless, the draft also recognizes that Article 13(4) is found in only about 35% of tax treaties.
As the premise of taxing OIT in the toolkit is based on immovable property, it drafts the definition of immovable property rather broadly to cover any exploration, prospecting, developing or similar rights related to immovable property, including a right to explore natural resources and right to exploit such resources (such as telecom spectrum, natural gas extraction license, etc.).
Another critical aspect highlighted in the draft is the importance of the domestic tax law framework to contain an indirect transfer taxing rule as well as appropriate enforcement rules to collect the resulting liability, as a tax treaty cannot create such taxing rights or enforcement mechanisms if they do not exist in domestic law. For designing the tax liability rule, the toolkit discusses two common models.
- Model 1 seeks to tax the local entity that directly owns the asset in question, by treating that entity as disposing of, and reacquiring its assets for their market value where a change of control occurs.
- Model 2 seeks to tax the non-resident seller of the relevant shares or comparable interests.
The toolkit explicitly inclines in favour of Model 1 for reasons of enforcement simplicity (as tax collection from a local resident entity is much easier than from a non-resident) and basis adjustment logic (i.e. tax cost of assets is stepped up to market value to ensure that double taxation does not arise in the event of subsequent change in control).
The toolkit recommends certain rules for enforcement and collection of the resulting tax liabilities; furthermore, the toolkit recommends certain rules, such as notification/ reporting and information exchange mechanisms, withholding tax mechanisms, mechanisms imposing tax payment obligation on a relevant local entity as agent of a non-resident seller and other legal protections.
The draft also suggests that the above principles of taxation of OITs should not apply only as an anti-avoidance device to combat “double non-taxation,” but rather constitute a fundamental aspect of the international tax architecture, in which rights to tax gains arising on such assets when subject to an indirect transfer offshore, would be primarily allocated to the location country.
Country practices for taxing OITs
However, there is considerable diversity in countries’ approaches to taxing OITs. The local laws in some countries, including India, are not limited to taxing OIT only for immovable assets. In Peru, currently, all offshore indirect sales of resident companies are taxed, regardless of the proportion that immovable property belonging to the Peruvian subsidiary may represent in the total value of the parent company.
China’s approach to taxation of capital gains on transfers of interests is different because it is structured as an anti-abuse provision, i.e., China taxes OITs when it deems they have been structured to avoid Chinese tax and not taxed appropriately in another jurisdiction.
It is essential to add that certain countries provide logical exemptions that apply to taxation of OITs. For instance, South Africa provides capital gain relief on disposal arising from intra- group corporate restructures.
How significantly does India differ/ match with the contents of the draft
The Indian indirect transfer tax makes two significant deviations from the global version:
- The OIT provisions in India (introduced in 2012) extend to all types of offshore entities, which derive value substantially from assets (tangible or intangible) located in India and is not limited to only such entities that derive value from immovable property in India. Notably, while most tax treaties of India had a provision for taxing OIT deriving value from immovable property, the domestic law itself had no provision to tax any kind of OIT of immovable property until 2012.
- India has adopted Model 2 to tax OIT (i.e. taxing the non-resident seller) by incorporating relevant “source of income” provisions. While the toolkit Model 2 recognizes the need of cost step up for a subsequent OIT, the Indian domestic law is silent on the mechanism and results in clear double taxation when there are multiple entities in the holding structure. For example, if there are three levels of overseas companies (say F Co 1, F co 2 and F Co 3), which derive substantial value from an underlying Indian company. In overseas internal reorganization, where F Co 1 transfers F Co 2 to another group entity, and subsequently, F Co 2 transfers F Co 3 to a third party, both F Co 1 and F Co2 will be taxed on the same gains for the underlying Indian asset, as every entity is considered a separate tax paying entity. Therefore, cost step up at one level (for an underlying Indian asset) may not automatically step up cost for all levels.
- The provisions provide limited exemptions for corporate reorganization, only in case of amalgamation and demergers of overseas companies, in spite of the fact that the seller’s local country tax may have exempted other form of transfers, which are also covered in the ambit of corporate reorganizations, and therefore, considers the gains as notional.
Indian indirect transfer regime is based on the premise that every indirect transfer is “taxable” and this approach needs special consideration to facilitate ease of doing business.
As envisaged under the toolkit, once indirect transfer tax becomes an international phenomenon, it would be essential for countries such as India to resort to international standards for consistency and elimination of double taxation. The anticipated consistency can be achieved through bilateral negotiations and amendments of tax treaties or neutralizing the domestic indirect transfer tax provisions in-line with global standards. Although the toolkit is a discussion draft, which might undergo changes, an interesting aspect would be to see how India (an observer of the OECD) would alter its domestic law provisions to ensure international uniformity adaptation of indirect transfer provisions.
Views expressed are personal to the author. Article includes inputs from Ramya Arora – Assistant Manager – M&A Tax, PwC India
