This article has been written by Baneet Kaur Kohli, pursuing a Diploma in Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from LawSikho. The article has been edited by Aatima Bhatia (Associate, LawSikho) and Dipshi Swara (Senior Associate, LawSikho)
Table of Contents
Introduction
Inbound investment is basically, an international company making investment in India either by setting up a business unit or merging with an already existing Indian company in any sector.
Tax implications which may arise in such a set-up (inbound merger) is similar to that of domestic merger. All the provisions, laws, regulations etc. which are applicable in a domestic merger, also apply with respect to an inbound merger. The only exception here being those of carry forward and set-off of losses. Under the Indian tax regime, accumulated losses and unabsorbed depreciation are allowed to be carried forward and set off over a period of 8 years. Since foreign companies are not chargeable to tax in India.
Accordingly, accumulated losses and unabsorbed depreciation of foreign amalgamating companies may not be permitted to be carried forward and set-off by the Indian amalgamated companies pursuant to an inbound merger. However, there is one way to benefit from the aforesaid provision. If a foreign amalgamating company has a Place of Effective Management (POEM) in India already in existence before the merger. Then the foreign amalgamating company might be permitted to carry forward and set-off its losses by the Indian amalgamated company considering the prior existence of POEM.
As we have established above, the nature of taxation for an inbound investment is the same as that of a domestic merger. Let’s dive a little deeper into its framework:
Capital gains
Capital gains, arising in the hands of the transferor being the amalgamating company or its shareholders, on account of a merger would be exempt, as per the provisions of the Income-tax Act, 1961 (Act), subject to the satisfaction of certain conditions. Cross-border mergers for this purpose include:
- A foreign company merging with an Indian company; or
- A merger between two foreign companies, and the amalgamating foreign company transfers the shares of an Indian company on account of the merger (direct transfer); or
- Transfer of shares by the shareholders, being shares that derive its substantial value from assets located in India, on account of a merger between two foreign companies.
Income tax
Historically, it has been noticed that an enormous amount of inbound investments have been in the field of IT & ITES industries. Since, these industries enjoy a tax holiday u/s 10A/10B of the Income Tax Act.
For instance, Bharti Airtel, agreed to sell off its 20% stake in its DTH arm to a US based PE firm for around $350 million,Idea received 100% FDI following its following its merger with Vodafone (brief description of the company)
Routing investments majorly through Mauritius as IHC (International Holding Companies) was hugely advantageous in the case the investor company wanted to keep the profits generated from overseas operations outside of India:
- Any transactions taking place are deemed to be RBI approved subject to other regulatory approvals.
- Start-ups to get relaxations from angel tax provisions.
- Reduced corporate tax rate of 25% for certain domestic companies.
- Local sourcing norms to be eased for FDI in single-brand retail.
Stamp duty
Stamp duty is applicable on the property being transferred to the amalgamating company. Such transfer of title generates the payment of stamp duty. Stamp duty varies from state to state. But mostly falls in the bracket of 5% – 10% for immovable properties and 3% – % % in case of movable properties.
Exchange control regulations
Without the approval of the Government of India, undertaking of foreign investments is a bit difficult. However, a court-approved merger is specifically exempt from obtaining any such approvals where, post-merger, the stake of the foreign company does not exceed the prescribed sectoral cap.
Assessing the impact of GAAR
Under the Indian tax regime, the enactment of General Anti-Avoidance Rules (GAAR) and the modification of tax treaties bearing the Multilateral Instrument (MLI) have had a significant impact on inbound investments into India.
GAAR first came into effect on April 1st, 2017 with an objective to trigger any inbound investments which fall under the Impermissible Avoidance Arrangement (IAA). An IAA consists of two tests:
Primary test – When the said arrangement focuses only on obtaining a tax benefit.
Secondary test –When the said arrangement satisfies any one of the following conditions:
- It is not at arm’s-length;
- It results in misuse or abuse of the provisions;
- It lacks commercial substance; and
- It is entered in a manner not employed for bona fide purposes.
GAAR provisions do not apply to:
- Any arrangement where the total tax benefit inclusive of all the parties do not exceed INR 30 million in a single financial year.
- Foreign portfolio investor (FPI), who has not availed the treaty benefits.
- Any direct or indirect offshore FPI investment by a non-resident.
- Any income arising from transfer of an investment made prior to April 1st, 2017.
The provisions of GAAR mainly state that the reasons for investing in India should mostly be driven by commercial reasons rather than from a tax-saving mindset.
What happens when GAAR provisions are triggered?
In such an event, tax authorities may:
- Completely disregard the arrangement or any portion of it.
- Let go of the corporate structure.
- Change the place of residence of the arrangement.
- Since GAAR overrides tax treaties, they may completely disregard the treaty benefits.
- They may interchange the equity-debt ratio.
Assessing the impact of multilateral instruments
An OECD initiative – a multilateral instrument under the (Base Erosion and Profit Shifting) BEPS project, is signed by over 90 countries to prevent base erosion and profit sharing.
Why was BEPS implemented in India?
- To curb the loopholes, mismatch, and other gaps in tax rules to avoid paying taxes.
- Current treaty provisions were inadequate in nature.
- Anti-abuse measures were not strong and lacked effectiveness.
Numerous tax treaties have been amended due to MLI, including treaties with but not limited to Canada, Singapore, Cyprus, France, Australia, Netherlands to name a few.
- MLI has introduced the concept of PPT (principal purpose test) in tax treaties to prevent any misuse of such a treaty.
- MLI has also introduced changes to mitigate the artificial avoidance of PEs (permanent establishments) and also by enhancing the scope of dependent agency PEs.
Although both GAAR and PPT are in place to avoid tax benefits. However, there are certain points of distinction:
| GAAR | PPT | |
| Primary Test | Triggered when the main objective is to obtain tax benefit | Triggered when one of the main objective is to obtain tax benefit |
| Secondary Test | In addition to the above test, one of the four elements tests needs to be met | No additional tests to be met |
| Exemption Limit | Not applicable if tax benefit arising from the arrangement is > INR 30 million | Not applicable |
| Object and Purpose of Treaty | May apply even when the tax benefits arising from the arrangement are in accordance with the object and purpose of the treaty | Not applicable when the tax benefits arising from the arrangement are in accordance with the object and purpose of the treaty |
| Approving Authority | In case of GAAR provisions being applicable, the matter needs to be approved by the authorities | No approval is required |
The functional aspects for inbound merger have been primarily provided in Regulation 4 of Foreign Exchange Management (Cross Border Merger) Regulations, 2018.
Transfer or issue of securities
When a foreign company merges into an Indian company, the consideration gets paid in either of the following methods-
- Paying off the ascertained value of the total assets of the other party, either in cash or in depository receipt or partly in cash and partly in depository receipts, or
- By issuing its securities to the shareholders of the other party, or
- Through both the modes.
When it comes to the issuance of securities, the transferee Indian company is to be guided by the FDI Regulations 2017 in respect of pricing guidelines, entry routes, sectoral caps, attendant conditions and reporting requirements for foreign investment. While if the merging foreign company is Joint Venture(JV)/Wholly Owned Subsidiary(WOS) of an Indian company then the transfereeIndian Company has to comply with the ODI Regulations, 2004.
Holding assets outside india
Apart from issuing securities, the transferee Indian company may on account of a cross border merger also hold or acquire any asset outside India, if permitted under the Foreign Exchange Management Act, 1999, its rules, regulations and may further perform any transaction in respect of the same. And if any such asset is not permitted to be acquired, it shall be sold off within two years from the approval of the CBM scheme by the Tribunal and the sale proceeds to be repatriated to India through Banking Channels.
Office of the transferor foreign company outside India shall be deemed to be a branch office of transferee Indian company in the process of execution of CBM scheme. Hence any transaction may be performed through such an office, so permitted to it under Foreign Exchange Management (Foreign Currency Account by a person resident in India) Regulations, 2015.
Moreover, overseas borrowings of such transferor company becomes the liability of resultant company and therefore it needs to confirm with the External Commercial Borrowing norms or Trade Credit norms or other foreign borrowing norms, as laid down under Foreign Exchange Management (Borrowing or Lending in Foreign Exchange) Regulations, 2000, within two years of approval of the scheme.
Conclusion
It is important to understand the tax implications in an inbound investment. During cross-border structuring, it has to be ensured that it achieves tax efficiency in India and also works in other countries without leading to adverse tax consequences. Companies need to have an overall idea of the taxation framework in inbound investment with respect to the corporate gains, income tax, stamp duty, regulations and an assessment of the impact of GAAR and how it is different from a PPT.
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