India's federal budget threatens retrospective taxation

19 March 2012

India's federal Finance Bill 2012-2013 introduces retroactive tax amendments enabling the government to tax historical cross-border transactions, perhaps going back fifty years.

The measures are included in the Budget's widely expected general anti-avoidance rule, which allows the tax authorities to deny investors tax relief on a transaction judged to be carried out exclusively for the purpose of reducing tax. The Indian authorities wanted a GAAR because Indian residents frequently use firms established in Mauritius and elsewhere to channel their funds into Indian resident firms - so-called round-tripping. Such entities are often set up in Mauritius with the sole intention of claiming exemption from Indian capital gains tax, under the India-Mauritius double taxation treaty.

The tax department already has some discretion to "look through" cross-border transactions conducted for tax planning purposes. But several court decisions have set limits on these powers through the "substance test": if a document or transaction is genuine, the court cannot look behind it to some supposed underlying substance. For example the courts have held that a certificate of residence from Mauritius authorities is sufficient proof for the taxpayer to claim the CGT exemption provided under the India-Mauritius tax treaty.

Moreover, in January this year, the UK-owned telecom giant Vodafone won a significant victory over its tax liabilities over the Hutchison acquisition. The firm had been charged Rupee112 billion ($2.2 billion) in CGT on its 2007 purchase of Hutchison Essar India, made through shares in intermediate companies based in the Cayman Islands and Mauritius. Ultimately the Indian Supreme Court overruled the charge.

In an unwelcome surprise to foreign direct investors in India, the new GAAR's retrospective nature turns the tables yet again. In essence, it states that if a transfer of a share or other interest in a company or entity has occurred outside India, but its value depends primarily on assets in India, then income arising from the sale shall be deemed to accrue or arise in India.

It is clear that Vodafone (and many hundreds of other recent IFC transactions) are the main targets - although the Finance Bill explicitly states that retrospection goes back to the enactment of India's existing tax code in April 1962. Government ministers have since suggested that the measure will not in practice be applied to deals more than six years old.

So, assuming that the Finance Bill's clauses are upheld, companies including Vodafone will soon be issued tax notices. However, there is likely to be a challenge to the retrospective nature of the new rules on constitutional grounds.

In any case, the government will have to be careful that the GAAR does not frighten off large corporations. India's economic boom is heavily dependent on foreign direct investment, which jumped by 13 per cent to US$51 million in 2011, according to figures released in January. The USA is the leading investor, followed by Japan and the UK. Foreign investors in India do receive a guarantee against double taxation of their earnings, but the fact that some financial centres (like Mauritius) do not charge any capital gains tax undoubtedly has put a strain on that promise - culminating in the unexpectedly harsh new measures of the Finance Bill.

Sources

Bloomberg

Economic Times of India

Moneylife (technical analysis)