The multibillion-dollar mega buyout of a major Indian e-commerce company by a U.S. retail giant is once again in the news. The Authority for Advance Rulings (AAR) in India has ruled that the capital gains earned by the Singapore company’s Mauritius-based seller shareholders (Foreign Sellers) from such sale are taxable in India.
The Singapore-registered company holds a majority stake in the Indian e-commerce company. The deal was structured in such a manner that the U.S. retail giant acquired about 77% stake in the Singapore entity for $16 billion. This effectively resulted in the transfer of ultimate ownership in the Indian e-commerce company to the U.S. retail giant. Notably, the indirect transfer of Indian assets (including shares of an Indian company) is also subject to Indian capital gains tax trigger, unless protected by a tax treaty.
In this case, as per the ruling, the ultimate beneficial ownership of the Foreign Sellers lay with a U.S. based private equity fund. Interestingly, the AAR has pierced the corporate veil and seen through the Foreign Sellers in order to reject their application for advance ruling and held that the arrangement was structured for avoidance of tax in India. Though the rulings pronounced by the AAR are binding only on the concerned applicant and the tax authorities, this ruling assumes significance because the tax authorities are likely to take recourse to this ruling to deny tax treaty benefits in similar deals. Hence, from a deal perspective as well as a litigation management perspective, it becomes imperative to understand what the aspects and factors are that have been considered by the AAR in arriving at this conclusion.
Set out below are some key points which became the bedrock of the AAR’s ruling wherein they ruled that “the head and brain of the companies and consequently their control and management was situated not in Mauritius but outside in USA.” Also set out are some hygiene checks that may be kept in view by investors with similar facts or organization/holding structures:
Independent Decision-Making Capacity of Board of Directors
In this case, the tax department was able to demonstrate that the Board of Directors (BOD) of Foreign Sellers was not independent, but were mere puppets of the ultimate beneficial owners (who were not Mauritius residents). This is one of the most important aspects whenever questions are raised by the tax department regarding the independence of a Mauritius-based shareholder. Hence, in shareholding structures with Mauritius based shareholders, it is always advisable to have a BOD (preferably composed of majority of local directors) which has the necessary technical expertise, wherewithal, capacity and ability to take crucial decisions (like investment of funds, exit from investments etc) on their own, without the need for outside intervention.
Like many other cases, in this case also, the minutes of meetings of the BOD of Foreign Sellers proved that they did not have independent decision-making capacity. This was evidenced by the fact that nonresident directors (U.S. residents) were present in all the meetings of the BOD where crucial decisions were taken. Lately, this aspect is being used by Indian income tax authorities as a deciding piece of evidence to see through foreign shareholders and claim lack of commercial substance to deny tax treaty benefits. Hence, depending on the facts and circumstances of each case, it is helpful if the foreign shareholders can demonstrate that vital business decisions were taken on the basis of advice received from local directors.
Bank Signatory/Control of Funds
In this case, the power to operate bank accounts for transactions above $250,000 lay with a U.S.-based person, who was not on the BOD of Foreign Sellers. Coincidentally, this person was also disclosed by the Foreign Sellers as their ultimate beneficial owner in local regulatory filings in Mauritius.
Looking at this aspect, the AAR observed that as the principal bank account of the Foreign Sellers was maintained in Mauritius, it would have made sense if a local person based in Mauritius was appointed to sign the checks on behalf of the directors. Based on this, the AAR ruled that the head and brain of the Foreign Sellers and consequently their control and management was situated not in Mauritius but in the U.S.
Having a cap on the financial limits of local directors is not uncommon in private equity holding structures. Hence, all such holding/organization structures should revisit their distribution and delegation of their financial powers to mitigate the risk of any potential challenge by tax authorities.
In this case, the Foreign Sellers had submitted that Mauritius was chosen as an investment holding jurisdiction because of its comprehensive tax treaty network with various countries (and not just India) which facilitated efficient asset management and achieved a competitive return for their investors. However, the Foreign Sellers had not made any other investment other than in the shares of Flipkart Singapore. This aspect went against the Foreign Sellers because based on this, the AAR ruled that the real intention of the Foreign Sellers was to avail the benefit of the India–Mauritius tax treaty. This is a crucial aspect and it highlights the importance of the ability to demonstrate the stated objective with facts. This also means that if the Mauritius-based shareholders’ only holding, directly or indirectly, is an Indian asset, the possibility of tax authorities challenging tax treaty relief upon exit cannot be ruled out.
This ruling is vital, not only because it deals with an often debated subject of “tax avoidance,” but also because it touches upon the aspect of whether indirect transfers of Indian assets are exempt under the India–Mauritius tax treaty.
In this ruling, the AAR has ruled that the India–Mauritius tax treaty does not exempt an “indirect transfer” of an Indian company’s shares. This could be an important consideration for the taxpayer to decide as to whether it would want to challenge this ruling in higher forums (writ petition before Bombay High Court).
Notably, the view in the professional fraternity to date has been that “indirect transfers” of Indian assets are exempt from Indian capital gains tax under the India–Mauritius tax treaty.
Further, with the onset of the “principal purpose test” (PPT test) concept under the MLI, the factors identified by the AAR in this ruling will be important for taxpayers to demonstrate that the principal purpose of a transaction (i.e. investment made via Mauritius ) was not to avail tax treaty benefits.
Having said this, it is worth noting that this is a fact-specific ruling and the AAR looked into aspects like financial control, control and management aspects, beneficial ownership, etc., to come to a conclusion that the real control and management of the Foreign Sellers was not in Mauritius. Therefore, this ruling does not really disturb the otherwise legally settled position in the context of the India–Mauritius tax treaty read with CBDT Circular No 789 dated April 13, 2000, Supreme Court ruling in the Azadi Bachao Andolan case (UOI v Azadi Bachao Andolan  (263 ITR 706) (SC) and a host of previous advance rulings like E-Trade Mauritius (E-Trade Mauritius., In re  324 ITR 1 (AAR)), etc.
Another important aspect of this ruling is an interesting technical issue: the advance rulings scheme provides that the AAR should not give its ruling on questions raised in an application if the concerned transaction was designed prima facie to avoid tax in India. This would mean that if, in a given case, the AAR reaches a finding (on prima facie basis) that the transaction covered in an advance ruling application was designed for avoiding income tax in India, it needs to reject such application.
However, in this particular case, even though the AAR held that the subject transaction was designed prima facie to avoid tax in India, it still considered the application on merits and held negatively that on these facts benefit of the India–Mauritius Tax Treaty cannot be applied to the Applicant’s case. This seems to be a case of jurisdiction of the Hon’ble AAR whether it had a legal ability to rule on merits once it rejects the application on the basis that it was a case of prima facie tax avoidance and thus hit by exclusion mandated in clause (iii) of the proviso to Section 245R(2) of the Indian Income-tax Act 1961.
It has been observed in many cases that some of the most important aspects on which the tax authorities focus to dispute the treaty entitlement are: control and management of the Mauritius entities, credibility and independence of their BOD, perusal of minutes of the board meetings, substance in Mauritius Companies, real beneficial owners, etc. All in all, the dispute around the India–Mauritius Tax Treaty does not seem to end!
Sanjay Sanghvi is a Tax Partner and Raghav Kumar Bajaj is a Principal Associate at Khaitan & Co, India
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