Taxing a Permitted Transferee: Any IDEAs?
The Bombay High Court recently pronounced its judgment1 relating to the transfer of shares of an Indian joint venture company, Idea Cellular Ltd. (“ICL”) and also the transfer of shares of a Mauritian company which held shares in ICL wherein the Court dismissed the writ petitions filed by Aditya Birla Nuvo Limited, New Cingular Wireless Services Inc., (“U.S. Co.”) and Tata Industries Limited (“TIL”) and expressed its prima facie view that such sale of shares is liable to capital gains tax in India. This case dealt with whether any income chargeable to tax in India accrued or arose to U.S. Co. on account of US$ 150 million paid by Aditya Birla Nuvo Limited to AT&T Mauritius (“M. Co.”, a wholly owned subsidiary of U.S. Co.) for the sale of about 16% stake in ICL and the subsequent consideration paid by TIL to U.S. Co., for acquiring the M Co. which held the remaining 17% interest in ICL.
Entities Involved – An All Star Cast
On 5 December 1995, U.S. Co. (then, AT&T Corp / AT&T Wireless Services Inc., U.S.) and the Birla Group2 (“Birla”) entered into a joint venture (“ICL” or “JV”) for carrying on wireless telecommunication in India. The agreement between the parties provided the shares in ICL shall be held by the ‘founders’ in their own name or through a ‘permitted transferee’ i.e. any corporation which is a wholly owned subsidiary of the founder of ICL. Accordingly, M Co. subscribed to the shares of ICL and such investment was made after seeking an approval from the Reserve Bank of India (“RBI”). However, as stipulated in the JV agreement, all rights in respect of the said equity shares (voting rights, rights of management, right of sale or alienation etc.) vested in U.S. Co. It may be noted that subsequently TIL also subscribed to the shares of the JV Co. and on 15 December 2000, a Shareholder Agreement (“SHA”) was entered into between U.S. Co., Birla and TIL, whereby there was a change in the shareholding (as depicted hereunder).
In 2005, Birla and TIL were desirous of purchasing the entire 74,35,61,480 equity chares of ICL offered by U.S. Co. for USD 30 million, and it was agreed that each party could get 37,17,80,740 equity shares of ICL on payment of USD 150 million. Therefore, on 28 September 2005, Indian Rayon (now Aditya Birla Nuvo Limited, representing the Birla Group) pursuant to a Sale and Purchase Agreement (“SPA”) purchased 37,17,80,740 equity shares of ICL from M Co. and U.S. Co. for US$ 150 million. Further, TIL entered into an agreement on the same day for acquiring the entire issued and paid up share capital of M. Co. from U.S. Co.
As a result, the issue in question is whether the said ICL shares were owned by M Co. or by U.S. Co. According to the Revenue, the said shares were owned by U.S. Co. and the capital gains arising or accruing thereform is taxable in India either in the hands of U.S. Co. or in the hands of Indian Rayon as an agent of U.S. Co. as per Section 163(1) of the Income Tax Act, 1961 (“Act”). Additionally, TIL was sought to be treated as an assessee in default, since it failed to deduct tax as required under the provisions of the Act before making a payment to U.S. Co. for the purchase of shares of M Co. on the grounds that it represented a sale of shares of ICL by the U.S. Co.
Arguments Advanced – Who said What
Beneficial ownership of shares transferred vis-à-vis taxing capital gains in India
Indian Rayon contended that the beneficial ownership of ICL shares vested solely in M Co. and not U.S. Co., and therefore applying India – Mauritius Tax Treaty (“Treaty”) the capital gains accruing to M. Co. shall be taxable only in Mauritius and therefore there is no question of treating Indian Rayon as a representative assessee. Further, due emphasis was given to the fact that the RBI had approved such a share transfer. Established principles of tax law were relied on in this regard, specifically the principle of separate legal personality of a subsidiary company and the Azadi Bachao Andolan case where the Supreme Court of India validated the benefits of the Treaty for residents of Mauritius subject to there being a valid tax residency certificate issue by the Mauritian Government. It was argued that the sale proceeds received by M. Co. and immediately thereafter transferred to U.S. Co., as reflected from the cash flows of M. Co. was towards dividends and repayment of loan.
The Revenue Authorities argued that the allotment of ICL shares in the name of M. Co. was only in the capacity of a permitted transferee of U.S. Co., and that M. Co. was not conferred any ownership rights relating to the shares.
Decision of the Court
The Court after considering the arguments held that U.S. Co. was carrying on business in India and according to the JV agreement, M. Co. was not conferred any beneficial ownership since it held the shares only as a permitted transferee i.e. U.S. Co. was designated a representative to exercise all the rights and to perform all the obligations, with a few exceptions. The Court further noted that all the rights in the shares under the JV agreement vested with the U.S. Co. Further, the Court highlighted that U.S. Co. was a party to the SPA jointly with M. Co. and the contention raised by Indian Rayon that U.S. Co. was made party to the SPA on account of the warranties given by it was without merit since the shares of ICL could not be sold by M. Co. without U.S. Co’s consent. The Court observed that the RBI approval does not elevate the status of M. Co. from that of a permitted transferee to a party shareholder.
Additionally, the Court distinguished the Azadi Bachao Andolan verdict on facts and stated the same cannot be applied to the present case since in this case the investment was made by U.S. Co. and not the Mauritian Company. Further, the Court denied recourse to the Azadi Bachao Andolan since the transaction (between TIL and U.S. Co.) was a colorable transaction and the U.S. Co. discharged its liability to pay for the equity shares of ICL by a device of advancing a loan to / subscription of shares of the Mauritian Co.
The Court held that3:
“In our opinion, the fact that the shares of the JV stood in the name of AT&T Mauritius did not make AT&T Mauritius the legal owner of the shares because in the present case, allotment of shares of the JV was to the JV partner, receipt of the shares of ICL by AT&T Mauritius was on behalf of the JV partner and the sale of the said shares was from one JV partner another JV partner under the JV Agreement / Shareholder Agreement.”
In light of the above, the Court held that the income accruing or arising in India to U.S. Co. on transfer of a capital asset situate in India, (sale of shares of ICL to Indian Rayon) would be income deemed to accrue or arise in India to U.S. Co. and can be assessed in the hands of the U.S. Co. or in the hands of Indian Rayon as an agent of the non-resident under Section 163 of the Act.
The 97 page judgment delivered by the Court reflects the judicial concurrence to the opinion of the Revenue Authorities that the income accrued to U.S. Co. is taxable in India and consequently this amount can be recovered from TIL as an agent of U.S. Co. Interestingly, while the Court on the one hand admits that the shares were registered in the name of M. Co. and, hence, it would be holder of the said shares, however it has taken a stance that the holding of the said shares by M. Co. was only as a permitted transferee of U.S. Co. and the actual (beneficial) ownership of the shares vested with U.S. Co. Therefore, the Court seems to have adopted a different approach to ascertain the legal owner of shares i.e. the person exercising control as opposed the name on the share register and the name / person to whom the shares are allotted.
It must also be noted that the Court decided that the Azadi ruling would be inapplicable on the grounds that the transaction is a colorable transaction and hence in such cases, the tax authorities are permitted to determine as to the real owner of the shares. The question this case poses is whether there is now effectively a change in the judicial approach when it comes to the application of the Treaty benefits and whether Courts are now prone to look at the substance of the transaction and not merely rely on the tax residency certificate that was thought to be sufficient in light of the Azadi ruling.
This case also demonstrates the crucial importance of proper documentation while structuring such transactions involving the sale / transfer of capital assets between resident and non-resident parties. It must be noted that the Court appears to have made an in-depth scrutiny of the transaction documents in arriving at its conclusion that the U.S. Co. was the actual (beneficial) owner of the shares. Further, from a tax payer’s standpoint, the dilemma of whether to withhold or not withhold taxes in respect of sale of shares by a Mauritian company again comes to forefront. The Court in this case did not consider the scope of the obligations of the tax payer, since a tax payer cannot be expected to lift the corporate veil independently. Additionally, in such cross-border transactions, there are usually provisions providing for the investment to be made from a group entity and not the entity entering into the agreement and it is ultimately a commercial decision as to which entity in the group shall finance the purchase / acquisition of shares. This should not be used as a parameter for determining the ownership of the shares and should not influence the right to tax the transaction.
While this ruling is not a bar per se on investing into India through Mauritius, it most definitely leaves a number of doubts for the investment community and raises a number of crucial questions relating to the circumstances when the Treaty benefit may not be available.
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1 Writ Petition No. 730 of 2009 & No. 345 of 2010 and No. 1837 of 2009 and No. 38 of 2010; TS – 346 – HC – 2011 (Bom).
2 At that time, the Birla Group consisted of Grasim Industries Limited, Hindalco Industries Limited, Indian Rayon and Industries Limited and IndoGulf Fertilizers and Chemicals Corporation Limited.
3 Paragraph 50 of the Judgment at Page 56.