Advance Ruling Holds GAAR Irrelevant Today–Extends Mauritius Tax Benefits

In the midst of fervent disapproval by the Indian corporate world and multinationals worldwide, the finance minister of India has deferred the implementation of the General Anti Avoidance Rule ("GAAR") included in the Finance Act, 2012, from 1st April, 2012 to 1st April, 2013. This pragmatic move of deferring GAAR provides very little time though for corporates to reconsider what they thought is “tolerable tax planning”. The judgment of India’s Supreme Court (“SC”) in the Vodafone case is notable on the issue of what is considered “unacceptable and acceptable” tax avoidance.

Further, in Azadi Bachao Andolan’s case, the SC had recognised the requirement of tax treaties and the importance of avoidance of double taxation to promote foreign investments in developing countries. Keeping this in mind, in the case of Ardex Investment Mauritius, the Authority for Advance Ruling ("AAR") had held that taking advantage of the India-Mauritius tax treaty (the "Treaty") was not objectionable treaty shopping and upheld the capital gains exemption.

The AAR has once again, in its latest ruling on 18th July, 2012, held that Dynamic India Fund-I ("Dynamic-I"), the appellant, which is a company incorporated in Mauritius, and a 100 per cent subsidiary of Dynamic India Fund-II ("Dynamic-II"), another company based in Mauritius, and registered as a foreign venture capital investor with the Securities Exchange Board of India, be given capital gains tax exemption under the Treaty because the new GAAR regulations announced in the Finance Act, 2012 have not yet taken effect. Article 13(4) of the treaty confers the power of taxation of the gains derived by a resident of a contracting State from the alienation of specified property only in the State of residence, i.e., in Mauritius. In other words, capital gains arising to a resident of Mauritius from sale of shares of an Indian Company are exempt from tax in India.

The facts of this case are - the appellant holds a Tax Residency Certificate ("TRC") issued by the Mauritius Revenue Authority ("MRA"). The appellant made investments in the shares of Indian companies, which were intended for generating long term capital appreciation. The appellant proposed to sell the shares it had acquired in 2007 and 2008, which would generate capital gains. The appellant, accordingly, sought an advance ruling from the AAR on the issue of (i) whether capital gains arising on sale of shares of the Indian companies will be exempt from tax in India under Article 13(4) of the Treaty and (ii) whether the buyer will be required to withhold any taxes in India. It was the appellant’s contention that being a tax-resident of Mauritius, it is exempt from payment of capital gains tax in India under the Treaty by virtue of section 90(2) of the Income Tax Act, 1961 (the “IT Act”).

The income tax authorities passionately argued on three grounds. First, that this was a scheme for avoidance of tax in India as only 4 out of the 55 investors (individuals plus institutions) were from Mauritius. Thus, it was a case of routing the investments by the investors through Mauritius for evading taxes on the capital gains that may arise from such transfer in India. Second, that only two of the five directors of the appellant were from Mauritius and the other three were from India and, therefore, the control and management of the affairs of the appellant was in India, thereby making it a tax resident of India. Third, as the gains on transfer are not actually taxed in Mauritius, the provisions of the tax treaty should not apply.

The AAR ruled that there is no material on record put forward by the income tax authorities that could demonstrate that the routing of investment by the appellant through Mauritius is really a scheme to avoid payment of tax in India. Additionally, there is no adequate material on record to support the contention of the income tax authorities that decisions of the appellant were taken from India. Further, in the light of the SC’s ruling in the case of Azadi Bachao, the third argument was also rejected by the AAR.

It may be noted that the SC’s ruling had upheld (a) that section 90 of the IT Act was enacted specifically to empower the Indian Government to issue notifications with regard to treaties. Provisions made in exercise of such authority overrode the provisions of the IT Act; (b) the validity of Circular No. 789 dated 13th April, 2000, issued by the Central Board of Direct Taxes, Ministry of Finance, Government of India was not ultra-vires of section 119 of the IT Act; and, (c) where a TRC is issued by the MRA, such a TRC will constitute sufficient evidence for accepting the status of residence of the Mauritius entity as well as the ‘beneficial ownership’ of the shares for applying the treaty.

Further, the SC had held that the treaty was not ultra-vires section 90 of the IT Act merely on account of its susceptibility to “treaty shopping” by residents of third countries. The term “resident”, as used in the Treaty, was for the purpose of limitation so as to prevent a person who may not be liable to tax in the contracting state, to take benefit of the same. What is relevant was the “liability to tax” and not the “payment of tax”. The SC had rejected the contention that the application of the Treaty and, consequently the double taxation could arise only when tax had been paid in at least one of the contracting states.

"Once introduced, GAAR is perceived to play an iniquitous role at the introduction stage; the facility of obtaining advance ruling on applicability of GAAR provisions should be a respite and go a long way in reducing uncertainty before undertaking any cross-border transactions."

Accordingly, the AAR held that Article 13(4) of the Treaty would cover the proposed sale of shares of the Indian companies by Dynamic-I, and hence, the capital gains tax arising from the same will be exempt from tax in India and no tax is required to be withheld. Importantly, the AAR observed that the Finance Act, 2012, which introduced GAAR into the IT Act, would come into effect only on 1st April, 2013. Therefore, section 90(2A) of the IT Act, which provides that GAAR provisions will override treaty benefits and section 90(4) of the IT Act, which provides that an assessee shall not be entitled to claim treaty benefits unless a certificate "(containing such particulars as may be prescribed) of his being resident of that country is obtained by him from the Government of that country", has no relevance at this stage.

The AAR, however, held that the income tax authorities may consider such aspects as and when GAAR provisions come into effect 'notwithstanding this ruling'. The AAR has adopted a view (other than its observations on the principles of GAAR) that is consistent with its earlier rulings in the case of E*Trade Mauritius, Ardex Investments, DB Zwirn Mauritius.

The approach adopted by the AAR seems appropriate at this stage, considering that a Committee has been recently set up in July 2012 by the Indian Prime Minister to review and lay down the GAAR guidelines after taking into account, the views and opinions of various stakeholders. Previously the investors had voiced reservations against the implementation of the GAAR provisions. This ruling aids to remove any uncertainty from the minds of the foreign investors as to the applicability of the Treaty as per the current laws in India. It reassures the foreign investors that as long as GAAR provisions do not come into effect, the benefits under the Treaty will be extended to the taxpayers.

We are all aware of the Finance Ministry’s manifesto of codifying “substance over form” and targeting aggressive tax planning, which is associated with sophisticated structures (such as routing investments through Mauritius, Singapore, Cyprus, etc) to conceal the real objective and rationale of transactions, which has been the trigger for the introduction of GAAR provisions. The recommendations of the committee constituted by the Indian Prime minister for formulating rules and guidelines will play a fundamental role in giving concrete form to GAAR provisions.

They are expected to finalise their recommendation after discussions with various stakeholders by 30th September, 2012. Once introduced, GAAR is perceived to play an iniquitous role at the introduction stage; the facility of obtaining advance ruling on applicability of GAAR provisions should be a respite and go a long way in reducing uncertainty before undertaking any cross-border transactions. Notwithstanding the above, the effectiveness of AAR on such matters will hold the key to future GAAR litigation in the country.

It is pertinent to note that when the UK was evaluating GAAR, an expert committee was set up with a combination of leading lawyers, economists and sitting judges as members who were given more than a year’s time to come up with their report. The scope of reference to the committee was also very wide—it even included the question of whether GAAR was appropriate in the UK at all. It was concluded that introducing a broad spectrum general anti-avoidance rule would not be beneficial for the UK tax system. This would carry a real risk of undermining the ability of corporates and individuals to carry out sensible and responsible tax planning. Such tax planning is an entirely appropriate response to the complexities of a tax system such as the UK’s.

To reduce the risk of this consequence, a broad spectrum rule would have to be accompanied by a comprehensive system for obtaining advance clearance for tax planning transactions. But an effective clearance system with such a broad spectrum rule would impose very substantial resource burdens on taxpayers and the UK tax authorities alike. It would also inevitably, in practice, give discretionary power to the UK tax authorities who would effectively become the arbitrer of the limits of responsible tax planning. However, introducing a moderate rule which does not apply to responsible tax planning, and is instead targeted at specific types of abusive arrangements, would be beneficial for the UK tax system. Such a rule could bring a number of significant benefits. Is India listening?

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