Delhi HC joins dots on indirect transfer debate

The verdict serves as reference for invoking treaty abuse provisions in the absence of General Anti-Avoidance Rules

In a ruling demonstrating wise judicial discipline, the Delhi High Court (HC) recently upheld non-taxability of sale of shares in an offshore company reasoning out that shares of target company didn't derive substantial value from assets located in India.

The HC dismissing Revenue's writs against rulings of the Authority for Advance Rulings (AAR), has upheld that share sale transaction between Copal Group shareholders (sellers) and Moody Analytics US, (buyer) were not designed to avoid tax.

A pleasing outcome of the ruling is the 'obiter' on 'substantial value' test as the court held that sale of shares of overseas holding company couldn't be brought to tax in India, since shares derived less than 50 per cent of their value from assets located in India (i.e. shares of Copal India).

The HC verdict also underscored the important principle of 'commercial rationale' underlying a transaction while approving capital gains exemption for transfer or entities under the tax treaty. This will serve as reference, going forward for invoking treaty abuse provisions, in the absence of General Anti-Avoidance Rules.

The ruling entails the first-ever judicial analysis of 'substantial value' test in the domestic jurisprudence and assumes significance in the wake of the ongoing debate on Vodafone-controversy emerging from a favourable ruling of the apex court which led to the retrospective law change in 2012. Following amendments in Finance Act 2012, to section 9 of the Income Tax law, the tax administration has upped its ante on Vodafone-like transactions, often disregarding the most important trigger for taxability of such transaction, i.e. 'substantial' value test enshrined in Explanation 5 to section 9, ostensibly in the absence of definitive administrative guidance to enforce the draconian 2012 law.

The ratio of Copal ruling should please investors, as the HC didn't hesitate from taking a bold view on definitional aspect of the statute, particularly when the lawmakers did not explicitly ascribe meaning to the term 'substantial' in the context of indirect transfer tax.

In doing so, the court has placed definitive reliance on the Direct Taxes Code (DTC) Bill, albeit of 2010 version, and recommendations of the Expert Committee Chaired by Dr Shome, both of whom had unequivocally advocated a 50 per cent asset value threshold. Supplementary interpretational aids drawn upon by the HC from international commentaries on tax treaties (under OECD and UN Model) is encouraging, as it reinforces the judiciary's confidence in bilateral conventions, particularly in the matter of administering sophisticated portions of tax statutes dealing with cross- border matters.

What pleasantly surprises me is the short shrift accorded by the HC to the revised DTC Bill (of 2013) which prescribes a lower 20 per cent threshold for applying the 'substantial value' trigger. Now, an important question before the lawmakers is whether the court's verdict (albeit an obiter), could assail against the lower threshold and prevail whilst the newly appointed special committee of the Central Board of Direct Taxes (CBDT) commences review of cases on taxability of indirect transfers, a step taken by the new government in 2014 budget to address the woes of foreign investors.

Legal effect of 'obiter'
It is trite that a court judgment is a decision on the facts of the case, and would bind the parties on the principle of res judicata; however, insofar as the binding nature of any such verdict is concerned, what should bind the administration and subordinate courts is the ratio decidendi, ie the underlying legal principle pronounced by the court, and not the decision per se. Ordinarily, whilst there are certain judicial principles to suggest that an obiter dicta of the apex court ought to be binding on lower authorities /courts (though there are contrary rulings too), the same legal effect or precedence value may not be accorded to HC's obiter. This however, does not preclude the administration from relying on the HC's observations.

Taxability of indirect transfer hangs in balance
The hierarchy of courts' judicial action and binding effect thereof could be a legal debate, what however intrigues me is the conundrum taxpayers will have to deal with for doing business in India in general, and for India to take the indirect transfer debate to its logical conclusion.

For one, the Revenue's Special Leave Petition before the Supreme Court in Sanofi case is an outcome keenly anticipated by investors; on the other hand, multiple writs under Article 226 Bombay and Calcutta HC will only keep the investors conjecturing the constitutionality of retrospective amendments as much as the final contours of administrative guidance for interpreting the 'substantial value' test. Besides, the incumbent government's abstinence in not withdrawing retrospective amendments and a move to address via administrative committee under the tax administration complicates matters for investors.

Since the FM in his 2014 Budget speech announced that he would instead await the judicial view on this debate, I wonder if this is his opportunity to pick cues from the logic espoused by the HC's obiter on substantial value test, and carry out appropriate legislative amendment.

It would be certainly regressive for the administration to consider filing an appeal against the HC verdict on the pretext of the lower threshold test proposed by the DTC Bill of 2013. This is certainly an opportunity to join the dots and put a full stop to a debate which has attracted negative press for India in the past few years.
(Assisted by Sumit Singhania)
The Author is Partner, BMR Legal. (Views are personal)