INSIGHT: Bombay High Court Recognizes Mauritius Capital Gains Tax Exemption

The Bombay High Court has concluded that absent material on record to prove that the transaction was designed for tax avoidance due to lack of business activities and administrative expenses would be eligible prima facie for capital gains tax exemption, under the India–Mauritius double taxation avoidance agreement (tax treaty).

Facts

Indostar Capital (taxpayer or Indostar), an investment holding Mauritius company, holds a Category 1 Global Business License and a Tax Residency Certificate (TRC) issued by the Mauritian authorities.

Indostar acquired shares of Indostar Capital Finance Limited (ICFL or Indian company), held for over four years. In order to raise funds the taxpayer decided to liquidate its partial holdings in the Indian subsidiary through listing under an initial public offering (IPO).

Indostar, for certainty on the taxability of shares offered under the IPO transaction in India, applied to the Revenue for nil withholding of taxes by the payer on remittance of the sale consideration to Mauritius. The application made was on the premise that no tax is liable in India for withholding purposes on the gains derived by the taxpayer arising from the sale of ICFL shares, applying Article 13 of the India–Mauritius tax treaty.

The Revenue, on carrying out a detailed examination of the transaction, rejected the nil withholding tax application and passed an order directing the payer to withhold taxes at a specified rate. Indostar filed a writ before the Bombay High Court (court) challenging the taxable order.

High Court Ruling

The court concluded that gains arising to a Mauritius tax resident, from alienation of shares of an Indian company acquired on or before March 31, 2017, are not taxable in India but only in Mauritius under the provisions of Article 13, paragraph 4 of the tax treaty.

Arriving at this decision, the Court recognized the Central Board of Direct Taxes (CBDT) Circular No. 789 of 2000 which clarifies that a TRC is regarded as a sufficient document of residency proof in Mauritius as well as for beneficial ownership of shares to claim tax treaty benefits, as referred in the rulings of Azadi Bachao Andolan, Serco BPO (P) Ltd and JSH (Mauritius) Ltd.

Accordingly, the court reviewed the transaction and the nil withholding tax application to state that the Revenue cannot conclusively decide on the taxability of receipts in the hands of the payee. Particularly when Indian domestic laws treats any nil withholding tax order as provisional in nature where the Revenue is granted an option under the tax audit to perform regular assessment in detail to assess the income and determine the final tax liability.

The court accepted Indostar’s contention to decide that the Revenue, whilst disposing such withholding tax order, need not perform a thorough inquiry where the taxpayer is prima facie entitled to obtain tax treaty benefits.

The court stated that to evaluate the authenticity of the transaction and its taxability, the Revenue may reject the withholding tax application if prima facie it is established that the transaction was a sham and plausible device structured to avoid tax.

In this regard, the court relied on the principle of Vodafone International Holdings B.V. to confirm that the Revenue can question and disregard the transaction if it was fraudulent or fictitious but it cannot review a genuine transaction to divulge a supposed underlying substance for tax avoidance.

The court also observed that because the taxpayer did not have any other business transactions, administrative expenditure, employment structure or directors’ involvement, it gave the Revenue reasons to believe from a prima facie view the existence of a fraudulent transaction; however, such factors may be used to appraise during a tax audit proceeding if the transactions were sham in nature.

Accordingly, the court instructed the Revenue to release the tax withheld along with applicable interest and issue a revised nil withholding tax order to Indostar. Though the court realized there was a practical difficulty to recover tax from nonresidents if under a tax audit, tax treaty benefits are denied resulting in a tax liability.

In this situation, the court directed the Revenue to issue a conditional revised order that Indostar keep a requisite number of shares in the Indian company as security to discharge any subsequent tax liability resulting from the tax audit.

Planning Points

The court dealt with a tax controversy to grant capital gains tax benefits under the tax treaty using the CDBT Circular and a series of court judgments with a favorable outcome.

The decision relied on the rationale used in the Azadi Bachao Andolan case on the applicability of tax treaty benefits, as well as discussed contrary rulings of the Aditya Birla Nuovo Ltd and “AB” Mauritius cases.

The observations of the court remain inconclusive, due to the pending assessment of the transaction, which is open for scrutiny to evaluate tax evasion and assess the final tax liability, taking into consideration the substantive operations and activities of the Mauritius resident for entitlement to the tax treaty benefits. It would be pertinent for holding entities to review their operations of such an establishment to see if it qualifies for tax treaty benefits.

The conditional order for nil withholding tax is subject to a detailed assessment of the capital gains transaction by the Revenue, exposed to evaluation under the General Anti-Avoidance Rule. Separately, it would be worthwhile to examine whether such transactions are compliant with the principal purpose test and substance requirement to grant tax treaty benefits in line with the OECD’s BEPS Action Plan 6 on Preventing the Granting of Treaty Benefits in Inappropriate Circumstances.

Shailendra Sharma is a chartered accountant with a multinational financial services firm, India