In a decision issued on 14 August 2014 (Director of Income Tax (International Tax) v. Copal Research Limited, Mauritius), the Delhi High Court examined the meaning of the term 'substantially' in the amended version of the provisions of the Income Tax Act (ITA) dealing with indirect transfers and opined that the purpose of the amended rules is not to expand the scope of taxation to include income derived from transfers that do not have a territorial nexus with India. The court ruled in favour of the taxpayer and stated that capital gains arising from a transfer of shares of a foreign company should not be liable to tax in India if such shares derive less than 50% of their value from underlying assets located in India. In other words, a threshold of 50% or more should be met before taxation of capital gains is triggered in the country. The court also upheld the applicability of the capital gains tax exemption under the India-Mauritius tax treaty.
While the Delhi High Court decision provides welcome clarification with respect to the interpretation of the term 'substantially' that is used in the provisions of the ITA relating to indirect transfers, the fact that the court addressed the meaning of the term even though this issue was not specifically before it means that its interpretation may be considered nonbinding dicta that may have only persuasive value in other cases.
Following the India Supreme Court's decision in the Vodafone case in 2012, that year's Finance Act introduced a controversial and far-reaching amendment into the ITA that clarified that a nonresident would be subject to tax in India on a transfer of shares or an interest in a foreign entity if such shares/interest derive their value substantially from assets located in India. The fact that the word 'substantially' is not defined in the amended rules has created considerable uncertainty regarding the application of the rules, particularly for foreign companies with business interests in India; such companies have faced ambiguity about the capital gains tax and withholding tax implications of certain share transfers overseas that result in the indirect transfer of an India business as well as potential challenges by tax authorities.
Facts of the case
The Copal Group had undertaken the sale of shares of its companies to the Moody's Group via three transactions:
- Copal Research Limited, Mauritius (CRL) sold a wholly owned Indian subsidiary to Moody Cyprus (transaction 1);
- Copal Market Research Limited, Mauritius (CMRL) sold a wholly owned US subsidiary that, in turn, was the 100% owner of an Indian subsidiary to Moody USA (transaction 2); and
- One day after transactions 1 and 2, the Copal Group shareholders holding 67% of the shares in Copal Partners Limited, Jersey (CPL), the ultimate holding company at the head of the Copal Group, sold their shareholdings to Moody UK; the balance of 33% of shares in CPL continued to be held by banks and financial institutions (transaction 3).
The taxpayers claimed that transactions 1 and 2 were not taxable in India under the provisions of the India-Mauritius tax treaty and requested a ruling from India's Authority for Advance Rulings (AAR) on the capital gains and withholding tax implications of these transactions. The AAR determined that the capital gains resulting from the transfers were not taxable in India and, consequently, did not attract withholding tax.
The Indian tax authorities challenged the AAR's ruling, claiming that:
- Transactions 1 and 2 were carried out with the objective of avoiding tax and had no commercial substance. All three transactions should be viewed together as a transfer of the entire business of the Copal Group to Moody's Group, which would have been taxable in India if transactions 1 and 2 had not been executed because the shares of CPL (involved in transaction 3) derived significant value from assets located in India. Effectively, all three transactions were part of a single larger transaction.
- The management and control of the Copal Group were carried out by a UK resident and not in Mauritius; therefore, the companies involved in transactions 1 and 2 should not have been entitled to beneficial treatment under the India-Mauritius tax treaty.
Delhi High Court ruling
The Delhi High Court upheld the determination of the AAR, concluding that the sales of shares by the Mauritius companies were bona fide transactions with a commercial justification.
Specifically, the court held that transactions 1 and 2 were commercially justified and not structured to avoid tax. Executing transactions 1 and 2 before transaction 3 allowed the Moody's Group to acquire 100% of the Copal subsidiaries sold (rather than the 67% it would have acquired from a direct transfer of the shares in CPL) and allowed the Copal Group to distribute the entire consideration from the sale of these subsidiaries to the Copal shareholders and the other 33% shareholders in CPL by way of a dividend.
Although it was not necessary for the high court to consider whether the sale of CPL would have been taxable in India if transactions 1 and 2 had not been respected, the court considered it appropriate to address the tax authorities' argument.
The Delhi High Court noted that, according to the amended law dealing with indirect transfers, income from a transfer of shares of a foreign company is deemed to be income from an asset located in India if the shares substantially derive their value from assets located in India. The court determined that the purpose of the amended rules is not to expand the scope of taxation to include income derived from transfers that do not have a territorial nexus with India. It opined that the term 'substantially' should be interpreted to mean 'principally', 'mainly', or at least 'a majority' and stated that capital gains arising from a transfer of shares of a foreign company should not be liable to tax in India if such shares derive less than 50% of their value from underlying assets located in the country. In arriving at the 50% threshold, the court referred to relevant provisions of the proposed Direct Taxes Code (DTC) 2010 and the 'Shome Committee' report (which recommended that the term be defined at a threshold of 50% of the total value being derived from assets located in India). The court also referred to the capital gains articles in the UN and OECD model treaties (which provide a threshold of 50% to determine whether or not shares derive their value 'principally' from immovable property situated in the relevant contracting state).
The court considered the values of the consideration for transactions 1 and 2 (which involved the Indian subsidiaries) as well as transaction 3 and concluded that only a fraction of the value of the shares in CPL (less than 50%) was derived indirectly from India. Accordingly, even if transactions 1 and 2 had been disregarded, the court concluded that the income from the sale of CPL would not have been taxable in India.
Although the court agreed with the AAR that a UK individual played a broader role than that of an agent with respect to the transactions, it concluded that this fact alone, in the absence of further evidence, was insufficient to conclude that CRL and CMRL were managed from the UK rather than by their Mauritius boards of directors. Accordingly, the court did not deny the benefits of the India-Mauritius treaty for transactions 1 and 2.
As noted above, the decision of the Delhi High Court provides much-anticipated clarification of the term 'substantially' in the law relating to indirect transfers. However, the meaning of this term was not an issue specifically before the court; therefore, the court's interpretation is dicta that may have only persuasive value. More guidance also is awaited from the government.
It is relevant to note that the proposed DTC 2013 defines the term 'substantial' to mean 'an interest of 20% or more' (in the instant case, the Delhi High Court considered the earlier, 2010 version of the DTC). It would be interesting to see what the court's conclusion would have been if it had an opportunity to consider the DTC 2013.
Taxpayers should carefully review their cross-border sales and acquisitions of businesses as well as intragroup restructurings in light of this decision.