Alternative Investment Fund International Tax Developments
March 05, 2012
The purpose of this Alert is to update the alternative fund industry on significant international tax developments and their impact. In the past two years, there have been significant developments — almost on a weekly basis. For example, Germany has significantly changed the way it taxes non-resident investors on gains derived from German securities; and Australia has issued numerous announcements on how it plans to tax non-resident funds. In India, the recent Vodafone case is going to have a significant impact on non-resident investments in India and may impact other jurisdictions that have started to tax non-residents on gain or attempt to tax the transfer of shares of a non-resident company which in turn owns a domestic company. The U.S. has also introduced legislation in the FATCA provisions that will tax some non-resident investors for the first time on capital gains derived from the sale of U.S. securities.
In this Alert, we are going to discuss the recent Vodafone case and its impact on alternative investments funds as well as recent developments in anti-avoidance legislation in India and the renegotiation of the Indian-Mauritius Tax Treaty.
Vodafone Case, New Legislation in India, Renegotiation of the India-Mauritius Tax Treaty, and the Ramifications
It was announced on January 20, 2012 that Vodafone won its appeal in the India Supreme court. This decision provides some welcome relief for investors with holdings in India. As noted below, the case will have a significant impact on investments in India.
There are two other developments which should not currently impact the Vodafone decision, but may have an impact in future years. First, the new Indian Direct Tax Code (DTC) imposes General Anti Avoidance Rules (GAAR) provisions starting April 1, 2012; these provisions can be used to attack structures investors have used to invest in India. In September of 2011, Mr. Sunil Gupta (Secretary for Tax Policy in India) announced that structures that were created before the DTC came into effect would not be subject to the GAAR provisions. In addition we understand from Indian counsel that the effective date of the GAAR provisions will likely be pushed back and there is a significant degree of uncertainty as a result of the Vodafone case as to the proposed GAAR legislation. Second, the India-Mauritius Income tax treaty is currently being renegotiated and will likely contain limitation on benefits provisions that could also be used to attack some of the structures that have been put in place. The renegotiation will likely take some time, and may as well be impacted by the Vodafone decision.
Before understanding the impact of these developments, it is helpful to understand the India-Mauritius tax treaty, formally known as the Double Taxation Avoidance Agreement of 1983 (the “DTAA”). The DTAA generally provides that a Mauritius resident that sells shares of an Indian company (assuming holding periods are satisfied) is not subject to capital gains tax in India, but is subject to tax in Mauritius. (Mauritius does not tax capital gains, while India taxes long-term capital gains at a rate of approximately20 %.) Under the DTAA and a 2003 decision by the Supreme Court of India, the treaty applies to any person or entity that holds a duly issued Mauritius tax residency certificate, whether or not that person or entity actually has any substance in Mauritius, so long as it does not have a permanent establishment in India. This means that in most cases a foreign private equity investor can set up a Mauritius investment vehicle with nothing more than a contract with a service provider in Mauritius, obtain a tax residency certificate and effectively avoid paying capital gains tax in India for gains on sales of shares of Indian companies. The Indian tax authorities view this result as permitting tax avoidance by non-Mauritius investors.
A proposed new tax code and a decision in the landmark Vodafone case have received much notice and are discussed in further detail below.
Direct Tax Code
On August 30, 2010, the Indian government introduced the Direct Tax Code of 2010 (the “DTC”). Among other provisions of the DTC, which if adopted would go into effect on April 1, 2012, are the following:
- Anti-Avoidance. Under the General Anti-Avoidance Rules (commonly referred to as “GAAR”), the Indian tax authorities will have broad discretion to look through many commonly utilized structures for foreign direct investment into India. Accordingly, the Indian tax authorities could use the GAAR to deny the benefits of the DTAA to a private investment fund or vehicle organized in Mauritius and holding a Mauritius tax residency certificate if the beneficial owners of that fund or vehicle are mostly U.S., European or other non-Mauritius investors.
- Treaty Override. While the DTC recognizes the preferential status of international treaties, including the DTAA, as noted above the tax department may override such treaties if the GAAR or CFC provisions are invoked.
- Capital Gains Exemption for On Market Transactions. While the GAAR and CFC provisions may have the effect of imposing capital gains tax for transactions in Indian shares, the DTC did retain an important benefit for transactions in listed securities made on the market. Such transactions will generally remain exempt from capital gains tax in India so long as the transactions are made on a recognized stock exchange, the securities are held for at least one year and the seller has paid a nominal securities transaction tax. This should be good news for hedge funds investing in India.
The Vodafone Case
On September 8, 2010, the Bombay High Court surprised many observers and sided with the tax department’s decision to impose a US$2 billion tax obligation on Vodafone for a transaction between two non-Indian companies.
For those not familiar with the Vodafone case, in 2007 Vodafone and Hong Kong-based Hutchison Group entered into an agreement for the sale by Hutchison of the Indian mobile carrier Hutchison Essar Limited to Vodafone for a total purchase price of approximately US$11 billion. The transaction was structured as a sale by a Cayman Islands subsidiary of Hutchison of the shares of another Cayman Islands subsidiary (which itself held the shares of certain Mauritius subsidiaries which, in turn, held shares of Hutchison Essar) to a subsidiary of Vodafone organized in the Netherlands.
The Indian tax authorities claimed that the transaction was subject to taxation in India in the amount of approximately US$2 billion, and that Vodafone should have withheld the amount of the tax from the purchase price paid to Hutchison and remitted the same to the Indian tax authorities. The Bombay High Court Vodafone decision was overturned on January 20, 2011.
Although the Vodafone structure did involve a Mauritius company (which held the shares of an Indian company), the decision did not in reality address the application of the India-Mauritius Tax Treaty. Rather, the court focused on the fact that a non-Indian company had been sold and India did not have the legislation to tax the transaction absent a sham. The court concluded that if there was a business purpose for the structure it would be respected.
The victory in the Vodafone case is significant for companies and funds that have invested into India. In essence it means that India will not be able to attack a number of structures investors have used to go into India.
The DTC and the possibility of a new tax treaty between India and Mauritius are warnings to private equity and other foreign investors in India that they should be careful in structuring their activities and investments in India. These steps could involve using multi-tiered investment structures so as to increase the likelihood of the applicability of one or more tax treaties and incorporating strategies to step up the basis of unlisted shares so as to minimize any capital gains tax in India, if applicable. Additionally, investors should consider whether at the time of purchase they should seek an advance ruling regarding the applicability of any withholding tax obligation, withhold and remit any capital gains tax or get adequate assurances from the seller that the investor will not bear any liability for the tax if imposed.
- Building Substance in a Treaty Jurisdiction. Firms should review the various countries that have favorable tax treaties with India. Mauritius is the most widely used, while Singapore, Cyprus and the Netherlands also have beneficial treaties. Whichever jurisdiction is selected, if the GAAR rules are adopted it will be essential to build substance in that jurisdiction. There is broad consensus among India tax practitioners that the Indian authorities will continue to challenge the applicability of treaty benefits to companies in Mauritius (or any other treaty jurisdiction) that lack substance in that country. Already there has been a trend among foreign investors to take separate office space and hire staff on the ground in the applicable treaty jurisdiction. Firms that lack such substance take on additional tax risk in India.
Tax Treaty Update
- Mauritiushas agreed to negotiate and revise the existing Double Taxation Avoidance Agreement (DTAA) with India and the two sides are meeting soon to work out the details:
- Press reports (as of January 6, 2012) indicate that the tax treaty may be revised to introduce:
- 1. Exchange of information on banking transactions (in addition to the existing information exchange article).
- 2. Limitation on benefits (LOB) clause to restrict the benefits of the treaty – this should provide guidance on meeting the substance test to qualify for treaty benefits.
- Thus, under the revised treaty, a mechanism can be put in place to prevent its abuse. It remains to be seen the conditions which will be prescribed under the LOB clause.
On February 1, 2012 EisnerAmper partners together with professionals from Nishith Desai put on a webinar on the Vodafone decision and its impact on investment in India. The following is a series of questions and answers from the webinar.
- How will the Indian government respond to the decision? Is the Indian government’s response expected to be in line with the Indian tax authorities?
The government’s response is likely to be in line with the tax department’s approach. News reports have mentioned that the tax department has convened a committee to review its strategy post Vodafone decision. It is possible that the government/tax department may push for new legislation to tax offshore transaction and also include some sort of a general anti-avoidance rule. Such provisions are contained in the proposed Direct Taxes Code Bill, currently being reviewed by Parliament. The government/tax department may try to expedite the enactment of the new law.
- Is there certainty that in situations similar to Vodafone no Indian tax will be assessed?
The Supreme Court’s decision is based on the reasoning that the structure was not a sham and was backed by legitimate business purpose. It is possible that the tax department may challenge other cases by distinguishing them on the basis of facts and circumstances.
- Is there a distinction between operating companies (like Vodafone) and private equity funds invested in India?
For tax purposes, there should not be any difference. Further, it should be possible to demonstrate adequate business purpose for standard PE structures as well.
- In Vodafone a Cayman Island company was sold. Would the result be any different if a Mauritius company had sold the shares of the Indian company?
A Mauritius company is entitled to treaty protection and the beneficial circular issued by the tax department.
- How many cases like Vodafone exist in India? How much will be owed in refunds? Is there an estimate of revenue lost from Vodafone decision?
The loss of revenue caused by the tax department’s defeat in the Vodafone case is estimated at around USD 2.4 billion. A number of cases similar to the Vodafone case are currently being litigated. The tax department is likely to continue litigating such cases on the basis that they may be distinguished from the Vodafone case.
- What types of rulings have been issued by India on non-resident investors selling Indian companies? Have rulings been limited to non-resident companies that have operations in India as opposed to private equity funds that are investing in India?
Contrary views were taken by the authority for advance rulings in the Sanofi case and the Karnataka High Court’s decision in the Richter case. The Vodafone decision is likely to change the outcome of such cases in the taxpayer’s favor. There have been early advance rulings that are of significance to the fund industry. The Mauritius case should also cover Mauritius-based fund structures. The Vodafone decision is, as of date, the most comprehensive decision covering issues of tax planning, treaty entitlement and offshore transfers.
- Will the Vodafone decision have an impact on other jurisdictions?
The analysis used by India’s highest Court in a case of such a magnitude will definitely be considered by Courts around the world deciding the tax implications of cross-border M&As.
- How should the Vodafone decision impact FIN 48/ASU 740 positions of financial statements with respect to (a) past sales, and (b) existing structures in which U.S. investors indirectly invest in Indian companies?
Vodafone decision should definitely reduce the level of risk exposure for the purpose of FIN 48 analysis for both past sales and existing structures. However, risks may still exist based on the facts and circumstances of each structure.