Direct Tax Alert

BACKGROUND

Taxation of capital gains arising from the transfer of shares of Indian Companies, by non-residents, is governed by the provisions of the Income Tax Act, 1961 (IT Act) and applicable tax treaties entered into by India. Article 13(4) of the India–Mauritius Double Taxation Avoidance Agreement (DTAA or treaty), prior to its amendment in 2016, provided exclusive taxing rights on capital gains arising from the sale of shares in an Indian company to the country of residence. In this context, the production of a valid Tax Residency Certificate (TRC) from the Mauritian Revenue Authority (MRA) is generally regarded as conclusive evidence of treaty eligibility.

Prior to its amendment, the India–Mauritius DTAA did not contain a Limitation of Benefits (LOB) clause. Unlike other DTAAs entered into by India with countries such as the United States of America (USA), Singapore, and the United Arab Emirates (UAE), which incorporated specific anti-abuse provisions, the India–Mauritius DTAA did not impose any additional restrictions or thresholds for accessing capital gains exemption. The LOB clause was introduced prospectively through Article 27A¹, effective from 1 April 2017 and did not apply retrospectively to earlier years.

In this regard, the Delhi Tax Tribunal, in a significant ruling² involving a Mauritian company of the Essar Group, examined whether the capital gains arising from the sale of shares of Vodafone Essar Ltd. (VEL) to a Vodafone group entity were taxable in India or exempt under Article 13(4) of the India–Mauritius DTAA. The key issues under adjudication included the determination of residential status under section 6(3) of the IT Act, the legal sanctity of the TRC, commercial rationale behind restructuring and liquidation of Indian subsidiaries, and the applicability of anti-avoidance principles.

We, at BDO India, have analysed and summarised the key aspects of the said guidelines and provided our comments on their impact hereunder:

FACTS OF THE CASE

• The taxpayer, a company incorporated in Mauritius, was engaged in the business of making and holding investments. It held a valid TRC issued by MRA and a Category-1 Global Business License issued by the Financial Services Commission, Mauritius, since its inception.

• Essar Communications (Mauritius) Limited (ECML), the taxpayer’s holding company in Mauritius, raised a loan from Standard Chartered Bank, UK (SCB), in January 2007, which was later refinanced and upsized from a consortium of banks led by SCB. A portion of the funds was transferred to the taxpayer directly by the lenders as share application money on behalf of ECML.

• The taxpayer utilised these funds to infuse capital into Essar Telecom Investments Limited (ETIL), an Indian company and into Essar Com Limited, Mauritius (ECom), its wholly-owned Mauritian subsidiary. This enabled ETIL and Ecom to hold equity shares in VEL and also facilitated ETIL to repay existing debts previously taken to acquire VEL shares.

• The VEL shares held by the taxpayer and ECom were effectively pledged as security for the loans arranged by ECML. In order to have greater enforceability over the security of VEL shares, the lenders wanted a direct pledge of the VEL shares. However, the Reserve Bank of India (RBI) rejected ETIL’s application to pledge the VEL shares with lenders directly. Consequently, ETIL was liquidated in July 2008, and the VEL shares were distributed to the taxpayer, giving it direct ownership and enabling the lenders to hold a valid direct pledge over the shares as security for the consortium loans.

• The taxpayer and ECom ultimately sold all VEL shares to Euro Pacific Securities Ltd. (EPSL), a non-resident entity nominated by Vodafone International Holdings B.V. The total consideration from such sale of shares was received after withholding of tax at source (TDS). The taxpayer claimed that the capital gains arising from the sale were not taxable in India by virtue of Article 13(4) of the India–Mauritius DTAA and claimed a refund of TDS.

• However, the tax officer denied benefits under Article 13(4) of the India-Mauritius DTAA by treating the taxpayer as a resident of India under section 6(3) of the IT Act, as the control and management of the taxpayer’s affairs was wholly situated in India. The tax officer further held that the taxpayer lacked commercial substance and was a sham entity incorporated solely to avail the benefits of the India-Mauritius DTAA.

• Aggrieved, the taxpayer filed an appeal before the First-Appellate Authority, which denied the exemption under Article 13(4) of the India–Mauritius DTAA. Further aggrieved, the taxpayer filed an appeal before the Delhi Tax Tribunal.         

DELHI TAX TRIBUNAL RULING

The Delhi Tax Tribunal, while allowing the taxpayer’s claim for capital gains exemption, made the following key observations:

• Determination of residential status under section 6(3) of the IT Act

  • As per section 6(3) of the IT Act, a company which is not incorporated in India is considered to be a resident in India only if the control and management of its affairs are wholly situated in India during the relevant previous year. Therefore, if any part of the control and management is situated outside India, the company cannot be considered a resident in India.

  • Moreover, it was held that the tie-breaker rule under the DTAA was not applicable in the instant case as there was no proof that the taxpayer was also a tax resident of India under the IT Act, by virtue of control and management in India. Further, there was no record to show that the taxpayer was not a tax resident of Mauritius.

  • Further, with respect to the tax officer’s contention that the TRC was not furnished for earlier years, the TRCs for the earlier years are irrelevant since the residential status for each year has to be determined separately, and TRCs of earlier years have no bearing on the year under consideration.

  • For the purpose of section 6(3) of the IT Act, what matters is de facto control, i.e., where the control and management are actually exercised. From inception until the relevant fiscal year (FY) 2011-12, the taxpayer held all its Board meetings in Mauritius and its Board comprised people with significant qualifications and experience, all of whom were non-residents of India, except the nominee director appointed by lenders. Hence, since the taxpayer was controlled and managed by its Board and all decisions concerning its affairs—including those relating to the sale of VEL shares—were taken during 11 Board meetings held at its registered office in Mauritius, the control and management of the taxpayer was not wholly situated in India, and was situated in Mauritius.

  • There was no evidence to show that the promoter family made decisions in any capacity other than as directors. Further, there was a clear distinction between management control and ownership control as affirmed by the decision of the Calcutta High Court in Universal Cargo Carriers Inc., wherein it was held that control and management are distinct from ownership.

• Commercial substance of the holding structure

  • The taxpayer was incorporated in Mauritius in 2005, much before the acquisition of VEL shares in 2008, reinforcing that its presence was not created solely for availing tax treaty benefits. Accordingly, it cannot be contended that the taxpayer was established solely to claim India-Mauritius DTAA benefits.

  • The Principal Purpose Test was introduced only with the Limitation of Benefits (LOB) clause with effect from 1 April 2017 and was not applicable to the relevant year.

  • The Apex Court in the case of Vodafone International Holding B.V.³ held that claiming of treaty benefits is one of the relevant factors of making investment through the Mauritius route and that in the absence of LOB clause and the presence of Circular No. 789 of 2000 and TRC, benefits cannot be denied to Mauritius companies under treaty at the time of sale/disinvestment/exit from FDI. Further, the Apex Court recognised the use of tax-efficient Special Purpose Vehicles (SPVs) and held that corporate structures are created for genuine business purposes, generally at the time when investment is being made.

  • The taxpayer, as part of a globally structured group with a long-standing presence in Mauritius, was a genuine investment holding company engaged in legitimate business activities, including holding and monetising investments.

  • Accordingly, the taxpayer’s use of a Mauritius-based holding structure for investment in VEL shares was consistent with legitimate business practices. Hence, since there was nothing unusual in the fact that the investment in VEL shares was itself the legitimate business of the taxpayer and the taxpayer was not a conduit or a sham entity with a lack of commercial/business substance.

• Commercial rationale behind transactions

  • The transfer of VEL shares and the subsequent investments and loans routed through Mauritius entities were undertaken for commercial/business reasons, such as deleveraging balance sheets, complying with Foreign Direct Investment (FDI) norms and accessing overseas capital markets with greater efficiency and fewer regulatory constraints.

  • The taxpayer and other group entities acted in accordance with regulatory approvals, and it was incorrect to allege that ETIL was a paper entity or that the transactions lacked any business activity or commercial rationale. Further, since the money could not be borrowed in India on favourable terms, the only other option was to borrow money at the level of the holding company in Mauritius. Additionally, the mature overseas financial markets provided funds at a lower cost of borrowing.

  • ETIL’s voluntary liquidation in July 2008 and the subsequent direct transfer of VEL shares to the taxpayer were driven by lender requirements in the loan agreement, specifically to enhance the enforceability of the pledged security. The taxpayer, being a guarantor, would have faced serious consequences if liquidation had not been completed within the given time period.

  • Further, liquidation of a company is a shareholder’s function, and there is no provision under the Companies Act, 1956, which empowers a company to restrict its shareholders from voluntarily dissolving a company.

• Migration of VEL shares to Mauritius

  • The situs of shares of VEL continued to be in India in view of the shares being of an Indian company and even in the absence of liquidation, if the taxpayer had sold the shares of ETIL, the capital gains arising to the taxpayer would not have been taxable in India under Article 13(4) of the India-Mauritius DTAA.

• Sale of VEL shares and validity of executing the put option

  • It is common in multinational group structures for group entities to support one another financially and operationally for mutual benefit. The taxpayer received both monetary support (in the form of interest-free loans) and non-monetary support (such as personnel, guidance, and assistance) from group entities.

  • The sale of VEL shares by the taxpayer in FY 2011–12 was executed under an Offshore Underwritten Put Option Agreement in 2007, following several amendments and board-level deliberations. However, contrary to the tax authorities’ assumption, the option agreement entered in earlier years did not amount to a sale or transfer. The actual decision to sell was made in FY 2011–12 after the Board carefully evaluated commercial factors, including fair value and dispute resolution terms.

• Use of sale proceeds and commercial justification for the sale of VEL shares

  • The sale of VEL shares was commercially driven by the urgent need to repay the loan taken by ECML from a consortium led by SCB, for which the taxpayer was a guarantor. It would have been commercially imprudent to keep the sale proceeds idle, and the transaction was necessary to meet the financial obligations.

  • Treaty benefits cannot be denied by stating that the sale proceeds received by the taxpayer had ultimately been paid over by it to the shareholder (ECML). It is not open to the tax authorities to step into the shoes of the Board and question the business purpose of a transaction.

• Liquidation of ETIL was commercially driven

  • The liquidation of ETIL was undertaken due to the rejection of ETIL’s application to pledge VEL shares by the RBI and the express requirement by foreign lenders in the loan agreement that the shares be held directly by the taxpayer to ensure greater enforceability. Hence, liquidation was not initially intended, and only when the lenders insisted on direct shareholding (due to rejection by the RBI), did the taxpayer proceed with liquidation, which was later validated by the RBI's approval post-liquidation in November 2008.

  • Additionally, even in the absence of liquidation, any capital gains arising from the sale of ETIL shares would have been exempt in India under Article 13(4) of the India–Mauritius DTAA. Further, even if ECML had sold shares of taxpayers, there would have been no tax liability in India under the IT Act and India-Mauritius DTAA. Hence, it cannot be said that the motive behind the liquidation of ETIL was tax avoidance, as it was undertaken for a commercial purpose, and no tax benefit was obtained by the taxpayer by undertaking the liquidation.

• TRC as conclusive proof for treaty benefits under India–Mauritius DTAA

  • The taxpayer held a valid TRC issued by the MRA since its inception, including for the relevant year. The MRA, through its letter dated 20 May 2012, clarified that TRC was issued to the taxpayer based on both incorporation and control and management being situated in Mauritius.

  • As clarified in CBDT Circular No. 789 and 682, TRC will constitute sufficient evidence for accepting the status of residence as well as beneficial ownership for applying the provisions of DTAA. The binding nature of the Circulars has been consistently upheld in various judicial pronouncements.

  • The Apex Court in the case of Azadi Bachao Andolan⁴ and Vodafone International Holdings B.V. categorically held that once TRC is issued by the MRA, the treaty benefits under Article 13(4) of the India-Mauritius DTAA cannot be denied on the basis of vague allegations or suspicions of treaty abuse.

  • Therefore, in view of Article 13(4) of the India–Mauritius DTAA, the TRCs issued by the MRA, the CBDT Circulars and binding Apex Court judgments, the capital gains arising to the taxpayer on sale of VEL shares to EPSL are not taxable in India and the denial of treaty benefit is unsustainable.

• Relevance of mutual agreements and prior AAR proceedings

  • VEL had initially filed an application before the Authority for Advance Ruling (AAR) to determine the taxability of the sale transaction under Article 13(4) of the India–Mauritius DTAA, which also involved the taxpayer and ECom. The AAR application was later withdrawn, and VEL deducted and deposited TDS on the sale consideration with mutual agreement between the parties, which the tax authorities interpreted as acceptance of taxability in India.

  • What is relevant for consideration is whether the transaction under consideration is taxable under Article 13(4) of the India-Mauritius DTAA/IT Act or not. It is irrelevant to consider the mutual agreements reached between the two parties.

• Absence of LOB clause in India–Mauritius DTAA

  • India–Mauritius DTAA did not contain any Limitation of Benefit (LOB) clause for the relevant FY 2011–12, which restricted the benefit available under Article 13(4) of the DTAA nor provided for any condition to be fulfilled for claiming the benefit of Article 13(4) of the DTAA unlike DTAAs that India has entered into with countries like the USA, Singapore, UAE, and Luxembourg.

  • In the absence of any restriction placed in the India-Mauritius DTAA, the treaty benefits cannot be denied based on alleged treaty shopping or commercial substance claims invoking conditions which are not part of the DTAA.

  • The Apex Court in Vodafone International Holdings B.V. held that in the absence of an LOB clause in the India-Mauritius DTAA, there was no justification in denying treaty benefits to a company incorporated in Mauritius solely on the ground that the investment was routed through Mauritius for availing such benefits.
  • LOB clause was inserted into the India–Mauritius DTAA only with effect from 1 April 2017 and applied prospectively. CBDT’s press releases clarified that these amendments applied only to capital gains arising from the transfer of securities purchased after 1 April 2017. Therefore, Article 27A of the DTAA does not apply to the relevant FY 2011-12, i.e. the year under adjudication for entitlement of DTAA benefits.

  • Further, even if the LOB clause was hypothetically applied to the relevant year, the taxpayer would satisfy the expenditure threshold, having incurred more than Mauritian Rupees 1.5 million in Mauritius during the FY as evidenced by audited financial statements. Accordingly, the denial of treaty benefits under Article 13(4) of the DTAA is contrary to the legal position, judicial precedents, and the DTAA.

• Grandfathering of capital gains for shares acquired before 1 April 2017

  • The amendments to Article 13 of the India–Mauritius DTAA, including the insertion of Article 13(3A) of the DTAA and the revised Article 13(4) of the DTAA, became effective from 1 April 2017. These changes provide that only gains from shares acquired on or after 1 April 2017 may be taxed in India. Hence, the jurisdiction to tax capital gain in India is vested only with effect from 1 April 2017 and only for the capital gains arising on alienation of shares acquired on or after 1 April 2017.

  • Therefore, the amended Article 13(4) of the India-Mauritius DTAA effectively provides that the capital gains arising on alienation of shares acquired before 1 April 2017 cannot be brought to tax in India in any situation.

  • The CBDT clarified through its press release that the new provisions apply only to shares acquired on or after 1 April 2017, and the capital gains arising on transfer of shares which were acquired before 1 April 2017 have been grandfathered and will not be subject to capital gains taxation in India.

  • Accordingly, the capital gains from the sale of VEL shares in FY 2011–12, which were acquired before 1 April 2017, fall squarely within the grandfathering provisions and therefore, the denial of DTAA benefits is unsustainable.

• Commercial transactions vs. allegation of colourable device

  • The sale of VEL shares by ECL was commercially driven—primarily to repay loans raised by ECML—and not undertaken for tax avoidance. Even without the liquidation of ETIL, ECL could have claimed DTAA benefits by selling ETIL shares directly. Allegations regarding a colourable holding structure of the Essar Group are unfounded, as the structure was disclosed to Indian and global regulators. There was no evidence to show that there was round-tripping of money or any other illegal activities.

  • The Apex Court in Vodafone International Holdings B.V. has laid down the "look at" test, not "look through," to determine whether or not a colourable device exists. This test is satisfied in the present case through factors such as long holding period, genuine investment purpose, continuity of business, and existence of economic substance.

  • Further, even if there had been a reduction of tax arising out of the liquidation and other transactions which were undertaken for legitimate business purpose, the tax treaty benefits should not be impacted since under the Indian income-tax jurisprudence, arrangements which do not contravene provisions of existing statutes and are within the four corners of law, cannot be faulted and are to be treated as legitimate tax planning.

Considering the above, the Delhi Tribunal held the taxpayer was a tax resident of Mauritius and was entitled to the benefits of Article 13(4) of the India-Mauritius DTAA. Therefore, the capital gains on the sale of VEL shares in FY2011-12 were not chargeable to tax in India.

BDO INDIA COMMENTS

Delhi Tribunal’s ruling is a significant affirmation of treaty protection available under the India–Mauritius DTAA, especially in the context of pre-2017 investments. The Tribunal reinforced that capital gains on shares acquired before 1 April 2017 continue to enjoy treaty exemption under Article 13(4) of India-Mauritius DTAA and that such benefit cannot be denied on the basis of vague allegations of tax avoidance, absence of commercial substance, or shareholder-level influence.

The Tribunal emphasised that the residential status of a foreign company, prior to the amendment introduced by the Finance Act, 2015, must be determined under section 6(3) of the IT Act as it then stood, requiring that the control and management of the company’s affairs be wholly situated in India for it to be treated as a resident. In the absence of evidence establishing exclusive control exercised from within India, the company could not be regarded as a tax resident of India. The ruling reaffirms that a valid TRC is conclusive evidence of tax residency and beneficial ownership, and treaty benefits cannot be denied without concrete evidence of treaty abuse.

The Tribunal reiterated that in the absence of an LOB clause or any explicit restrictive provision, treaty benefits cannot be denied by invoking general notions of tax avoidance or assumptions about the purpose behind incorporating in Mauritius.

The ruling also underscores the importance of maintaining robust records and documentary evidence to establish commercial substance and to substantiate that control and management are situated outside India.