In a recent ruling, the Tax Authorities of India have held that taking advantage of a tax treaty by itself is not "objectionable treaty shopping". Every transaction that seeks to benefit from a treaty is not equivalent to tax evasion.This article discusses the Ardex Investments Mauritius Ltd. ruling, and provides a few steps to demonstrate substance in similar such investment. A small island...
In a recent ruling, the Tax Authorities of India have held that taking advantage of a tax treaty by itself is not "objectionable treaty shopping". Every transaction that seeks to benefit from a treaty is not equivalent to tax evasion.
This article discusses the Ardex Investments Mauritius Ltd. ruling, and provides a few steps to demonstrate substance in similar such investment. A small island in the Indian Ocean has stood the test of time with regard to the formation and administration of global business entities investing in India. Mauritius-based investors account for as much as 40 per cent of the Foreign Institutional Investors (FII) portfolio investment and more than 42 per cent of strategic investment in India. Under the India-Mauritius tax treaty (the Treaty), there is no levy of capital gains tax either in India or in Mauritius on the sale of shares of an Indian company by a Mauritius enterprise.
Otherwise, the sales proceeds are generally taxed in India even if the seller is not a tax resident of India. Therefore, the intermediary structure at the Mauritius level provides flexibility in the exit strategy, and the benefit that Mauritius does not tax capital gains. Consequently, the Mauritius-based taxpayer does not pay capital gains tax either in India or in Mauritius, much to the chagrin of Indian tax authorities (the "ITA"), who believe that such cases entail double non-taxation and that therefore, the Treaty benefits should not apply.
We are all aware, that the Treaty has been subject to expensive litigation in India time and again. Unquestionably, any murmur about the Treaty or efforts to renegotiate it, ignites a chain reaction, starting with the media through tax-lawyers, chartered accountants, investors, stock markets, and finally, the Government. Considering the amount of investment at stake, such a reaction is anticipated. Every Government needs to collect legitimate taxes and India is no exception.
So, what the ITA tend to do is to make a detailed enquiry into the facts, documentation and conduct of the parties, to question the legal / beneficial ownership of shares in the Mauritius entity and, thereafter, explore whether the benefits of the Treaty need to be given. In certain cases, such benefits are denied, especially when the investment jurisdiction cannot prove "substance" to the ITA.
The ITA have frequently sought to debate the Treaty benefits (in cases such as Natwest, AIG, DB Zwirn, Saraswati Holdings, E*Trade, Richter, AB Nuvo etc.), and the uncertainty continues, despite consistent disposition of the issue in favour of foreign investors by the Authority for Advance Rulings ("AAR") and India's Supreme Court in the Azaadi Bachao decision. It is, therefore, imperative for Mauritius based companies to demonstrate substance before the ITA.
In November 2011, the AAR, in the case of Ardex Investments Mauritius Ltd. (A.A.R. No.866 of 2010) held that taking advantage of the Treaty by itself is not "objectionable treaty shopping", where the investment structure existed for a considerable period of time. The brief facts of the case are as under:
Ardex Investments Mauritius Ltd. ("Ardex Mauritius"), the applicant, is a wholly-owned subsidiary of Ardex Holdings UK Ltd ("Ardex UK"). Ardex Mauritius held 50 per cent of the equity share in the Indian entity ("Ardex India"). Ardex Mauritius proposed to sell its entire stake to Ardex Beteiligungs ("Ardex Germany") at a fair market value prevailing at the time of the proposed sale. Ardex Mauritius sought an advance ruling on whether such a transfer would trigger capital gains tax.
The ITA's contention was that Ardex Mauritius was created as a frontage by Ardex UK with the prime intention of taking advantage of the Treaty. They further argued that since the entire funds were sourced from Ardex UK, the beneficial ownership of the shares was vested with Ardex UK. Hence, the ITA claimed that the Treaty benefits should not apply. Ardex Mauritius argued that it was created in 1998 by Norcros (Holdings) Ltd ("Norcros UK"), another UK holding company and an unrelated party to the Ardex Group.
And that it was then known as Norcros Investments (Mauritius) Ltd ("Norcros Mauritius"), which had made substantial investment over the years in the Indian company, Building Adhesives India Pvt. Ltd ("BAL"). Subsequently, Ardex UK acquired Norcros UK in 2001, as a result of which, Ardex Mauritius and BAL (renamed as Ardex India) came into existence. On this basis, it was argued that Ardex UK was not involved in the creation of Ardex Mauritius. Furthermore, Ardex Mauritius stated that the investment decision to transfer Indian shares was taken by its Board; and that the investment in Ardex India was made by Ardex Mauritius, and not Ardex UK.
The AAR ruled that since the applicant was a tax resident of Mauritius, the Tax Residency Certificate ("TRC") had to be accepted as sufficient evidence in view of the Supreme Court's verdict in the Azaadi Bachao decision. In the present case, because Ardex Mauritius sold the shares of Ardex India to Ardex Germany, any capital gains would be taxable only in Mauritius and not in India.
Notably, the AAR observed that even though the funds for acquisition of shares in Ardex India were provided by Ardex UK, the shares in Ardex India were purchased almost 10 years before the application, and thereafter, the shareholding was steadily increased. The arrangement did not come into existence all of a sudden. Even if the formation of the Mauritius subsidiary was an attempt to take advantage of the Treaty, it cannot be characterized as objectionable treaty shopping. Therefore, the contention of the ITA with respect to non applicability of the Treaty was rejected.
The AAR also noted that because the shares had been held for a significant period before they were sold by way of a regular commercial transaction, it would not be possible to raise an enquiry on beneficial ownership to probe who made the original investment for the acquisition of the shares and the consequences arising therefrom. Accordingly, the AAR ruled that capital gains on the sale of shares will not be taxable in India under the Treaty and, therefore, no withholding of tax at source was required.
It is possible that the ITA may prefer an appeal against AAR's decision before the Supreme Court, as they have done in the case of E*Trade Mauritius, to seek denial of the Treaty benefits. In the E*Trade Mauritius case, the AAR had relied on the Azaadi Bachao ruling, and held that capital gains arising from transfer of shares by E*Trade Mauritius to HSBC Mauritius were not liable to taxation in India. The decision of the Supreme Court, in this regard, is awaited.
The judicial approach in India has permitted the ITA to determine the real owner of shares in the case of colourable transactions. The question now is whether there is effectively a change in the judicial approach, when it comes to the application of the Treaty benefits, and whether the courts are now prone to look at the substance of the transaction and not merely rely on the TRC, which was earlier thought to be sufficient.
Over the last few years, media reports suggest that the Government has sought to review the Treaty. However, such attempts have not borne fruit yet. India's recently negotiated treaties include a limitation of benefits ("LoB") article, to prevent treaty abuse. Any treaty renegotiation can only happen with the mutual consent of both the contracting states. The Indian Finance Minister had taken the trouble to highlight, as a reaction to the Indian press reports, that any tax treaty negotiation with Mauritius is a sensitive matter for Mauritius, and that India "cannot take a unilateral decision in this regard since 'there are political and diplomatic sensitivities'".
So, what does this mean for taxpayers? Firstly, taxpayers will need to exercise sufficient prudence on their holding structures which involves the use of beneficial tax treaties, and recognize the importance of facts, documentation and conduct in relation to these structures. A focus on these issues will assist in managing the risk of denial of Treaty benefits. Taxpayers will also have the option to seek an advance ruling on the taxability of a transaction which involves reliance on a beneficial tax treaty. The main benefit of an advance ruling is the upfront certainty it provides, and the binding nature of the ruling.
Given the aggressive bent of the ITA in India, foreign enterprises that seek to rely on the Treaty may be subjected to a detailed scrutiny. The inquiry is more likely to go beyond the mere existence of a TRC, and may require the taxpayer to demonstrate beneficial ownership of the shares sold. Therefore, conceptually, in order to claim the Treaty benefits, the Mauritius entity will have to demonstrate satisfactorily to the ITA that it is substantially controlled and managed from Mauritius; and that it has been established for sound commercial reason beyond tax considerations.
It is advisable for the Mauritius entity ("MCo") to obtain the TRC, get it renewed on an annual basis, and comply with all the terms prescribed by the Mauritius tax authorities. The reason as to why Mauritius has been chosen as a holding company jurisdiction should be documented, with reasons.
The reasons could be including
- the motive to consolidate the group's foreign subsidiaries;
- formation of a platform for prospective business acquisitions, joint ventures and other opportunities;
- Mauritius being able to provide a stable political and economic environment;
- moderate corporate law/ liberal foreign exchange control regulations;
- good infrastructure, including reasonable costs for setting-up and operating a company, etc.
Other than this, it is extremely important that all corporate rights arising from the shareholding in the Indian company, including the right to appoint directors, voting rights etc., should be exercised by the MCo. Further, the MCo should be party to the shareholders’ agreement for investment in or for divestment from the Indian company and should exercise all rights arising from such an agreement.
All transactions involving the MCo (such as remittance for purchase of shares, remittance for dividends, and consideration for sale of shares) should be made through the bank account of the MCo. The MCo should be involved in discussions and documenting the sale/purchase transactions and related documents duly authorized by it. All expenses relating to the transactions should be incurred by the MCo. All critical Board of Directors ("BOD") meetings (especially those where the BOD discusses matters relating to investment/ divestment, including in the Indian company) should be held in Mauritius, with all the directors of the MCo present for the meeting.
The minutes of the BOD meeting should demonstrate that active discussions were undertaken before reaching a decision. There should be sufficient documentation to show that the MCo has dominion and control over its funds, including investments made by its parent company or income/proceeds received from dividends/sale of shares.
To the extent possible, the Indian company should not recognize the ultimate parent company as its investor in press releases, website, interviews, accounting disclosures etc. Likewise, the ultimate parent company should also not represent the Indian company in press releases, website, interviews, accounting disclosures etc. as its direct subsidiary. Further, no company within the group (other than the MCo) should represent the Indian company as its direct subsidiary.
There should be no provisions that conflict with the above in the Articles of Association of the Indian company, or other legal agreements. The letterheads, visiting cards, stationary, firm signs etc. of the Mauritius Company must be kept at its registered office in Mauritius. Technically, as of date, the application of the Treaty remains unaffected. So, if certain precautions, as stated above, are taken by a foreign investor while incorporating the MCo, they will be in a better position to defend against any attempt on the part of the ITA to deny the Treaty benefits.
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