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India: Demystification of scope for claiming tax treaty benefits – welcome stride for foreign investors

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The Bombay High Court (the High Court) has delivered a landmark precedent while disposing the writ petition filed by a Mauritian company (the petitioner).

The Bombay High Court (the High Court) has delivered a landmark precedent while disposing the writ petition filed by a Mauritian company (the petitioner). The issue involved the granting of a capital gains tax exemption for the purpose of obtaining a nil withholding tax (WHT) certificate where benefits as per the India-Mauritius double taxation avoidance agreement (the tax treaty) were at play.

About nil/lower WHT certificates

The Income-tax Act, 1961 (the Act) casts the WHT obligation on the payer responsible for paying any sum to a non-resident which is chargeable to tax under the Act. Consequently, no obligation is cast on the payer where the income arising to a non-resident is not chargeable to tax under the Act or applicable tax treaty. If such a payer fails to withhold the tax, then the payer is deemed to be an assessee in default and penal consequences would follow.

Subject to fulfillment of specified conditions, section 197 of the Act recognises the facility and procedure to issue a lower or nil WHT certificate. Where a 197 certificate is issued, the payer shall be undertaking lower/nil WHT as per the rates specified in the certificate.

A certificate under section 197 of the Act helps the payer to arrive at the WHT rates so as to imbibe immunity for non-compliance and avoid any risk of being declared as an assessee in default. Thus, the section strikes a delicate balance between the WHT liabilities of a payer, release of requisite cash flow to the payee and discharge of tax dues at the earliest opportunity.

Transaction before the High Court

The petitioner is a Mauritian company incorporated to undertake business of investment holdings. It was set up by many well-recognised and well-established foreign institutional investors to explore opportunities of investment in India. The Board of the petitioner consists of nominees from each of the institutional investors. The petitioner held a valid tax residency certificate (TRC) and other prescribed documents essential for obtaining benefits under the tax treaty.

The petitioner is a promoter and equity stakeholder of a non-banking financial company ('I Co'). These investments were made over a period of four years, all before April 1 2017. During the initial public offering of shares of the I Co, the petitioner had sold a portion of its investments under offer. The petitioner had, on the resultant capital gain, moved an application under section 197 of the Act (the application) to the assessing officer requesting a nil WHT certificate, claiming exemption from capital gains tax in India under the Article 13(4) of the tax treaty.

The assessing officer rejected the petitioner's claim, stating that the entire holding structure was not genuine and had been created to avoid taxes in India. The officer denied benefits under the tax treaty to the petitioner.

A WHT certificate was issued under section 197 of the Act with an effective rate of 10% (plus applicable surcharges and cess) on the capital gain computed in accordance with section 112 of the Act.

The assessing officer had in his order (the 197 order) for rejection of the application specified that Nil WHT could not be adopted as the petitioner was not engaged in any other business, nor had any place of establishment or any employees. Further, he also held that the TRCs of stakeholders of the petitioner or details of the ultimate beneficiary were not submitted by the petitioner.

Aggrieved by the assessing officer's 197 order, the petitioner filed a writ before the High Court.

Decision of the High Court

The petitioner and the income tax department of the Central Board of Direct Taxation (CBDT) advanced their argument on the matter. Having heard both sides, the High Court specifically ruled on the prima facie ground being the correctness of the 197 order passed. The High Court order also touched upon various other aspects including preliminary views on taxability of the capital receipts in hands of the petitioner. The High Court has, in its ruling, observed that the petitioner's application was valid and that the petitioner was entitled to claim tax treaty benefits.

Based on the detailed evaluation, the plea was accepted and the writ was disposed of holding conclusive actions as follows:

  • Quashing of the 197 order;

  • Issue of a fresh Nil WHT certificate; and

  • Directing issue of refund of WHT already deposited along with applicable interest.

The High Court also instructed the petitioner to maintain a certain portion of holding of its equity interest in I Co until the completion of assessment.

While delivering the order, the High Court observed the following:

  • That, prima facie, if TRC is available, the capital gains arising out of sale of shares shall not be taxable under the tax treaty. It placed reliance on various ruling and CBDT Circular while observing the same;

  • That despite existence of the tax treaty, in case of fraudulent and fictitious/sham transactions, the revenue authority might still have a case to tax such capital gains. However, in the present case the allegation of the assessing officer of the transaction to be a sham was not backed by sufficient reason and material on record to demonstrate the same; and

  • That the observations made by the assessing officer in the 197 order while rejecting the applications are only indicative but not sufficient. Further, such aspects need to be taken into consideration at the time of assessment proceedings.

Concluding remarks

In the times where such capital gains transactions are under intense scrutiny and the tax department explores every opportunity to deny tax treaty benefits, the High Court order is a welcome and balanced move. The High Court has affirmed that at 197 stage, tax treaty benefits cannot be denied once there is a valid TRC in place and transaction is genuine. In tandem, the High Court Order does not, in any way, extend the ability of the assessing officer to deny tax treaty benefits in case of sham/fraudulent/bogus transaction.

It is noteworthy that the conditions for maintaining security (as discussed above) by the petitioner appears to be only for safeguarding the interest of revenue since it involved the 'refund of taxes' to a non-resident. There are no such conditions/restrictions attached for the purposes of issuing a nil/lower 197 certificate. Further, there are no provisions under the Act governing this. Section 197 of the Act does not envisage any form of security being provided as a pre-condition for issuance of 197 certificate.

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