Final Rules to determine FMV for indirect transfer - An insight into

Background

The Central Board of Direct Taxes (CBDT), the apex administrative body for income-tax in India, has issued the final rules for determination of the fair market value (FMV) of assets (tangible or intangible) and the income attributable to assets located in India for the purpose of taxation

ofindirect transfer of assets. The final rules will be effective from 28 June, 2016 i.e. their date of publication in the Official Gazette.

As per the indirect transfer tax provisions, transfer of shares or interest in a foreign company is chargeable to tax in India if the value of such shares or interest is substantially derived from assets located in India. The share or interest is said to derive its value substantially from assets located in India, if the fair market value (FMV) of assets located in India comprises at least 50% of the FMV of total assets of the foreign company. The CBDT had issued draft rules in this regard on 23 May, 2016 inviting public comments on the same. After due consideration on the comments received, the CBDT on 28 June, 2016 has notified final rules for determination of FMV for indirect transfer and the reporting requirements thereon.

The final rules cover the following broad areas:

♦		Computation of the FMV of the various classes of assets
♦		Computation of income attributable to assets in India
♦		Information and documents that are required to be furnished by an Indian Concern

Computation of FMV of the Indian Company

Situation	Nature of Indian asset	FMV of the Indian asset
1	Where the Indian company is listed on a recognised stock exchange on the specified date and shares of such Indian company do not confer right of management/control	FMV of listed shares = Observable price on recognised stock exchange
2	Where the Indian company is listed on a recognised stock exchange on the specified date and shares of such Indian company confer right of management/control	FMV of listed shares = (A+B)/C,where A = Market capitalisation based on observable price of its shares quoted on the recognised stock exchange B = Book value of liabilities C = Total number of outstanding shares
3	Where the Indian company is not listed on a recognised stock exchange on the specified date (irrespective of whether shares of such Indian company confers right of management / control)	FMV of unlisted shares = FMV as per internationally accepted valuation methodology as determined by a report from a merchant banker or an accountant for valuation of shares on arm's length basis Add: Liability considered in determination of such FMV
4	Where the foreign company being transferred holds an interest in a partnership firm (PF)/ Association of Persons (AOP)	FMV of PF/ AOP = FMV as per internationally accepted valuation methodology as determined by a report from a merchant banker or an accountant Add: Liability considered in arriving at such FMV Such value arrived at shall be allocated as follows: 1. First, amount equal to partners or members capital in the ratio of capital contribution 2. Residual value to be allocated on the basis of asset distribution ratio on dissolution of PF/AOP or in absence thereof, in profit sharing ratio
5	Where the foreign company holds any asset other than the assets covered above, say interest in an Intellectual Property Right (IPR) or a Branch Office (BO) in India	FMV of other assets= Price that IPR/BO would fetch if sold in the open market as determined by a report from a merchant banker or an accountant Add: Liability considered in arriving at such price

It has also now been clarified that for determining FMV of shares of an Indian company or interest in partnership firm/ AOP, all the assets/ business operations of the company/ partnership firm / AOP shall be taken into account, even if such assets/ business operations are located outside India.

In order to facilitate computation, definitions such as observable price, book value of liabilities, right of management or control, etc. have been outlined in the rules.

We can understand the computation mechanism with the help of following illustration:

Illustration A:

(A1) Financial attributes of the Indian asset:

Particulars	Amount in INR million
FMV/Market capitalisation of Indian asset	90
Liability	2,000

(A2) Computation of FMV as per Rule 11UB:

Situations	1	2	3	4	5
Particulars	Listed Indian Co without management right	Listed Indian Co with management right	Unlisted Co	PF/ LLP	Other Asset
FMV/ Market Capitalisation	90	90	90	90	90
Add: Liability	-	2,000	2,000	2,000	2,000
Value of Indian assets (MR million)	90	2,090	2,090	2,090	2,090

As per the rules, the value of Indian assets has to be converted into foreign currency by using the telegraphic transfer buying rate (TTBR) of such currency as on the specified date.

Assuming the TTBR to be USD 1 = INR 65,the value of Indian assets in USD million shall be:

Situation	1	2	3	4	5
Value of Indian assets (USD million)	1.3	32	32	32	32

Computation of foreign company's FMV to determine if it derives substantial value from India

The rules discuss various situations to determine fair value of assets of the foreign company:

Situation	Nature of the foreign company	FMV of the foreign company
1	Where shares of the foreign company are transferred between persons who are not "Connected Persons" (i.e. unrelated persons)	Market capitalisation of the foreign company on the basis of full value of consideration for transfer of shares Add:Book value of liabilities
2	Where shares of theforeign company are transferred to aConnected person (i.e. related party) and such shares arelisted on a stock exchange	Market capitalisation on the basis of the observable price of its shares quoted on the stock exchange where shares of the foreign company are listed Add: Book value of liabilities
3	Where share of theforeign company are transferred to a Connected Personand such shares are unlisted	FMV of the foreign company as determined according to the internationally accepted valuation methodology Add: Liability considered in determination of FMV

We can understand the above situations with the help of an illustration:

Illustration B:

(B1) Financial attributes of the foreign company:

Particulars	Amount in USD million
Market Capitalization / FMV	50
Liability	10

(B2) Computation of FMV as per Rule 11UB:

Situations	1	2	3
Particulars	Transfer to unrelated party	Listed Foreign company and transfer to related party	Unlisted Foreign company and party
FMV/ Market capitalisation	5	5	5
Add: Liability	10	10	10
Value of Foreign Company	60	60	60

As per the Indian tax regime, indirect transfer tax provisions gets triggered under the following conditions:

Condition 1: The value of Indian assets is more than INR 100 million and

Condition 2: FMV of assets located in India comprises at least 50% of the FMV of total assets of the company or entity whose shares are transferred.

Both the conditions have to be cumulatively satisfied in order to trigger indirect transfer tax provisions.

Let us analyse the trigger of indirect transfer tax based on the illustrations discussed above:

Situation 1 (Indian listed Co without management right):As the value of Indian assets (in situation 1 of the illustration A2) computed as per the rules is less than INR 100 million, indirect transfer tax provisions are not triggered in that situation.

Other Situations:

As the value of Indian assets in other situations in illustration A2 is more than INR 100 million, condition 1 of indirect transfer tax provisions is triggered.

In order to analyse the trigger of condition 2 in the illustration A & B discussed above, the threshold of 50% needs to be evaluated:

Illustration C:

Particulars	Other Situations (Amount in USD million)
Value of Indian assets	32
Value of foreign company	60
Ratio	53%
Indirect transfer tax provisions applicable	Yes

Since as per Illustration C above, the value of assets located in India comprise at least 50% (53% in the instant case) of the FMV of total assets of the foreign company whose shares are transferred, indirect transfer tax provisions will be triggered.

Determination of Income attributable to assets in India

♦

Income arising pursuant to transfer of shares of foreign company shall be calculated as under:

	A	B
		C

		where, A = Income from transfer of shares or interest of foreign company
		B = FMV of asset located in India in accordance with Rule 11UB
		C = FMV of all assets of foreign company in accordance with Rule 11UB
♦		Assuming the income from transfer of shares is USD500 million, the income attributable to assets in India shall be USD500 million X 32/60 = USD265 million.
♦		If the seller fails to provide information to apply the above-mentioned formula, then the tax authorities have the power to determine the extent of income attributable to India. The above is a deviation from the draft rules that had provided for taxation of the entire income from transfer of shares in case information for application of formula is not available.

Filing requirements

The Indian concern and the seller will have to comply with the following filing requirements in India:

(A) By the seller of foreign company(deriving substantial value from assets located in India):

♦		Accountant's certificate to be filed by the seller in Form No. 3CT providing the basis of the apportionment in accordance with the formula and certifying correct computation of income attributable to assets located in India
♦		Return of Income in India

(B) By the Indian entity (whose shares are being indirectly transferred):

♦		Form 49D – to be electronically filed within 90 days from the end of the financial year in which the indirect transfer takes place.
		Such timeline shall be 90 days of the transaction where the transaction has the effect of directly or indirectly transferring the right of management or control in relation to the Indian concern. This period of 90 days has been increased from the 30 days period as was outlined in the draft rules.

Reporting requirements

Indian companies will now have to comply with the reporting framework covering 11 different areas that have been laid down by the CBDT. A few critical areas include:

♦		Financial and accounting statements of the foreign company or entity that directly or indirectly holds the assets in India through, or in, the Indian concern for two years prior to the date of transfer of the share or interest
♦		Information relating to the decision or implementation process of the overall arrangement of the transfer
♦		Information relating to the business operation, personnel, finance and properties, internal and external audit or the valuation report, if any, forming the basis of the consideration in respect of the share, or the interest
♦		The asset valuation report and other supporting evidence to determine the place of location of the share or interest being transferred

Further, it is also now provided in the final rules that where a group has more than one Indian Concern, any one Indian Concern designated by the group can report on behalf of all the other Indian Concerns. The above facts needs to be informed to the Tax Officer in writing.

Parting Thoughts

The final rules will bring clarity on the computational aspect of income chargeable to tax in India in case of indirect transfer. In the final rules, some of the suggestions of the draft rules have been incorporated such as aligning the Balance Sheet definition with that of Specified date, single compliance by one Indian entity on behalf of group entity, etc. that is really a welcome step. However, some other suggestions such as adopting equity value as the basis for valuation instead of enterprise value have not been incorporated. Debt value which is neither paid for by the buyer nor received by the seller is factored in the enterprise valuation. Accordingly, adopting equity value as the basis for valuation may have been a better parameter.

Further, the book value of liabilities have been defined to exclude paid up equity share capital, securities premium related to the paid up capital, general reserve and surplus. However it does not specifically exclude preference share capital and reserves other than free reserves, such as revaluation reserve, capital reserve, etc.

Also, the discretionary power given to the tax authorities in the scenario where seller fails to provide desired information may lead to subjectivity and thus litigations.

Also, clarity is needed on the computation of income and reporting thereon for transactions concluded prior to the date of applicability of such rules.

Additional responsibility has been cast on the Indian concern to maintain and report detailed information with respect to indirect transfer which seems to be quite onerous. There will be situations where the Indian concerns might face challenges in providing such information. Also, the rules also do not provide clarity on the maintenance of documentation by the Indian concern and the seller in case capital gains are not taxable in India pursuant to treaty benefits, if any, being available.

The draft rules had prescribed valuation of limited liability partnership (LLP) where the foreign company being transferred held an interest in an LLP. However the same has been omitted in the final rules. It seems that the intent is to cover LLP cases in the provisions governing computation of FMV for partnership firm as the Income Tax Act provisions defines 'firm' to include LLP.

The rules on indirect transfer tax are in line with the government's objective of bringing in clarity and stability and removing ambiguity around the tax provisions and follows the other initiatives like introduction of draft guidelines for Place of Effective Management, source-based taxation under the India-Mauritius treaty and grandfathering of past investments from applicability of General Anti Avoidance Rules (GAAR).