Delhi High Court recently held that the amendments to the Income-tax Act to bring ‘indirect transfer’ of Indian assets under the tax net was not applicable to the transaction of Copal’s sale of Indian assets to Moody’s.

The Court also confirmed the decision of the Authority for Advance Ruling which had ruled  that Mauritius Tax Treaty benefit was available to the transaction.

The Transaction

The key shareholders of the Copal group had transferred their entire 67% (approx) stake in the group holding  company Copal Jersey to Moody’s. Financial Institutions held the remaining 33% (approx).

A day before the transfer of 67% stake in Copal Jersey, the Maurutius-based subsidiary of the Copal group, Copal Research Limited, transferred its entire direct and indirect holdings in two Indian companies of the group to Moody’s.

Separate consideration was paid for both the above set of transfers.

The transaction resulted in Moody’s acquiring 100% control of the Indian companies (on account of transfers effected by Mauritius companies) and 67% control of rest of the Copal group (on account of acquisition of 67% stake in Copal Jerrsey).

Revenue’s Challenge to the Transaction Structure 

The Revenue alleged that separating the Transaction relating to transfer of Indian companies was a device to evade taxes in India (through the use/abuse of Mauritius Treaty) and the real transaction was the entire transfer of the Copal group to Moody’s at the level of the holding company – Copal Jersey. On this basis, it was contended that embedded in the transaction relating to transfer of Copal Jersey, there was an indirect transfer of Indian companies which was taxable in India, on account of the  recently enacted provisions relating to taxation of indirect transfer of assets in India.

In defense to Revenue’s allegation, it was argued that there was commercial substance behind separate transfers for Indian companies, since Moody’s wanted 100% control of Indian companies, which could not be achieved if the entire transaction was carried out at the group holding company level.

The Court accepted the defense and ruled against Revenue’s challenge to the Transaction as a scheme for tax evasion.

Applicability of  provisions relating to  ‘indirect transfers’  

Despite upholding the substance of the Transaction, the Court also went on to consider the Revenue’s argument relating to applicability of ‘indirect transfers’ provision to the Transaction. It was held that even if the Revenue’s stand was accepted and the transfer of Indian companies was considered to be a part of the global transfer of Copal group, the transaction would still not be taxable in India under the recently enacted provisions relating to ‘indirect transfers’.

The Court noted that under the aforesaid provisions relating to ‘indirect transfers’, the transaction could be taxed in India only if the value of the transaction is derived “substantially  from assets located in India”. Referring to the recommendations of the expert panel constituted to examine the issue relating to indirect transfers, proposals under the Direct Tax Code and UN Model convention, the Court opined that the term “substantially” should be construed as more than 50% of the value of the Transaction.

Since the value of the Indian transfer was significantly less than the overall consideration for transfer of Global assets of the Copal group, the Court held that even under the amended provisions of law, the transaction cannot be taxed in India.

Mauritius Tax Treaty benefits

The Revenue also launched an improvised attack on Mauritius structure, bringing to question the real residency status of the Mauritius based company. It was alleged that the Board of Directors was merely a rubber stamp and the real control of the company vested with Mr.Rishi Khosla, a key promoter of the group who the Revenue alleged had sweeping powers to conclude the transactions relating to the sale of the group companies and had infact acted beyond the mandate of the Board resolution granting him the power to act on behalf of the company. On this basis, it was contended that the Mauritius company did not satisfy the test of residency as it was effectively managed from UK, where Mr.Khosla resided.

The Court, while accepting that Mr.Khosla did not act merely as an agent of the company  nevertheless upheld the decision of AAR that the presumption that the mangement of the company was vested with the Board was not rebutted conclusively by the Revenue . It was also noted that the company was not a shell company and had earned revenues from services activity, although to other group companies.

Our Comments

The ruling once again highlights the need for having sufficient commercial substance to defend increased scrutiny that one may expect in conducting layered transactions and invoking Tax Treaty benefits.

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.