Indian Ruling Signals Shift in Tax Treaty Benefit Assessments

In a landmark decision, India’s Supreme Court significantly altered the approach to determining tax treaty claims. The ruling recalibrates the framework for evaluating treaty protection and reinforces that Indian tax authorities may question arrangements that lack genuine commercial substance.

Among other things, the ruling emphasizes that, despite an entity holding a tax residency certificate, tax authorities are empowered to look beyond documentation. Therefore, demonstrating commercial substance may be necessary, with a focus on decision-making authority, control, and the location of the real decision-making.

While this doesn’t spell the end of treaty benefits, it does signal that form must be matched with substance.

Given the impact of the ruling, it is expected that the Supreme Court or legislative intervention will clarify the scope of some of observations in the ruling. In the meantime, taxpayers need to review their existing structures and processes to determine any impact.

The case involved Mauritian entities of the Tiger Global Group seeking an exemption from capital gains tax on their stake sale in Flipkart to Walmart in 2018. The Supreme Court ruled against the entities, holding that, prima facie, based on the facts, the structure appeared to be designed for tax avoidance, and in such a case, a tax residency certificate alone can’t shield a taxpayer.

The Dispute

The Mauritian entities, during the period 2011 to 2015, acquired shares in Flipkart Private Limited, a company incorporated in Singapore that holds investments in India. The Mauritian entities held global business licenses, maintained offices and employees in Mauritius, and possessed tax residency certificates issued by the Mauritian tax authorities.

When Walmart acquired Flipkart in 2018, the Mauritian entities realized capital gains on the transfer of their shareholding in Flipkart Singapore, which in turn resulted in gains on the indirect transfer of Indian investments held by Flipkart Singapore. Given that Indian domestic law taxes the gains arising from such indirect transfer of Indian investments, the Mauritian entities sought a tax exemption under the India-Mauritius tax treaty.

The Indian tax authorities questioned the Mauritian entities’ tax residency in Mauritius, arguing that the Mauritian entities lacked independence in decision-making and a US entity controlled them. The tax authorities alleged that the Mauritian entities had no independent source of income and their investments in Flipkart Singapore were funded through their shareholders. Their nonresident director served as the General Counsel at the US entity. A nonresident individual held authority to operate their bank accounts for transactions exceeding a specified threshold, and served as an authorized signatory for certain shareholder entities in Mauritius and as a director of the ultimate holding company of those entities.

Based on these facts, the Indian authorities sought to deny the treaty benefit to the Mauritian entities.

The Mauritian entities applied to the Authority for Advance Ruling, seeking confirmation on the availability of treaty benefit. This was rejected at the threshold on the grounds that the arrangement appeared to have been designed mainly for tax avoidance, which is impermissible under the General Anti-Avoidance Rule, or GAAR, introduced in India effective April 1, 2017.

The Delhi High Court had initially sided with the Mauritian entities. The court held that investments originating from Mauritius can’t be inherently suspect and a valid tax residency certificate must be sacrosanct. It further ruled that investments made before April 1, 2017 were grandfathered under the GAAR and couldn’t be subjected to GAAR scrutiny.

The tax authorities appealed to the Supreme Court.

Supreme Court’s Reasoning

The Supreme Court re-examined the earlier positions in relation to the sanctity of tax residency certificates. It acknowledged that a certificate serves as evidence of residence but clarified that it isn’t a conclusive proof. The Indian tax authorities are empowered to examine the control, management, and commercial substance of an alleged interposed entity.

The shift in the Supreme Court’s position is admittedly triggered by the changed legal environment, particularly the introduction of the GAAR and amendments to the status of a tax residency certificate in domestic tax laws.

The Supreme Court further observed that in keeping with the spirit of the treaty, which is also to prevent double non-taxation, the availability of treaty relief presupposes that the relevant transaction attracts tax liability in the taxpayer’s state of residence.

The court also remarked that Article 13(4) of the treaty, which provides capital gains tax exemption to Mauritius residents, applies only to direct transfers of Indian shares and an indirect transfer falls outside the protective umbrella of this provision.

Another aspect of the ruling concerns the GAAR and interaction with investments made before April 2017. The Mauritian entities argued that since their investments predated April 2017, they were fully grandfathered and immune from GAAR scrutiny. However, the court held that under Indian law the GAAR can be invoked even where the original investment was made before April 2017, if the exit and consequent tax benefit occurred on or after April 1, 2017.

The Supreme Court emphasized that the GAAR may apply if the primary purpose of an arrangement is to obtain a tax benefit, and it lacks commercial substance. In any case, where the GAAR is inapplicable, the judicial anti-avoidance rule remains available to the Indian authorities as an alternative. This empowers them to look through corporate structures and set aside arrangements where interposed entities possess no commercial substance.

Way Forward

The Supreme Court has raised the bar to claiming treaty benefits and has had a rethink on protections that were assumed to be accorded under the law, including those under the GAAR for pre-2017 investments. The fact that the judicial anti-avoidance rule can be invoked even when statutory GAAR is inapplicable dilutes the threshold protections provided under the GAAR against its invocation by Indian tax authorities.

The status of tax residency certificates has been recalibrated, potentially necessitating a review of existing arrangements to demonstrate commercial substance for claiming bona fide residency in the treaty state.

While this ruling has broad impact, it has been given in a particular factual context. It may not necessarily apply in all situations, which is why a review of the facts in all cases involving treaty benefits becomes essential.

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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