Remember Vodafone? It was the first attempt to tax capital gains arising to non-residents out of indirect transfer of important assets under the domestic tax law of India. The efforts of the Indian revenue was pilloried by sundry experts at every forum- national or international. The Bombay High Court judgement in that case had upheld the basic principle that what is taxable, if done directly, should also be taxable, if done indirectly. The Supreme Court thought otherwise and discussed topics like importance of FDI that were totally unconnected with the issue.

The Supreme Court had to examine the existing law on transfer of assets and taxation of capital gains arising therefrom. Article 9(1) at the relevant time read as follows:

"9(1). The following incomes shall be deemed to accrue or arise in India: -

(i) all income accruing or arising, whether directly or indirectly, through or from any business connection in India, or through or from any property in India, or through or from any asset or source of income in India or  through  the transfer of a capital asset situate in India.

Basically, the Court had to interpret the terms like ‘through' used in section 9(1). Whether one agrees with the decision or not, the Court took the position that the existing domestic law was not sufficient to tax the capital gains arising out of such indirect transfer of assets.

The then government therefore amended the relevant sections to clarify that the legislative intention was always to tax such transactions. The amendment was made retrospective. Many respectable commentators do not forget to mention that it was given effect from 1.4.1962 implying thereby that all completed assessments were in danger of being reopened, conveniently ignoring the fact that procedurally the same was impossible.

An Explanation 4 was added to section 9 as follows: "For the removal of doubts, it is hereby clarified that the expression "through" shall mean and include and shall be deemed to have always meant and included "by means of", "in consequence of" or "by reason of ".

More importantly an Explanation 5 was added, which stated as follows: "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."

Rattled easily by the obvious adverse reactions from the FIIs, the government appointed a committee headed by Dr. Parthasarathi Shome who recommended that the amendment should not apply retrospectively. However, even with the change of the government in 2014, the retrospective nature of the amendment remains although through administrative measures, the government specified that the provision should be used sparingly and then also with the approval of a high powered Committee.

In the 2015 budget, the government clarified through a new Explanation 6 that Explanation 5 will only be applicable, if on the specified date the value of such assets exceeds the amount of Rs 10 crore and represents at least 50% of the value of all the assets owned by the company.

Another Explanation, no 7 was also added to provide an exception for small investors having no right of management or control of such company and holding less than 5% of the total voting power or share capital of the company that directly or indirectly owns the assets in India.

Besides, a new Section 285A was also introduced by the Finance Act, 2015 to cast a reporting obligation on the Indian concern whose shares are substantially held directly or indirectly by a company or entity registered or incorporated outside India.

Responding to the plea of difficulties in implementing the provisions, in 2016, the CBDT also issued a Circular No 41 clarifying certain further issues. The most important was the one related to the applicability of the provisions to FPI investors.

"Question No1: A Fund is set-up in a popular jurisdiction and registered as FPI for undertaking portfolio investment in Indian securities. It pools monies from retail/ institutional investors and invests in shares of Indian listed companies. The value of asset is in India i.e. shares of Indian companies held by the Fund constitute more than 50% of its total assets and exceed Rs.'10 crores. The Fund buys and sells shares on the Indian stock market and pay taxes as per section 115 AD of the Act or applicable tax treaty rates. On the ongoing basis, the Fund, on request of its unit holders/ shareholders, redeems their units/ shares. Does Explanation 5 to section 9(1)(i) of the Act apply to above redemption made by the Fund?

Answer: Explanation 5 to section 9(1)(i) of the Act will be applicable in respect of investors in the Fund also, as their case falls within the ambit of clause (a) of Explanation 6 of the said section. However, the investors covered under Explanation 7(a) (i) of the Act are excluded."

The FIIs were still not satisfied since according to them multiple taxation could ensue. Therefore, the Circular was kept in abeyance. Subsequently, through Finance Act, 2017, two provisos were added. As a result, the provisions of Explanation 5 will not apply to any asset or capital asset being investment held by non-resident, directly or indirectly, in a Foreign Institutional Investor, and registered as Category-I or Category II Foreign Portfolio Investor under the Securities and Exchange Board of India (Foreign Portfolio Investors) Regulations, 2014 on the ground that these entities are regulated and broad based.

But this does not solve the problems faced by Vodafone, Cairn and such others. The government had also came up with a dispute resolution scheme ( Direct Tax Dispute Resolution Scheme, 2016 ) that basically said that companies such as Vodafone, Cairn etc. that are caught in the cases of indirect transfer could avoid penalty and prosecution, if they paid up the tax. (Other taxpayers had to pay interest and a certain penalty also). The companies did not opt for the same.

Vodafone had in the meantime challenged the legality of the retroactive amendment under the then existing India-Netherlands Bilateral Investment Protection Agreement (BIPA), and the outcome is still awaited. As a result of such litigations involving BIPA, India introduced a new model BIPA and kept taxation explicitly out of its ambit. The existing BIPA with many countries including the one with the Netherlands have been unilaterally terminated by India. It is also interesting to note that it was the Hutchison group of Hong Kong that had transferred its Indian telecom business to the Vodafone group. So, the liability to capital gains arises in the hands of Hutchison. Vodafone's liability arose because of its refusal to deduct tax at source from the payments made to Hutchison. Reports suggest that recently assessment has also been made against Hutchison for its liability to capital gains.

It is a fact that the action of the Indian revenue in proceeding against Vodafone had surprised many and a lot of hue and cry was made in the name of protecting foreign investment. However, Vodafone has not left India and is very much an important player in the Indian market despite all that has transpired. In the meantime, a lot of water has passed through the different sacred rivers of India.

First came the BEPS report of the OECD. In one line, the report concentrated on how the corporate tax revenue of the capital exporting countries could be increased without annoying the moneybags. It did not touch upon areas of concern specifically to developing countries. Then came the IMF spillover report that, for the first time, considered the indirect transfer of assets in developing countries to be an issue of concern.

Recently, the IMF, OECD, UN, and World Bank Group, through a joint initiative known as the "Platform for Collaboration on Tax," has released a draft toolkit discussing proposed approaches for countries to adopt to address tax avoidance through offshore indirect transfers of assets.

The report mentions that the tax revenue involved in all many cases is quite large. It gives examples of the Indian Vodafone case, besides one case from Peru and one from Uganda. Following India's Vodafone case, China had also issued its circular to effectively tax such transactions involving indirect transfer of Chinese assets, in certain circumstances.

Before discussing the recommendations of the Platform, it will be interesting to notice the other cases where revenue authorities had tried to tax such transactions.

The Uganda case is interesting since it involves our own Bharti Airtel that is also in telecom business just like Vodafone. Unlike the Vodafone case in India, in Uganda, the Supreme Court saw merit in the arguments of the revenue. Bharti had gone on an acquisition spree in Africa. Although the decision of the Court is not readily available, it is obvious that Indian multinationals are no less adept in tax planning than their western counterparts.

The transfer was from the Zain group of Kuwait to the Bharti Group. Apparently, for the purpose of the acquisition, Bharti had formed a company in the Netherlands, Bharti Airtel International BV and it is this company that acquired shares of other BV companies to finally acquire the operating company in Uganda, Celtel Uganda limited .

The structure of the deal was as follows: The shares of Celtel Uganda Limited were held by Celtel Uganda Holding , a company incorporated in the Netherlands. Zain Africa BV in turn held the shares of Celtel Uganda BV. The shares of Zain Africa BV are, in turn, held by Zain BV. These shares of Zain BV were transferred to Bharti BV, a company incorporated by Bharti in the Netherlands, thereby giving it the right to all downstream investments including the operating company in Uganda. The transaction took place on 30th March 2010.

Unlike the Vodafone case, this is a case there was a tax treaty between Uganda and the Netherlands. The Revenue Authorities of Uganda issued a tax assessment on Zain on the ground that the transaction was one of gain arising from the disposal of an interest in immovable property located in Uganda. It was argued that in terms of Article 13 of the DTA between Uganda and the Netherlands, Uganda had the right to tax such gains. However, just like Vodafone, Zain argued that it had sold its shares in the Netherlands to a Netherlands entity, and hence no income accrued in Uganda. The High Court ruled in favour of the taxpayer holding that that the Ugandan Revenue had no jurisdiction to tax Zain International BV. On further appeal, the Court of Appeal, however ruled that Uganda had jurisdiction to tax proceeds on sale of shares between two foreign companies involving the sale of assets in Uganda. The matter was set aside to the revenue authorities to determine what taxes to claim.

It appears that the Ugandan revenue relied on Section 88(5) of Uganda's Income Tax Act that is an anti-treaty shopping provision and states as follows:

"Where an international agreement provides that income derived from sources in Uganda is exempt from Ugandan tax or is subject to a reduction in the rate of Ugandan tax, the benefit of that exemption or reduction is not available to any person who, for the purposes of the agreement, is a resident of the other contracting state where 50 percent or more of the underlying ownership of that person is held by an individual or individuals who are not residents of that other Contracting State for the purposes of the agreement ."

The provision thus denies the benefits of the treaty to a company whose ‘underlying ownership' is mostly in a third country.

The Peruvian case, involved the indirect sale of the Peruvian oil company Petrotech Peruana. In 2009, Ecopetrol Colombia and Korea National Oil Corp purchased a Houston-based company (Offshore International Group Inc.) whose main asset was Petrotech Peruana (the license-holder), a company incorporated and resident in Peru for approximately US$900 million, from Petrotech International, a Delaware incorporated company. Since Peru's income tax law at the time did not have a specific provision taxing offshore indirect sales, the transaction remained untaxed there. The potential foregone tax revenue for Peru was estimated at US$482 million.

The case triggered a Congressional investigation in Peru that eventually led to a change in the law and currently, all offshore indirect sales of resident companies are taxed in Peru, regardless of the proportion that immovable property belonging to the Peruvian subsidiary may represent in the total value of the parent company (Article 10, Income Tax Act, Peru) . For the provisions to apply, the portion of the parent company subject to sale must derive its value at least 50 percent from Peruvian assets, and at least 20 percent of the Peruvian assets must be transferred in order for the transaction to be taxable in Peru.

Apart from Vodafone and the Peruvian case, there was also a case from Mozambique. In 2011 a change in ownership of mining projects in Mozambique was achieved through the sale, on the Australian stock market, of shares in the mining company holding interests in the projects. The value of the transaction was around $4 billion. No tax was collected on the transaction in Mozambique. Changes were subsequently made to the tax code, on January 1, 2014, to ensure taxation of capital gains resulting from a direct or indirect transfer between non-residents of assets located in Mozambique.

The new draft document released by the platform on collaboration, titled "The Taxation of Offshore Indirect Transfers - A Toolkit," concludes that when there is an indirect transfer of immovable assets there is a strong case for allocating taxing rights with respect to capital gains associated with the transfer to the country in which the asset is located regardless of whether the transferor is resident there or has a taxable presence there.

The document suggests that countries should consider adopting a broad category of immovable property subject to taxation, including gains arising in relation to location specific rents clearly linked to national assets, such as from licenses to exploit public goods.

The draft report gives examples of such property to include electric, gas, or other utilities and telecommunications and broadcast spectrum and networks.

Moreover, document suggests countries could consider going even further, extending the definition of immovable property subject to taxation to rights to receive variable or fixed payments in relation to extractive industry rights or government issued rights with an exclusive quality.

Two different options have been proposed in the toolkit for a domestic tax law framework to tax indirect transfers. There are also suggestions for enforcement and collection.

Briefly, one of the proposed method proposes taxing the local resident asset-owning entity under a deemed disposal model where a gain is deemed when there is a sufficient change in the ownership of the entity. This is the method preferred by the platform. The other method proposes to tax the non-resident seller on the ground that the transfer gives rise to gain with a local source in the country where the asset is located.

It may be mentioned that tax planning using indirect transfers has been identified as a cause for concern by many countries, particularly the developing ones where extractive industries are important.

While it is good to see that unlike Indian experts, the Platform consisting of premier think tanks do acknowledge that indirect transfer is an important issue and source countries have legitimate concerns regarding revenue loss, it is not clear why the action proposed by the platform should be restricted to only cases of immovable properties even when the definition of immovable property is artificially increased to include rights relating to telecommunication, mining etc. Conceptually, the same principle should be adopted for all kinds of properties.

One problem often cited in the context of indirect transfer is how the tax administration will come to know of such transactions. This can be solved by putting the onus on the transferee to inform the government of any substantial change in shareholding as has been done in section 285A of the Indian Income Tax Act. The option given by the platform to tax the resident local company also does not seem to be equitable. The actual beneficiary is the non-resident seller and there is no reason why the non-resident seller should not be taxed.

To conclude, it may be stated that despite the tag of being aggressive given to the Indian revenue by the tax practitioners in India, the concerns raised by India are all very valid and these are being recognized by both the tax administrations elsewhere and also by the international organisations.