In a happy ending to the latest twist in the case of E*Trade Mauritius (ETM), the Authority for Advance Rulings (AAR) has ruled that the company is entitled to the beneficial capital gains tax treatment under the India-Mauritius tax treaty and so is not taxable in India.
The income tax department’s approach, though flawed, was a cause of much anxiety among the global investing community. Finally, the AAR has followed the Azadi Bachao Andolan case and ruled that the benefits of the treaty should be given to ETM.
E*Trade Mauritius is a wholly owned subsidiary of US-based Converging Arrows (CAI), which in turn is a wholly owned subsidiary of another US company, E*Trade Financial Corporation (ETFC). ETM held shares of an Indian company, IL&FS Investmart (IL&FS), which it purchased with funds from CAI, its parent company.
The transaction in question was the sale of the entire stake of ETM in IL&FS to the Mauritius-based HSBC Violet Investments. In view of the capital gains tax benefit under the India-Mauritius tax treaty, ETM sought a certificate from the Indian tax authorities authorizing payment by HSBC without any withholding tax.
Surprisingly, the tax authorities refused to grant a nil withholding tax certificate. ETM filed a writ petition before the Bombay High Court but without examining the merits of the case the court directed ETM to file a revision application before the tax authorities. Following the January 2009 decision on the revised application, ETM went to the AAR to determine the tax implications of the sale of an Indian company’s shares by a Mauritius company and the applicability of the India Mauritius treaty.
The tax authorities claimed that though ETM is the legal owner of the shares in IL&FS, it is merely a facade developed to avoid tax on capital gains in India. The real beneficiary of the capital gains is ETFC, the ultimate parent company of ETM that indirectly funded the purchase of the shares and as such the India-US Tax Treaty should be applied instead of the India-Mauritius Tax Treaty.
The AAR reiterated the Supreme Court’s decision in the landmark case of Azadi Bachao Andolan and stated that the motive of tax avoidance was not relevant so long as the same was within the framework of law. It held that “treaty shopping” was not against law and the corporate veil cannot be lifted to deny treaty benefits.
The AAR also stated that since ETM was recognized as a shareholder of IL&FS and also received dividends in its capacity as a shareholder, merely because the transaction may have been indirectly funded by ETFC it cannot be inferred that ETFC owned the shares in IL&FS. To take such a view would blur the mutual business and economic relations between a holding and subsidiary company.
Lastly, on the argument with respect to beneficial ownership, the AAR held that the concept of “beneficial ownership”, which is used in the India-Mauritius tax treaty in connection with interest and dividends, was irrelevant in the context of taxability of capital gains. Again, relying on Azadi Bachao Andolan and on circulars issued by the Central Board of Direct Taxes (CBDT), it concluded that a certificate of residence issued by the Mauritian authorities constitutes sufficient evidence for accepting the status of residence as well as beneficial ownership of shares.
This case created a lot of uncertainty among foreign investors and private equity firms with respect to investments made from Mauritius. Following this case, with a view to avoid litigation, some of the parties in private equity investment transactions preferred to make payments after deducting tax at source even though they were exempt from tax in the first instance.
The tax authority’s attempt to introduce the concept of beneficial ownership in the context of taxability of capital gains is novel to Indian jurisprudence. In most treaties, it is used in connection with interest, dividends, royalties and fees for technical services. However, as regards capital gains, as rightly pointed by the AAR, the concept of beneficial ownership has no relevance.
This ruling definitely gives a breather to foreign investors. In it the AAR point out that as an inevitable effect of the India-Mauritius tax treaty read along with the circulars issued by CBDT and the law laid down in the Azadi Bachao Andolan case, Indian tax authorities are not in a position to levy capital gains tax even on transfer on an Indian capital asset.
The legislative and regulatory update is compiled by Nishith Desai Associates, a Mumbai-based law firm. The authors can be contacted at nishith@nishithdesai.com. Readers should not act on the basis of this information without seeking professional legal advice.
