“Heralding a new era of tax enforcement for the country, India’s Finance Minister told the OECD on 13 June that India would be setting much stricter standards in the areas of transfer pricing, capital gains attribution and tax haven identification.”

That’s how we described Finance Minister Shri Pranab Mukherjee’s speech in our August 2011 edition. And eight short months later, plus a favorable judgment for Vodafone in its Supreme Court case (not to mention the refusal of the Supreme Court to dismiss a subsequent review petition from the government), his words have rapidly solidified into action in a series of unprecedented tax measures announced in India’s recent Union Budget.

Many tax executives and CFOs breathed a sigh of relief when the India Supreme Court issued its judgment in the landmark Vodafone tax case in January 2012. But it likely wasn’t very many breaths later that the same audience thought, “So how will the Indian tax authorities respond?”

The answers became clear just a few weeks later, with a Union Budget that both echoed and surpassed the rapid and widespread introduction of anti-abuse measures being deployed elsewhere in the world and affirmed just how high the pace and significance of change continues to be in India.

Indirect transfers of assets: proposal for a 50-year retrospective measure

The Union Budget for 2012–13 was presented by Finance Minister Mukherjee on 16 March 2012. The Finance Bill for 2012 (FB 2012) that was introduced in Parliament as part of the budget proposals contains a number of far-reaching tax proposals for amending the Indian tax laws.

The prime item of the two-hour budget speech goes to the unprecedented retrospective measures on all offshore indirect transfers of assets situated in India.

Quite obviously stung by the reversal in fortunes at the Supreme Court in the Vodafone case, the Indian government has chosen to respond with a 50-year retrospective amendment (i.e., from 1962) which demonstrates a fiscal vengeance unprecedented in India’s fiscal history, notwithstanding assertions to the contrary by senior government officials.

By one stroke of legislative action, Budget 2012 seeks to subject all offshore indirect transfer of assets in India to capital gains tax under all possible circumstances, negating the well-settled and time-tested interpretation of the relevant provisions of law.

To add insult to injury, fierce post-budget debate on the issue also included officials from the Income Tax Department of India stating that the Supreme Court had indicated that government should bring in “tax certainty” by clarifying its intention behind a particular law and that the judgment did not indicate whether it should be retrospective or prospective.

This position of government will, if passed into law, be one of the greatest challenges to “tax certainty” in the annals of tax legislation.

Effectively this means that the Indian tax authorities believe that a non-resident payer of sale proceeds for the offshore transfer of a foreign company’s shares — from 1962 onward! — should have had the vision and foresight to know of this retrospective amendment in Budget 2012 and deducted tax at the source accordingly.

The potential for this measure to pass into law will do little to support a wider foreign direct investment policy, which had been warmly received by many.

Other clarifying amendments in support of the measure

In pursuance of the above measure, the following related clarifying amendments are also proposed in FB 2012:

• In the source rule, the expression “through” shall mean to include “by means of” or “in consequence of” or “by reason of” transfer of a capital asset in India.
• Any share or interest in a company or entity outside India shall be deemed to have been situated in India if the share or interest substantially derives its value, either directly or indirectly, from the assets located in India.
• In the definition of “capital asset,” the term “property” shall include any rights in or in relation to an Indian company, including rights of management or control or any other rights whatsoever.
• The definition of the term “transfer” is clarified to have a wide meaning by including disposition of an asset or any interest therein or creating any interest in any asset in any manner, directly or indirectly, absolutely or conditionally, voluntarily or involuntarily, by way of an agreement entered in or outside of India. Further, this definition will be irrespective of the fact that such transfer of rights has been characterized as being effected or dependent upon or flowing from the transfer of shares of a company incorporated outside India.

New validation clause

FB 2012 also proposes to provide for validation of demands raised under Indian tax law in certain cases in respect of income accruing or arising under the above source rule of transfer of a capital asset situated in India.

Through the validation clause, any notice sent or to be sent, as well as any taxes levied, demanded, assessed, imposed or collected or recovered, during any period prior to the validation clause coming into force shall be deemed to have been validly made, and such notice or levy of tax shall not questioned on the grounds of any interpretation of the above source rule.

Further, the validation clause shall operate notwithstanding anything contained in any judgment, decree or order of the Indian judiciary or the tax authority.

Like the retrospective measures on all offshore indirect transfers of assets situated in India, the above amendments — except the validation clause — are proposed to apply retrospectively with effect from 1 April 1962. The validation clause shall be effective from the enactment of FB 2012.

An outlier among peers?

When compared with tax law of other similar countries, the decision to push for such a high level of retroactivity (50 years) seems completely unaligned to practice among India’s peer group. In Brazil, for example, new tax legislation should only have prospective effects, although under very specific matters it may be possible to find tax legislation with retroactive effects — but certainly not past the five-year statute of limitations.

In Russia, legislation that either establishes or increases new taxes or levies or otherwise worsens the position of taxpayers or levy-payers do not have retroactive force. China may provide the most easily comparable situation.

Circular 698, which deals with beneficial ownership for treaty purposes and taxation of direct/indirect transfers of the shares of a Chinese company, was issued on 10 December 2009, but is retroactively effective to 1 January 2008 only. Even within India, the 50-year retroactive period — particularly given the nature of the very sizable and sensitive issue it addresses — seems particularly unusual.

That said, Finance Bill 2010 did contain a measure (that interest, fees for technical services and royalty would be taxable in India regardless of where the services were provided, as opposed to formerly being taxable if the services were provided in India) that was retroactive for a period of 34 years, right back to when the tax was actually introduced.

Potential timeline to enact the retrospective measure

These unprecedented changes within FB 2012 still need to pass through India’s Lower (Lok Sabha) and Upper (Rajya Sabha) houses before being promulgated by the President of India.

It is thought that the bill will be debated in the Lower House either at the end of April or at the beginning of May, passing into the Upper House shortly thereafter.

India gets its GAAR

Another provision in the Budget that is of major concern is the General Anti-Avoidance Rule (GAAR), which has been fast-forwarded from Direct Tax Code 2010 (DTC).

While it was introducing these provisions, the government seems to have ignored some very sensible suggestions of the parliamentary Standing Committee on the DTC (SCF) to address concern expressed by various stakeholders.

First and foremost, the SCF recommended the onus of proving tax avoidance should be on Revenue and not the taxpayer. Secondly, it recommended suitable grandfathering provisions to protect the interest of taxpayers who have entered into arrangements under the existing law.

Thirdly, it recommended that applicable tax treaty provisions should prevail over GAAR so that India’s credibility as a reliable treaty partner is not affected. Unfortunately, none of these well-meaning recommendations find a place in the Budget.

The Indian GAAR is proposed to be effective for tax years starting 1 April 2012. Where the following two conditions are fulfilled, an arrangement may be declared as an “impermissible avoidance arrangement”:

1. The taxpayer enters into an arrangement, the main purposes of which is to obtain a “tax benefit.”
2. The arrangement fulfils any one of the following criteria:

• Creates rights or obligations that are not ordinarily created between persons dealing at arm’s length
• Results, directly or indirectly, in the misuse or abuse of the Indian tax law provisions
• Lacks commercial substance or is deemed to lack commercial substance, in whole or in part
• Is entered into, or carried out, by means or in manner that are not ordinarily employed for bona fide purposes

All of the above criteria are defined in FB 2012 and can be reviewed in Ernst & Young’s Budget PLUS 2012 handbook at www.ey.com/india.

The Indian GAAR is sufficiently all-embracing to deter tax avoidance. However, there is always the danger of penalizing those who enter into a bona fide transaction.

In that regard, it is likely to increase taxpayers’ uncertainty and therefore goes against one of the fundamental aims of any tax system. A further criticism of any GAAR is that it detracts from the rule of law by being too vague or indeterminate.

We hope the government gives due consideration to the checks and balances suggested in the SCF’s earlier report before any enactment of FB 2012 so as to frame the implementation guidelines to address the wide and varied concerns that many taxpayers have put forward to date.

Definition of royalty

A third and somewhat “hidden secret” in the fine print of FB 2012 is a retrospective amendment to tax payments of all kinds of software (including ready-made or shrink-wrapped software) and payments for transmission by satellite as royalty.

Once again, a plethora of court decisions over the years would be negated by this amendment, which seeks retroactivity back to June 1976 (i.e., since the introduction of a tax on royalties).

This will lead to tremendous on-the-ground commercial complexities, as past contractual payments would need to be revisited to enforce tax cost on such royalty payments.

Transfer pricing a key focus of the Union Budget

It is no secret that a number of taxpayers in India find themselves in the challenging position of documenting and defending their transfer pricing (TP) issues as disputes in this area rise due to increasingly well-staffed tax authorities applying more sophisticated and sweeping transfer pricing tools.

The introduction of Advance Pricing Agreements (APAs) as proposed in FB 2012 is expected to provide an alternative channel of resolving TP disputes in advance — a very welcome tool to taxpayers struggling with controversy in this area.

The additional amendment expanding the definition of international transactions to cover business restructuring and business reorganizations requires a careful review by taxpayers in order to assess its impact. Taxpayers will need to review the TP implications arising from cross-border redeployment of functions, assets and risks — an emerging and particularly complex issue.

Introducing APAs to Indian tax law

Indian tax law does not currently provide a mechanism for APAs. FB 2012 proposes to introduce a scheme of APAs by empowering the Central Board of Direct Taxes (India’s tax administration body) to enter into an APA with any person undertaking an international transaction.

FB 2012 proposes to empower the board to formulate a scheme providing for the manner, form, procedure and any other matter generally with respect to the APA mechanism.

The APA mechanism proposed in the FB 2012 would operate broadly as follows:

• The taxpayer can approach the board for determination of the arm’s length price (ALP) in relation to an international transaction that may be entered into by the taxpayer.
• The ALP in an APA shall be determined using any method including the prescribed methods, with necessary adjustments or variations.
• The ALP determined under the APA shall be deemed to be the ALP for the international transaction with respect to which the APA has been entered into.
• The APA shall be binding on both the taxpayer and the revenue authorities as long as there are no changes in law or facts that served as the basis for the APA.
• The APA shall be valid for the period specified in the APA, subject to a maximum period of five consecutive financial years.
• The proposed APA mechanism requires a person entering into an APA to necessarily furnish a modified return, for previous years to which the APA applies, within three months of the end of the month in which the said APA went into effect. The modified return has to reflect the modification to the income only with respect to the issues arising from the APA and should be in accordance with it.
• The mechanism also requires the revenue authorities to complete the assessment or reassessment (audit proceedings) in accordance with the APA and any modified return, if applicable. The period of limitation for completion of audit proceedings is extended by one year where a modified return has been filed and where the audit proceedings are pending completion. Where the audit proceedings have been completed before the expiration of the period allowed for furnishing the modified return, the mechanism requires the revenue authorities to re-calculate the total income based on the APA and the modified return. The period of limitation for completing the audit proceedings in such cases is one year from the end of the financial year in which the modified return is furnished.
• The mechanism empowers the board to declare, with the approval of the Central Government, any APA to be void ab initio (i.e., void from the start) if it finds that the agreement has been obtained by the taxpayer by fraud or misrepresentation of facts. Once an agreement is declared void ab initio, all the provisions of the ITL shall apply to the taxpayer as if such APA had never been entered into.

These amendments are proposed to take effect from 1 July 2012.

Definition of the term “international transactions”

The Indian transfer pricing provisions apply to “international transactions,” which Indian tax law defines as a transaction between two or more associated enterprises, either or both of which are non-residents, in the nature of purchase, sale or lease of tangible or intangible property or provision of services or lending or borrowing of money, or any other transaction having a bearing on the profits, income, losses or assets of such enterprise.

It shall include a mutual agreement or arrangement between two or more associated enterprises for the allocation or apportionment of, or any contribution to, any cost or expense incurred or to be incurred in connection with a benefit, service or facility provided or to be provided to any one or more of such enterprises.

However, there has been some controversy as to whether the definition covers certain transactions pertaining to intangibles, business restructuring and services. Further judicial precedents have also excluded certain international transactions from the scope of transfer pricing if they do not have a bearing on the profit or loss of the taxpayer or such profit or loss is not determinable under normal circumstances.

FB 2012 proposes to amend the definition of international transaction, by including an explanation, to include the following categories of transactions within the scope of the definition:

• Tangible property transactions: the purchase, sale, transfer, lease or use of tangible property including building, transportation vehicle, machinery, etc., or any other article, product or thing
• Intangible property transactions: the purchase, sale, transfer, lease or use of intangible property, including the transfer of ownership or the provision of use of rights regarding land use, copyrights, patents, trademarks, licenses, franchises, customer list, marketing channel, brand, commercial secret, know-how, industrial property right, exterior design or practical and new design or any other business or commercial rights of similar nature
• Financial transactions: capital financing, including any type of long-term or short-term borrowing, lending or guarantee
• Provision of services: provision of market research, market development, scientific research, legal or accounting service, etc.
• Business restructuring: a transaction of business restructuring or reorganization, entered into by an enterprise with an associated enterprise, regardless of whether it has bearing on the profit, income, losses or assets of such enterprises at the time of the transaction or at any future date

Defining intangible property

FB 2012 further proposes to provide an explanation to define the term “intangible property” for the purposes of an international transaction. It proposes to include:

• Marketing-related intangible assets
• Technology-related intangible assets
• Artistic-related intangible assets
• Data processing-related intangible assets
• Engineering-related intangible assets
• Customer-related intangible assets, such as customer lists, customer contracts and customer relationships
• Contract-related intangible assets, such as favorable supplier contracts and license agreements
• Human capital-related intangible assets, such as a trained and organized work force and employment agreements
• Location-related intangible assets
• Goodwill-related intangible assets
• Methods, programs, systems, procedures, campaigns, surveys, studies, forecasts, estimates, customer lists or technical data
• Any other similar item that derives its value from its intellectual content rather than its physical attributes

This amendment will be effective retrospectively from the financial year 2001–02.

Changes to the Dispute Resolution Panel

Under Indian tax law, the tax authorities do not have a right to appeal the directions given by the Dispute Resolution Panel (DRP), and the DRP directions are binding on the tax officer. However, the taxpayer has a right to appeal the directions of the DRP before the Income Tax Appellate Tribunal (ITAT).

FB 2012 proposes to provide the right for the tax officer to file an appeal before the ITAT against the directions of the DRP with respect to objections filed before the DRP on or after 1 July 2012. This amendment will take effect from 1 July 2012. Current provisions provide that the DRP has the power to confirm, reduce or enhance the variations proposed in the draft assessment order.

FB 2012 proposes to widen the powers of the DRP for consideration of an issue arising out of the audit proceedings relating to the draft order, regardless of whether such matter was raised by the eligible taxpayer or not. This amendment will be effective retrospectively from 1 April 2008.

FB 2012 also proposes to provide that, similar to the other assessments, the time limit for completion of assessments involving search and seizure will also be as per the provisions relating to the DRP and that the other provisions regarding time limit will not apply to such assessments.

FB 2012 further proposes an exclusion of orders passed by the tax officer pursuant to the DRP directions, from the jurisdiction of the CIT (A), and provides for filing the appeal directly with ITAT in such cases. These amendments will be effective retrospectively from 1 October 2009.

Assessment timelines

The due date for completion of a transfer pricing assessment is extended by three months. Transfer pricing assessments for FY 2009–10 need to be completed by 31 January 2013.

More on transfer pricing: India sends a letter to the United Nations

It wasn’t just in the Union Budget that the Indian government gave global business cause for concern. In a letter dated 12 March 2012 addressed to the United Nations (UN), the Indian government effectively condemned the use of the OECD Transfer Pricing Guidelines by the UN, reigniting a debate that was first raised by the Indian Finance Minister in June 2011.

Issuing the letter in conjunction with the 15 March release of the new UN Model Convention, it appears the Indian government proposes the UN develop a manual on transfer pricing that departs from the OECD Transfer Pricing Guidelines to the benefit of developing countries.

The letter is a response to a report on the role and work of the Committee of Experts on International Cooperation in Tax Matters. In the letter, the Indian government expresses its disagreement with the OECD Transfer Pricing Guidelines as a foundation for transfer pricing applicable to developing countries.

According to the Indian government, “These Guidelines on transfer pricing only reflect the agreements amongst Government of those countries that are members of the OECD (developed countries) and accordingly tend to take care of interest of only developed countries. The guidelines do not give right of taxation to source countries accordingly eroding taxing rights of developing countries.”

In the letter, the Indian government expresses its belief that “the Committee of Experts do not have jurisdiction to decide the critical issue of whether the OECD Transfer Pricing Guidelines agreed by Governments of developed countries should be followed by the Governments of developing countries when these Governments are not party to the OECD Transfer Pricing Guidelines.”

The Committee of Experts has mandated a subcommittee consisting of 13 members of the developed and 7 members of the developing countries to develop a practical manual on transfer pricing. Pursuant to the letter from the Indian government, the manual should not be based on the OECD Transfer Pricing Guidelines.

Instead, the Indian government proposes that the UN establish an inter-governmental commission with representatives from governments of the developed and the developing countries. It would be the task of this commission to develop guidelines that serve the interests of the developing countries on the basis of consensus among the governments of all countries.

The proposals of the Indian government are a key area to monitor, particularly when one takes into account the fact that all BRIC countries consider themselves developing countries in the context of the UN. Any move away from the OECD guidelines has significant impact for global business.

Where to next?

That the world has been moving toward more stringent anti-abuse measures is no secret; that is evidenced by the British government proposing to bring forth legislation for a GAAR in 2013, recent changes to Australia’s GAAR and a whole host of other, more specific anti-abuse measures elsewhere in the world.

What is far more surprising is the sheer scope and depth of the proposals currently on the table in India. Clearly the time period between now and these measures being enacted is a key opportunity for companies to review past positions and carry out impact assessments of what may be if the legislation is passed.

With many commentators estimating that the Indian tax authorities are sitting on a bank of around $8 billion of similar positions, it makes great sense to do so. And of course, the multi-year, multi-jurisdictional impact of such positions should also be carefully studied; this is particularly the case now that India as recently as November 2011 ratified the OECD’s Convention on Mutual Administrative Assistance in Tax.

Immediate opportunities to engage directly with government should also be considered, either on a lone basis, as part of a wider coalition of like-minded peers or as part of an industry-type grouping.

Of course, this article can only begin to dig into the huge scope of FB 2012. For full coverage, we suggest you access our dedicated budget website at www.ey.com/india.

Oh, and by the way — corporate tax rates in India, including the surcharge and education charge (CESS), remained the same in the Union Budget!

Contact

• Ganesh Raj, +91 120 671 7110, ganesh.raj@in.ey.com
• Rajan Vora, +91 22 6192 0440, rajan.vora@in.ey.com

This article was first published in the Ernst & Young Global Tax Policy and Controversy Briefing which can be accessed using the link below:

• Global Tax Policy and Controversy Briefing, Issue 10, June 2012 (pdf 12.98 MB)