Mauritius route upheld, yet again: AAR analyzes Control & Management and commercial substance of structure
Recently, the Authority for Advance Ruling (“AAR”) in the case of In re, Mahindra BT Investment Company (Mauritius) Limited upheld capital gains relief under the India-Mauritius tax treaty (“Mauritius Treaty”) on transfer of an Indian company’s shares by a Mauritius company to a US company under an Option Agreement. The AAR observed that based on the decisions taken by its Board of directors, the constitution of the Board, and the fact that all Board meetings were held in Mauritius, the control and management of the company’s affairs could not be said to have been wholly situated in India. Rejecting the Revenue’s classic objection that the incorporation of the applicant lacked any ‘economic substance’ and was done with the sole intent of availing Mauritius Treaty benefit, the AAR upheld the commercial rationale of the arrangement and allowed the benefit under the Mauritius Treaty.
Mahindra – BT Investment Company (Mauritius) Limited (“MBTM / Applicant”) is a company incorporated in Mauritius which is jointly held by Mahindra Overseas Investment Co. (Mauritius) Limited, a Mauritius company, and BT Holdings Limited, a UK company. MBTM holds 8.12% in Tech Mahindra Limited (“TML”), an Indian listed company. However, prior to acquiring these shares in TML, an Option Agreement was entered into between MBTM, AT&T International Inc. (“AT&T”) a US Company and TML, among other parties, whereby AT&T was given an option to purchase the 8.12% of the shareholding of TML from the Applicant upon achieving certain milestones stipulated in the Option Agreement. On achieving the said milestones, AT&T exercised the option and purchased the shares of TML from MBTM resulting in a long term capital gain for MBTM. The transaction has been diagrammatically represented below:MBTM
approached the AAR for a ruling on whether the capital gains earned by it would be exempt by virtue of Article 13 of the Mauritius Treaty.
The AAR held that the Applicant was not chargeable to tax in India on the capital gains earned due to availability of relief under Article 13(4) of the Mauritius Treaty. On the question of whether the control and management of the affairs of Applicant’s business was wholly situated in India, the AAR examined the nature of decisions taken by the Applicant’s Board in Mauritius and ruled that the control and management of all affairs of the Applicant were wholly in Mauritius. The AAR based its ruling on the following:
The AAR rejected the Revenue’s argument that MBTM was incorporated without any economic substance with the sole purpose of holding shares in TML to facilitate a tax neutral transfer to AT&T under the Mauritius Treaty. It upheld the commercial rationale of the holding structure and noted that it was commercially agreement between TML and AT&T that the latter would be offered an opportunity to become a shareholder in TML only when it had given a certain level of business to TML for which certain milestones were set. This was done in order to incentivize AT&T to give business to TML and the option was exercised only after accomplishment of the milestones. The AAR ruled that there was nothing unusual about such conditions in the Option Agreement.
Control and Management of Applicant’s affairs was not in India
The main argument of the Revenue was that the control and management of the Applicant’s affairs is situated wholly in India and therefore the Applicant should be considered an Indian resident under the Income Tax Act, 1961 (“ITA”). This would trigger Article 4(3) of the Mauritius Treaty which provides that a resident of both India and Mauritius shall be deemed to be a resident of the country in which its place of effective management is situated. Therefore, in examining whether the Applicant’s control and management was situated wholly in India, the AAR made the following observations:
The AAR relied on the judgment of the Supreme Court in the case of CIT v. Nandlal Gandalal1 which held that the expression ‘control and management’ means de facto control and management and not merely right or power to control or manage. Further, it also cited VVRNM Subbayya Chettiar v. CIT2 where the Supreme Court held that the word ‘affairs’ must mean affairs which are relevant for the purpose of the ITA and which have some relation to income.
Upon observing the above facts, the AAR did not find any evidence to show that any important affairs of the Applicant were being controlled from India. It rejected the Revenue’s primary argument that the real transaction was between TML and AT&T and therefore the Applicant’s control and management should be treated as situated in India. The AAR held that there was nothing wrong in the Applicant holding the shares and transferring them at a later stage upon fulfillment of the conditions by AT&T under the Options Agreement.
This ruling once again demonstrates the support of the Indian judicial authorities for the Mauritius route. The judiciary has time and again upheld capital gains tax relief under the Mauritius Treaty on alienation of Indian shares by Mauritius residents, starting from Azadi Bachao Andolan3, which has been followed and upheld several times in cases such as Vodafone International Holdings BV4, E*Trade Mauritius Limited5, and recently also in Serco BPO (P) Ltd. v. AAR6. In all these cases, the Revenue’s challenge was primarily based on the sole tax objective of interposing the Mauritius holding company, despite the fact that the operating parent was situated elsewhere. However, courts have consistently refused to question the substance of the structure so long as the taxpayer is able to demonstrate that it holds a valid Tax Residency Certificate (“TRC”) issued by the Mauritius tax authorities, the transaction is not a sham or a colourable device, and there is some degree of commercial rationale behind the structure. Needless to say that with the new protocol to the Mauritius Treaty, such transactions in shares will become subject to Indian capital gains tax from April 1, 2017, if the transferred shares were acquired by the transferor after that date. Further, this judicial position is expected to change with the onslaught of General Anti-Avoidance Rules (“GAAR”) on income accruing or arising on or after April 1, 2017, as GAAR empowers the Indian tax authorities to declare any arrangement as an "impermissible avoidance arrangement"7 and consequently to disregard the structure, reallocate income, and deny a tax benefit or treaty relief.
The analysis in the ruling fundamentally revolves around the tax residency of MBTM based on the erstwhile control and management test under the ITA. Under Section 6(3) of the ITA, as it existed during the concerned period, a foreign company could be regarded as an Indian tax resident only if the control and management of its affairs was situated wholly in India. This test of residency was fairly straightforward and has prevailed in the Indian income tax regime for approximately 100 years. During this period it has led to minimal litigation since there is almost never an ambiguity with regard corporate tax residency as it requires the control and management to be situated wholly in India for the foreign company to be considered an Indian tax resident. The simplicity of this test is also evident in this ruling where on a cursory glance, it was clear that the Applicant could not be considered an Indian resident. The AAR examined so many factors only because that was the principal argument of the Revenue on the basis of which it sought a denial of the Mauritius Treaty benefits to the Applicant.
It would be difficult to adopt such straightforward analysis of tax residency under the new test of “place of effective management” (“POEM”) which has replaced the control and management test in the ITA from April 1, 2015. The POEM test deems a foreign company to be an Indian tax resident during a year, if during that year the place where its key management and commercial decisions that are necessary for the conduct of its business as a whole are, in substance, made in India. While the Indian Government has released draft guidelines8 to address the ambiguity of the POEM test, the guidelines appear to raise more concerns than resolving them, and are yet to be finalized despite the POEM test being in effect (our hotline on POEM http://www.nishithdesai.com/information/research-and-articles/nda-hotline/nda-hotline-single-view/article/poem-new-criteria-for-corporate-tax-residence-in-india.html?no_cache=1&cHash=441d8fd361ff3271a3788c9d241e2037). It is yet to be seen how the question of corporate tax residency under POEM test plays out in courts.
1 40 ITR 1 (SC)
2 (1951) 19 ITR 168
3 Union of India v. Azadi Bachao Andolan,  263 ITR 707 (SC)
4 Vodafone International Holdings BV v. Union of India,  341 ITR 1 (SC)
5 2010 324 ITR 1 (AAR)
6  379 ITR 256
7 An impermissible avoidance arrangement is one where the arrangement is entered into with the main purpose of obtaining a tax benefit and is either (i) not at arm's length, (ii) non-bona fide, (iii) results in abuse or misuse of the tax provisions, or (iv) lacks commercial substance.
8 Available at - http://www.incometaxindia.gov.in/news/poem-note-for-uploading.pdf