Direct Tax Alert: 

BACKGROUND

Under offshore holding structures, controversies have centred on whether foreign investment vehicles holding valid Tax Residency Certificates (TRCs) under the tax treaty entered into with India are eligible for treaty benefits in respect of capital gains. Recently, the Supreme Court (SC), in a significant ruling¹, had an occasion to examine the issues in the context of the sale of shares as part of a large multinational acquisition, touching upon treaty benefits, tax treaty abuse, the effect of Central Board of Direct Taxes (CBDT) circulars, and the scope of General Anti-Avoidance Rule (GAAR) override under section 90(2A)² of the Income-tax Act, 1961 (the Act), and the circumstances in which treaty relief may be denied notwithstanding the existence of a TRC.

We, at BDO India, have analysed and summarised the key aspects of this decision and provided our comments on its impact hereunder:

FACTS OF THE CASE

• The taxpayers are Mauritius-incorporated investment companies holding Category-I Global Business Licences, holding valid TRCs under the India–Mauritius tax treaty.

• The taxpayers held shares in Flipkart Private Limited, Singapore, whose value was substantially derived from assets located in India, and sold such shares to Fit Holdings S.A.R.L., Luxembourg, as part of Walmart Inc.’s acquisition of Flipkart, receiving substantial sale consideration.

• Prior to transfer, the taxpayers sought NIL withholding certificates under section 197³ of the Act, but the tax authorities denied treaty benefits, alleged a lack of independent decision-making, and prescribed withholding at specified rates.

• The Authority for Advance Rulings (AAR) rejected the taxpayers’ applications as being prima facie a tax-avoidance arrangement. However, the Delhi High Court quashed the AAR’s order and held that the validity and sanctity of the TRC issued by the competent authority must be considered as sacrosanct and hence, based on the India-Mauritius tax treaty, capital gains shall not be taxable in India.

• Aggrieved by the same, tax authorities filed appeal before Supreme Court.   

SUPREME COURT DECISION

The Supreme Court held that TRC is not conclusive evidence and a treaty exemption has to be denied where the arrangements are posed without any commercial substance. Justice Mahadevan made the following key observations in his decision:

• To claim a benefit under Article 13(4)⁴ of India-Mauritius tax treaty, the person must not only qualify as a ‘resident’ of Mauritius but also establish that the movable property or shares forming the subject matter of the transaction are directly held by such resident entity.

• An indirect sale of shares would not, at the threshold, fall within the treaty protection contemplated under Article 13⁵ of the India-Mauritius tax treaty.

• Parliament has statutorily empowered the AAR to reject applications at the threshold where the transaction appears prima facie tax-avoidant. The provision is couched in such a way that the burden lies on the person claiming a particular fact, and such a prima facie opinion is sufficient to reject the application. The level of satisfaction required to arrive at a prima facie conclusion is much less when compared to a case where a fact has to be proved.

• As per section 90(4) of the Act, TRC is only an ‘eligibility condition’. It does not state that TRC is ‘sufficient’ evidence of residency, which is a slightly higher threshold. TRC is not binding on any statutory authority or Court unless the authority or Court enquires into it and comes to its own independent conclusion.

• Circulars issued earlier, though binding on the Revenue at the time of their issuance, operate only within the legal regime in which they were issued and cannot override subsequent statutory amendments. Decisions on circulars issued in the pre-amendment regime (dealing with TRC applicability) would not be relevant for the taxpayer.

• Mere holding of a TRC cannot, by itself, prevent an enquiry subsequent to the amendments brought into the statute, particularly by the introduction of section 90 (2A) and Chapter XA to the Act and the Rules, if it is established that the interposed entity was a device to avoid tax.

• The protocol to the India-Mauritius tax treaty was made for the purpose of shutting the back door that was available to residents of the contracting parties to completely evade taxation, and to residents of foreign countries to have wrongful access to the treaty through evasive practices such as treaty shopping, establishment of conduit structures, round-tripping, hybrid structures, shell companies, etc.

• By inserting section 90(2A) of the Act, Parliament expressly subordinated tax treaty benefits to GAAR. GAAR is applicable for the period under consideration, empowering Revenue to declare the transaction to be an impermissible arrangement.

• Rule 10U(2) of the Income-tax Rules, 1962 (IT Rules) clarifies that arrangements are not automatically grandfathered in entirety, even pre-existing investments fall within the ambit of GAAR if tax benefits arise on or after 1 April 2017. By use of the words ‘without prejudice to the provisions of clause (d) of sub-rule (1)’ in Rule 10U(2), the prescription of the cut-off date of investment under Rule 10U(1)(d) stands diluted, if any tax benefit is obtained based on such arrangement. The duration of the arrangement is irrelevant.

• Where prima facie evidence suggests that the arrangement was designed with the sole intent of evading tax, i.e. an impermissible avoidance arrangement, mere reliance on possession of a TRC or pre-amendment circulars is insufficient to claim treaty relief.

• Judicial Anti-Avoidance Rule (JAAR) continues to operate in parallel with GAAR and empowers Indian authorities to deny treaty benefits in cases involving treaty abuse or conduit structures.

• The unlisted equity shares, on sale of which the taxpayer derived capital gains, were transferred pursuant to an arrangement impermissible under the law. The taxpayer is not entitled to claim an exemption under Article 13(4) of the India-Mauritius treaty.

• Accordingly, capital gains arising from the transfers effected after the cut-off date, i.e. 1 April 2017, are taxable in India under the Act read with the applicable provisions of the India-Mauritius tax treaty.

Justice J.B. Pardiwala agreed with Justice Mahadevan and made certain observations on tax sovereignty.

BDO INDIA COMMENTS

The Supreme Court judgment lays emphasis on economic substance over legal form, and in this context, taxpayers will need to establish commercial substance to claim treaty benefits. Further, by holding that TRC is merely an eligibility condition and not conclusive proof of residence or substance, the Court has enhanced the onus on taxpayers to substantiate commercial rationale/ substance.
 
The SC has held that indirect transfers of shares, i.e. shares deriving substantial value from assets located in India, are not protected under Article 13 of the tax treaty. It is unclear whether this ratio applies to all cases involving indirect transfer of shares or only to such transactions where shares are transferred pursuant to an arrangement impermissible under law. 
 
This leads to issues for foreign investors who have routed their investment in India via intermediate treaty jurisdictions, and grandfathering past investments is no longer a blanket shield from capital gains tax. In the context of exits involving historical holdings, investors may have to reassess the tax position and relook at estimated tax costs.