By Suresh Swamy and Kiran Bhatia

The Finance Minister has presented this budget at a time when the world is looking at India and China with awe given its stupendous growth rate. The world growth is projected at 4.1%; the United States is estimated to grow at 1.5%; Europe by 1.6%; while India and China are expected to grow at 8.7% and 9.5% respectively.

With such high growth rate, India was witness to a large number of overseas Mergers & Acquisition deals. But the tax office seemed concerned about these since they involved transfer of beneficial interest in an Indian company without any transfer of the shares of the Indian company.

The companies claimed that the gains on sales of shares of the overseas company were not taxable in India. Take the classic example of the leading telecom deal wherein the controversy of taxing the transfer of share capital of an Indian entity is being deliberated at the Mumbai High Court level. Similarly, another deal in the Information Technology Sector which was consummated a couple of years ago is also under the scanner. Although, the overseas groups had invested in the Indian company through Mauritius, the tax department believed that the Mauritius entity was a conduit company and effectively, it was the overseas group which invested in India, resulting in capital gains tax liability in India.

The Indian revenue authorities had sought to bring such deals under the ambit of the India tax net. To enable them do so, newspaper reports indicated that they were expecting the Finance Minister to amend the tax law which could have brought these offshore M&A transactions to tax in India.  Though certain amendments have been brought about in the tax law, the question is whether they are sufficient enough to bring these offshore deals to taxation in India.

An honest answer is no.  The amendment which has been introduced seeks to impose a liability on the buyer of the shares to withhold tax before it pays the money to the seller. However, it ignores the fundamental aspect of tax law which requires withholding tax only on income which is taxable in India. Of course, one may have to approach the tax officer to determine the income embedded in the payment but that is merely procedural. Also, one may not approach the tax authority when the law is amply clear on how these amounts should be taxed.

Probably, a better way to subject these offshore deals to tax in India was to bring about a change in the charging provisions of the Act and deem these sales as taxable in India.  Even then such an amendment would have impacted only deals of entities incorporated in countries, which do not have a tax treaty with India. Multinational Corporation (MNCs) generally have sound tax advisors and it is unlikely that they would be many MNCs who would not have considered favorable treaty jurisdiction to invest in India. The cardinal rule that treaty overrides the provisions of the Act would therefore have prevailed.  Countries having a tax treaty with India such as Mauritius, Cyprus and Singapore provide capital gains tax exemption in accordance with the tax laws would have still prevailed over the Act.

It was also being suggested that a unilateral amendment to the tax law should be brought in to give overriding effect to the treaty. However, luckily no such amendment has been brought about.  That would have meant that India has gone back on its word to give a particular relief under the treaty and would have reflected badly to the international investing community. The constitutional validity of such an amendment could have also been challenged. The Finance Minister has therefore rightly not brought any amendments to the Income tax Act.

Apart from the above, there had been various discussions on re-negotiating India’s treaty with Mauritius and Cyprus. The Finance Minister had a great platform to clarify status of the treaties. In the budget speech for 2007, he had mentioned that the government would adopt a consultative approach to treaty renegotiation. However, he has opted to be silent on that front. The large investor population has a right to receive some information on the direction of treaty renegotiation, at the least.

The authors, Suresh Swamy and Kiran Bhatia are with Pricewaterhouse Coopers Pvt. Ltd.