28 August 2014 EY Tax Alert Delhi High Court rules 50% as the benchmark to evaluate substantial value on taxation of indirect transfers 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 EY advisor. This Tax Alert summarizes a ruling of the Delhi High Court (HC) in a batch of cases, with the lead case being that of Copal Research Limited, Mauritius [WP (C) 2470/2013] (Taxpayer) on the issue of taxability of direct/ indirect transfer of shares in certain Indian companies. In a series of transactions, shares of India and US entities were transferred by Mauritius companies. The Taxpayer had approached the Authority for Advance Rulings (AAR) which ruled, among other things, that the transaction would not be taxable in India. Against this ruling, the Tax Authority filed a writ petition in HC whereby, HC was required to evaluate implications under the Indirect Transfer Provision (ITP) of the Indian Tax Laws (ITL). ITP taxes sale of shares of an overseas entity if the same derives substantial value from underlying assets in India. The HC ruled that the requirement of substantial value for ITP is met if the underlying value of Indian assets exceeds 50% of the total value of the overseas entity. Where however, if the underlying value is less than 50% then, there shall be no tax liability. Further, having regard to the facts of the case, the HC held that the corporate veil of the Mauritius companies cannot be pierced for the reason that such entities had independent corporate personality, and business purpose, and was not a device for avoiding Indian tax.
Background and facts While transfer of shares in an Indian company is taxable in India under the ITL, an indirect transfer was held not taxable by the Supreme Court (SC) in the case of Vodafone International Holdings BV (341 ITR 1). However, the ITL was amended in 2012, with retroactive 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. Moody s Group Limited (Moody-UK) a company incorporated in UK, and its subsidiaries acquired shares of Copal- Jersey (CJ) and its subsidiaries through a series of transactions entered between the parties by way of share purchase agreements (SPA). CJ had various subsidiaries situated in Mauritius, India and US. Moody-UK desired to acquire 67% participation in CJ. However, Moody-UK wanted to acquire 100% stake in Copal Research India Private Limited (CRIL) and Exevo US. To achieve this commercial result, three different transactions were entered into. SPA-I and SPA-II were entered into on 3 November 2011 for effecting transfer of CRIL and Exevo US respectively by Copal Research Limited, Mauritius (MauCo1) and opal Market Research Limited (MauCo2). To acquire 67% stake in CJ, SPA-III was entered into on 4 November 2011. All the SPAs were executed for different considerations, i.e., SPA-I was for USD 31 Mn, SPA-II was for USD 11 Mn, and SPA-III was for USD 93 Mn. Having regard to the overall valuations and sale consideration of the three SPAs, it was clear that value of CRIL, Exevo US was about 31.50% of the overall consideration paid pursuant to all the SPAs. Further, since SPA-I and SPA-II were concluded with MauCo1 and MauCo2, respectively, MauCo1 and MauCo2 invoked the benefit of the DTAA to support that transfer of shares of CRIL and Exevo-US did not result in any tax liability in India. The parties to the transaction approached the Authority for Advance Rulings (AAR) on taxability of the transactions under SPA-I and SPA-II. The AAR ruled that capital gains arising from the transactions were not taxable in India. Aggrieved, the Tax Authority appealed by way of writ before the HC. Tax Authority s contentions SPA-I and SPA-II was executed on 3 November 2011, whereas SPA-III was executed on 4 November 2011, which clearly indicates that both, SPA-I and SPA-II are not to be viewed in isolation but in conjunction with SPA-III as it formed an integral part. Further, the commercial understanding between the Stakeholders and Moody-UK was to structurally transfer the entire business and interest of CJ, which however, was effectuated by three different transactions. If the Stakeholders had divested their stake in CJ, the gains arising from such sale would be taxable under the ITP of the ITL, as shares of CJ derived their value substantially on account of the value of the assets situated in India, namely, shares of Exevo-India and CRIL. Thus, the effect of executing SPA-I and SPA-II was to merely avoid ITP. The route through Mauritius (MauCo1 and MauCo2) to hold companies in India had been evolved with the object of avoiding tax since capital gains from sale of shares in the hands of a Mauritius resident is not taxable in India under the India-Mauritius Double Taxation Avoidance Agreement (DTAA). Thus, execution of SPA-I and SPA-II were interspersed, and as such were transactions structured prima facie for tax avoidance. RK, a resident of UK, was one of the prime-mover of CJ and had de facto control and management of all the entities under CJ. Further, MauCo1 and MauCo2 were shell companies and were not operative since their revenues were generated from within the CJ group. RK, an individual and resident of UK, played a dominant role in the transaction, and had
also varied various terms of SPA-I, SPA-II and SPA-III, which indicated that the control and management of MauCo1 and MauCo2 was in UK, and not Mauritius. Accordingly, the series of transactions are taxable in India. Taxpayer s contentions The commercial rationale for sale of shares of CRIL and Exevo-US was to enable the buyer to acquire 100% stake of the holding interest of the Indian Companies. Share transfer was accordingly effected by MauCo1 and MauCo2. If simplicitor sale of shares of CJ was undertaken then, Moody Group would not have acquired 100% direct control over CRIL and Exevo-US but only an indirect 67% economic interest. The purchase consideration received by MauCo1 and MauCo2 was ultimately distributed as dividends to Stakeholders, including other shareholders (banks and financial institutions). Thus, execution of SPA-I and SPA-II resulted in Stakeholders, including the banks and financial institutions, receiving dividends, and therefore, the SPAs need to be looked at independently. MauCo1 and MauCo2 were effectively managed by their respective Board of Directors, situated in Mauritius. Both, MauCo1 and MauCo2 were registered as category-i Global Business Licenses (GBL). Further, MauCo1 and MauCo2 received substantial revenues from providing services relating to financial and market research to the group entities. Accordingly, MauCo1 and MauCo2 were not shell companies, but had adequate substance. Even otherwise, the DTAA did not include a Limitation of Benefits clause and thus, it was not open for the Tax Authority to contend that MauCo1 and MauCo2 should be denied the treaty benefit. HC s ruling Each SPA has commercial rationale and is independent of other SPAs Three SPAs were executed, each having an independent consideration, and commercial rationale. Further, the Tax Authority s argument that SPA-I and SPA-II had been executed only for the purposes of avoiding tax, and as an alternative to sale of shares by Stakeholders of CJ (which would not be as tax friendly) is incorrect as the transaction, if structured in the manner as suggested by the Tax Authority, i.e., sale of shares of CJ alone, would not achieve the same commercial results and therefore, cannot be considered as a transaction structured differently to avoid incidence of tax. The edifice of Tax Authority s contention is based on the assumption that gains arising from sale of shares of CJ would be subject to tax, if shares of Exevo-US and CRIL had not been sold by MauCo1 and MauCo2. This contention also cannot be accepted for the reason that if the shares of CJ had been transferred by the Stakeholders (to the extent of 67%) instead of executing SPA-I and SPA-II, the value from India assets would only be 30.50%, and may not be regarded as substantial in terms of ITP. Transfer of overseas entity s shares - Impact of SC ruling Under the ITL, any income arising from transfer of a capital asset situated in India would be taxable in India. A share of a company incorporated outside India is not an asset which is situated in India (but for ITP), the gains arising therefrom would not be taxable in India. This would be true even if the entire value of the shares of an overseas company was derived from the value of assets situated in India. This controversy arose in the case of Vodafone International Holdings BV (supra), and SC held that the transaction of sale of shares of an overseas company between two nonresidents would fall outside the ambit of
the ITL. However, in 2012, the ITL was retroactively amended, to shift the situs of an overseas entity to India, if such asset derived substantial value from assets in India. Thus, the ITL introduced a legal fiction by way of ITP, to tax transfer of assets outside India if such asset derived substantial value from India. It is trite law that a legal fiction must be restricted to the purpose for which it is enacted. The object of ITP was not to tax incomes which had no territorial nexus with India, but to tax income that had a nexus with India. This nexus was defined to mean assets deriving substantial value from India. ITP is required to be construed restrictively, and at best, covers situations where in substance, the assets in India are transacted by transacting in shares of overseas companies only. No tax if overseas entity does not derive substantial value from Indian assets ITP however, does not define the term substantial. The expression substantial would necessarily have to be read as synonymous to principally, mainly, or at least majority. ITP should not be invoked to tax income which arises from transfer of assets overseas, and which do not derive bulk of their value from assets in India. Reliance can be placed on the draft Direct Taxes Code Bill, 2010, recommendations of the Shome Committee set up by the Indian Government in 2012, Article 13 of the United Nations as well as OECD Model Conventions which suggest more than 50% as reasonable and contractual threshold. Accordingly, gains arising from sale of shares of a company incorporated overseas, which derives less than 50% of its value from assets situated in India would certainly not be taxable under ITP. MauCo1 and MauCo2 are not shell entities The contention of Tax Authority that the entire structure of investments to hold the companies in India had been evolved only with the object of avoiding tax, and the intermediary companies in Mauritius (MauCo1 and MauCo2) had been incorporated with a view to avoid tax in the event of a future sale is devoid of any merit. MauCo1 and MauCo2 cannot be stated to be shell companies so as to ignore their corporate identities. Both the entities are providing services in relation to financial and market research, and are generating revenues from intragroup services. The fact that a company renders services to its related enterprise would not reduce the company to be nonexistent or give reasons for lifting its corporate veil. On the issue of treating MauCo1 and MauCo2 as residents of UK, and not Mauritius, by virtue of the role played by RK, unless it is proved by the Tax Authority that the effective management of both, MauCo1 and MauCo2 was not where the Board of Directors were situated, i.e., Mauritius, but in UK, the residential status of the companies cannot be shifted. Undoubtedly, RK had a vital role to play in the affairs, and cannot be stated to be playing a role of a mere agent employed for concluding the transactions as contemplated under various agreements (SPA-I, SPA-II and SPA-III). However, in the absence of any substantial evidence placed by the Tax Authority, the corporate structure of MauCo1 and MauCo2 cannot be ignored, and the residence of RK, i.e., UK, cannot be considered as the situs of MauCo1 and MauCo2.
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