In a significant ruling, the Delhi Court upheld the bona fides of investment into a Realty SPV by a Mauritius based company through the route of Compulsorily Convertible Debentures with call/put options, thereby allowing Capital Gains tax relief to the investor under the India-Mauritius Treaty. Here’s a low-down on the ruling.
What was the Transaction?
The Taxpayer, a Mauritius based company (Zaheer Mauritius) had invested in a real estate JV along with an Indian promoter. The investments were made by subscribing to the Compulsorily Convertible Debentures (‘CCD’) issued by the JV company.
What was the Tax issue?
This time not with the Mauritius Treaty per se. The controversy was on the ‘true character’ of CCD instruments – more specifically, whether they were merely loans camouflaged as equity instruments.
What was the Taxpayer’s stand?
The taxpayer contended that the gains from sale of CCDs resulted in “capital gains” in its hands since CCD constituted a “capital asset”. Invoking the India-Mauritius Tax Treaty, the Taxpayer contended that such gains were not taxable in India
What was Revenue’s position?
The Revenue’s argument was that the gain from sale of CCDs should be taxed as ‘interest’ income since the Transaction was effectively in the nature of loan. Revenue alleged that the clauses relating to call/put option in the Shareholders agreement guaranteed a fixed return to the investor.
How did the matter reach the Delhi High Court?
The Taxpayer had approached the Authority for Advance Rulings (‘AAR’) for a ruling on the Taxability of the transaction. The AAR disregarded the arrangement between the parties by ‘lifting the corporate veil’, held the transaction by way of CCD as a sham transaction intended for tax avoidance and upheld the Revenue’s position on the taxability of gain from CCDs as ‘interest’.
Since there are no appeal provisions under the Indian Tax law against the order of AAR, the Tax payer filed a writ petition before the Delhi High Court, assailing the order of the AAR.
What did the Delhi High Court decide?
The Honourable High Court ruled in favor of the Taxpayer based on the following:
(a) The clauses relating to call/put options cannot be interpreted to mean that the Taxpayer was only entitled to a fixed return – the Taxpayer also stood to gain an equity value of the project.
(b)Upon a perusal of the terms of the share holder agreements, the Court ruled that the terms as negotiated between the parties evidenced that there was genuine commercial substance behind those agreements
(c) The Court also noted that CCD’s were permitted mode for investing in India under the Foreign Direct Investment policy
(d)Based on the above, and relying on the ‘look at’ principle as enunciated by the Apex Court, the Court upheld the validity of arrangements between the parties and struck down the ruling of the AAR.
Consequently, the Taxpayer’s stand met with Court’s approval.
Our Comments
The Ruling was not so much on the issue of the tax impacts arising to CCD instruments. As the Court itself observed, the tax position is very clear that the CCD were capital assets and therefore gains arising from sale of CCDs would clearly be taxable as Capital Gains.
The dispute in the instant case was really on the aspect of “Substance Vs. Form” in the context of use of CCD instruments, given that the terms of the agreement between the parties contained call/put options which, the Revenue alleged, provided for a Fixed rate of return.
The Court returned a favorable verdict upon being satisfied that the agreements between the parties had commercial substance and the FDI policy permitted investments by way of CCD.
However, a key contention of the Revenue – to the effect that call/put options guaranteed a fixed rate of return – seems to have been overcome by adverting to the terms which stated that the investor (Taxpayer) was not only entitled to a fixed return, but also an ‘equity value’ of the project. There does not seem to be any specific observation or finding on legality of the said option arrangement in light of the RBI Circular which was issued earlier this year. As per the aforesaid Circular [AP (DIR Series) Circular No.86 dated January 9, 2014] while clause relating to buyback by way of exercise of options has been permitted, there is a specific bar that the investor cannot be guaranteed any assured return. It appears that Revenue has not specifically brought the Circular to the notice of the Court and the Court has adverted only to the FDI policy document, while deciding the matter.