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Tax aspects related to investment transaction

When a non-resident (i.e. foreign investor) makes an investment or contemplates carrying out a business in India, it is important for him to ascertain the tax implications of the intended transaction.[1]  Foreign investment transactions are closely watched by tax department for tax recovery – hence a mistake or even clever structures intended to avoid tax liabilities can prove very costly. One recent example is that of Vodafone’s entry to the Indian telecom market (one of the biggest ever foreign investments in India[2]). Vodafone was issued a show-cause notice by the Indian tax authorities when it purchased a controlling stake through a complex structure involving a holding company (based in Cayman Islands) of Hutchison – Essar’s telecom business in India. This led to an extended litigation where Vodafone was eventually relieved by the Supreme Court from tax liability, but subsequently tax laws retrospectively to tax transactions of a similar nature. In these chapters we will discuss the impact of tax laws on both domestic and foreign investment transactions. 
To understand the impact of tax laws on investment transactions, we will divide the life of an investment transaction over different stages as below:
  1. Taxation of receipt of money at the time of investment
Till 2012, investment or receipt of funds by a company was not taxable. However, since 1st April 2013, investment transactions will be taxed, if they meet certain considerations. Before exploring how they are taxed, let’s understand this – at the time of investment, startups have to issue shares above the face value (or even the fair value of their shares) – this is known as the premium. Investors are not buying shares in a startup for the existing value of the share, which is only a small fraction of the amount they pay for each share, but are paying a premium to the face value in the hope that in the long run the fair value of these shares will grow a lot and exceed the price which they are paying now. For the company and its promoters, issuing shares at a premium also enables the promoters to retain managerial control over the company, while being able to raise the necessary funding for expansion.
Since 1st April 2013, if the amount received by a company for issue of shares is greater than the fair value (reflects the real value of the company based on its assets and liabilitiesas well as face value (nominal value of the share – usually Rs. 10 or 100 in most cases), then the company will have to pay tax on such income at corporate income tax rates – 30% (40% for foreign companies).


A startup issues 100,000 shares of face value Rs. 10 at a price of Rs. 50 to an investor. If the shares are issued at a price which is higher than their fair value, it will be treated as the income of the startup, and the startup will be taxed on it. Assume that the fair value of the shares is Rs. 20. Therefore, the income of the startup form such funding will be 50 – 20 = Rs. 30 per share, or Rs. 3,000,000 (three million). The startup will have to pay a tax of 30%, Rs. 900,000 (nine hundred thousand) on this.


What are the consequences of this provision?

This tax is applicable, unless the investor is registered with SEBI as a venture capitalist. Apart from large venture capital funds and private equity investors which are professionally organized which are registered, many early stage financial investments are made by invidividuals or by groups of individuals acting jointly, without pooling in their money. These individuals do not typically go through the process of obtaining registration from SEBI. Such transactions will need to be undertaken in a way that the investor can represent to the tax officer that the investment corresponds to the fair value of the company, else it can lead to a significant portion of the investment being paid in taxes instead of the growth of the company. 
  1. Taxation of ongoing income (of the investee) over the duration of the investment
Typically, investors will be concerned about how to take out income from the company, and how income distribution from the investee is taxed, but not over how the investee’s own business is taxed.  However, we will explain that briefly here. After the investment, recurring income of the investee is typically taxed as business income under tax law. A foreigner may actively open up an office in India or invest in an Indian business. Tax consequences of a foreign entity opening an office in India are discussed later in this chapter. The foreigner is typically taxed on this income because the Indian presence qualifies as a ‘permanent establishment’. Where a foreigner incorporates a separate business entity in India, the Indian entity’s income may still be treated as the foreigner’s income if the Indian entity qualifies as a permanent establishment. Detailed discussion of this concept is provided subsequently. Mere financial investment into Indian companies where the Indian company continues to operate independently will not typically create a permanent establishment.
Investors can also earn through dividends (for equity shares or preference shares) or interest (for debentures) from the securities they hold.
If they have licensed technology or brands (this usually applies to strategic investors and joint venture partners), they may have to look at tax related provisions applicable to royalties or license fees.
  1. Taxation of exits (explained in a separate chapter) – Exit transactions typically attract capital gains tax, as discussed in detail in the next chapter.
Special provisions related to taxation of foreign investment or foreign entities which undertake business activities are explained below.
The Income Tax Act, 1961 provides that in case of a person non-resident in India, only the following incomes are taxable in India:
  1. income received in India,
  2. income deemed to be received in India
  3. income which accrues or arises in India,
  4. income which is deemed to accrue or arise in India, including, inter-alia, any income from:
    • a business connection in India,
    • any property in India,
    • any asset or source of income in India, or
    • transfer of a capital asset situated in India.
If a non-resident carries out only a part of its operations in India, only such income which is reasonably attributable to its Indian operations will be taxable in India.
This chapter will introduce you to the tax aspects of foreign investments in India and provide a brief outline of international taxation (where investors intend to exit from a company). We will classify the most common types of transactions in the following way for the sake of simplicity:
  1. Situations where an Indian branch or subsidiary earns income from India.
  2. Situations where payments are directly made by Indian entities to foreigners (since this would be income of the foreigner that has arisen in India) – this will attract tax deduction at source or withholding tax. The withholding tax rate depends on the nature of the payment that is made.
  3. Sale of shares by foreign investors in Indian companies - This attracts capital gains tax (see below for details).
With respect to points 1), 2) and 3) above, also refer to double taxation avoidance treaties (see below for more details) signed by India with other countries assume importance as they contain special provisions (in the form of relaxations) to see tax rates on different kinds of international transactions.
For example, no capital gains tax is levied when the foreigner has entered through Mauritius (provided the transaction is genuine), due to an exemption under the India-Mauritius double taxation avoidance agreement.
  1. In addition, special provisions are applicable to international transactions by entities which are commercially related or within the same group to ensure that they undertake transactions at independent prices. This is known as ‘transfer pricing’ - the objective behind this is to ensure that there is no tax arbitrage (that is, shifting of income to a place where a lower rate of tax is applicable).

[1] Foreign investors (and the Indian party with whom the transaction is contemplated) may obtain an advance ruling from the Authority of Advance Ruling in order to ascertain the tax implications of the proposed transaction.
[2] http://articles.economictimes.indiatimes.com/2012-03-20/news/31215018_1_vodafone-tax-case-territorial-tax-jurisdiction-offshore-transaction

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