Gains arising in the hands of Mauritian company from sale of equity shares and CCDs of an Indian company are not taxable as interest income in India

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1 KPMG FLASH NEWS KPMG IN INDIA Gains arising in the hands of Mauritian company from sale of equity shares and CCDs of an Indian company are not taxable as interest income in India 5 August 2014 Background Recently, the Delhi High Court (the High Court) dealt with a writ petition challenging the advance ruling in the case of Zaheer Mauritius 1 (the taxpayer). The High Court held that the gains resulting to the taxpayer from the sale of equity shares and Compulsorily Convertible Debentures (CCDs) held in the JV company are not taxable as interest under Section 2(28A) of the Income-tax Act, 1961 (the Act), and Article 11 of the India-Mauritius tax treaty (the tax treaty). The High Court observed that there is sufficient commercial reason for the taxpayer to have routed its investment from Mauritius into the real estate project in India through equity shares and CCDs. Thus, neither the legal nature of CCDs can be ignored nor the corporate veil between the Indian investee company and the Indian JV company be lifted. 1 Zaheer Mauritius v. DIT International Taxation-II [W.P.(C) 1648/2013 & CM NO.3105/2013] (Del) taxsutra.com Facts of the case The taxpayer, a company incorporated in Mauritius, is inter alia engaged in the business of investment into Indian companies which are engaged in construction and development business in India. Vatika Limited (Vatika), an Indian company, is inter alia engaged in the business of developing and dealing in real estate. SH Tech Park Developers Private Limited (the JV company) is an Indian company and was incorporated as a 100 per cent subsidiary of Vatika. The taxpayer entered into a Securities Subscription Agreement (SSA) and a Shareholder s Agreement (SHA) with Vatika and the JV company. The SHA recorded the terms of the relationship between the taxpayer, Vatika, and the JV company, their inter se rights and obligations, including matters relating to transfer of equity shares and the management and operation of the JV company.

2 As per the SSA, the taxpayer agreed to acquire 35 per cent ownership interest in the JV company by making a total investment of INR1 billion in five tranches. The taxpayer agreed to subscribe to 46,307 equity shares having a par value of INR10 each, and 882,585,590 zero per cent CCDs having a par value of INR1 each, in a planned and phased manner. The SHA also provided for a call option given to Vatika by the taxpayer to acquire all the aforementioned securities during the call period and likewise, a put option was given by Vatika to the taxpayer to sell to Vatika all the aforementioned securities during the determined period. Subsequently, Vatika and the JV company executed a Development Rights Agreement (DRA) in terms of which Vatika transferred the exclusive development rights, entitlements, and interest in certain land to the JV company for development of the land, with the right to retain the sale proceeds thereof exclusively. Vatika partly exercised the call option and purchased 22,924 equity shares and 436,924,490 CCDs from the taxpayer for a total consideration of INR800 million. Subsequently, the taxpayer transferred further equity shares and CCDs to Vatika. The taxpayer filed an application under Section 197 of the Income-tax Act, 1961 (the Act) before the Assessing Officer (AO) requesting for a nil withholding tax certificate to receive the total consideration from Vatika for transfer of equity shares and CCDs without deduction of tax. The AO held that the entire gain on the transfer of equity shares and CCDs would be treated as interest and tax at the rate of 20 per cent (plus surcharge and cess) should be withheld on the same. High Court s ruling A debenture indisputably creates and recognises the existence of a debt and till it is discharged, either by payment or by conversion, the debenture would essentially represent a debt. A CCD is a debt which is compulsorily liable to be discharged by conversion into equity. Any amount payable by the issuer of debentures to its holder would usually be interest in the hands of the holder. However, gains arising from the sale of capital assets would not be in the nature of interest. Under normal circumstances, the gains arising from transfer of a debenture, which is a capital asset in the hands of the transferor, in favour of a third party, would be capital gains and not interest. Article 10 of the SHA did not indicate that the taxpayer was only entitled to a fixed return on the investments made by it in the equity and CCDs issued by the JV company. Article 10(1) of the SHA entitles Vatika to call upon the taxpayer to sell its investment at a price to be computed in the manner as provided in the clause. If this option was exercised after the expiry of three years from the first closing date, the price to be computed would also include a component of equity payment which was defined to mean an amount equal to 10 per cent of the project value and consequently, a portion of the assets of the JV company. In the event that the taxpayer exercised such option, it would be entitled to receive the price which would include the component of equity payment (i.e. 10 per cent of the project value). Merely because an investment agreement provides for exit options to an investor, the nature of the investment made would not change. The options were granted to Vatika as well. The AAR has concluded that the entire transaction which is embodied in the SSA, SHA, and other documents is a sham and the real transaction was only of the taxpayer granting a loan to Vatika. Based on Article 10 of the SHA, the AAR concluded that these agreements indicated that the taxpayer would receive a fixed rate of return. Accordingly, the AAR held that the entire gains on the sale of equity shares and CCDs held by the taxpayer are interest within the meaning of Section 2(28A) of the Act and Article 11 of the tax treaty, and are taxable in India. The SHA indicates that it was a joint venture agreement. Although, the SHA enables the taxpayer to exit the investment by receiving a minimum return, the same cannot mean that the CCDs were fixed return instruments, since the taxpayer also had the option to continue with its investment as an equity shareholder of the JV company.

3 Article 11 of the SHA provides the taxpayer the right to sell its entire equity in the JV company to a third party and recover the value as determined by the SHA. The rights with regard to options and additional rights under Article 11 of the SHA were the mutual rights and obligations between Vatika and the taxpayer, and not the JV company. The JV company would in any event, whether the options were exercised inter se Vatika and the taxpayer or not, convert the CCDs into equity shares on completion of 72 months from the first closing date. The SHA indicates that the JV company was to be managed as a joint venture between the taxpayer and Vatika and, the JV company and Vatika were not a single entity. As per the SHA, all decisions that were considered important required the consent of both the taxpayer as well as Vatika. Further, all transactions with related parties would be conducted on an arm s length basis. Perusal of the SHA indicates that the affairs of the JV company were to be managed separately and distinctly from that of Vatika. The reading of the agreement as a whole indicates that the taxpayer was entitled to participate in the management and affairs of the JV company, not only by appointing its nominee directors but also by ensuing independent auditors and an independent asset manager. According to Press Note 2 of 2005 issued by the Department of Industrial Policy & Promotion, 100 per cent Foreign Direct Investment (FDI) under the automatic route was allowed for investments in townships, housing, built up infrastructure, and construction-development projects subject to the guidelines specified therein. In terms of the Circular No. 74 dated 8 June 2007 issued by the Reserve Bank of India (RBI), an instrument which is fully and mandatorily convertible into equity shares within a specified time would be reckoned as part of equity under the FDI Policy. Thus, in terms of the policy of the government, the taxpayer could invest in a project of the requisite size/nature, and an investment into CCDs would be reckoned as equity. The Supreme Court in the case of Vodafone International Holdings BV 2 v. Union of India and Anr. [2012] 6 SCC 613 (SC) had held that the court must look at the entire transaction as a whole and not adopt a dissecting approach. Further, the Supreme Court also held that the court cannot start with the question of whether the transaction is a tax saving device, but should instead apply the look at test to ascertain its true legal nature. In the present case, there is sufficient commercial reason for the taxpayer to have routed its investment in the real estate project through equity and CCDs. The pre-mature exit options as recorded in the SHA and the minimum return assumed by Vatika on its investment are commercial agreements between the parties, and these do not change the legal nature of the transaction entered into between the parties. The terms of the arrangements between Vatika and the taxpayer reveal that the JV was a genuine commercial venture, in which both partners had management rights. Based on the above, neither the legal nature of the instrument of a CCD can be ignored nor the corporate veil be lifted to treat the JV company and Vatika as a single entity. Accordingly, the gains resulting to the taxpayer from sale of equity shares and CCDs held in the JV company are not taxable as interest under Section 2(28A) under the Act and Article 11 of the tax treaty. Our comments In 2012, the AAR 3 in the taxpayer s case observed that the calculation of the purchase price of CCDs is almost entirely dependent on the period of holding of the investment. Accordingly, the AAR held that income from sale of CCDs by the applicant is taxable in India as interest under Section 2(28A) of the Act and Article 11 of the tax treaty. Further, the AAR considered the Indian holding company and the Indian subsidiary company as one and treated the entire transaction as a sham, and therefore held that sale of Indian company shares by a Mauritius company is not exempt under the tax treaty. In this case, the High Court has set aside the AAR ruling. 2 Vodafone International Holdings BV v. UOI and Anr. [2012] 6 SCC 613 (SC) 3 Z (A.A.R. No of 2011)

4 The High Court has relied on the RBI Circular which holds that an instrument which is fully and mandatorily convertible into equity shares within a specified time would be reckoned as part of equity under the FDI Policy. Based on the perusal of SSA, SHA, and other relevant documents, the High Court held that the Indian JV for real estate development was a genuine commercial venture. The legal nature of the instrument of a CCD would not be ignored nor would the corporate veil be lifted to treat the JV and Vatika as a single entity. Based on the decision in the case of Vodafone International Holdings BV, the High Court applied the look at test to ascertain the true legal nature of the equity shares and CCDs, and held that the gains arising from their sale would be exempt from capital gains tax under Article 13(4) of the tax treaty. The GAAR provisions will help empower the AO to recharacterise equity as debt and vice versa, if the arrangement is treated as an impermissible avoidance arrangement. Further, it has been provided 4 that the GAAR provisions will apply even if such provisions are not beneficial to the taxpayer as compared to the tax treaty. 4 Under Section 90 of the Act

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