Re-characterization of income to deny capital gains exemption under India Mauritius Treaty
The Authority for Advance Rulings (“AAR”) has in two significant rulings in the recent past re-characterized income in the hands of the investor from capital gains to interest and dividend income thereby denying exemption in respect of capital gains under the India-Mauritius Tax Treaty (“Treaty”). The AAR has disregarded the legal form of the transaction, alleging the transactions to be sham and imputing on the investors the intention to avoid Indian taxes. We have discussed the two rulings in greater detail below.
The first case decided by the AAR deals with income arising from the sale of shares and Compulsorily Convertible Debentures (“CCDs”). The AAR re-characterized the income arising on such disposition as interest income and not capital gains income on the grounds that a CCD is in the nature of a debt till the time it is converted and any income arising on account of a CCD should be considered interest income, regardless of the fact that the income has arisen on account of sale of such CCD to a party.
The applicant (“A Co (India)”) was a closely held public company incorporated in India. Its shareholding pattern was as follows: (a) 48.87 % held by A Co (US), a company incorporated in the US, (b) 25.06% held by A Co (Mauritius), a company incorporated in the Mauritius, (c) 27.37% held by A Co (Singapore) , a company incorporated in Singapore and (d) 1.76% held by the general public. Z.
V exercised the call option and purchased the CCDs from Z in multiple tranches. V approached the tax officer for a nil withholding certificate for the consideration paid to Z for the CCDs as such income, in the opinion of V, was in the nature of capital gains income exempt from tax under Article 13 of the Treaty. The tax officer however rejected the application and asked V to deposit the withholding tax on this transaction. Z subsequently approached the AAR for a ruling on the issue.
Z contended that the consideration received from V was on account of sale of a capital asset and therefore the amount received over the purchase price was in the nature of capital gains and not interest income. The tax authorities, on the other hand, contended that CCDs are debt instruments carrying a fixed rate of return, and therefore any payments made for such instruments should be treated as interest income.
As a first step, the AAR examined various authorities and case laws to hold that a CCD was in the nature of a debt instrument which continues to so remain till the time the debt is repaid. The AAR also observed that the obligation to repay the principal and an interest component were embedded in the concept of debt and that such payments were not necessarily required to be in the form of debt and could be in the form of cash, as was in this case. The AAR further observed that the definition of 'interest' under the Act and the Treaty to conclude that 'interest' denotes any type of income that become payable on a debenture.
The AAR studied the provisions of the investment agreement which set out the purchase price required to be paid by V to Z for the CCDs, which purchase price was an aggregate of:
The AAR further examined the other provisions of the investment agreement to conclude that while S and V were two separate legal entities, S had no power to exercise any management control over its business and that for all practical purposes V and S were a single entity. The AAR based this conclusion on provisions in the agreement which provided rights to V and Z to nominate directors to the board, right of V and Z with respect to material business decisions of S, consent requirement for S to enter into any related party transaction by S, among other management rights granted to V and Z. Additionally, V was required to share with Z, its financial statement, debt servicing status etc.
In light of such provisions, the AAR observed that on a close reading of the investment agreements, it was apparent that the commitment to repay the debt was on V, the parent of S and not S and therefore, the purchase of CCDs by V from Z should be considered repayment of the debt such that income arising to Z should be treated as interest income.
In the second case, the AAR ruled that the applicant’s scheme for buyback constituted a transaction that was “designed prima facie for avoidance of income-tax”. Under Section 245(R) of the Indian Income Tax Act, 1961 (“ITA”), the AAR can refuse to admit an application on certain grounds, such as where the question raised in the application “relates to a transaction or issue which is designed prima facie for the avoidance of income-tax”. In this case, the AAR held that the buyback scheme was designed prima facie for avoidance of income-tax and ruled that the income earned by the applicant’s Mauritius shareholder from the buyback was taxable in India as dividend and not capital gains, as would have ordinarily been the case.
The applicant (“A Co (India)”) was a closely held public company incorporated in India. Its shareholding pattern was as follows: (a) 48.87 % held by A Co (US), a company incorporated in the US, (b) 25.06% held by A Co (Mauritius), a company incorporated in the Mauritius, (c) 27.37% held by A Co (Singapore) , a company incorporated in Singapore and (d) 1.76% held by the general public.
In June 2010, A Co (India) proposed a scheme of buy-back of its shares from its existing shareholders. While A Co (US) and A Co (Singapore) declined the buy-back offer, A Co (Mauritius) proposed to accept the same. Accordingly, A Co (India) applied to the AAR to determine whether the income that would arise to A Co (Mauritius) as a result of the buy-back was chargeable to tax in India and whether A Co (India) was required to withhold tax on the consideration to be paid to A Co (Mauritius). A Co (India)’s stand before the AAR was that the income earned by A Co (Mauritius) from the buyback was in the nature of capital gains, which was not taxable in India as per the provisions of Article 13 of the Treaty.
Arguments put forth by the Revenue
The Revenue argued that subsequent to the introduction of Dividend Distribution Tax (“DDT”) in 2003, under which there is an additional tax of 15% imposed on dividend distributed by a company, A Co (India) had intentionally not declared dividends to its shareholders in order to avoid payment of DDT and had instead allowed its free reserves to accumulate with the objective of eventually buying back the shares from A Co (Mauritius), a transaction that would not have been taxable in India by virtue of the provisions of the Treaty. The Revenue also pointed out that the other shareholders of A Co India, namely A Co (US) and A Co (Singapore), had not participated in the buyback offer since the income that would have accrued to them would have been taxable in India in their hands. In response, A Co (India) claimed that the decision to not pay dividends was a commercial decision that A Co (India)’s management was free to take and was not done to avoid payment of DDT. Similarly, the decision of A Co (Singapore) and A Co (US) to decline the buyback offer was also a commercial call, which these companies were free to take. A Co (India) argued that since Section 46A clearly specified that income arising from a buyback was taxable as capital gains, the question of characterizing the buyback consideration paid to A Co (Mauritius) as dividend could not arise.
The AAR accepted the arguments put forth by the Revenue. It noted that prior to the introduction of DDT in the year 2003, dividends were being distributed periodically by A Co (India) to its shareholders and there was no reasonable explanation offered by A Co (India) as to why dividends were not declared subsequent to the year 2003 even though A Co (India) was earning profits. The AAR held that the transaction was a colorable device for avoiding payment of tax (i.e. DDT) and the entire arrangement was one designed prima facie for the avoidance of income-tax. It went on to rule that the proposed payment was to be taxable in India as dividend as per paragraph 2 of Article 10 of the Treaty and A Co (India) was liable to withhold tax on the payment to be made to A Co (Mauritius).
In Z’s case, while the AAR may have been correct in holding that a CCD is inherently a debt instrument, it has not appreciated the fact that a debt instrument is an asset for the holder of the CCD. A debt instrument is in a nature of a right or a property for the holder and thus a ‘capital asset’. Therefore, any income arising from the sale of such CCDs should result in capital gains income in the hands of the holder. Further, there have been judicial precedents on this particular aspect which have even held that a sale of a CCD prior to the maturity ought to be treated as capital gains.
Further, the AAR has failed to appreciate that the sale of the CCD was undertaken pursuant to a call option whereby V actually exercised the option to purchase the CCD. The existence of a put / call option in respect of CCD’s, Compulsorily Convertible Preference Shares and even equity shares is common in respect of most deals undertaken by private equity investors and is usually designed to provide downside protection besides other exit options. Merely having such options and exercise of the options should not change the characteristic of the transaction. The AAR appears to have taken a myopic view of the structure without appreciating the well-established law on the subject. Additionally, the re-characterization of the transaction is surprising considering that India has traditionally followed form of the transaction and not substance and it is not possibly to re-characterize transaction structure adopted by the parties except in limited circumstances.
Further, similar re-characterization in A’s case, purely on the basis of the Revenue’s allegation that A Co (India) had not distributed any dividends after the introduction of DDT and that the buyback offer was only accepted by A Co (Mauritius), is surprising considering that companies are entitled to take bona-fide decisions to refrain from declaring dividends or participating in buybacks. The establishment of the transaction as a colorable device without any evidence or material being adduced in support of the same raises a critical issue as to what is the burden of proof that would need to be discharged in respect of such a claim. It must be noted that a tax payer is entitled to arrange his affairs so as to reduce his tax liability and except in circumstances where the legal nature of the transaction is different from the actual transaction undertaken, the doctrine of colorable device should not be invoked.
Moreover, in A’s case, in ruling that income arising from a buyback was taxable as dividend, the AAR failed to consider Section 46A of the ITA which was enacted for the sole purpose of clarifying that income earned on buy back of shares would be deemed to be capital gains and not dividend income. Finally, the larger question that arises from the ruling in A’s case is that how could the AAR proceed to provide a ruling on the questions put forth even after it refused to admit the application on the ground of tax avoidance.
The ruling in A’s and Z’s case is likely to significantly impact existing investment structures since these are common investment structures / methods that are used by investors in respect of Indian investments. Further, with the proposed introduction of the General Anti-Avoidance Rules in the Budget 2012, this will only add to the uncertainty faced by Indian and foreign investors in relation to structuring Indian investments. The ever-increasing aggressive approach of the tax authorities and legislators is bound to dampen the spirit of the existing as well as potential investors into India.
1 A.A.R. No.1048 of 2011
2 A.A.R. No. P of 2010