The India–Mauritius grandfathering clause: is converted equity eligible?

Mauritius and Singapore have historically been attractive routes for investments into India owing to favourable capital gains tax treatment under tax treaties. Prior to April 2017, the India–Mauritius tax treaty (the Treaty) provided that capital gains income earned by residents of Mauritius from the alienation of shares shall be exigible to tax solely in Mauritius. With effect from April 2017, the Treaty was amended to provide a right to tax such gains to the source country (i.e., India). However, for providing relief to genuine investments made in the past, the Treaty, inter alia, set forth that the amendment shall not be applicable to shares that were acquired before April 1 2017. This is colloquially referred to as the ‘grandfathering benefit’.

With the above amendment, taxpayers were left in doubt as to whether the grandfathering benefit can be availed in cases where convertible instruments were acquired prior to April 1 2017 but are converted into equity shares post April 1 2017. The Delhi Bench of the Income Tax Appellate Tribunal (the Tribunal) dealt with a similar situation in the case of Sarva Capital LLC in 2022, where cumulative convertible preference shares (CCPS) were acquired by a Mauritius-based investor prior to April 1 2017, but the shares were converted into equity shares and sold post April 1 2017.

The moot question that arose was whether the grandfathering benefit under the Treaty can be claimed in respect of the equity shares. To answer this question, the Tribunal had to decide whether the date of acquisition of the equity shares was the date of the conversion of the CCPS into equity shares or the date when the CCPS were originally issued.

The Tribunal held that the date of acquisition of equity shares shall be the date on which CCPS were initially ‘acquired’. The Tribunal held so after noting that there is no substantial change in the rights of the investor upon the conversion of CCPS into equity shares, except that holders of CCPS have a preferential right for receiving a fixed dividend/repayment of capital over holders of equity. Furthermore, the Tribunal observed that the grandfathering benefit in the Treaty is applicable to “shares”, which includes equity and preference shares (Article 13(4) of the Treaty). While the Tribunal gave a categorical finding, it did not go into the depths of the issue.

It is worth noting that the Treaty defines the ‘alienation of shares’ to mean the sale, exchange, transfer, or relinquishment of a property or the extinguishment of any rights therein, or the compulsory acquisition thereof under any law in force in the respective contracting states. The Indian income tax law (the IT Act) provides a similar definition for a ‘transfer’, which is the foundation for taxing capital gains income.

On the conversion of CCPS to equity, there is a relinquishment of rights that preference shareholders are entitled to with respect to a fixed dividend or preferential repayment of capital. Furthermore, the conversion of CCPS to equity shares also qualifies as an exchange. Thus, the conversion of CCPS to equity qualifies as a transfer under the IT Act and as an alienation under the Treaty.

However, such a transfer enjoys an exemption from capital gains tax under the IT Act (Section 47(xb) of the IT Act). Besides this, taxpayers are given the benefit of setting off the acquisition cost of a convertible instrument (Section 49(2AE) of the IT Act) and including the period (Section 2(42A)(hf) of the IT Act) for which such instruments were held while calculating capital gains income on the transfer/alienation of converted equity shares.

In other words, the cost and date of acquisition of converted equity relates back to the cost and date of acquisition of the convertible instrument under the IT Act. Can this benefit offered under the IT Act for the computation of capital gains be extended to provide a substantial grandfathering benefit under the Treaty is a question worth exploring.

As mentioned earlier, the key reasoning provided by the Tribunal is that there is no substantial change in the rights of CCPS vis-à-vis equity shares. There is a need to critically examine the terms and conditions of the instruments in each case to decide whether this ruling is capable of being applied to the conversion of all categories of preference shares.

Recently, the IT Act has set forth valuation methods for calculating the fair market value (FMV) of compulsory convertible preference shares. The taxpayers are given an option to value the FMV of compulsory convertible preference shares as per the prescribed methodology or take the FMV of equity shares as the FMV of compulsory convertible preference shares. This move also strengthens the conclusion reached by the Tribunal that convertible preference shares and equity shares can be treated on an equal pedestal and, hence, the cost of acquisition and the date of acquisition of equity shares can relate back to the cost of acquisition and the date of acquisition of the compulsorily convertible preference shares.

Though the ruling given by the Tribunal in the case of Sarva Capital is a shot in the arm for investors, the issue of the applicability of a grandfathering clause to converted instruments under the Treaty requires an in-depth analysis on a case-by-case basis.

A similar question came up for consideration for implementing general anti-avoidance rule (GAAR) provisions that also became effective from April 1 2017. The Central Board of Direct Taxes (CBDT) had earlier clarified that the grandfathering benefit under the GAAR will be applicable to compulsorily convertible debentures and compulsory convertible preference shares that were acquired before April 1 2017 and are converted into shares after April 1 2017, provided the conversion happens on the terms that were pre-decided at the time of issuance of the debentures/preference shares. Even the facts before the Tribunal involved the conversion into equity shares at the terms that were decided at the time of issuance of CCPS.

It will be interesting to see how this issue will be dealt with by higher courts, especially when a similar grandfathering benefit from the applicability of statutory GAAR provisions was extended by the CBDT. The ruling comes at an interesting time, when the Indian tax authorities are closely scrutinising the grandfathering benefit claimed by many investors located in Mauritius and Singapore.