Structuring The Right Deal In India

Monday, November 2, 2009 - 00:00

Editor: Please describe your practice, particularly your practice advising on investments and joint ventures in India from a tax perspective.

Taylor: I am based in the London office of King & Spalding. I have been practicing in London for almost ten years and prior to that worked as a tax lawyer in the United States. My practice focuses primarily on international taxation, the taxation of financial products and recently I have been more involved in renewable energy transactions. I structure a lot of cross-border investments and financings. My work involving India generally focuses on the structuring of investments and financings to ensure that they are globally tax efficient.

Editor: Why is India an attractive destination for western companies and what are the major impediments?

Taylor : India is the world's largest democracy and in terms of purchase power parity is the fourth largest economy. It is one of two countries with more than one billion people. It's gotten less attention than China, but that is changing. In terms of doing business there, it is a common law jurisdiction with English as an official language. It has the potential to be an incredibly prosperous nation. It is moving in the right direction, and I hope that trend continues.

India is still a developing nation. The government is aware that certain things need modernization in order to fulfill the economy's growth potential. I believe there is a general commitment to continue to improve India's climate for foreign investment.

Its infrastructure is one area often cited as an impediment to additional foreign investment. I think that the infrastructure poses an issue for certain types of investments but not others. Nevertheless, it is an issue that receives a lot of attention. We are seeing a lot of investment interest in Indian infrastructure projects.

My view is that things in India still seem to be going in the right direction, and that is what is important.

Editor: My understanding is that M&A activity in India has soared over the past few years. What is the reason for this increase?

Taylor: There are several reasons. Most importantly, the Indian government has made the Indian market more accessible to foreign investment and that tends to generate increased M&A activity both domestic and cross-border. Also, I think there is a perception that the BRIC economies - Brazil, Russia, India and China - are still places where investors can do well. These economies still have room to grow before catching up with the U.S. and Europe. Many people want to bet on this growth potential, especially when returns on investment in the U.S. and Europe are not what they were a few years ago. Editor: As a common law country, does this factor appeal to U.S. and other common law countries?

Taylor: I definitely think so. The English common law provides the framework for the Indian and United States legal systems. Because of this many American clients find the legal side of deal-making in a common law jurisdiction more familiar and take comfort in that. Every country is different, of course, but having a common legal heritage is useful. For example, when negotiating the remedies provisions of a contract, having the same general concepts of damages and remedies provides a common ground from which to work even if the two jurisdictions have diverged substantially or even rejected the original common law position. In contrast, in dealing with civil law jurisdictions it sometimes takes quite a bit more work to achieve the same level of understanding between the parties. For example, I recall being involved in situations where certain remedies, such as specific performance, were critical to a deal governed by civil law. In one deal it took quite a bit of time to bottom out that true specific performance in the common law sense was impossible even if the contract specifically called for it. These types of difficulties occur even between two common law jurisdictions, but I think the differences are usually less profound, and at least everyone can work from the same original premises in seeking a workable solution. That common starting point can be critical.

Editor: In any deals you do, why is it important to include an arbitration clause?

Taylor: From an American perspective, litigation in India can take a long time. Arbitration is seen as a shorter route to dealing with conflict in an independent forum and therefore is perceived to be more commercially viable.

Editor: Would you explain how the Foreign Direct Investment Rules affect foreign ownership?

Taylor: I am not an Indian lawyer, but I have a basic understanding of how the foreign direct investment rules work. Investments in certain industry sectors require review by a government board. If board review is not required, an investor just needs to notify the Reserve Bank of India (RBI) concerning the investment. This is commonly referred to as the RBI or automatic entry route. Certain industry sectors, such as defense related industries, have foreign ownership caps, and some industries are ineligible for foreign equity investment. For example, I believe that the tea sector is not eligible for the RBI route, but has no cap on foreign equity investment if approved. In contrast, I believe that no foreign direct investment is allowed in any other type of plantation.

The foreign direct investment provisions are continually reviewed by the Indian government. Changes to the sector or equity ownership percentage caps are made by press release. These releases are available on the Indian Department of Industrial Policy and Promotion's web site.

Editor: Why is it so important to design your deal with tax in mind?

Taylor: Any deal has three phases: investment, operation and exit. The most important thing is being able to get the client's money out of a jurisdiction in an efficient manner in the latter two phases. This means getting the right structure in place at the beginning. This is especially true in India because it has high withholding taxes - withholding taxes imposed on investors can be over 42 percent. In addition, capital gains realized by a foreign investor can be taxed by India. Since India's tax rates are higher than comparable U.S. rates, even if you can credit that tax against your U.S. liability, the overall effective tax rate on investments can be non-economic. That is why up-front tax planning is essential.

Another important reason to seek advice early for Indian deals is to manage the Indian tax risk for the client. Indian revenue authorities set a low threshold for creating a taxable presence in India. For example, in most countries being present in a country and negotiating a contract without authority to finalize and conclude the contract should not create a taxable presence for that person's employer. In contrast, India is much more likely to find that a taxable presence has been created. This is a real trap for the unwary and illustrates the need for tax advice even in the initial stages of evaluating an Indian investment.

Editor: Is there any one vehicle that U.S. investors use that is most tax efficient?

Taylor: Most investments by U.S. companies in India are done through an intermediary company based in Mauritius. This is due to the favorable income tax treaty between Mauritius and India. Tax treaties generally allocate the right to tax between the two countries. The United States has an income tax treaty with India, but it is not as favorable as the treaty between Mauritius and India for certain types of income. That is why many U.S. companies form a subsidiary in Mauritius and have that Mauritius entity invest in India. Some U.S. companies also form a subsidiary in Cyprus to loan money to their Indian subsidiary because the Indian income tax treaty with Cyprus is more favorable for interest payments than India's treaties with the U.S. or Mauritius.

These types of complex ownership/ financing structures are an area that is now getting a lot of attention. The Indian revenue authorities want to limit or eliminate this type of treaty shopping. Like the United States, the Indian government is considering significant international tax reform. There is a lot of noise in India about changing the law. This is causing companies to consider whether it is still worthwhile to set up these structures for Indian investment because the structures may not survive Indian tax reform. However, there is a general feeling that the Indian government will target specific abuses rather than go for a broad-based elimination of the tax benefits currently available to genuine foreign investors in India. I don't think the Mauritius holding company structure is dead yet. And if it dies, something comparable should take its place. It is still worth doing in my view.

Editor: What role do the Indian tax authorities play in creating a favorable climate for foreign investment?

Taylor: Just like the Internal Revenue Service in the United States, the revenue authorities in India can have a huge impact on tax policy and therefore the attractiveness of a jurisdiction for foreign investors. Their power comes from the authority to interpret and, more importantly, enforce the revenue laws. The Indian Parliament may pass the laws but it really comes down to the department interpreting and enforcing those rules. In India, I believe that tax enforcement has a tremendous impact on the climate for foreign investment.

The best example of how tax enforcement can impact foreign investment is the ongoing litigation involving Vodafone, the mobile phone company. Vodafone is a U.K. based mobile phone group. Through a Dutch subsidiary, Vodafone acquired shares in a Cayman Islands special purpose vehicle from a Hong Kong company. The Indian revenue authorities asserted that Indian tax was due as a result of the sale. According to the government, India could tax this transaction because the Cayman Islands special purpose vehicle held a significant stake in an Indian company. It is very unusual for a revenue authority to assert this kind of extraterritorial reach. Revenue authorities tend to respect transactions that go on well beyond their borders, even if the company has a direct or indirect shareholding in a company in their own jurisdiction. It is important to note that the government is apparently arguing that existing and long-standing provisions of the Indian direct tax act, while not explicitly providing for taxation in this instance, covers this type of extraterritorial transaction.

The Vodafone case is still being litigated, but it has gotten widespread attention in the international tax community. If the government's position is ultimately upheld by the courts in a very government-friendly opinion, this could have a profound effect on foreign investment in India. For example, if a U.S. group sells a U.S. subsidiary to another U.S. company, would the Indian government seek to tax the inherent gain in any Indian subsidiary held by the company being sold? Hopefully this would not happen, but it illustrates how tax enforcement can impact the attractiveness of a jurisdiction for foreign investment. As a U.S. tax lawyer representing many foreign clients, I am very aware of how aggressive tax enforcement policies by the U.S. Internal Revenue Service can discourage foreign investment in the United States. The line between adequate enforcement and discouraging investment is a difficult one to get right. I hope India stays on the right side of the line.

Please email the author at jtaylor@kslaw.com with questions about this interview.