Introduction

The Authority for Advance Ruling (“AAR”) constituted under the provisions of the Income-tax Act, 1961 (“ITA”), is an independent adjudicatory body empowered to issue rulings in respect of a transaction or a proposed transaction, which is binding on the Income-tax department (“Revenue”) as well as the Applicant seeking such ruling.  However, it exercises restraints where the issue involved is pending adjudication before another Income-tax authority or an appellate forum; or where the issue concerns determination of the fair market value of any property; or where the subject transaction, in view of the AAR, has been designed prima facie for avoidance of income-tax in India.

The AAR, in the decision of Tiger Global International II Holdings, In Re, (AAR/ 04/ 2019, decision dated March 26, 2020), made some pertinent observations in the context of afore-stated restraints, while denying a ruling at the brink of admissibility of the application[1].  In this article, we have attempted to point out certain critical aspects of the said decision, which may be extremely relevant for investing in India through layers of holding companies abroad, specifically concerning exposure to capital gains taxation in India.  While the fate of the decision will unravel in due course before the Delhi High Court, it is definitely destined to trigger stimulating discussions on some rather intriguing incidental issues.

Indirect Transfers

The ever so popular decision of the Apex Court in Vodafone[2] was the trigger for the introduction of indirect transfer provisions in the ITA.  The Apex Court in the said decision held that the sale of shares of a non-resident company by a non-resident would be exempt from capital gains tax in India even if such non-resident company directly or indirectly held Indian assets.

To overcome this verdict, section 9 of the ITA was amended in 2012 (with retrospective effect from 1962), by virtue of which, indirect transfer of Indian shares by a non-resident became taxable in India.  To elaborate, gains derived by non-residents through transfer of shares in a non-resident company were made exigible to tax in India, if such shares derived, directly or indirectly, more than 50% of their value from assets located in India.

Tax Avoidance and the Mauritius Route

Investment into India through Mauritius has historically been made to achieve tax advantages, that the domestic law in Mauritius read along with the Double Taxation Avoidance Agreement between India and Mauritius (“Tax Treaty”) provide.  For instance, there is neither a capital gains tax in Mauritius, nor is there any tax on dividend distribution by a Mauritius company to its shareholders.  Therefore, until before April 01, 2017, by virtue of the Tax Treaty, it was possible for a Mauritian company to sell shares held in an Indian company and derive capital gains thereon, which would then be distributed to its shareholders, without attracting any income-tax either in India or Mauritius whatsoever.  In fact, the Apex Court in UOI v. Azadi Bachao Andolan, (2003) 263 ITR 706 (Supreme Court), specifically recognised the Mauritius route as being a suitable treaty conduit for South Asia and South Africa.

To understand as to why the Apex Court used the word “suitable” before “treaty conduit”, it is imperative to understand the background in which the decision in Azadi Bachao (supra) was rendered.  The Tax Treaty was entered in 1983.  Article 13 therein dealt with capital gains taxation and provided that:

1. Gains from alienation of immovable property “may” be taxed in the country in which such property was situated.

2. Gains from alienation of movable property, that forms part of the business property of a permanent establishment, “may” be taxed in the country in which such permanent establishment exists.

3. Gains from the alienation of ships and aircraft operated in international traffic and movable property pertaining to the operation of such ships and aircraft, “shall” be taxed in the country where the place of effective management of the enterprise owning/ operating such ships/ aircraft exists.

4.  Gains from alienation of any other property “shall” be taxed in the country of residence of the alienator.

Therefore, as per the express provision of Article 13(4) of the Tax Treaty [“residuary clause”], India did not have the right to tax capital gains arising to a Mauritian resident from alienation of shares of a company.  In fact, the Central Board of Direct Taxes (“CBDT”) vide Circular No. 682 dated March 30, 1994, clarified that capital gains arising to any Mauritian resident from alienation of shares of an Indian company shall be taxable only in Mauritius and according to Mauritian tax law.  Subsequently, however, the Revenue started scrutinising gains derived by Mauritian entities from sale of shares held in Indian companies.  The basis for such scrutiny was the belief of the Revenue that such entities were “shell” companies, whose main purpose was investment of funds in India, and were controlled and managed from countries other than India or Mauritius.

To curb the panic created as a result thereof, the CBDT issued another clarification vide Circular No. 789 dated April 13, 2000, where under the stand of CBDT as per the earlier clarification was reiterated and reinstated.  The CBDT also clarified in the said Circular that for the purposes of availing the benefits under the Tax Treaty and to be treated as the “beneficial owner” as regards the income in question, it was enough for the resident of Mauritius to hold a valid Certificate of Residence issued by the Mauritian authorities.

This Circular was challenged through “public interest litigation” before the High Court of Delhi and was quashed.  Interestingly, it was the Government of India that appealed to the Apex Court and contended that:

1. There was no Article in the Tax Treaty to preclude a national of a country other than India and Mauritius to enjoy the benefits of the Tax Treaty, like Article 24 in the Tax Treaty between India and USA;

2. Motive with which entities are incorporated in Mauritius is irrelevant and cannot in any way affect the legality of the transaction undertaken by such entities; and

3. Entitlement to the Tax Treaty cannot be denied, merely because an exemption has been provided for in the Mauritian tax law.

The Apex Court agreed with the contentions of the Government of India and made the impugned Circular vis-à-vis Mauritius route, valid for all purposes.  It is in this context, that the Apex Court recognised the Mauritius route and the practice of allowing treaty shopping, while observing as follows:

“The developing countries allow treaty shopping to encourage capital and technology inflows, which developed countries are keen to provide to them. The loss of tax revenues could be insignificant compared to the other non-tax benefits to their economy. Many of them do not appear to be too concerned unless the revenue losses are significant compared to the other tax and non-tax benefits from the treaty, or the treaty shopping leads to other tax abuses.”

Therefore, the Apex Court, very clearly recognised the Mauritius Route as a legitimate route for investing in India and non-taxability of gains arising to a Mauritian resident from a direct transfer of Indian shares in India by virtue of Article 13(4) of the Tax Treaty.  Logically, therefore, an indirect transfer of Indian shares by a Mauritian entity would also not be taxable by virtue of Article 13(4) of the Tax Treaty.

In fact, the Apex Court, later in 2012 in Vodafone (supra), held that even for the purposes of the ITA, indirect transfer of Indian shares was not taxable in India.  The Court therein, also observed that it was a common practice in international law, which is the basis of international taxation, for foreign investors to invest in Indian companies through an interposed foreign holding or operating company, such as a Mauritius based company for both tax and business purposes.  It was further observed that in doing so, foreign investors are able to avoid the lengthy approval and registration processes required for a direct transfer (i.e., without a foreign holding or operating company) of an equity interest in a foreign invested Indian company.  Furthermore, in the said decision the Apex Court opined that Revenue/ Courts may invoke the “substance over form” principle to decipher whether the dominant purpose of the impugned transaction was tax avoidance or not.  While doing so, in the opinion of the Apex Court, the Revenue/Courts should keep in mind the following factors: (i) the concept of participation in investment; (ii) the duration of time during which the Holding Structure exists; (iii) the period of business operations in India; (iv) the generation of taxable revenues in India; (v) the timing of the exit; the continuity of business on such exit etc. (“Parameters”).

Therefore, indirect transfer of Indian shares through the Mauritius route was not only taxable as per Article 13(4) of the Tax Treaty but was also not taxable under the ITA.  The situation became slightly more complicated after the amendment in 2012, when indirect transfer provisions were added to the ITA.  However, the said amendment had no impact on the Mauritius route in light of Article 13(4) of the Tax Treaty.

With effect from April 01, 2017, the General Anti-Avoidance Rule (“GAAR”) was introduced in the ITA that made the requirement of obtaining tax benefit as the main purpose of the impugned transaction, an essential condition for its invocation.  Basically, the Revenue has now been enabled to render any transaction as an impermissible avoidance arrangement by invoking the GAAR provisions under the ITA.

Simultaneously, the Tax Treaty was also been amended with effect from April 01, 2017 and specifically, in the context of Article 13 dealing with capital gains taxation, the following provisions have been inserted:

“3A. Gains from the alienation of shares acquired on or after 1st April 2017 in a company which is resident of a Contracting State may be taxed in that State.

3B. However, the tax rate on the gains referred to in paragraph 3A of this Article and arising during the period beginning on 1st April, 2017 and ending on 31st March, 2019 shall not exceed 50% of the tax rate applicable on such gains in the State of residence of the company whose shares are being alienated”

Therefore, capital gain arising from a direct transfer of Indian shares acquired by a Mauritian resident on or after April 01, 2017, has now become taxable in India.  Article 13(4) of the Tax Treaty remains intact and unchanged.  What can be discerned from the above is that the Indian Government, while being conscious of the indirect transfer provisions contained in section 9 of the ITA, made no effort to re-negotiate the Tax Treaty, to cover within its ambit, gains arising from indirect transfer.

Therefore, where a direct transfer of Indian shares by a Mauritian resident has been made taxable in India, there has been no whisper in the amendment as far as indirect transfer of Indian shares by a Mauritian resident is concerned.

In connection therewith, support can be drawn from the decision of the Andhra Pradesh High Court in the case of Sanofi Pasteur Holding SA v. Department of Revenue, (2013) 354 ITR 316 (Andhra Pradesh).  The Court therein, while dealing with a case where shares of French entity (that held shares in an Indian entity) were sold by one French entity to another French entity, held that gains from such alienation would only be taxable under the residuary clause of Article 14(6) of the Double Taxation Avoidance Agreement between India and France.  The Double Taxation Avoidance Agreement between India and France specifically deals with direct transfer of Indian shares in Article 14(5) and has an identical residuary clause 14(6) like Article 13(4) of the India – Mauritius Tax Treaty as also recognised by the High Court[3].  Therefore, it seems that capital gains arising to a Mauritian resident from indirect transfer of Indian shares would also be covered under Article 13(4) of the Tax Treaty and would accordingly, not be taxable in India.

A new Article 27A, dealing with limitation of benefits, has also been inserted in the Tax Treaty with effect from April 01, 2017, and the same operates to restrict the benefit under the newly introduced Article 13(3B) only.  The said Article does not affect Article 13(4) of the Tax Treaty.

Ruling of the AAR in Tiger Global

The AAR in Tiger Global (supra), was dealing with a case where certain Mauritian entities derived capital gains from sale of their stake in a Singaporean entity (that held shares in Indian companies) to an entity in Luxembourg.  This ruling of the AAR was rendered in the context of the restraints that the AAR has to observe in accordance with the first proviso to section 254R(2) of the ITA, while admitting an application.  Following are the key observations:

1. Pendency of / final determination by the Revenue in an application filed under section 197 of the ITA (for NIL withholding certificate), during/ prior to filing of the application before the AAR is not a bar for entertaining the application.

2. Merely because a ruling on the question of capital gains has been sought in an application before the AAR, does not raise issue of fair market valuation in order for it to become a bar for the AAR to entertain such application.

3. The transaction in question was a device to avoid tax in India and therefore, the bar under the clause (iii) of the first proviso to section 245R(2) of the ITA was applicable in order for the AAR to decline the admission of the application.  Following are the key arguments made by the Revenue that persuaded the AAR to hold so:

(i) The Mauritian entities were set up in Mauritius to for making investments in India and other markets.  They were acting as “conduit” for the real beneficial owners based out of USA.

(ii) Given that cheques of value more than USD 250,000 were to be mandatorily signed by a director of the Mauritian entities along with two key personnel of Tiger Global Management LLC (ultimate parent of the Tiger Global Group), who were not part of the Board of Directors of any of the Mauritian entities, the financial control of the Mauritian entities was outside Mauritius; and

(iii) The Mauritian entities had specified Mr. Charles P Coleman as the beneficial owner of the entities on the documents submitted to Mauritius Financial Services Commission.

Apart from the above, the AAR held that on merits, the case of the Mauritian entities did not fall within Article 13(4) of the Tax Treaty and that they were taxable in India, in the following manner:

“In the present case capital gains has not been derived by alienation of shares of any Indian company rather the applicants have come before us in respect to capital gains arising on sale of shares of Singapore Company…. Thus as per the amended DTAA between India & Mauritius as well, what was not taxable was capital gains arising on sale of shares of a company resident in India. It is thus crystal clear that exemption from capital gains tax on sale of shares of company not resident in India was never intended under the original or the amended DTAA between India and Mauritius. In view of this clear stipulation in the India-Mauritius DTAA, the applicants were not entitled to claim benefit of exemption of capital gains on the sale of shares of Singapore Company. Thus, the applicants have no case on merits and fail on the ground of treaty eligibility as well.”

Analysis

In our view, while the AAR was justified in not exercising the first two restraints as provided for in the first proviso to section 245R(2) of the ITA, it may have acted out in haste while deciding the question of tax avoidance.  Furthermore, in our view, it appears that the AAR has made a fundamental flaw of jumping to the merits of the matter at the admission stage itself.  Not only is it inconsistent with the prescribed procedure, it raises doubts of the influence of such decision on merits on the question of tax avoidance itself.

To elaborate, the AAR held that the residuary clause (4) of Article 13 of the Tax Treaty (capital gains taxation) was inapplicable in a case involving indirect transfer of shares, and that a transaction of indirect transfer of shares, like the one in hand, was taxable in India.  If that was the view of the AAR, then there was no question of any avoidance of tax by the Mauritian entities.  Justice O. Chinnappa Reddy, in his concurring view in McDowell and Co. Ltd. v. Commercial Tax Officer, AIR 1986 SC 649 (Supreme Court) observed that tax avoidance was the “art of dodging tax without breaking the law”.  Therefore, if the Mauritian entities were taxable in India on the gains derived by them from selling their stake in the Singaporean entity (that held Indian shares), there was no question of getting into the issue of whether the impugned transaction was designed specifically to avoid tax in India.  In our view, for the purposes of adjudicating a claim on tax avoidance, it is necessary that the benefit under the taxing regime is admitted to exist.  In any case, in our view, the ruling as far as it deals with the merits of the matter, is against the dictum of the Andhra Pradesh High Court in Sanofi (supra).  Furthermore, in our view, the AAR also fell in error in concluding that whereas gains arising from direct transfer of Indian shares were exempt prior to the amendment in 2017, gains arising from indirect of Indian shares were taxable.

On the issue of avoidance of tax, the AAR seems to have completely ignored the decision of the Apex Court in Azadi Bachao (supra).  The Government of India had urged that since there was no limitation on benefits clause under the Tax Treaty, there was no prohibition for a person resident in a country other than India and Mauritius to avail the benefit of the Tax Treaty.  This contention was specifically accepted by the Apex Court to be correct.  If that was the concession of the Government of India, does that make the contentions of the Revenue that persuaded the AAR to adversely observe on the tax avoidance issue, unethical and the decision of the AAR itself per incuriam? In our view, perhaps it does.

That apart, in our view, the AAR has blindly accepted the contention of the Revenue to impose conditions that are not even prescribed in the Tax Treaty.  There is a detailed elucidation on the concept of beneficial ownership, which does not find place in Article 13 of the Tax Treaty, neither before or after the amendment.  This concept is relevant for Article 11 of the Tax Treaty and by no stretch of imagination, can the same be imported in Article 13 in the absence of express reference thereto.  Thus, one fails to understand where this condition was imported from which became a determinative factor for the AAR to deny the application.

The AAR also observed in its ruling that the Parameters for checking avoidance of tax, as set forth in Vodafone (supra) were also not met in the present case since the Mauritian entities did not invest directly in India and were not paying taxes in India.  This is where the haste seems quite apparent.  The facts in the case of Vodafone (supra) were identical to the facts that were presented before the AAR.  The AAR limited itself to checking the Parameters in question vis-à-vis the Mauritian entity.  In our view, and in line with the manner in which the Apex Court applied the Parameters, the AAR should have applied the Parameters to the entire holding structure, and not just the Mauritian leg.  In furtherance thereto, once having admitted that there was neither a direct investment nor business operation in India, there was no reason for the AAR to comment on there being no taxable revenue in India.  In fact, the conclusion that in the absence of direct investment in India, the arrangement seems to be a pre-ordained transaction created for avoidance of tax is ironically self-contradictory, given the AAR’s own interpretation that capital gains arising as a result of direct investments in India through Mauritius route were exempt from capital gains taxation in India.

Furthermore, the AAR in its ruling has observed that the ground that the Mauritian entities were conduits based on the holding structure, was not enough, and it had to be necessarily seen in the context of the role that the management of the upper tier entities played in the operation of the Mauritian entities.  Therefore, the only legitimate ground that seems to have persuaded the AAR into adversely observing on the tax avoidance issue is the fact that two key personnel of the ultimate parent had a limited authority to countersign on certain cheques on behalf of the Mauritian entities.  This ground, in our view, is a mere speculation of “significant control” and the conclusion of the AAR based on this ground, in our view, may not stand the test of judicial scrutiny.

In our view, the purpose of the AAR is to bring finality and not to allow itself to be misdirected on frivolous issues.  In this ruling, what has been completely missed by the AAR is that the issue of avoidance of tax had to be seen qua the period of time when the investment was structured by the Applicants.  At that time, if the Mauritian investor was not to suffer a capital gains tax by making a direct investment in India, then the routing of the said investments through Singapore could not be labelled as a device for avoidance of tax in India.  This very critical aspect of the matter seems to have been completely ignored by the AAR and that’s why its conclusions, in our view, are patently erroneous.  It cannot be the case of anyone that the Mauritian investors, in this case at the time of making the impugned investments (2011-2015), could have imagined that the Tax Treaty will be amended in 2017 and hence the said investments were routed through Singapore instead of a direct investment.  The facts that have been stated in the body of the ruling itself reveal that the investment was initiated in 2011, even before the induction of indirect transfer provisions in the ITA (with retrospective effect).  Thus, at the threshold itself, in our view, the ruling of the AAR suffers from the vice of irrationality and is likely to be overruled on this ground alone.

Conclusion

In light of the above and in our view, it is arguable that the AAR was manifestly misguided in rejecting the Application before it at the threshold, holding the transaction involving indirect transfer of Indian shares, a prima facie design to avoid payment of tax in India.

It is noteworthy that the order passed by the AAR is an order under section 245R(2) of the ITA, not under section 245R(4) of the ITA.  Whereas an order under section 245R(2) is an order where the AAR exercises restraints as far as the admission of an application is concerned, an order under section 245R(4) is an order on the merits of an application by the AAR, once the AAR chooses not to exercise restraints under section 245R(2).  However, in order impugned before the High Court presently, the AAR has also expressed its mind over the merits of the questions.

If the High Court decides that the Application ought to have been admitted by the AAR in view of the persisting bars under section 245R(2) being inapplicable, it will be interesting to see whether the High Court will direct a de-novo adjudication under section 245R(4) or whether the High Court will consider the merits of the questions in the Application before the AAR i.e., whether indirect transfer of Indian shares by a Mauritian entity was taxable in India or not.  In any case, in our opinion, any direction, other than for the AAR to eat the humble pie, would perhaps render the efforts of the Petitioners before the High Court futile.

Authors:

Deepak Chopra, Senior Partner
Anmol Anand, Senior Associate
Priya Tandon, Associate

Footnotes:

[1] The Delhi High Court vide order dated September 22, 2020, in a Writ Petition bearing W.P. (C) No. 6764 to 6766 of 2020, challenging the decision of the AAR, has stayed the regular assessment proceedings initiated against Tiger Global.  The matter is now fixed for hearing on January 18, 2021.
[2] Vodafone International Holdings B.V. v. UOI, (2012) 341 ITR 1 (Supreme Court)
[3] The said decision of Sanofi (supra) was followed by the AAR in GEA Refrigeration Technologies GmbH 2017 SCC OnLine AAR 2, decision dated November 28, 2017 and by the Income Tax Appellate Tribunal, Mumbai in Sofina S.A. vs. ACIT, ITA No. 7241/Mum/2018, decision dated March 05, 2020.