Under the provisions of the Income-tax Act, 1961 (the “ IT Act”), the income of a non-resident will be deemed to accrue or arise in India if it arises, directly or indirectly, through or from any business connection, property, asset or source of income, or from a transfer of a capital asset (shares or other interest) situated in India. The indirect transfer provision was introduced in the Finance Act, 2012, by way of Explanation 5 to Section 9(1)(i) of the IT Act, clarifying that an offshore capital asset will be treated as situated in India if it substantially derives its value (directly or indirectly) from assets located in India. Generally, for a foreign company, the indirect transfer provision is applicable only if the value of the assets located in India exceeds INR100 million and the assets in India represent at least fifty per cent (50%) of the value of all the assets owned by the offshore transferor company. This provision does not apply to Category I and Category II foreign portfolio investors registered under the Securities and Exchange Board of India (Foreign Portfolio Investors) Regulations, 2014. The recent changes to the indirect transfer provisions are discussed here.
On December 21, 2016, the Central Board of Direct Taxes (the “ CBDT”) issued a circular addressing questions raised by various stakeholders (foreign portfolio investors, pension funds, and private equity and venture capital investors) in the context of the applicability of the indirect transfer provision under the IT Act. While the circular of December 21, 2016 provided some clarity on the circumstances in which the indirect transfer provision was to be applied, it failed to, inter alia, address the issue of double taxation of the same income in case of a multilayered fund structure.
To clarify this, the CBDT has issued a circular on November 7, 2017 (the “ Circular”) acknowledging the concerns expressed by foreign portfolio investors, pension funds, and private equity and venture capital investors that are set up as multi-tier investment structures outside India and suffer multiple taxation of the same income at the time of subsequent redemption or buyback (i.e., firstly, at the India level, they pay short term capital gains tax on any direct transfer of shares, or income tax; and then they can be subject to tax at every tier of investment in the fund chain on any subsequent redemption or buyback under the indirect share transfer provision assuming it gets triggered). The CBDT has now clarified in the Circular that the indirect transfer provision will not apply to specified funds (such as foreign portfolio investors, pension funds, and private equity and venture capital investors who are registered with the Securities and Exchange Board of India) if their income has already been subjected to tax in India, provided the proceeds of redemption or buyback arising to the non-resident do not exceed the pro rata share of the non-resident in the total consideration realized by the specified fund from the transfer of shares or securities in India. Moreover, a non-resident investing directly in the specified Indian fund shall continue to be taxed as per the provisions of the IT Act.
In order to get exposure to Indian capital markets, various offshore funds are registered with the Securities and Exchange Board of India and are, accordingly, investing directly in listed Indian companies. Such funds are typically open-ended allowing for frequent subscriptions and redemptions by foreign investors in the fund on the basis of net asset value calculations. The fund in India is already subject to short term capital gains tax (of about 15.80%) and securities transaction tax on the gains earned on the transfer of listed Indian securities. Therefore, subjecting gains derived by foreign investors at the time of redemption of their shares in the fund would amount to economic double taxation of the same income. Further, if investors are subject to tax in their home jurisdiction on the gains from redemption, there may be economic triple taxation, especially in cases where the availability of tax credits may be limited or probably non-existent.
Therefore, the Circular is a step in the right direction. However, the requirement that the proceeds of redemption in India arising to the non-resident should not exceed the pro rata share of the non-resident in the total consideration realized by the specified fund will be difficult to deal with. Further, the Circular applies only to foreign portfolio investors, pension funds, and private equity and venture capital investors that are registered with the Securities Exchange Board of India and have a multi-tier investment structure outside India, but not to all non-resident entities.
We hope that the CBDT issues a further clarification on the foregoing matters.