Source-based capital gains taxation & impact on

acquisition financing in the emerging markets

19 November 2014

Presented by: Peita Menon & Prabhu Narasimhan

Introduction

• “Tax policy remains one of the key investment considerations for firms engaging in business activities in the Asia-Pacific economic region.” – Deloitte Report 2014

• Asian markets high on complexity and low on predictability.

• Tax planning cannot be based solely on current position but needs to factor in tax trends and tax authority behavior!

• Makes acquisition financing less than precise science – tax can be factored in but cannot be satisfactorily quantified.

Introduction

• Attractiveness of domestic economy has meant that emerging markets do not need to use the “tax carrot” to attract inward investments.

• In fact, tax is a cost of doing business in such markets (particularly India and China).

• Source based taxation focussing on the nexus between the taxing state and the assets generating revenue is one clear trend to watch.

• Substance over form – fears about tax avoidance result in aggressive tax authority behaviour which often transcend legal boundaries!

Vodafone case - India

• Long drawn soap opera-like tax case which opened Pandora’s box in Asia!

• This concerned a provision of the Indian Capital Gains tax code which stated that income arising from the transfer of a capital asset located in India should attract Indian tax. Historically, the Indian tax authorities interpreted this logically that Indian tax was payable where Indian assets (including Indian shares was sold). Until that is the Vodafone case happened.

• In the Vodafone case, HTIL sold shares in CGP which indirectly held shares in the Indian telecommunications operating company. CGP did not have any other assets and therefore the economic substance and motive behind the transaction was the sale of the Indian telecommunications group.

HTIL (Cayman)Vodafone

(Netherlands)

BVI Cos

CGP (Cayman)

Mauritius and

Indian cos

OperatingCo

(India)

SPA -

consideration

Sale of shares

Vodafone case - India

• Beyond the law and established practice.

• Tax authority argued Indian tax was also payable where Indian assets (including Indian shares) were sold whether by a direct sale of the Indian assets or by an indirect sale. The economic substance meant that the tax authorities could "look through" the structure.

• The Supreme Court rejected this and said that in the absence of sham or tax evasion, no "look through" was possible:

• "certainty and stability form the basic foundation of any fiscal system. Tax policy certainty is crucial for taxpayers to make rational economic choices in the most efficient manner".

• Legislature overruling judicial finding of the highest court through retrospective laws!

• Retrospective legislation effectively states that an overseas shares sale will be treated as though it was an Indian share sale if the overseas shares derive their value substantially (??) from the assets located in India.

Vodafone case – where are we now?

• Vodafone and Indian Government now engaged in arbitration under the Bilateral Investment Treaty between India and the Netherlands.

• If the transaction structure had been different (i.e. if the Seller Group had used a Mauritius sale vehicle), the end result may well have been different courtesy of India/Mauritius double tax treaty with no LOB.

• Also, contractual allocation of risk of this tax between Vodafone and Hutchinson not covering this point!

• Tax authority went beyond the wording and spirit of the law!

Circular 698 - PRC

• Inevitable that Vodafone case and the approach of the Indian tax authorities would “influence” tax authority behaviour in other Asian markets.

• On 10 December 2009, the State Administration on Taxation ("SAT") issued its "Notice on Strengthening the Administration of Enterprise Income Tax on Share Transfer Income of Non-resident Enterprises No. 698" ("Circular 698") to enforce taxation offshore "indirect equity transfer" contract made to avoid PRC taxation.

• Circular 698 requires disclosure by off-shore investors of certain indirect equity transfers. An "indirect equity transfer" is the sale of an off-shore company holding PRC-resident entities. If the transferred entity is in a jurisdiction with a tax rate lower than 12.5% or does not tax overseas income, then that entity must disclose the transaction to local tax administration authority of the Chinese resident entity. If the foreign investor cannot show a reasonable business purpose for the off-shore transaction, then the State Administration of Taxation may treat the transfer as if it occurred on shore.

Circular 698 - PRC

• The disclosure must include, inter alia, the equity transfer contract, the relationship between the off-shore investor and the holding company's funds and management, and the relationship between the holding company and the PRC resident's funds and management.

• High degree of power for administrative organs in China (including tax authority) in interpreting tax law. Same judicial mechanism as India does not exist in China for redress and so tax authority behaviour does not have natural “checks and balances”.

• Draft guidance being consulted upon to clarify applicability of this circular.

Lone Star case - Korea

• Lone Star case a classic example of how accepted investment structures historically can nevertheless crumble in the face of increasing tax authority hostility.

• Treaty shopping and investment structuring very topical in Asia and historic benevolence in these areas are not insurance policies for future. E.g Azadi BachaoAndolan v. Union of India.

• Lone Star Funds, a private equity firm headquartered in the US, invested in the Korea Exchange Bank through a Belgium holding company. When the Belgian holding company sold its 51% stake in the Korea Exchange Bank in January 2012, the National Tax Service of South Korea imposed a 10% withholding tax on capital gains from the sale. Although such gains should be exempt under the Belgium-Korea tax treaty, the Supreme Court in Korea denied that treaty benefit under the “substance-over-form” principle.

• Tax treatments of partnerships – reverse engineering the desired result.

BEPS and G-20 obsession with tax avoidance• In 2013, OECD adopted declaration on Base Erosion and Profit Sharing and launched an action plan

on BEPS identifying 15 specific actions that will give governments the domestic and international instruments to prevent corporations from paying little or no taxes.

• China and India actively involved and voluntarily adopting proposals. Australia (chairing G-20 in 2014) and Korea actively driving the process and adopting proposals.

• The OECD Action Plan items are targeted to be complete by September 2015. The plan is ambitious, and it will be difficult to align the taxation approaches of so many countries, especially given their different economies and stages of development.

• Emboldened tax authorities. Global debate allowing them to take a hard line in their tax collection and enforcement techniques. Indian and Chinese approach of strict unilateral tax measures, such as anti-treaty shopping rules, vindicated.

• Treaty abuse going to remain the key area of focus for multinationals.

• G20 meeting in Australia continues to focus on tax avoidance and increasing cooperation and transparency.

• Future uncertain – more disputes likely!

Structuring considerations

• Prepare for uncertainty and utilise working structures. Novel techniques best not used in the region.

• Tax trends need to be visualised into the future – i.e. present and past considerations not enough.

• Recent trends focus on substance rather than form. Increasing attention of source to capture offshore transactions having domestic nexus.

• Withholding mechanism increasingly used to police transactions.

• Predicting tax authority behaviour difficult. Financing margins therefore affected.

• Documentation and contractual protection critical!

Structuring considerations

• In share sales, clearly allocate risk of capital gains of sellers. Gross-up provisions need to be bespoke.

• Consider indemnity to force compliance by parties with reporting requirements locally of transactions.

• Escrow mechanics where uncertainty exists needs to be considered. Pricing in risks difficult given arbitrary tax authority practice at times.

• Utilise tax treaty jurisdictions and focus also on Bilateral Investment Agreements and their interaction.

• Treaty shopping remains topical –substance becomes critical!

Thank You

Peita Menon & Prabhu Narasimhan

White & Case LLP

pmenon@whitecase.com

pnarasimhan@whitecase.com

www.whitecase.com