The Covid-19 pandemic has delivered a big jolt to the global economy. However, many are hopeful that in the post-lockdown world, attractive valuations will give a fillip to cross-border deals and it will soon be business as usual. Moreover, once this happens, the pace of growth is anticipated to be higher in the case of emerging market-oriented economies like India.
Historically, amidst other factors such as ease of doing business and robust regulatory and financial systems, bilateral tax treaties have also played a pivotal role in encouraging cross-border trade and investment. But, as business dynamics evolved and multinational enterprises (MNEs) adopted aggressive tax-avoidance strategies, a need was felt for a complete overhaul of the global tax treaty network and international taxation. Implementing such changes would have been a herculean task if it were not for the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (MLI).
What is the MLI?
The MLI is an outcome of the ambitious G-20/OECD BEPS Project (a collective project undertaken by multiple jurisdictions to avoid base erosion and profit shifting) and modifies the applicability of tax treaties around the world without the need to carry out bilateral amendments. Essentially, MLI lays downs more stringent conditions for claiming tax treaty relief.
India—though not a member of the OECD—is a signatory to the MLI. Hence, India’s tax treaties also stand modified due to the applicability of the MLI, provided there is also a matching of positions adopted by India and the respective country.
Some of the major tax treaties of India that are modified or will be modified due to the MLI are the tax treaties with Singapore, Netherlands, U.K., Japan, France, Cyprus, Ireland and Luxembourg. Notably, as of now, India’s tax treaties with the U.S., Germany, and Mauritius are not affected by the MLI.
While the applicable start date of the MLI for each tax treaty with India may vary, generally the MLI would affect tax treaties for inbound investments in India from April 1, 2020.
Key Notable Provisions of the MLI
Principal Purpose Test (PPT)
Undoubtedly, the PPT is the most important provision of the MLI. According to the PPT, a benefit under a tax treaty will be denied if it is “reasonable” to conclude that obtaining such benefit was one of the principal purposes of any arrangement or transaction that resulted directly or indirectly in that benefit. However, this PPT-based denial will not apply if it is established that granting that benefit would be in accordance with the object and purpose of the relevant provisions of the tax treaty.
Notably, investments made from inter alia Singapore, Netherlands, Cyprus and Luxembourg would need to pass the PPT muster if tax treaty relief is to be claimed. Accordingly, in such cases, critical decisions relevant to a deal (which factor treaty benefits) such as choice of jurisdiction for investment in India, instrument (equity/debt/quasi-equity) for investment, mode of acquisition, etc. will have to be examined through the lens of the PPT, when evaluating the availability of tax treaty relief.
In this evaluation, non-tax reasons like commercial and regulatory considerations will be essential. This means that every business decision should be backed by a strong commercial rationale which should be documented in internal communications, board minutes, etc.
What will be interesting to see is the interplay of the PPT with India’s domestic general anti-abuse rule (GAAR). This is because unlike GAAR (under which gains from transfer of investments that were acquired before April 1, 2017 have been grandfathered), there is no grandfathering provision in the MLI.
This would mean that with respect to capital gains tax exemption, the PPT will be applicable even for shares which were acquired before April 1, 2017. Further, when it comes to recently amended bilateral tax treaties like that with Singapore, the applicability of the PPT is debatable. This is because the India–Singapore tax treaty was amended a few years ago to incorporate a specific limitation of benefit rule for availing capital gains tax relief.
In view of these specific bilateral amendments, one may argue that the PPT need not be applied in case of investments made from Singapore in India before April 1, 2017, as complying with the specific limitation of benefit provisions in the treaty would be in line with the “object and purpose” of the India–Singapore tax treaty. Considering its generality and broad scope, the PPT is a subjective criterion that requires a careful analysis of specific facts and circumstances of each case.
Further, the MLI also provides an option for jurisdictions to adopt a specific anti-abuse rule (in addition to the PPT), called the Simplified Limitation of Benefits (SLOB Rule), which provides certain objective criteria to evaluate whether a person is eligible to obtain treaty benefits.
India has opted for the SLOB Rule. It is important to note that even if a person or entity satisfies the criteria mentioned in the SLOB Rule for availing treaty benefit, the person/entity may still be denied treaty benefits if it does not satisfy the PPT. The SLOB Rule will apply only if both countries opt for it. As of now, from India’s perspective, the SLOB Rule will apply only to the tax treaties with Denmark, Iceland, Norway and Slovak Republic.
Profit Repatriation from India
It is pertinent to note that with effect from April 1, 2020, India’s tax law has been amended to introduce a significant change for dividend taxation.
The Dividend Distribution Tax (DDT) which was levied on a domestic company distributing dividends has been abolished and dividends will now be taxed in the hands of the shareholder (whether resident or nonresident). Consequently, the dividend article in Indian tax treaties has become critical in order to reduce the tax burden on nonresidents because as per India’s tax treaties, the tax rate on dividends is generally capped between 5% to 15% (concessional rate); whereas under India’s domestic tax law, tax rate on dividend income is 20% (plus applicable surcharge and cess) for nonresidents.
Notably, some tax treaties provide that the benefit of this concessional rate is available only if certain qualifying levels of shareholding (like 25% shareholding in distributing company) are met (qualifying shareholding). The MLI modifies the applicability of such tax treaties by providing that where the concessional rate is subject to a qualifying shareholding, the benefit of the concessional rate will be available only if such qualifying shareholding criterion is met during a consecutive period of 365 days. For India inbound investments, the practical implication of this aspect of the MLI would be that the timing of profit repatriation will need to be carefully considered for tax efficient profit repatriation from India.
It is noteworthy that currently, from India’s perspective, this 365-day test is applicable only to its tax treaties with Canada, Denmark, Slovakia and Slovenia. However, with the revised dividend taxation mechanism introduced in India from April 1, 2020, it will be interesting to see whether in future more countries bilaterally negotiate for a qualifying shareholding criterion and opt for this 365-day test to be applied in their tax countries.
Owing to the onerous withholding tax obligations under the Indian domestic tax laws and possible adverse consequences in case of non-compliance, it would be crucial for the Indian company while distributing the dividends to nonresident shareholders to carefully assess its withholding tax impact and have necessary safeguards in terms of documentations and comfort as regards the eligibility of the nonresident shareholder (whether as Foreign Direct Investment/Foreign Portfolio Investment/Nonresident Indian/American Depository Receipts holder, etc.) to avail any tax treaty relief (such as lower rate of withholding tax).
Structures Having Property-Heavy India Entity
Many tax treaties contain a provision for Indian capital gains tax trigger in case the company whose shares are transferred by the foreign shareholder derives its substantial value from immovable property(ies) situated in India (immovable property trigger). The immovable property trigger seeks to confer taxing rights to the source country (in this case, India). However, since there was no testing period window within which this immovable provision trigger was to be tested, it was possible for taxpayers to take a view that the immovable property trigger was to be tested only on the date of share transfer and thereby arrange/rearrange their affairs in such a manner that the immovable property trigger was not satisfied on the date of transfer.
The MLI seeks to curb such practices and amends the immovable property trigger provision of tax treaties by providing that:
- capital gains tax trigger will be attracted if the immovable property trigger is met at any time during the 365-day period preceding the date of transfer (as against being met only on the date of transfer); and
- the immovable property trigger provision will apply not only for shares in a company but also “comparable interests,” which includes interests in a partnership or trust. “Comparable interests” could also be interpreted to mean instruments that bear equity-like characteristics, e.g. debt which is akin to equity.
Notably, India’s tax treaties with inter alia Australia and Netherlands are modified to include this change in the immovable property trigger.
The MLI also allows treaty partners to adopt an alternative provision which provides for not only the changes outlined above but also provides for the immovable property trigger threshold to be fixed objectively at 50% of value (directly or indirectly) of shares or comparable interest.
As can be seen from the above, this alternative option allows capital gains tax trigger on “indirect transfers” also. This implies that transfer of shares (or comparable interests) of a foreign entity which derives more than 50% value from immovable property located in India (directly or indirectly) can be taxed in India as per treaty provisions. Notably, India has exercised this option and some major tax treaty partners that have also exercised this option are Canada, France, Ireland and Japan.
This means that foreign investors who are planning to invest in Indian immovable property or have stake in an Indian entity that holds substantial immovable property- (e.g. in the manufacturing, real estate, hospitality and infrastructure sectors) should keep this aspect in mind to evaluate whether Indian capital gains tax will get triggered at the time of their exit. This aspect also becomes crucial because Indian income tax law casts a withholding tax obligation on persons making payments to nonresidents which are chargeable to tax in India. Hence, if Indian capital gains tax gets triggered, there will be withholding tax obligations also for the payer.
M&A Deals: Does MLI Impact You?
For a nonresident investor, claiming tax treaty reliefs at any stage of investment (e.g. while claiming lower withholding tax rate on repatriation of profits such as dividend, interest, fees, etc. under the relevant tax treaty with India or claiming exemption at the time of exit) would require MLI impact evaluation.
Perhaps some of the instances which may be tested are as follows:
Direct Transfer Deals
Global Deals (Indirect Transfer)
Global deals involving any Indian entity (directly or as part of the global structure) that is property-heavy would need to evaluate whether exemption from indirect transfer taxation (provided by respective tax treaty) would continue to apply in view of the new anti-abuse rule brought about by the MLI, as discussed above. The evaluation would need to be done keeping in mind the respective treaty provisions, the treaty partner’s MLI position and India’s position on the same.
For instance, India’s treaty with Singapore has not been amended to incorporate this anti-abuse rule, while India’s treaty with Netherlands, Japan and France (among others) have been modified to include the same.
Applicability of MLI to Outbound Investments from India/Indian Business Having Offshore Presence
The MLI provisions discussed above (from inbound investment perspective) apply almost similarly in case of outbound investments from India. To gauge the impact of the MLI on outbound investments, a thorough evaluation of positions (on MLI) adopted by both countries and application of MLI provisions in case of non-matching of country positions is required.
In particular, it is important to check the date from which MLI changes will be applicable for outbound investments, as it may be different from the date when MLI will apply to inbound investments in India.
Factoring MLI in Deals: Documentation and Compliance Perspective
Lastly, it is noteworthy that the MLI can also equally impact the payer’s/buyer’s perspective, owing to the onerous withholding tax obligations under the Indian domestic tax laws. The payer (resident or nonresident) is required to ensure proper taxes are withheld and failure to do so results in adverse consequences for the payer.
From a documentation perspective, the definition of tax treaty in the documents must include not only the respective tax treaty but also the MLI. This is because technically, the changes from the MLI are not ipso facto incorporated into an existing tax treaty—instead, the MLI applies alongside the tax treaties.
Importantly, negotiations and drafting of contracts in a deal will have to factor in the far-reaching amendments on tax aspects due to MLI and accordingly provide for adequate contractual protections. Similarly, insurance coverage, which is a popular form of risk mitigation strategy adopted by parties in M&A deals, would need to be modified suitably.
Way Forward
The post Covid-19 world will not be the same. Only time will tell whether it marks the beginning of a new de-globalization era or whether the supply chains move from a synchronous world to an asynchronous world.
Whatever happens, it is certain that there will be significant unlocking of value in new sectors, business models will have to undergo significant transition, and innovative ways to earn profit will have to be unleashed. All this would mean that the deal market will be buzzing, with increased scope for inorganic growth opportunities being available. This would also mean that the assessment and evaluation of tax treaty relief will become all the more important, especially because of the “substance over form” basis of taxation due to the application of the Indian GAAR and MLI.
At a fundamental level, the MLI now demands a critical assessment of whether tax treaty benefits would be available or not for every stage and component of deal making. This would also ensure that unnecessary tax litigation can be avoided. Considering far-reaching amendments in the tax sphere due to the MLI, it surely paves way for further negotiations and robust documentation safeguards.
In conclusion, it would be fair to say that the MLI coming into effect is indeed a watershed event in the field of international taxation. Coupled with the Indian GAAR, the need for ensuring substance and commercial rationale in every transaction is now inevitable. Suffice to say that in the world of international taxation—the “times they are a-changing (rather changed)!”
Vinita Krishnan is a Director, Raghav Kumar Bajaj is a Principal Associate and Jugal Mundra is an Associate at Khaitan & Co, India
The views of the author(s) in this article are personal and do not constitute legal / professional advice of Khaitan & Co. For any further queries or follow up please contact us at ergo@khaitanco.com.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
To read more articles log in.