EY Tax Alert. Executive summary

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1 28 May mber 2012 EY Tax Alert SLP filed before SC against HC s ruling on non-taxability under India France treaty of an indirect transfer of Indian shares Executive summary Tax Alerts cover significant tax news, developments and changes in legislation that affect Indian businesses. They act as technical summaries to keep you on top of the latest tax issues. For more information, please contact your Ernst & Young advisor. This Tax Alert summarizes a recent development where the Tax Authority in a Special Leave Petition (SLP) filed before the Supreme Court of India (SC) has challenged the order of the Andhra Pradesh High Court (HC) in the case of Merieux Alliance, France (MA) and Groupe Industriel Marcel Dassault (GIMD) [1] (collectively referred to as Taxpayers) holding that an indirect transfer of shares of an Indian company is not taxable under the India-France Double Taxation Avoidance Agreement (France treaty), regardless of the amendment made to the Indian Tax Laws (ITL) to tax such transfers. The arguments raised by the Tax Authority in the SLP are (i) Transfer of shares of the French Company, ShanH (which in turn held shares in Indian company) was a scheme for avoidance of tax in India as ShanH did not have commercial or economic substance and the real intent was to acquire the shares and entire business interest in the Indian company (ii) The HC erred in not appreciating the approach of the Bombay HC in Aditya Birla Nuvo Ltd. and Others [2] (ABNL) wherein the subsidiary was ignored and the parent company was treated as the real owner of the shares (iii) India has the right to tax the capital gains under the provisions of the France treaty (iv) Conflict between the rulings in the case of Azadi Bachao Andolan (Azadi) [263 ITR 706] [1] Kindly refer to Ernst Young Tax Alert dated 18 February 2013, titled High Court in India rules on taxation of indirect transfer under India-France Double Taxation Avoidance Agreement. [2] Kindly refer to Ernst Young Tax Alert dated 16 July 2011, titled Bombay HC rules on taxation of cross-border transactions involving India-Mauritius DTAA and indirect transfer of shares of an Indian company.

2 and Vodafone International Holdings B.V. [3] (Vodafone) [341 ITR 1] against the ruling in the case of McDowell [154 ITR 148] to be resolved by referring the matter to an appropriate bench and (v) Refer Vodafone (supra) ruling to a larger bench for reconsideration. It may be noted that the SC has the discretion to admit or dismiss the SLP. The petition is yet to be heard by the SC. Background The ITL was amended by Finance Act (FA) 2012, with retrospective effect from 1 April 1962 to clarify that transfer of shares of a foreign company would be taxable in India if the shares of the foreign company derived its value, directly or indirectly, substantially from assets located in India. As per the France treaty, capital gains arising to a French tax resident from alienation of shares representing a participation of at least 10% in a company resident in India may be taxed in India [Article 14(5)]. However, gains from alienation of shares of a company the property of which consists, directly or indirectly, principally of immovable property, may be taxed by the country where the immovable property is situated [Article 14(4)]. Gains arising to a French tax resident from alienation of any other asset (e.g. shares in a French company) shall be taxable only in France [Article 14(6)]. The Taxpayers were companies resident in France. MA incorporated a wholly-owned subsidiary (ShanH) in France. With a view to invest in India, MA entered into a share purchase agreement (SPA) in 2006 with shareholders of Shantha Biotechnics Ltd. (Shantha), an Indian company. Nearly 80% of the shares of Shantha were purchased by ShanH, a subsidiary wholly owned by MA. Over the years, other investors like GIMD acquired shares in ShanH from MA. Thereafter, in 2009, MA and GIMD transferred their shareholding in ShanH to Sanofi, another French company (Transaction). The Transaction has been depicted in the diagram below: France India MA GIMD Sanofi ShanH Shantha Transfer of shares in ShanH by MA & GIMD to Sanofi The Taxpayers approached the Authority for Advance Rulings (AAR) which held that the transfer of shares of ShanH was a scheme for avoidance of Indian tax and that the capital gains arising from the Transaction was liable for tax in India, going by a purposive interpretation of the France treaty [4]. Aggrieved by the ruling of the AAR, the Taxpayers had filed a writ petition before the HC. In February 2013, the HC gave its ruling in favor of the Taxpayers. It held that the corporate veil of the French company, ShanH, cannot be pierced as it was an independent corporate entity with commercial substance and business purpose and it was not a device for avoiding tax in India. As the Taxpayers had transferred shares of a French resident company, taxation of capital gains arising therefrom is allocated exclusively to France under the France treaty and, therefore, not taxable in India. The HC also held that the retrospective amendments to the ITL would not impact the allocation of taxing rights under a treaty. Aggrieved by the order, the Tax Authority has now filed a SLP before the SC against the ruling of the HC. We have summarized the key arguments presented by the Tax Authority in [3] Kindly refer to Ernst Young Tax Alert dated 20 January 2012, titled The Vodafone case: SC rules transfer of shares of a foreign company that indirectly held underlying Indian assets not taxable. [4] Kindly refer to Ernst Young Tax Alert dated 2 December 2011, titled AAR holds indirect transfer of Indian shares is taxable on grounds of tax avoidance.

3 its SLP based on the reports of Taxsutra.com and other publicly available news reports. At the outset, the SLP states that it raises substantial questions of law having wide implications on taxability of cross-border transactions between multinational companies resulting in profit making (capital gains) which has a source of income that arises in India. Summary of arguments raised in the SLP by the Tax Authority ShanH had no commercial or economic substance ShanH had no commercial substance and the intent of the Transaction could not be to acquire such a non-descript company. ShanH neither enjoyed any rights and privileges as a shareholder, nor did it have any control over the management of Shantha. ShanH was not a legal or beneficial owner of shares of Shantha and it may, at best, be regarded as a nominee of the Taxpayers. Real intent of the parties who entered into the SPA in 2009 was the acquisition of Shantha (whose primary business was development of vaccines) and the potential market generated by it. Various clauses in the SPA indicate that the intent is not merely to acquire shares of ShanH but the entire business interest in Shantha. (e.g. Sanofi undertook warranties in relation to functioning and business operations of Shantha, sale consideration dependent upon level of progress in R&D/sales/marketing of Shantha, independent transfer of control and management of Shantha etc). The transactional documents and surrounding circumstances clearly demonstrate that shares of ShanH were simply selected as one of the modes to transfer the shares and business interest in Shantha. The mode of disposal of the property would not determine the true nature of the transaction between the parties. Further, approval granted by Reserve Bank of India or Foreign Investment Promotion Board does not confer ownership rights to ShanH. Though the shares were registered in the name of ShanH, it cannot be regarded as the real owner. ShanH has to be ignored as the Taxpayers exercised the rights and obligations of ShanH as it had no commercial or economic substance and was only a puppet subsidiary. Reliance on ruling in ABNL (supra) by Bombay HC The HC erred in not appreciating the approach of the Bombay HC in the case of ABNL (supra) as the factual situation was similar to the Transaction. In ABNL, the Bombay HC ignored the subsidiary company incorporated in Mauritius which was the registered owner of Indian shares and held that the real owner of the shares was its parent company, which exercised the rights and obligations on behalf of the subsidiary. India has the right to tax under the France treaty India has the right to tax the Transaction as per Article 14(5) of the France treaty and the ITL. Once the source country has the right to tax the gains, it is immaterial whether such gains are realized by disposal or deemed disposal of asset, as the France treaty would apply to both cases. In terms of Article 14(5) of the France treaty: The term alienation has not been defined under the France treaty and it would derive its meaning from the ITL. Under the ITL, disposal of capital assets is defined under the word transfer and this would operate/apply to define the term alienation also. The term transfer is defined widely and inclusively under the ITL and also its natural meaning is very wide to cover direct as well as indirect transfers. The term alienation is intended to have a wider scope than the expression sale or exchange and it has to be understood to include direct and indirect alienation for a proper and purposeful construction of the provisions. The HC erroneously proceeded on the assumption that the term participation stipulated under Article 14(5) means only participation in share of another company. As the term is not defined in the France treaty, the word would derive its meaning from the provisions under the ITL which extends to capital, control or management of an entity.

4 The HC also erred in holding that see through is not permitted under Article 14(5). Use of the words directly or indirectly under Article 14(4) which seeks to tax immovable property would be necessary in that context but not under Article 14(5) as the basis of allocation of rights to the source country is participation in excess of 10% in the company. Under the facts and circumstances in the given case, the question of application of the retrospective amendment in the ITL (introduced vide FA 2012) to the France treaty would not arise. Conflict between Azadi and Vodafone against McDowell ruling The HC relied on the SC rulings in the case of Azadi and Vodafone and applied a much narrower test by holding that the device would be colorable only if its sole aim was to avoid tax. The rulings of the SC in the case of Azadi (two-judge bench) and Vodafone (threejudge bench) is in conflict with McDowell (Constitution bench of five judges) on observations on tax planning against tax avoidance issue. The decisions in Vodafone and Azadi must be referred to an appropriate bench for deciding on the correctness of the issue. Refer Vodafone to Larger Bench Various notings/observations from the Vodafone ruling are cited as incorrect and, hence, it is pleaded that the ruling should be referred to a larger bench for reconsideration. Comments Cross-border acquisition of Indian companies has been a focus of the Tax Authority over the last few years. Pursuant to the Vodafone ruling, the ITL was amended retrospectively to tax transfer of shares of a foreign entity whose value is derived, directly or indirectly, substantially from assets located in India. However, it is generally recognized that a number of India s tax treaties would protect such gains from Indian tax. This principle was upheld by the HC in the case of the Taxpayers. This view was also articulated by the Indian Finance Minister (FM) in his speech in Parliament during a discussion on the Finance Act, 2012 amendments [5]. An Expert Committee formed by the Government of India to examine indirect transfer taxation had also recommended that the Government clarify this aspect [6]. With the Tax Authority filing an SLP before the SC against the ruling of the HC, one awaits finality on this matter. Taxpayers intending to rely on tax treaty protection in case of crossborder transactions involving indirect transfer of Indian assets may need to consider the implications of this development on their structures. [5] Kindly refer to Ernst Young Tax Alert dated 8 May 2012, titled Budget Plus Finance Bill 2012 amendments based on FM s speech. [6] Kindly refer to Ernst Young Tax Alert dated 10 October 2012, titled Draft Report of Expert Committee on Retrospective Amendments relating to indirect transfer.

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