While the Authority for Advance Rulings has ruled against this in the case of E*Trade, the Vodafone case will come up in a few weeks - with 40% of Indian FDI coming through Mauritius, the issue is critical.
Former Chairman, Central Board of Direct Taxes
The issue of whether taxation should be ‘source-based’ or ‘residence-based’ needs to be sorted out, given how cross-border transactions are rising
The best way to understand whether Indian tax authorities have the right to tax transactions taking place overseas is to take the example of a house that is located in India and is sold. If the house is sold at a profit in India, the owner will have to pay capital gains tax. Now, assume the house is owned by a company and shares of this company are sold in India — once again, there will be a capital gains tax. But if the company that owns the house is registered overseas (even though the underlying asset is located in India), not asking it to pay taxes is unfair, to both the Indian tax authorities as well as Indian firms/individuals who have to pay these taxes. This is the underlying principle behind cases like Vodafone — if the asset is in India, the Indian tax authorities must have the right to tax the asset. If it is possible to escape this taxation, it means there is a lacuna in the Income Tax Act which needs to be plugged.
Of course, where there is a Double Taxation Agreement (DTA) between countries, there is a separate set of rules that come in since the DTA overrides the domestic law. India had eight such DTAs, like the one with Mauritius, which allow companies not to pay the capital gains taxes, but five of these have been amended — the one with Mauritius allows firms not to pay the capital gains taxes (since Mauritius does not levy capital gains taxes). Whether India can amend this DTA is something the government has to take a call on since there are other factors at play as well, but it has to be mentioned that the Direct Tax Code (DTC, which has now got stuck) had envisaged a situation where the tax officer could, if s/he felt a firm was abusing a structure (such as registering the company in a tax haven for instance) to avoid paying taxes, recategorise the transaction in order to levy the tax. The DTC said it would override any DTA — of course, I’m sure the DTC would have been challenged in court on the grounds that it was a domestic legislation which was seeking to override a global commitment.
Of course, none of this applies to the Vodafone case since the sale/purchase took place in the Cayman Islands with which India does not have a DTA. Indeed, if the deal had taken place at the Mauritius level, it would have been difficult for the Indian tax authorities to get the tax since there are several judgments saying you can’t tax such transactions.
Some argue the Indian position on seeking to tax transactions where the underlying asset is in India but the firm is registered overseas will lead to all manner of problems in real life. The example that is given is of Vodafone getting sold off to a US firm in a transaction in the UK. Since some part of Vodafone’s assets are located in India, the argument goes: Does this mean the Indian tax authorities will want part of the capital gains? There is no question of the Indian tax authorities seeking a tax since there is a DTA between the UK and India — Vodafone has to pay capital gains in India or in the UK, it cannot escape paying this. Similarly, if Tata sells off Tata Motors, the UK government may want a part of the capital gains tax since Corus is located in the UK, but it will go by the DTA. But the issue of whether taxation should be “source-based” or “residence-based” needs to be sorted out as it is becoming more important with so much foreign direct investment (FDI) and capital flowing from one area to another.
That said, it is also true that there are other issues to be considered — of development and investment, for instance. The government, and not the taxman, has to take a call on these.
But just like we have non-level playing fields because of treaties like the one with Mauritius, we also have un-level taxation within the country — areas like Uttarakhand, for instance, have tax advantages. Also, while it is true India needs to lower its tax rates (the DTC proposes 25 per cent), let us not exaggerate the importance of this. Investors are coming to India because of its market, not because of its tax breaks — while 40 per cent of FDI comes through Mauritius, another 60 per cent comes from the tax-paying route.
The author is currently member, Competition Commission of India
(As told to Sunil Jain)
Joint Leader, Tax and Regulatory Practice, PricewaterhouseCoopers
Reinterpreting long-established tax treaty provisions by the tax authorities creates confusion and has to be avoided as it affects investment into India
Any company seeking to enter a country ensures that it chooses a structure that suits its commercial requirements, one that is legally-compliant as well as tax-efficient. In the past, a lot of investment has flowed into India through Mauritius, given the favourable tax treaty between the two countries.
Of late, however, some international takeovers have been questioned by the Indian tax authorities, which have asserted that these transactions are taxable in India. In the first category of transactions, shares of an Indian company are sold by a foreign entity, invoking the favourable tax treaty provisions (as in the case of E*Trade by applying the India-Mauritius tax treaty). The challenge arises when the tax authorities contend that though legal ownership resides with the foreign entity (in Mauritius, for example), the “real” and “beneficial” ownership lies in the jurisdiction from where the foreign company is controlled, and thus the benefits of the India-Mauritius tax treaty are denied.
The second category of transactions involves a scenario where one foreign entity transfers shares of another foreign entity, but with a portion of the transaction value derived from underlying assets in India, even though the transaction has taken place outside India, and the asset (in this case, shares of the foreign holding entity) is also situated outside India.
As regards the first scenario, i.e. the taxability of gains derived by a Mauritian entity, the law was settled in favour of the taxpayer by the apex court in the case of Azadi Bachao Andolan in 2003. The court upheld the validity of circulars issued by the Central Board of Direct Taxes (CBDT) which provided that a Mauritian entity holding a tax residency certificate issued by a Mauritian authority would constitute sufficient evidence for accepting the status of residence for the application of the tax treaty.
The apex court found no legal prohibition if a resident of a third country (the US, for example), in order to take advantage of the tax reliefs and other economic benefits arising from the operation of a tax treaty between the two countries (India and Mauritius, for example), sets up an investment entity in Mauritius to route its investment in India. The motive behind setting up such holding companies and doing business through them in a country having a beneficial tax treaty was held to be not relevant to judge the legality or validity of the transactions. At that time, even the government defended the India-Mauritius tax treaty.
The reinterpretation of the long-established tax treaty provisions by the tax authorities creates confusion and uncertainty, and so, it must be avoided.
Under the second category, the tax authorities assert their rights to tax transactions where the shares of a foreign company (i.e. a capital asset situated outside of India) have been transferred, but due to such transfer the underlying assets and the controlling interest of a company operating in India have also changed, though indirectly.
The Indian Income-Tax Act suggests that income in the hands of a non-resident is taxable in India if it arises from the transfer of a capital asset situated in India. In the recent transactions under examination by the tax authorities, the capital asset, i.e. the shares, was situated outside India. Accordingly, the gains from the transfer are not taxable in India under the long-established tax principles. Notwithstanding that this was the well-understood position before the transaction took place, this issue is presently under examination by the Indian tax authorities and the outcome is expected shortly.
From a business perspective, the above positions can expose many buyers and sellers of shares in global companies to significant tax liabilities that they have not accounted for, and could create further uncertainty for similar transactions going forward.
Any reinterpretation of the established taxation principles must be avoided. Furthermore, the government also has to think about the adverse impact that its policy may have over the investments made by Indian multinational companies outside India. Lastly, any change in the tax polices or tax treaties must be done prospectively. If the law is amended to this effect, careful consideration will have to be given to how the law should be framed and where the line should be drawn between taxable and non-taxable transactions.