The proposed amendment to Section 9 is travel back in time machine, and travel wide to the world at large, and catch all transactions all over the world over last 50 years! Hats off to the imaginative and ambitious person who has drafted the clause!
The Finance Bill 2012-2013 has carried out several major amendments to the Income tax Act, 1961 to negate the effect of the court decisions and make transactions having effect in India taxable. Notably, the amendment (that is, insertion of proposed Section 9) dates back to 1st April 1962-the day the Income Tax Act came into force.
This article seeks to analyse and set out the interpretations and principles laid down by the Indian courts on what this substance would comprise and how the same may be established, vis-a-vis the retrospective amendments that the Finance Bill 2012-2013 brings.
Taxability of offshore entities in India-judicial overview
If an offshore entity having a transaction in relation to Indian assets fails the 'substance' test, it will be taxable in India. The important question is, what constitutes this 'substance' or when can it be said that the offshore entity is outside the domain of applicability of the Indian tax laws. The taxability of an offshore entity in India, inter alia, depends on the following key factors:
(a) Whether the entity is set up offshore merely to avail treat benefits?
(b) Whether the situs of a capital asset is in India;
(c) Whether the effective management of the offshore entity is being carried out of India; and
(d) Whether the offshore entity can be said to be non-resident of India for tax purposes.
The Indian courts have adjudicated on taxability of offshore entities on grounds of treaty shopping in a few cases, which may be referred to while determining the issue of taxability in India. Few of the importance cases are summarized as hereunder:
1. McDowell and Company vs Commercial Tax Officer
The five-judge bench laid down that tax planning may be legitimate provided it is within the framework of law. Colourable devices cannot be part of tax planning and it is wrong to encourage or entertain the belief that it is honourable to avoid the payment of tax by resorting to dubious methods. It can, therefore, be concluded that as long as tax planning is within the ambits of law, it is legitimate.
2. Union of India vs Azadi Bachao Andolan
The matter related to validity of investing through Mauritius and the question of 'residency' while determining taxability in India. The division bench of the apex court discussed and held several important aspects:
(a) For availing the treaty benefits under the India-Mauritius Double Taxation Avoidance Agreement, the Tax Residency Certificate (TRC) issued by the Mauritius Revenue Authority is sufficient proof to residency of the entity in Mauritius. It was further upheld that capital gains from sale of shares held in India by a Mauritius entity would be taxable in Mauritius where such Mauritius entity holds a TRC.
It may be noted that to obtain a TRC, the Mauritius entity needs to establish sufficient substance, viz. At least two directors shall be resident in Mauritius, the entity shall have board meetings and decisions making process taking place in Mauritius, a bank account in Mauritius shall be maintained and all monies shall be channelled through such account, all accounting records shall at all times be maintained at the registered office at Mauritius, etc.
(b) Analysing the McDowells decision, the division bench said that the decision may be interpreted to mean that a taxpayer shall have the liberty to choose the alternative which is more tax efficient and the act which is otherwise valid in law cannot be non-est merely on the basis of some underlying motive supposedly resulting in some economic detriment or prejudice to the national interests. The Court, therefore, declared the form over substance supremacy in case of tax planning.
The Vodafone thriller
The Bombay High Court holding the tax liability in India on the Vodafone transaction (sale of shares) between two non-resident entities, sent shivers of worry across the investors. Though the major aspect of the case was whether the corporate veil of the non-Indian entities can be lifted, mostly a question of form vs substance, the apex court also analysed and adjudicated upon the Mauritius route for investments into India. Not only did the Supreme Court hold transfer of shares between two non-Indian entities as not taxable in India (even though the underlying assets were located in India), the Supreme Court has, inter alia, also laid down several important principles that highlight the 'substance requirement' and taxability of offshore entities:
(a) Validity of tax planning:
(i) The cardinal principle is that if a document or transaction is genuine, the court cannot go behind it to some supposed underlying substance. The court stated the 'Look At' principle: it is the task of the court to ascertain the legal nature of the transaction and while doing so it has to look at the entire transaction as a whole and not to adopt a dissecting approach.
(ii) A transaction may fail if it is a 'fiscal nullity' which would arise where a transaction is devoid of any commercial substance.
(b) Lifting of corporate veil:
(i) A holding company and its subsidiaries are separate legal entities and, therefore, shall be resident of the country of incorporation, except where the business of the holding company is the business of the subsidiary (i.e. the subsidiary is an alter ego of the holding company). However, in a concurring judgement, justice KS Radhakrishnan was of the view that the identity of a subsidiary can be ignored where special circumstances exist indicating that it is a mere facade concealing true facts. Therefore, rejecting the alter ego stance, justice KS Radhakrishnan stated that the court will not permit a corporate entity to be used as a means to carry out fraud or evade tax, i.e. the business purpose test shall be satisfied.
(ii) India has a "judicial anti-avoidance rule" which allows the revenue authorities to invoke "substance over form" or "pierce the corporate veil" if it discharges its burden of establishing that the transaction in which the corporate entity is used is a "sham or tax avoidant". The lack of business purpose must not be a result of dissecting the legal form of a transaction. An investor shall be looked at in a holistic manner keeping in mind the following factors: (i) participation in investment, (ii) duration of existence of holding structure (prior to acquisition), (iii) period of business operations in India, (iv) generation of taxable revenues in India, (v) timing of exit and (vi) continuity of business on exit.
(c) Situs of capital asset in India:
(i) For taxation in case of transfer of capital asset in India, three elements shall exist: transfer, existence of a capital asset and situation in India. Section 9(1)(i) of the Income Tax Act, 1961 (I-T Act) does not cover indirect transfers.
(ii) Controlling interest is not a separate capital asset.
(iii) Section 9 of the I-T Act covers only income arising from a transfer of a capital asset situated in India and it does not purport to cover income arising from the indirect transfer of capital asset in India. This section does not have any "look through provision".
(d) Observation on the Mauritius route:
In the absence of a 'Limitation on Benefits' clause in the Indian-Mauritius DTAA, the court upheld the sufficiency of TRC in order to avail the benefits under the Mauritius Treaty. However, taking a step further from the Azadi Bachao case, the court also recognized the situations where the TRC can be ignored:
(i) Where there is no commercial substance and Mauritius entity has been made out to be the owner of the capital asset in India only to avoid taxation;
(ii) Where the treaty is used with a fraudulent purpose of evasion of tax;
(iii) Where round tripping can be established.
Retrospectivity of Section 9 of the I-T Act
The Finance Bill introduces retrospective amendments in Section 9 of the I-T Act. Section 9, it may be noted, deals with income accruing or arising in India. Indian taxation laws work on a residence cum territorial model of taxation whereby, in case of residents, global income is charged to tax, and in case of non-residents, income accruing or arising in India is taxable.
To put the proposed amendment of the I-T Act succinctly, it means to say that if a transfer of a share or other interest in a company or entity has taken place out of India, but the value of the share or unit depends primarily on assets in India, then income arising from sale of such share or unit shall be deemed to accrue or arise in India. Vodafone was using international holding companies for shifting the tax base out of India. There is no doubt that the assets with reference to which Vodafone acquired Indian telephony business were all Indian subscribers. But the transfer took place in shares of offshore holding companies. The proposed amendment would mean, Vodafone will be called upon to pay taxes to the tune of Rs12,000 crore. Of course, there will be a question of additional taxes, penalty and interest.
The proposed amendment will not be limited to Vodafone. Hundreds of holding company transfers that take place out of India will all be subjected to tax in India.
Taken to its extension, transfer of all depository receipts out of India pertain to assets in India-as the GDRs/ ADRs are nothing but proxies of shares. Hence, all such transfers also become taxable in India. However outrageous this may seem, all those non-residents who hold GDRs and ADRs in Indian companies may be slapped with tax liability in India. Those may be difficult to catch-as they are not subjected to the jurisdiction of the tax officers in India, but what about transfers of participatory notes, and other similar instruments issued by FIIs? They all derive their value from assets in India.
Summary and concluding remarks
In the author's view, it was quite logical for the tax authorities to write a substance-over-form rule-which is what courts in UK such as Indofood International Finance have done. The approach should have been to give recognition to the substance over form rule. However, what has been done in Section 9 is travel back in time machine, and travel wide to the world at large, and catch all transactions all over the world, that have bargained Indian assets over last 50 years ! Hats off to the imaginative and ambitious person who might have drafted the clause!
(The author can be contacted at [email protected])
Inside story of the National Stock Exchange’s amazing success, leading to hubris, regulatory capture and algo scam