The AAR ruled that such gains will be liable to tax only in Mauritius under the treaty between the two countries.
The decision confirms the position that a certificate of residence issued by the Mauritius tax authorities will constitute sufficient evidence for accepting the status of residence.
This news comes after the AAR in January ruled that a foreign company is entitled to a capital gains tax exemption when it transfers the shares held in its Indian subsidiary under the Netherlands-US tax treaty.
The case was brought before the AAR by E*Trade Mauritius, a financial company, which held 43.85% of the equity share capital of a listed Indian company. The applicant subsequently sold its entire holdings to HSBC Violet Investments under a private agreement.
After the sale, the applicant made an application under section 197 of the 1961 Income Tax Act for a zero withholding certificate for the sale of shares. However, this was rejected and it was held that the capital gains were liable to tax in India at the rate of 21% because the applicant was only a shell company and the real owner of the shares was its parent, E*Trade US.
Against this background, the applicant applied to the AAR seeking a ruling on whether the capital gains arising from transfer of shares would be liable to tax. E*Trade Mauritius argued that a 2003 Supreme Court ruling involving Azadi Bachao Andolan, an individual taxpayer, had analysed all relevant issues relating to the applicability of claiming the tax benefit under the provisions of the treaty.
In that case, the court held that treaty shopping should be understood in the scope of the global economy and accepted the legality of such a concept, as long as a treaty did not impose limitations on its use.
"This ruling should bring relief to the companies with Mauritius holding structures," said Mukesh Butani, tax partner at BMR Advisors – Taxand. "Despite a comprehensive ruling by the Supreme Court, the revenue continues to be aggressive in its approach on denying the tax treaty benefit for capital gains arising from sale of shares by a Mauritius company."
The tax authorities contended that beneficial ownership lies with E*Trade US while the legal ownership was with E*Trade Mauritius and hence, capital gain from the transaction would arise for E*Trade US and, as a result, the India-US treaty should be applied. They also argued that the transaction should be regarded as a sham because the funds for investments in shares were remitted as a reimbursement of excess funds.
The AAR disagreed with the tax authorities contentions by stating that a transaction entered into by an entity to take advantage of the tax relief which is available in the treaty between the entity and the company cannot be declared invalid.
"The AAR observed that since the subsidiary has its own corporate personality and is a separate legal entity, the fact that the holding company exercises acts of control over its subsidiary does not dilute the separate legal identity of the subsidiary," said Rahul Mitra, a transfer pricing partner at PricewaterhouseCoopers.
"The AAR has acknowledged the tolerance of treaty shopping based on political and economic considerations," said Naveen Aggarwal, a tax partner at KPMG.
This decision has raised questions about the lack of specific anti-avoidance provisions in India and the growing trend for transaction analysis from the tax authorities.
"The economic crisis prevalent globally has become an effective tool in the hands of tax authorities around the world to lift the veil of the legal form of a transaction and to analyse in depth the economic substance of the transaction in order to protect the fair share of taxes of the source countries," said Vispi Patel of Vispi Patel Chartered Accountants.
It should be noted that AAR rulings are only applicable to taxpayers who seek clarification on tax matters relating to a transaction. However, the decisions articulated by the AAR have persuasive value and can be applied in other tax cases.
"While the ruling of the AAR is binding only for the applicant, it would encourage several other companies to apply to the AAR to secure a ruling in their cases as well," said Butani.
The AAR panel consists of a chairman, who is a retired judge of the Supreme Court, and two members of the rank of additional secretary to the Indian government, one each from the tax authority and the legal system.
