Direct Tax Updates & Legal Developments - Q4 2023

Himanshu SinhaPartner

Aishwarya PalanSenior Associate

Paras AroraAssociate

Key Developments

• Delhi High Court analyses the availability of grandfathering benefit under India-Mauritius tax treaty and upholds validity of tax residency certificates for claiming treaty benefits

  Under the Income Tax Act, 1961, capital gains arising to a non-resident on the transfer of shares of an Indian company are generally taxable in India. However, under the India-Mauritius tax treaty (Treaty), capital gains arising on the sale of shares of Indian companies by investors resident in Mauritius were taxable only in Mauritius. This benefit was available only until 31 March 2017. However, the Treaty contains a grandfathering clause, under which this benefit is also available to transfers of shares after 31 March 2017, provided the shares were acquired before 1 April 2017. Given this, the availability of benefits of the Treaty has been subject to protracted litigation. One of the several contentious issues has been the validity of a tax residency certificate (TRC) for claiming Treaty benefits.

  The Delhi High Court reinforced the importance of a TRC as a mechanism for establishing tax residency and held that capital gains arising from the sale of shares of a Singaporean company (holding shares in an Indian company) by a Mauritius-based investor are not taxable in India since the transaction was not aimed at tax avoidance.¹

  The assessee in this case, Tiger Global International (TGI), is a private company holding a Category 1 Global Business License (GBL). TGI is a tax resident of Mauritius and was issued a TRC by the Mauritius revenue authorities. TGI was set up with the objective of making investments to earn long-term capital appreciation. Tiger Global Management LLC (TGM), a company incorporated in the US, is the assessee’s investment manager. Between October 2011 to April 2015, TGI acquired shares of Flipkart Singapore and subsequently, transferred them to Fit Holdings SARL.

  TGI approached the Advance Authority Ruling (AAR) to decide the taxability of this transaction. The AAR held that the assessee group (TGI and TGM) were merely conduit companies, disentitled to claim benefits of the Treaty since the transaction lacked commercial substance. TGI challenged the AAR's decision before the Delhi High Court, contending that shares were acquired before 1 April 2017, and therefore, resultant capital gains were exempt from tax in India under the Treaty. TGI also contended that a TRC is sufficient evidence of residence.

  The revenue authorities, on the other hand, contended that the ultimate control and decision-making authority was with TGM, and TGI was created without substantial commercial rationale. Therefore, TGI is not the owner of the shares, instead TGM is the investor in the transaction in question. The revenue authorities relied on the Supreme Court’s decision in the case of Vodafone² to state that if a non-resident enterprise makes an indirect transfer through abuse of organisation or legal form and without reasonable business purpose, then the revenue authorities may disregard the form of the arrangement, re-characterise the transfer and impose tax on the actual controlling non-resident. Accordingly, the corporate veil must be pierced, and the provisions of the Treaty will not apply.

  The Delhi High Court ruled in favour of TGI and held as under.

  • Applicability of Treaty: The transaction under consideration would be grandfathered and hence exempt in India since such shares were acquired before 1 April 2017.
  • Commercial substance and beneficial ownership: TGI did not lack commercial substance as it had a GBL and managed funds of over 500 investors across 30 jurisdictions. It was observed that factors like legal or contractual obligations may be instrumental in analysing beneficial ownership. In the absence of such factors and as TGM did not invest any funds in TGI, it could not be considered as the parent company or the beneficial owner of the shares transacted by TGI.
  • Tax residency certificate is sacrosanct: The Court held that doubting the validity of a TRC is not justified and observed that TRC is a mechanism adopted by countries themselves to dispel any speculation concerning the fiscal residence of an entity. It therefore cannot be cursorily ignored.
  • Mauritius as a tax favourable jurisdiction and treaty shopping: The mere fact that an entity is established in Mauritius must not raise a presumption of tax avoidance. The revenue authorities may doubt the bona fides of a transaction only where no other conclusion can be drawn except that the entity was a conduit intending to perpetrate tax fraud.

  This decision provides significant relief to investors who are eligible for the grandfathering benefit under the Treaty. The Court's affirmation of the sanctity of the TRC and its rejection of the presumption of tax avoidance solely based on the establishment of an entity in a tax-friendly jurisdiction are noteworthy.

  Overall, this decision reinforces the need for a balanced approach in evaluating the commercial substance and beneficial ownership of entities claiming tax treaty benefits. It will be interesting to see how the Supreme Court adjudicates the dispute on the eligibility of treaty benefits with respect to investment companies set up in tax-friendly jurisdictions, such as Singapore and Mauritius, in the case of Blackstone Capital Partners.³

• Delhi High Court reignites debate on whether profit can be attributed to the permanent establishment of a non-resident enterprise in India despite a global level loss

  A full bench of the Delhi High Court has reversed⁴ an earlier decision⁵ to hold that a permanent establishment (PE) must be viewed as a separate taxable entity, and its profits must be assessed independently, without considering the overall financial performance of the enterprise.

  The appellant in this case argued that if an enterprise had suffered a loss in a financial year at an entity level, no profit or income attribution would be warranted as far as the PE is concerned. On the other hand, the tax authorities contended that a PE must be treated as a distinct and separate entity for tax.

  The Court analysed the relevant provisions of the India-UAE tax treaty, including the definitions of ‘enterprise’ and ‘permanent establishment’, and rules for attributing profits to a PE under Article 7 in the context of the ‘source’ rule and concluded that the PE must be viewed as a separate and distinct centre for the purposes of taxation. The Court relied on the Organisation for Economic Co-operation and Development and UN Model Convention commentaries and noted the importance of viewing the PE as a separate and independent centre for tax purposes.

  This case assumes significance as it shakes the view expressed in the earlier decision that profit attribution to a PE would be warranted only if the enterprise as a whole had earned profits. It is expected to have far-reaching consequences, especially for entities attributing profits to PE in similar cases. (To read our detailed insights into the ruling, click here.)

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