UPSC Prelims 2022 Q8: Indirect Transfers and Retrospective Tax
Which one of the following situations best reflects "Indirect Transfers" often talked about in media recently with reference to India?
- An Indian company investing in a foreign enterprise and paying taxes to the foreign country on the profits arising out of its investment
- A foreign company investing in India and paying taxes to the country of its base on the profits arising out of its investment
- An Indian company purchases tangible assets in a foreign country and sells such assets after their value increases and transfers the proceeds to India
- A foreign company transfers shares and such shares derive their substantial value from assets located in India
Answer: (d) A foreign company transfers shares and such shares derive their substantial value from assets located in India
Statement-wise explanation
- a: incorrect — This describes an Indian company earning profits abroad and paying tax to the host country. That is an ordinary outward investment, and any double tax is handled by a tax treaty or a foreign tax credit. Nothing is being transferred indirectly, and no Indian asset is involved.
- b: incorrect — This describes a foreign company that invests in India but pays tax only in its home country. That is a question of where income is taxed (residence versus source), which tax treaties settle. It is not an indirect transfer, because nobody sells shares whose value comes from Indian assets.
- c: incorrect — Here an Indian company buys tangible assets abroad, sells them at a profit and brings the money home. That is a direct transfer of foreign assets. The gain is a capital gain taxable in India because the company is resident here. In an indirect transfer, the asset changing hands is offshore shares, and the value behind those shares sits in India.
- d: correct — This is the definition. The thing sold is shares of a foreign company, but those shares get their value mainly from assets in India. Explanation 5 to Section 9(1)(i) of the Income-tax Act, 1961, inserted by the Finance Act, 2012, treats such shares as located in India, so the capital gain can be taxed here. This is what the Vodafone dispute was about: in 2007, Vodafone bought the Cayman Islands company CGP Holdings, which indirectly held about 67% of Hutchison Essar.
How to eliminate
Read the phrase literally. A 'transfer' means a sale of an asset, so the answer should involve something being sold. Statements a and b are about investing and paying tax on profits, so no transfer happens. That leaves two options. 'Indirect' means India taxes something that does not look Indian on paper. In the third option, an Indian company sells foreign assets directly, so nothing is indirect. In the last option, foreign shares are sold, but their value comes from Indian assets. That is the indirect link. If you remember the Vodafone–Hutchison deal (a Cayman Islands company sold abroad, with the value lying in an Indian telecom company), you get the answer at once. The fact to remember: an indirect transfer is a sale of offshore shares that derive substantial value from assets in India.
Know more
Indirect transfer means selling an Indian asset without selling it directly. The seller sells shares of a foreign holding company, and that company owns the Indian asset, directly or through intermediate companies.
How it became law
- 2007: Vodafone paid about US$11.1 billion for CGP Holdings (Cayman Islands), which controlled Hutchison Essar. The tax department demanded capital gains tax.
- 20 January 2012: The Supreme Court ruled for Vodafone. It held that Section 9(1)(i) did not cover the sale of foreign shares unless the law said so explicitly.
- Finance Act, 2012 (assent 28 May 2012): Explanation 5 to Section 9(1)(i) said that shares of a foreign company are located in India if they derive substantial value from Indian assets. The change was retrospective, applying from 1 April 1962. This revived old demands, including those against Vodafone and Cairn.
- Finance Act, 2015: Explanations 6 and 7 defined 'substantial value' and exempted small investors.
- Taxation Laws (Amendment) Act, 2021 (assent 13 August 2021): No demand can be raised for indirect transfers made before 28 May 2012. Past demands are dropped if the taxpayer withdraws litigation, and amounts already paid are refunded without interest. CBDT notified the conditions as Rules 11UE and 11UF in October 2021.
| Test | Threshold |
|---|---|
| Value of Indian assets | More than ₹10 crore |
| Share of the foreign company's total assets | At least 50% |
| Small-investor exemption | Under 5% holding and no right of management or control |
The 2021 law removed only the retrospective reach. Indirect transfers made on or after 28 May 2012 can still be taxed.
Distinguish: Transfer pricing is about prices charged between units of the same multinational group. Indirect taxes (GST, customs) are taxes whose burden can be passed on to someone else. Neither is an 'indirect transfer'.
In the news
In August 2021, Parliament passed the Taxation Laws (Amendment) Act, 2021, which scrapped retrospective tax demands on indirect transfers made before 28 May 2012. This came after India lost international arbitrations brought by Vodafone and Cairn Energy over the 2012 retrospective amendment. CBDT notified the rules for settling these cases in October 2021, a few months before Prelims 2022.
NCERT Concepts to Revise
- Retrospective taxation: The 2012 indirect-transfer amendment applied back to 1962. Its repeal in 2021 is why the term was in the news.
- Capital gains tax: The tax at stake when offshore shares are sold is capital gains tax on the seller's profit.
- Transfer pricing: Transfer pricing is a different cross-border tax idea that sounds similar. Knowing it helps you avoid confusing the two.