AAR grants Capital Gain exemption under the India-Mauritius Tax Treaty to E*Trade Mauritius – Treaty Shopping permissible within the legal framework

The Authority for Advance Rulings (AAR) in the case of  E*Trade Mauritius Ltd. (AAR No. 826 of 2009) has held that that capital gains arising from the sale of shares in an Indian company would be exempt from tax in India under Article 13(4) of the India-Mauritius Tax Treaty (tax treaty).

The AAR, while relying on the principles laid down by the Supreme Court in the case of Union of India Vs. Azadi Bacho Andolan [2003] 263 ITR 706 (SC) , observed that –

• if a resident of a third country seeks to take advantage of the tax relief and economic benefits under any tax treaty through a conduit entity, the legal transactions entered into by that conduit entity cannot be declared invalid.
• the design of tax avoidance by itself is not objectionable if it is within the framework of law and not prohibited by law.

 Facts of the case

• E*Trade is an indirect subsidiary of E*Trade Financial Corporation, USA (US Co) which sold its stake in IL&FS Investmart Ltd.(IL&FS), an Indian company to HSBC Violet Investments (Mauritius) Ltd. (HSBC), another Mauritius company.
• E*Trade made an application under section 197 of the Income-tax Act, 1961 (the Act) to the tax authorities for issue of a ‘Nil’ withholding certificate authorizing HSBC not to deduct any tax from the sales proceeds payable to E*Trade.
• The tax authorities issued a certificate under section 197 of the Act directing HSBC to deduct tax on the amounts paid to E*Trade. E*Trade filed a writ petition before the Bombay High Court challenging the said certificate.
• With the consent of the parties, the Bombay High Court by its order dated 26 September 2008 disposed of the writ petition directing E*Trade to file a revision application before the Director of Income Tax (International Tax) (DIT). Pending the decision of the DIT, HSBC was also directed to deposit a sum of INR 245 million which would be withheld from the consideration paid to E*Trade. It is important to note that the High Court did not get into the merits of the case.
• Pursuant to the High Court’s order, the DIT, in his revision order confirmed the position taken by the tax authorities regarding withholding of tax by HSBC. Accordingly, the Bombay High Court, in its order dated 23 March 2009 directed the release of INR 243.1 million from the deposited amount to the government and the refund of the balance amount to E*Trade.
• E*Trade thereafter approached the AAR to determine the tax ability of the said transaction under the tax treaty.

Issue before the AAR :- Whether E*Trade is exempt from payment of capital gains tax in India under the tax treaty in respect of the transfer of shares of an Indian company to another Mauritius entity?

Tax department’s contention

• The real and beneficial owner of the capital gains from the sale of IL&FS shares is the US Company which controls E*Trade. E*Trade is merely a facade established by the US holding Company to avoid capital gains tax in India.
• The DIT has taken a prima facie view that the capital gains arising from the aforesaid transaction is taxable in the hands of the US entity.
• The Tax authorities have observed as follows:

-Investment in IL&FS has been funded by way of corresponding equity investments from US Co (the parent of E*Trade Mauritius).

-Personnel of US Co were appointed as Directors / employees of IL&FS.

-Executives deputed to IL&FS were in charge of key functions of IL&FS.

-US Co exercises shareholders rights in IL&FS.

• The term ‘beneficial ownership’ referred to in Circular 789 was used in the Circular in the context of the Article dealing with dividends and it shall be confined only to dividends. Therefore, the Circular would not be applicable in determining the eligibility to claim Treaty benefits vis-a-vis Capital gains(See Note- 1).
• There is sufficient justification to make further inquiries to arrive at the finding regarding the beneficial owner of the gains and to unravel the correct facts as regards the source of funds, treatment of shareholding, the manner of accounting and the role played by the US Co in the deal. It is, therefore, inappropriate at this stage to give a ruling on the questions raised by the applicant.

 Taxpayer’s contentions

• E*Trade Mauritius is entitled to Capital gains exemption under Article 13(4) of tax treaty in relation to the aforesaid transaction.
• E*Trade has filed all relevant material and clarifications before the AAR. The inquiry by the Tax Authorities as to whether or not E*Trade Mauritius is merely a facade is a futile and wholly unnecessary exercise in view of the Central Board of Direct taxes (CBDT) Circular No. 789 which is binding on the Tax department and the law is clarified by the Supreme Court in Azadi Bachao Andolan’s case.

AAR’s ruling

Applicability of Circular 789 to Capital Gains

• Circular 789 applies to dividends as well as capital gains arising from the sale of shares of Indian companies.
• It seems to be untenable that a certificate of residence will not be relevant to determine the beneficial ownership of capital gains.
• If a resident of Mauritius who gets dividends from the shares is considered to be the beneficial owner thereof, there is no rational reason to view the ownership of gains arising from their transfer on a different footing.

Eligibility to claim benefits under the India-Mauritius Tax Treaty

 Reliance on Azadi Bachao Andolan’s case

• The issue needs to be determined in light of the principles laid down by the Supreme Court in the case of Azadi Bachao Andolan. The AAR observed that in Azadi Bachao Andolan’s case, the Supreme Court found no legal taboo against ‘treaty shopping’. Treaty shopping and the underlying objective of tax avoidance/ mitigation was apparently not equated to a colourable device. That means, if a resident of a third country, in order to take advantage of the tax relief and economic benefits arising from the operation of a Treaty between other countries through a conduit entity set up by it, the legal transactions entered into by that conduit entity cannot be declared invalid. The motive behind setting up such conduit companies and doing business through them in a country having beneficial tax treaty provisions was held to be not material to judge the legality or validity of the transactions.
• The AAR further observed with respect to Azadi Bachao Andolan’s case that a transaction which is ‘sham’ in the sense that ‘the documents are not bona fide in order to intend to be acted upon but are only used as a cloak to conceal a different transaction would stand on a different footing.
• On the facts of the present case, it is difficult to assume that the capital gain has not legally arisen in the hands of E*Trade Mauritius especially in view of above principles laid down by the Supreme Court that the motive of tax avoidance is not relevant so long as the act is done within the framework of law.

E*Trade held to be the real owner of shares

• In the context of the facts of the case, the AAR further inferred that:

-the source of funds for the purchase of shares is traceable to the holding company; or

-the holding company had played a role in suggesting or negotiating the sale; or

-the consideration received ultimately goes to the parent company in the form of dividends; or

? -the diminution of capital of E*Trade Mauritius immediately after the transaction would not lead to a legal inference that the holding company in reality owned the shares.

• It is unrealistic to expect that a subsidiary would conduct its business independent of any control and assistance by the parent company.
• The subsidiary has its own corporate personality and the fact that the holding company exercises acts of control over its subsidiary would not in the absence of compelling reasons dilute the separate legal identity of the subsidiary.
• Thus, in the present case, to take a view that the recipient of capital gains arising from transfer of shares is the US entity and not E*Trade Mauritius would be contrary to the ground realities of the mutual business and economic relations between a holding and subsidiary company and the inter-se legal structure.
• Hence, it is clear that E*Trade was the legal owner of IL&FS’s shares, the transaction was validly entered into by E*Trade Mauritius (being backed up by Board’s resolutions) and E*Trade was the actual recipient of the sale price.

Conclusion

• In view of the above observations, E*Trade Mauritius would be entitled to the exemption from capital gains under Article 13(4) of the tax treaty in respect of the aforesaid sale of IL&FS shares to HSBC.
• The AAR further observed that whilst it is not within the domain of the AAR to restrain the tax authorities from making inquiries or elicit further information, the scope of such inquiry ought to be limited in the light of the observations in the ruling and could only be within the confines of the legal position clarified by the Supreme Court and in this order.

Our Comments

The AAR has applied Circular 789 and reiterated the principles laid down by the Supreme Court in the case of Azadi Bachao Andolan in the context of the tax treaty that a TRC is conclusive evidence of tax residency and eligibility of a Mauritius entity to avail benefits under the tax treaty. It also reiterates the principle that tax planning, as long as within the legal framework is permissible.

Even though the decision of the AAR is legally binding only on the parties involved in the particular case, the ruling would have a persuasive value in a similar litigation before the Indian tax authorities and courts.

Note:- 1

Extracts of CBDT Circular No. 789 is given below:

“…….It is hereby clarified that wherever a certificate of residence is issued by the Mauritian authorities, such certificate will constitute sufficient evidence for accepting the status of residence as well as beneficial ownership for applying the DTAC accordingly.

3. The test of residence mentioned above would also apply in respect of income from capital gains on sale of shares. Accordingly, FIIs, etc. which are resident in Mauritius should not be taxable in India on income from capital gains arising in India on sale of shares as per paragraph 4 of article 13.”