Indian Tribunal Ruling on Derivatives Gives Clarity to Investors

The Mumbai Indian Income Tax Appellate Tribunal has declared in 3 Sigma Global Fund that capital gains from derivatives traded by a Mauritius-based fund aren’t subject to taxation in India under Article 13(4) of the India-Mauritius Double Taxation Avoidance Agreement.

At a time when Indian tax authorities are tightening scrutiny on cross-border tax avoidance and treaty shopping, the ruling brings much-needed clarity to Mauritius-based investors and those in jurisdictions covered by similar treaties. It unequivocally states that receipts from the transfer of derivatives, which derive their value from underlying Indian shares, are distinct from such shares and aren’t subject to taxation in India.

Foreign investors, particularly those from Mauritius and Singapore, have often found themselves caught unaware by Indian tax issues. In recent years, aggressive tax demands and a lack of clarity around treaties have had an impact on investor confidence. The ruling provides certainty to investors who trade in Indian derivatives and reinforces India’s commitment to treaty protection.

The issue before the Tribunal was which of two clauses apply to derivatives that get their value from the shares of an Indian company.

Article 13(3A) of the India-Mauritius DTAA allows India to tax capital gains from shares of Indian companies acquired on or after April 1, 2017.

Article 13(4) provides that capital gains from any other property (not covered under earlier clauses of Article 13) are taxable only in the country of the investor’s residence—in this case Mauritius.

If such derivatives are like underlying “shares,” India would have the right to tax the capital gains by Article 13(3A). By contrast, if they’re “other property” under the residuary clause, Article 13(4), they will be taxable in Mauritius only.

The Tribunal ruled that derivatives are distinct from shares and therefore not taxable in India, in terms of Article 13(4) of the India-Mauritius DTAA. The decision was based on:

A distinction in terms of domestic company law. Under the Indian Companies Act, 2013 (section 2.84) “shares” means a share in the share capital of a company and includes stock. “Derivatives” haven’t been explicitly defined under company law, but are included in the definition of securities, which draws reference from the securities law. Therefore, shares and derivatives are distinct assets under company law.

Precedents and guidance. The tribunal relied on its earlier rulings in the context of sale of “rights entitlement” and “units of mutual fund” to infer that an asset which derives its value from underlying shares is separate from such shares.

It also relied on a public clarification by India’s Revenue Secretary that “residence-based taxation will continue for derivatives under the Mauritius pact. Meaning non-equity securities will be taxed in Mauritius if routed through there.”

Tax authorities in this case had denied treaty benefits to 3 Sigma Global Fund, claiming the Mauritius-based fund was merely acting on behalf of its real owners, located elsewhere‪—applying the beneficial ownership test—without delving into the merits of the issue. ‬‬‬‬‬‬‬

However, the dispute resolution panel, which an aggrieved nonresident taxpayer typically approaches in the first instance, found that:

• The tax officer didn’t investigate the actual operations or control structure of the fund.
• Although a tax residency certificate from Mauritius isn’t the sole criterion for granting treaty benefits, the tax authorities should have inquired more into the alleged treaty shopping.
• The tax officer couldn’t deny the benefit of the India-Mauritius DTAA to the fund but had chosen the shortcut of beneficial ownership.
• Using ultimate beneficial owner data from anti-money laundering regulations isn’t enough to deny treaty relief.

Key Takeaways

The ruling sets a persuasive precedent, given its alignment with official statements and domestic law position. The verdict may not only be useful concerning the specific issue discussed here, but also could serve as a template for:

• Using similar benefits under other tax treaties which have provisions identical to the India-Mauritius DTAA
• Distinguishing between financial instruments for treaty interpretation
• Preventing arbitrary use of the beneficial ownership test to deny legitimate treaty rights

The ruling comes at the same time as a similar ruling by the Delhi Bench of the Tribunal, which held that capital gains arising from the transfer of equity-oriented mutual funds, being distinct from shares, are exempt from tax in India in terms of Article 13(4) of the India-Mauritius DTAA.

However, the ruling doesn’t provide umbrella protection for all similar cases. Anti-avoidance measures, such as the beneficial ownership test and the principal purpose test, as well as possession of a valid tax residency certificate, still may need to be satisfied for a genuine treaty benefits claim.

Tax can be complex, especially in cross-border situations when dealing with hybrid financial instruments. This ruling provides clarity in this space and may also be helpful in transactions involving digital assets.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law, Bloomberg Tax, and Bloomberg Government, or its owners.

Author Information

Aditya Singh Chandel is partner and Akshat Jain is an associate with AZB & Partners in India.

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