Taxability of Offshore Indirect Transfer of Capital Assets situated in India by Non-Resident Corporations/Entities

Taxability of Offshore Indirect Transfer of Capital Assets situated in India by Non-Resident Corporations/Entities

In the context of Indirect Transfer, a fundamental challenge arises from the absence of a contractual transfer of the underlying asset. Consequently, no gain is realized within the jurisdiction where the asset is located (referred to as the “Source Jurisdiction Country”). The transaction solely involves the transfer of shares or interests in the entity possessing the asset, whether directly or indirectly. This transfer typically takes place in the seller’s country of residence or in a third jurisdiction. Hence, the source jurisdiction country gets a loss of tax revenue arising out of such transfer.

Particularly in developing countries, such indirect transfers raise concerns about potential revenue loss due to evasion of capital gains tax in the source jurisdiction country where the asset is located.

In the Vodafone case, Income Tax authorities sought to tax offshore Indirect Transfers under the Income-tax Act, 1961. This originated from Vodafone’s failure to withhold Indian taxes on payments to the selling entity ‘’Hutch” for transferring a share in a Vodafone Cayman Island company, ultimately owning an Indian subsidiary. However, the Supreme Court ruled in Vodafone’s favour, stating that such transactions between non-residents weren’t subject to tax under Income Tax Act and accordingly no taxes were required to be withheld on a transfer of assets between both companies.

In response to the Supreme Court judgment, significant amendments were introduced, notably in the definition of capital asset and transfer, and an explanation 5 is added under Section 9(1)(i) of the Income Tax Act. Below is the extract of Explanation 5 of Section 9(1)(i):

• For the removal of doubts, it is hereby clarified that an asset or a capital asset being any share or interest in a company or entity registered or incorporated outside India shall be deemed to be and shall always be deemed to have been situated in India, if the share or interest derives, directly or indirectly, its value substantially from the assets located in India…………………………………..

Therefore, shares of foreign companies are deemed to be located in India if such shares derive their value from assets located in India. Capital gains are applicable on the transfer of such shares of foreign company.

The shares of the foreign company derived their value substantially from Indian assets if on specified date:

• The Fair Market Value of Indian assets held by foreign entity exceeds Rs 10 crores AND
• At least 50% of the value of all assets owned by foreign entity is attributable to Indian Assets.

Please note that fair market value of Indian assets to be taken without the reduction of liabilities.

It is notably clarified that Income shall not be deemed to accrue or arise to a Non-Resident from transfer interest in a foreign entity if the transferor along with its associated enterprises does not hold the right of management or control in a foreign entity or share capital more than 5% of the total share capital in the foreign entity at any time during the 12 months preceding the date of transfer.

It is hereby clarified that in cases where the foreign entity holds assets outside India, only the income proportionate to Indian assets is deemed to accrue or arise in India for taxation purposes.

Please note that assets held by non-residents directly or indirectly in Category-I foreign portfolio investors shall not be deemed to be situated in India even if deriving its value substantially from assets located in India.

It is important to note that the declaration of dividend by a foreign company outside India doesn’t have the effect of the transfer of any underlying assets located in India. Circular No. 4/2015, dated 26-03-2015, therefore, clarifies that the dividends declared and paid by a foreign company outside India in respect of shares that derive their value substantially from assets situated in India would not be deemed to be income accruing or arising in India by virtue of the provisions of section 9(1)(i).

This article aims to address the challenges faced by the income tax department with respect of the indirect transfer of Indian capital assets by foreign entities. These provisions provide clarity and certainty in tax treatment, contributing to a fair and transparent tax regime.