United States: TPG Capital, Vodafone, China Notice 698 and Beyond: Local Country Taxation of Transfers of Stock Involving Tiered Structures

A Note Regarding Content

From time to time in the course of our practice we have encountered and informed clients about developments in matters of international taxation in various non-U.S. jurisdictions. This White Paper highlights our understanding of certain tax law developments in a number of non-U.S. jurisdictions and, most particularly, Australia, India and China, of potential importance to U.S. businesses and other multinational enterprises. Please note that, while McDermott Will & Emery has offices in the United Kingdom, Germany, Italy and Belgium as well as in the United States, and has a strategic alliance with MWE China Law Offices in Shanghai, it is not licensed to practice law in Australia, India or China or, with the exception of those mentioned above, any other international jurisdictions. This White Paper is solely informational in nature and does not constitute legal or tax advice.

There is a growing awareness within the investment community of the unanticipated tax dispute facing TPG Capital (formerly known as Texas Pacific Group) in Australia in connection with a public offering of shares of one of its portfolio companies. Against this backdrop, a number of private equity funds are evaluating their positions from a tax point of view in advance of exit events. Strategic as well as financial investors, of course, are affected by such developments, as Vodafone found in the case of its transaction with Hutchinson Telecommunications (described below) that has turned into a US$2 billion tax dispute with the Indian Revenue Department. Finally, investors into China will need to take careful note of new tax rules in China (effective retroactive to January 1, 2008) affecting dispositions indirectly involving transfers of shares in Chinese companies.

Set forth below is a brief description of the developments in Australia, India and China referred to above, drawn mainly from secondary sources. In addition, in coordination with local country tax advisers, we have conducted investigations as to the potential for any "TPG problems" in numerous other jurisdictions and touch on lessons learned through that effort at the end of this paper.

The TPG Case (Australia)¹

In 2006, a consortium controlled by Newbridge Capital, a unit of TPG Capital, purchased the Myer department store chain in Australia. The investment was structured as follows: Newbridge Capital invested into a Cayman Islands entity that invested into a Luxembourg entity that in turn invested into a Netherlands entity; the Netherlands entity effected the acquisition. This presumably was done with a view to the Australia-Netherlands tax treaty, under which a Dutch resident generally would be exempt from Australian tax upon an eventual sale of shares of the Australian company.

In October 2009, TPG Capital (via its indirect, Dutch subsidiary) realized an AUD 1.5 billion profit on the AUD 2.3 billion Myer share flotation. Within roughly a month's time, the Australian Taxation Office (ATO) issued TPG Capital a tax assessment in the amount of AUD 452 million and an additional AUD 226 million in penalties and interest on this profit.²

The principal basis for the ATO's action appears to be Australia's general anti-avoidance rule, which can override tax treaties in avoidance situations; i.e., since the indirect owners of the Myers shares had elected to invest in Australia through a tiered structure involving entities located in jurisdictions with which Australia has no tax treaty, the ATO argues the interposition of a Dutch holding company for which it discerns no non-tax commercial purpose should not alter the result and prevent the ATO from taxing such profits.³ TPG Capital's acquisition structure via the Cayman Islands, of course, is not unfamiliar to the investment community and the TPG Capital case consequently has garnered considerable attention. We understand that the private equity industry in Australia has been lobbying the Australian government intensely to change the position it appears to have adopted in the TPG Capital matter and is closely monitoring developments in the case.

The Vodafone Case (India)⁴

One of the most notable international tax cases involving a piercing of tiered structures is the ongoing, US$2 billion withholding tax case India has brought against UK telecom company, Vodafone. In that case, Hutchinson Telecommunications sold—but only indirectly sold—its interest in an Indian company, Hutchinson Essar (India) Ltd., which owns telecommunications assets located in India, to a Dutch subsidiary of Vodafone. The transfer was accomplished by Hutchinson transferring all of its shares in a Cayman Islands holding company which, in turn, indirectly held stock in Hutchinson Essar through certain Mauritius holding companies. The Indian Revenue Department (IRD), by way of a "show-cause" notice, asserted that since Indian domestic law deems all income accruing or arising through any transfer of a capital asset situated in India as income that accrues or arises in India, it follows that the gain on a disposition of shares in a nonresident company, by one nonresident to another, would be taxable in India if it results in an indirect transfer of assets located in India. The IRD therefore concluded that Vodafone was obligated to withhold Indian taxes from the amount paid to the seller.⁵ Although Vodafone has sought judicial intervention, the Indian courts have declined on technical grounds to intervene at this stage, and the IRD has informed Vodafone that it has withholding tax jurisdiction over the transaction. Vodafone has recently filed its response to the IRD's notice, and the outcome of the case presumably will establish India's position on its jurisdiction to levy tax in cases of indirect transfers of assets located in India. (India also has proposed legislation to tax these indirect transfers via a general anti-avoidance rule and related provisions that could override existing tax treaties in certain circumstances.)

Recent Tax Developments in China⁶

In general, companies that are "nonresident" for Chinese tax purposes are taxable on a gross basis through withholding at source on, among other things, proceeds from the disposition of an equity interest in a China resident enterprise. The rate of withholding is 10 percent unless reduced by a tax treaty (or exempted by treaty as is generally the case under China's treaties with Barbados, Ireland and Switzerland).⁷ On December 10, 2009, China issued Notice 698 (Notice on Strengthening the Administration on Collection of Enterprise Income Tax on Income from Equity Transfers by Nonresident Enterprises). The Notice, which appears to be based on China's general anti-avoidance rule, or GAAR, applies to indirect transfers by nonresident entities of equity interests in non-publicly traded PRC resident enterprises. The Notice extends to certain transfers, wherever occurring, involving a nonresident seller and a buyer (whether resident or nonresident) effecting an indirect transfer of an equity interest in a PRC company via a sale of interests in a nonresident upper-tier entity (Holdco) that owns the equity interest in the PRC company. The Notice requires the transferor of an interest in the Holdco that owns the equity interest in the PRC enterprise to disclose the transfer of Holdco shares to the Chinese tax authorities if the Holdco is located in a jurisdiction that imposes low taxes (an actual tax burden in Holdco's jurisdiction of residence of less than 12.5 percent) or that does not tax foreign source income. The Chinese tax authorities will evaluate the information provided in the disclosure document and are authorized to set aside the form of the transaction in abuse situations and tax the controlling nonresident shareholder of the Holdco effectively on a "look through" basis.

The Notice, which by its terms is effective retroactive to January 1, 2008, may trigger a need in some cases to review current holding company structures for Chinese companies and to devise new strategies for structuring transactions involving Chinese companies in the future that conform to the Notice's requirements for avoiding Chinese tax on indirect transfers of shares in a Chinese company. The Notice also by its terms gives rise to an obligation to report transactions caught up by its provisions that were concluded after December 31, 2007.

Notice 698 itself must be viewed in the broader context of the significant changes in Chinese tax law passed in 2007, with effect from January 1, 2008, by the Chinese Enterprise Income Tax Law (the EIT Law). Under the EIT Law, enterprises established outside the People's Republic of China whose actual management or control is located in the PRC can be considered resident enterprises for purposes of the EIT Law. According to the implementation rules of the EIT Law, "management" generally refers to the person or body of persons that exercises substantial and overall management and control over the manufacturing and business-operations, personnel, accounting and properties of an enterprise.

If a foreign company is treated as a PRC resident enterprise for purposes of the EIT Law, it will be subject to PRC enterprise income tax at a rate of 25 percent (the EIT) on its worldwide income, liable for the EIT on dividends it receives from subsidiaries (subject to certain exceptions), and required to withhold a 10 percent PRC withholding tax on dividends it pays to nonresident enterprise shareholders (subject to possible reduction under an applicable income tax treaty). In addition, gains derived by nonresident enterprise shareholders upon a disposition of shares in the company may be subject to a 10 percent PRC withholding tax (except as an applicable income tax treaty may otherwise provide).

All of these developments can have significant ramifications for foreign investment in China.

Other Jurisdictions

As mentioned at the outset, we have conducted a relatively extensive investigation into the tax rules in numerous additional jurisdictions (in coordination with local country tax advisers) to assess the risk that the local taxing jurisdiction would seek to tax indirect transfers of interests in local companies, whether as a matter of local legislation, application of anti-avoidance principles or otherwise. The answers we received varied somewhat considerably from one jurisdiction to the next. Certainly, if the facts involve significant real estate holdings in the local jurisdiction, in many cases a local tax may apply even in the case of only an indirect transfer of shares in the local company. Beyond that, though, the advice we received in a number of cases noted a risk, under general anti-avoidance principles such as substance over form, that intermediate holding companies could be disregarded for tax purposes in certain circumstances.

Clearly, significant developments are afoot as regards local country taxation of transfers of stock involving tiered structures. Hopefully, this paper has served as a useful introduction to the topic.

Footnotes

^{1 Based on secondary sources.}

^{2 Reportedly, a court order was granted (and subsequently lifted) freezing TPG's Australian accounts into which the proceeds from the offering had been paid.}

^{3 The ATO's position is set forth in two Draft Taxation Determinations issued in December 2009. One draft ruling (TD 2009/D18) characterizes as business profits, and therefore ordinary income (generally subject to tax in Australia in the absence of the application of an income tax treaty), profits from an offshore company's disposal of shares in an Australian public company where the offshore company is "carrying on a business of restructuring and floating companies." The second draft ruling (TD 2009/D17), in turn, concludes that the profits may be subject to assessment of an Australian tax where there are "no commercial reasons" for the interposition of intermediate entities even though the offshore company directly disposing of the shares is resident in a country having a treaty with Australia that exempts the gain from Australian tax. An example is given no doubt meant to mirror TPG Capital's fact pattern and an accompanying Explanation elucidates the ATO's concern:}

^{Upon being finalized, the rulings are proposed to apply with retroactive effect except that they "will not apply to taxpayers to the extent that [they] conflict with the terms of settlement of a dispute agreed to before the date of issue." There apparently is no fixed date by which the rulings have to be finalized.}

^{4 Based on secondary sources. See McDermott Will & Emery's White Paper, "At Cross Purposes: Recent International Tax Developments in India," by Kumar Paul and John Engel of McDermott's New York Tax Department (February 8, 2010).}

^{5 Interestingly, this issue might have been avoided if the direct Mauritius parent entities of Hutchinson Essar had sold their shares of Hutchinson Essar (India) to Vodafone, as it appears that Article 13 of the India-Mauritius tax treaty would have precluded India from taxing the capital gains realized by the Mauritian sellers. (For its part, Mauritius imposes no tax on capital gains or distributions.) The position is supported by both a 2003 decision of the India Supreme Court and circulars issued by the Indian tax authorities to the effect that the production of a valid Mauritian tax residency certificate should be sufficient to claim the benefits of the India-Mauritius tax treaty. It is also supported by a ruling released (over the IRD's objections) by the Indian Authority for Advance Rulings (AAR) on February 25, 2010, involving a German company's ownership of an Indian investment through a wholly owned Dutch holding company and the application of a similar exemption in the India-Netherlands tax treaty. However, in light of the position the IRD appears to have adopted in a number of recent cases, including in disputes with E*Trade and AT&T, there is some uncertainty.}

^{In the case of E*Trade, a wholly owned subsidiary based in Mauritius (E*Trade Mauritius) sold its holding in an Indian company to HSBC Violet Investments, also based in Mauritius. Under the India-Mauritius tax treaty, any gain arising from the transaction would be taxable only in Mauritius. However, the IRD took the position that the transaction was taxable in India, on the basis that E*Trade Mauritius was a façade or a shell company and therefore could not avail itself of treaty benefits. E*Trade sought and on March 22, 2010, obtained a ruling in its favor from the AAR (an independent body tasked with issuing rulings that bind the applicant taxpayer and the IRD on matters concerning a taxpayer's liability to Indian taxes). The AAR ruling followed the position established by the Supreme Court decision and the circulars referred to above. In AT&T's case, the IRD similarly has sought to tax the gains accruing to AT&T on the divestiture to its Indian co-venturers of its interests in an Indian joint venture held through a Mauritius intermediary company on the basis that the Mauritian entity and, with it, the India-Mauritius tax treaty should be disregarded. The IRD has taken the position that AT&T Mauritius was formed exclusively for the share transaction between AT&T and its co-venturers and to avoid paying capital gains tax in India and therefore is liable for an India capital gains tax on the sale. The IRD has assessed the tax against the Indian co-venturers in the capacity of "representative taxpayers" of AT&T Mauritius. The case currently is pending in court in India.}

^{6 Based on secondary sources. Thanks to Lawrence Hu of MWE China Law Offices for his input.}

^{7 A new Protocol amending the tax treaty between China and Barbados was signed on February 10, 2010, and will enter into force after both governments exchange instruments of ratification. The Protocol would amend the treaty to reflect certain changes to China's domestic tax laws discussed in the text that follows and would place certain conditions and limitations on the capital gains tax exemption provided under the current treaty. Similar changes may be in the offing with respect to the China-Ireland and China-Switzerland tax treaties, although there have been no developments reported in that regard to date.}

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.