Background: Per the extant India-Mauritius tax treaty ("Tax Treaty"), capital gains on sale of Indian company shares (acquired prior to 1 April 2017) and sale of derivatives by a Mauritian tax resident is not taxable in India. The Central Board of Direct Taxes ("CBDT") clarified in its Circular 789 dated 13 April 2000 ("CBDT Circular") (as affirmed by the Hon'ble Supreme Court of India in the case of Azadi Bachao Andolan), that tax residency certificate ("TRC") shall constitute sufficient evidence to confirm the residential status of the Mauritius entity claiming the capital gains tax exemption. Despite the favourable verdict of the Hon'ble Supreme Court, the "tug of war" between the taxpayer and the Indian tax authorities continues as the tax authorities are increasingly looking into parameters such as beneficial ownership, control and management, genuineness of the structure, treaty shopping, source of funding etc, while challenging the claim of benefits under the Tax Treaty.
Recent Ruling: In one such recent ruling, the Income Tax Appellate Tribunal, Delhi bench (Tribunal) in the case of Sapien Funds Ltd (Taxpayer) ruled that the Taxpayer, a Collective Investment Vehicle (CIV) is eligible to claim benefits under the Tax Treaty on derivatives income.
Facts of the case: The Taxpayer, was (i) incorporated in Mauritius; (ii) held a valid TRC of Mauritius; (iii) Set up as a CIV and registered as a foreign portfolio investor in India. The Taxpayer received funds from various non-resident investors which were invested in Government Securities (Bonds) and Exchange Traded Cash Equities, trades in Exchange Traded Derivatives, Equity and Currency (Future & Options). In the relevant year, the Taxpayer earned income from derivatives on which it claimed benefits under the Tax Treaty. However, the tax authorities denied the Tax Treaty benefit by claiming that the Taxpayer has adopted a treaty shopping mechanism for tax avoidance and there is no commercial rationale for setting up the CIV in Mauritius. Further, the TRC is not itself sufficient to establish Taxpayer's residential status if the substance establishes otherwise. Aggrieved, the Taxpayer filed an appeal before the Tribunal.
Tax authority's key objections: Firstly, "liable to tax" test is not met (which is a perquisite for the applicability of Tax Treaty) as CIVs are generally tax transparent entities, and its income is taxed directly in the hands of investors on a look-through basis and further, 80% tax exemption on CIV's income is provided under Mauritian tax law. Secondly, TRC itself is not sufficient for residency - the control and management of CIV was not in Mauritius and it was indirectly controlled by UK residents, as the ultimate shareholder of CIV and its Mauritian based fund manager entity were based in UK. Thirdly, applying the anti-abuse principles/base erosion measures under the Multilateral Instrument ("MLI") issued by Organisation of Economic Co-operation and Development ("OECD"), the Taxpayer has adopted treaty shopping mechanism and there is no commercial rationale for setting up the CIV in Mauritius as against UK (resulting into Indian tax in absence of any exemption). Lastly, Taxpayer cannot be treated as the beneficial owner of its income as all its income needs to be distributed to its investors and is a conduit entity.
Taxpayer's key contentions: "Liable to tax" test is met as it means liable to comprehensive taxation and not actually being 'subject to tax'. Taxpayer is liable to tax in Mauritius though it is entitled to 80% exemption as per Mauritius law. Tax residency is in Mauritius only as TRC itself constitutes sufficient evidence for accepting the status of residence in Mauritius, as clarified by the CBDT. The OECD MLI related provisions do not apply to the Tax Treaty. In any case, the Taxpayer was set up in Mauritius for various commercial reasons including complete range of financial products offered by Mauritius, availability of skilled managers and administrators (that are cost efficient as compared to the UK), etc. Further, the CIV continues to be in existence even after cessation of capital gains tax benefit under the Tax Treaty on sale of shares in an Indian company (acquired post March 2017). Therefore, the Taxpayer cannot be said to have been set up solely to claim such benefit. The Taxpayer does not pass on each income it earns to its investors. Per OECD's commentary, the term 'beneficial ownership' needs to be understood in the context and purpose of relevant tax treaty. While the recipient is deemed to be the beneficial owner of income where it has no contractual or legal obligation to pass on such income to another person, it does not include an obligation which is independent of receipt of the relevant income.
Tribunal Ruling: The Tribunal ruled in favour of the Taxpayer and held that "liable to tax" test is met and tax exemption under the Mauritian tax laws does not provide an automatic taxation right to India. Relying on the CBDT Circular and the ruling of Hon'ble High Court at Delhi in the case of Blackstone Capital Partners (Singapore) VI FDI Three Pte. Ltd, the Tribunal held that TRC is the only evidence required to claim benefits under the Tax Treaty. The Tribunal also rejected the allegation that Taxpayer is a conduit entity as it had 21 investors who were not Mauritius tax residents.
Comment
At the outset, this is first-of-its-kind ruling adjudicating on eligibility of a CIV to claim benefits under the Tax Treaty on derivative transactions. It clarifies that a taxable person in Mauritius (though enjoying certain exemptions) should be treated as Mauritius resident for the purposes of the Tax Treaty. As CIVs are generally treated as pass-through entities for tax purposes, whether a particular CIV (in other countries) would be eligible to claim tax treaty benefits should be assessed considering the tax laws of relevant jurisdiction, applicable tax treaty and ability to receive a tax residency certificate in home jurisdiction.
The CBDT Circular and rulings in the case of Azadi Bachao Andolan and Blackstone Capital Partners (Singapore) VI FDI has been strongly relied upon to hold that TRC is the only evidence required for tax treaty eligibility.
Despite courts having confirmed that TRC is sufficient evidence for claiming benefits under the Tax Treaty, the tax authorities continue to assess such claim based on substance of the transaction and genuineness of the structure. This is likely to be strengthened going forward considering the general anti-avoidance rules under Indian tax law and the applicable tax treaty.
While the capital gains tax exemption on sale of shares in Indian company (acquired post March 2017) has been virtually phased out, tax treaty benefits could be assessed for various other streams of income such as dividend and interest income, gain on debt instruments, grandfathered investments (ie shares acquired prior to 1 April 2017), shares of foreign company as well as gain from sale of portfolio investments (in case of certain specific tax treaties such as Netherlands, France and Spain). It is therefore important for the foreign investors to evaluate their tax treaty eligibility on various parameters such as commercial rationale of the structure, substance in relevant jurisdiction, control and management, beneficial ownership and other relevant factors.
Separately, under the Indian tax laws, there are onerous withholding tax obligations on persons acquiring shares from a non-resident sellers. If the buyer fails to do so, the Indian tax authorities have the power to recover such tax with interest, and penalty from the buyer. Owing to this, in any mergers and acquisitions transaction, it is important for the buyer to pre-empt and seek comfort on the taxability or tax treaty eligibility position of the non-resident seller and adequately address any risks thereof in form of suitable contractual protections (such as indemnity; backed by guarantee (if required) / tax insurance (which has quite evolved)).
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