Introduction

The foreign inflow of capital into India has been very high ever since the country became open to foreign investments (Post liberalization era). The reason for heavy inflow can be attributed to 2 reasons: 1) India with depleted foreign exchange reserves and huge current account deficits had policies and incentives in place to attract foreign capital 2) India being a developing country had a huge opportunities for multinationals to come and enjoy the benefits of low cost of production

The data shown below shows that the volume of net foreign investment into India has been raising constantly and in spite of the economic crisis of 2008-09 the investments picked up.

Foreign Investment Inflows (Amount in Billion US $)

60 50 40 30 20 10 0 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11 2011-12
Source: Reserve Bank of India; Data warehouse (http://dbie.rbi.org.in/DBIE/dbie.rbi?site=statistics)

43.325

50.361 41.597 39.177

13.003

14.64 16.261 8.311

Typically, foreign investors enter Indian markets via treaty platform investment vehicles located in tax-favorable jurisdictions such as Mauritius and Singapore. Such treaty platform vehicles enable access to Indian tax treaty network which provides a zero percent capital gains tax on sale or direct or indirect transfer of investments to India. The new provisions under DTC and GAAR may allow overriding of Double Taxation Avoidance Agreement (DTAA) between India and Mauritius or Singapore, and hence investors need to review current investment vehicle structures and ascertain whether such arrangements would withstand any regulatory scrutiny by Indias tax authorities.

Current typical investment structures

Let us try to understand the existing structure of capital inflows into India. This can be illustrated through the example mentioned below. Consider a hypothetical the investments done by a U.S. based company in India through a treaty platform

U.S.

U.S. Co

U.S. Co

Mauritius

Mauritius Fund

Any capital gains are taxed at 30% as per prevailing tax Takes requirements advantage of DTAA to avoid tax payment

India

India Co
Scenario 1

India Co Scenario 2

As shown in the Scenario 1 above, the U.S. firm invests money in an investment fund based out of Mauritius. This fund then invests in one or more companies in India. Since India and Mauritius have a Double Taxation Avoidance Agreement, any capital gains on the investment by the fund doesnt incur tax, neither in India (under DTAA) nor in Mauritius (as per local policies there).

Contrast this with scenario 2, where an investment is done directly by the US firm in India. Any capital gains in such an investment will be subject to 30% taxation under Indian tax requirements.

Real-life examples of such investments surfaced in several high-profile investment deals that involved transfer of Indian subsidiaries. Below is the example of Vodafone-Hutchison takeover, which involved transfer of shares in a Cayman Islands vehicle to Netherlands entity of Vodafone.

U.K.

Vodafone UK

Hutchison Telecom Intl

Netherlands

Vodafone Netherlands Actual Deal

Cayman Islands Vodafone took advantage of DTAA to avoid tax payment India

CGP Investments Owned 100%

Hutchison Essar India

Hutchison Essar India was completely owned by CGP Investments, which was a Cayman Islands investment vehicle formed solely for this company. In the deal, Vodafone Netherlands acquired CGP Investments directly, and hence, indirectly acquired Hutchison Essar India. As per the Income Tax department, this was a capital gain taxable to the amount of $2.5billion, which was avoided leveraging the DTAA between India and Cayman Islands.

Thus, following such experiences, India has now planned for roll-out of India Direct Taxes Code (DTC) and General Anti-Avoidance Regulations (GAAR).

The below discussions will cover in detail the existing tax regimes, provisions suggested through Direct Tax Code (DTC) and General Anti Avoidance Rules (GAAR) and their probable impact over the investment flows into India.

The following section explains the provision of DTAAs prevalent in India and the trends in the tax regimes in similar other countries

Double Tax Avoidance Agreements/ Double Tax Conventions

Double taxation is an incident where the income/ gain or a financial transaction takes place and concerns the jurisdictions from various countries and thus is subject to multiple taxations. Usually such issues are solved through the DTAA or DTC or simply Tax Treaties. These treaties are aimed at promoting the trade and capital flow across countries; avoid tax evasions and reasonable distribution of the tax revenues among the tax authorities of the different countries involved. The treaties for the above said purpose are usually based on two model conventions: a) UN Model Convention b) OECD Model Convention Since we are trying to understand the tax implications for the capital inflows into countries through the indirect transfers and related illegitimate tax avoidance, let us understand broadly these 2 conventions from that perspective.

UN Model Convention:
This usually deals with the income in nature of Capital gains. According to it the gains of a company in a particular state from selling of its stake in a company in some other state/ regime will be taxed in that particular state if the selling party had some specific percentage of the shares in the selling company for previous 12 months.

OECD Model Convention:

Here the convention state that any gain derived out of selling of shares of company deriving more than 50% of its value directly or indirectly from immovable property situated in other state will be taxed in other state. These 2 models along with lot of modifications and customizations, have been used to develop the Bilateral Trade Agreements treaties across world like the: European Union saving taxation Cyprus double tax treaties German tax avoidance

Indias Double Tax Avoidance Agreements (DTAA)

India has a DTAA with 88 countries as of now. The DTAA has been developed on the basis of OCED model; however there is no clarification on the 50% threshold requirement. The treaty is not clear on that. The DTAAs can be classified as

Comprehensive Agreements:
It deals with taxes on income from capital gains, income and capital transfers

Limited Agreements:
They deal taxes on income from shipping or air transport, inheritance or gifts.

General Salient Features:

Though the provisions in the tax treaties are different for different agreements but some of the salient features of the DTAA between India and other countries are as follows: DTAA typically covers the resident of India or the resident of the other contracting nation. Any person not falling under this categorization cannot claim benefit under DTAA. Any beneficial tax provision already available under the Indian Tax act or the regime of the contracting nation will not be denied Income from the business can be taxed:

i)

Only in the resident country if the business entity has no activity in source state

ii) In the source state if there is a fixed place of business, i.e. Permanent establishment iii) Income from immovable property arising to a non-resident is taxed in state of location: Source state

iv) Income from movable property like dividends, interest and royalties are taxed in the resident state.

The methods of eliminating the Double Taxations followed are:

i)

Exemption method: The residence country excludes the foreign income from its tax base and gives the source country a right to tax it

ii)

Credit method: Resident is liable in the resident country for the global income and the credit for the tax paid in the source country are given by the resident country

iii)

Tax Sparing: Tax credit is provided by country of residence, not only in respect to taxes paid in India but also in respect of taxes India foregoes due to its fiscal incentive provisions

There are detailed explanations regarding the Residency of a person: Its determined on the basis of liability of tax in a particular country by reason of domicile, residence, place of management or any other criteria of similar nature Concept of Permanent establishment: The DTAA allows the contracting nation to tax the income of the foreign enterprises only if such enterprises conduct business in India through a permanent establishment. It refers to a fixed place of activity through which the business is completely or partially carried out.

Explaining the current/ emerging trends in taxation for foreign capital flows
Before analysing the provisions of the new GAAR and DTC being proposed by the Indian Tax authorities its advisable to have a broad understanding of the taxation regimes in other similar countries (BRIC nations) The BRIC nations have been the centre of growth for most of the multinational companies. All of these companies have been investing aggressively in these countries to reap the benefit of low cost production. The taxation regimes followed by the host nations was initially targeted at attracting more and more capital inflow. However now the countries are moving towards the benefit sharing model, where there are sophisticated tax systems in place and tax incentives are losing relevance. The three major trends that can be seen in this regard are as follows:

1. Tax Incentives narrowed:

The tax incentives have been narrowed down to target specific regions and areas of operations. For example Brazil has been focussing majorly on software development, IT services and infrastructure projects. The enactment of the new Enterprise Income Tax Law in 2007 in China marked a change in their taxation regimes. This was done keeping in mind the target to narrow down the foreign investment to specific areas like IT services, software developments and environmental protection industries. The governments of these countries realize the attractiveness of their economies will continue to attract the capital inflow even in the absence of the complete tax holidays.

2. Anti-Abuse:
The local civil codes and general provisions along with the Anti-Avoidance rules of 2001 in Brazil have always aimed at working against the transactions aimed at just grabbing tax saving without any business relevance. The Chinese government have also tried to implement such anti avoidance rules through the Enterprise Income Tax law 2008. These rules based on the principal of substance over form have managed to increase Chinas tax revenue by about 24 billion renminbi. The finance bill 2012 proposed in India also recommends such rules to be established.

The practical application and implementation of such rules completely depend upon the political circumstances and attitude of tax authority in a particular country.

The rules have been seen as the measures adopted by the governments and tax authorities to create situations of uncertainties for the foreign investors. Thus this is seen as an infringement into the profits of multinationals.

3. Indirect Transfers:
Indirect transfers include transactions where assets in a country are owned by a country in different jurisdiction and are further sold to a third party. This route and the related taxation system where the companies try to avoid taxes that would be due in the countries where the assets lie has been used over the years by the multinationals to bring in foreign capital into developing countries. The Indian

legislation is in process of formulating a retrospective ruling in this regard and is analysing the implications for the same.

However China already has such regulation (enacted in 2009) in place where they have made it public that tax authorities hold power to tax any indirect transfer if it lacks sound commercial purpose. Even before the regulations the Chinese tax authorities had been scrutinizing such transactions under the purview of anti-abuse policies. Similarly though Brazil does not have a strong ruling in place but it holds the power to scrutinize such transactions under the light of anti-abuse provisions.

So the reforms indicate that the transactions will have to show a proper business purpose and there is no space for empty inactive transactions.

4. Legal Certainty:
Often the measures taken by the tax authorities of the countries have been criticized for creating a legal uncertainty regarding what is a legitimate transaction and what is illegitimate. This part is very important in a big country like China, where the process of clarification and application can be very time consuming and cumbersome. So the Chinese tax regime aims at maintaining a frank relationship with the corporates to simplify the process

India formally has a well-established ruling authority which can be reached out in case of any sort of ambiguity. However the story in Brazil is not the same. The tax structures, laws and implications are all too complicated and usually lead to lot of uncertainties. Brazil definitely needs to move in the direction in which its peers are headed.

So we see that baring 1-2 instances the tax regimes in the above countries is moving towards a system where they expect to share the benefits that the foreign investors aim to reap out of the investments in theirs countries. Also the efforts to attract foreign capital are now restricted only to certain sectors which are on priority list for the nations. Also the tax regimes are implementing measures which helps to establish better legal certainty and prevent potential tax avoidance.

Response to GAAR
Indian Context
The announcement to introduce GAAR was done in the Finance Bill 2012. The provision aiming at establishing the norm of Substance over form was interpreted in varied manners. The provision was seen as an effort to provide unlimited power to the tax authorities to bring any deal/ act of tax planning under scrutiny. If we see the figure below it depicts the trends foreign institution investments in the period of MarchMay, 2012. It is the period right after introduction of GAAR. The net FII inflow into India in February was greater than $7 billion. However the inflow was around $ 0.4 billion in March followed by a net outflow of $8 Billion in April. The huge fluctuations and outflow of investments signalled towards non acceptance of the GAAR updates by the investors. Foreign Institution Investments flowing into India for March-May 2012 (in Million USD)
300 200 100 0 -100 -200 -300 -400 -500 -600 12 16 20 24 28 2 6 10 13 15 18 20 25 30 2 6 Foreign Institutional Investors

March

April

May

Source: Database SEBI As seen in the figure below, we can see that there has been a consistent rise in the foreign investment flows into India. With the global markets being uncertain and the interest rates declining, the emerging markets like India are the centre of all foreign investments. Even after the setback of the 2008 crisis, the investment inflows into the country took up pace and increased. However we see that there was a drop in the flows in 2011-12, which is mainly due to the increased inflation situation in India which led to a series of measures by Indian government to curb it. So given the high current account deficit for India,

the capital inflows coming in form of foreign investments is very crucial to maintain the balance of payments and stabilise the exchange rate. So in these turbulent situations restrictive policies like GAAR can have instrumental effects for our economy.

Foreign Investment Inflows and Foreign Institutional Investments for India (in Billion USD)
60 50 40 30 20 10 0 -10 -20 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11 2011-12 2012-13 Foreign Institutional Investors Foreign Investment Inflows

Source: Database Reserve Bank of India