Author: Kulin Dave, Associate at King, Stubb & Kasiva.
Recently, in Indostar Capital v. ACIT[1], the High Court of Bombay set aside an order passed by the Indian tax authorities under section 197 of the Income Tax Act, 1961 (“ITA”), which denied benefits under the India – Mauritius Double Taxation Avoidance Agreement (“Mauritius Treaty”) to a Mauritius company which was selling shares of an Indian company under an IPO, on the grounds that the concerned transaction was a sham and colourable device to avoid tax. In doing so, the Court established that for the purpose of issuing a nil or lower withholding tax certificate (under section 197 of the ITA) (“197 Certificate”), the tax authorities are not required to conduct a detailed enquiry. And, if there was no prima facie evidence demonstrating that the transaction was a sham from its very inception, the tax authorities could not reject the application.
Background
Indostar Capital (“the Taxpayer”) is a private limited company incorporated in Mauritius. The Taxpayer held a Category 1 Global Business License and a Tax Residency Certificate (“TRC”) issued by the Mauritian authorities. It was incorporated as an investment holding company to promote an Indian company named Indostar Capital Finance Limited (“IFCL”) and had raised capital from various investors across the globe between 2011 and 2015 to acquire approx. 97.3% of the total share capital of ICFL. In 2018, the Taxpayer proposed to dispose of approx. 1.85 crores of the IFCL shares for a total consideration of INR 1058.68 crores through an IPO.
Under section 195 of the ITA, tax is required to be withheld at source on payments made to a non-resident (such as the Taxpayer) if they are chargeable to tax in India, and section 197 of the ITA permits an AO to issue a certificate allowing for non-deduction of such tax or deduction at lower rates in appropriate cases.
Thus, the Taxpayer made an application to its jurisdictional Assessing Officer (“AO”) in India for a 197 Certificate on the basis that no tax would be payable in India on the gains derived by it from the sale of IFCL shares due to applicability of Article 13 of the Mauritius Treaty, and in the absence of any income chargeable to tax, there could be no withholding tax.
The AO rejected the application of the taxpayer for nil withholding and instead passed an order requiring the taxpayer to deduct tax at 7.73% on the entire amount, on the ground that the entire transaction was not genuine and was a colourable device created to avoid tax liability, thereby denying Mauritius Treaty benefits. The AO based his reasoning on the fact that the Taxpayer had not carried out any other business transactions or commercial activities in Mauritius, not maintained an establishment nor had incurred administrative expenses in Mauritius, and had failed to produce TRCs of its ultimate beneficiaries.
Aggrieved by the order of the AO, the Taxpayer filed a writ petition in the Bombay High Court. The High Court accepted the Taxpayer’s contentions, quashed the order and directed the tax authorities to release the withheld payment to the Taxpayer subject to certain conditions.
The decision of Bombay High Court
At the outset, the High Court settled that the proceedings under section 197 of the ITA could not conclusively decide the taxability of the receipts in the hands of the payee. Despite issuing a nil withholding certificate, the tax authorities could nonetheless tax the income in the regular assessment proceedings. Conversely, if a 197 Certificate was not granted the taxpayer could still contest the taxability of the income in the normal assessment.
Therefore, the court accepted the Taxpayer’s contention that at the stage of deciding whether a 197 Certificate should be issued, a detailed inquiry is not required and if the Taxpayer prima facie proved its case, the tax authorities could not deny the 197 Certificate.
Thereafter, the High Court confirmed that it would prima facie appear that gains arising to the taxpayer on sale of IFCL shares were not taxable in India. The court reached this conclusion on a reading of Article 13, paragraph 4 of the treaty which states that gains arising to a Mauritius resident from the sale of shares of an Indian company acquired on or before 31.03.2017 would only be taxable in Mauritius and not in India under the Mauritius Treaty. It followed Circular 789 of 2000 (the “Circular”) issued by the Central Board of Direct Taxes, to state that the TRC would be sufficient proof of residency in Mauritius as well as for beneficial ownership of shares for obtaining treaty benefits. This position is indisputably settled by the Supreme Court in Union of India v. Azadi Bachao Andolan[2] (“Azadi Bachao Andolan”).
On the question of the genuineness of the transaction, the Court stated that the AO could reject the application under section 197 only if he could prima facie demonstrate that the entire transaction right from its inception was a sham and a colourable device created simply to avoid tax. For this, it relied on the decision of the Supreme Court in Vodafone International Holdings B.V. v. Union of India (“Vodafone”). This case has settled that tax authorities cannot go behind a genuine transaction to bring out a supposed underlying substance of tax avoidance. However, this did not override the power of the tax authorities to question and discard the transaction if it was fraudulent or fictitious.
However, the Court observed that merely because the Taxpayer had not transacted any other business, had no administrative expenditure or employment structure, it would not be sufficient by itself to create a prima facie case of a fraudulent transaction. Although such factors may be used to establish that the transaction was a sham in the assessment proceedings. Thus, the Court quashed the order and directed the withheld tax to be returned. However, the Court recognized the difficulty to recover tax from non-residents if it was determined payable in the normal assessment and thus ruled that the withheld amount should not be released without adequate protection of recovery. To this end, the Court directed the taxpayer to maintain shareholding in the Indian company equivalent to 200% of the disputed tax amount as security against potential future tax liability until 31.12.2021 (i.e., until the extended date for completion of assessment proceedings for the relevant tax year); and immediately inform the tax authorities if the value of the maintained shareholding dropped below 125% of the disputed tax amount, and provide additional security to the extent of shortfall below 200% to the satisfaction of the tax authorities.
[1] Writ Petition. 3296 OF 2018, Bombay High Court.
[2] [2003] 263 IT 707 (SC).