Taxing capital gains from share transfer
17 June 2016
On 10 May 2016, India signed a Protocol with Mauritius to amend the Indo-Mauritius Double Tax Avoidance Convention (DTAC). Among the various amendments agreed under the Protocol, the most significant amendment is to Article 13 of the DTAC which governs taxation of capital gains.
The DTAC is one of the most contentious Double Taxation Avoidance Agreements signed by India. The main reason being the abuse of Article 13 of the DTAC which exempts a Mauritian resident from tax on capital gains earned from sale of shares held by it in an Indian entity. As the said exemption could only be availed by a Mauritian tax resident, the issue as to what constitutes sufficient proof of tax residence has been litigated in catena of cases. To put this issue to rest, the Central Board of Direct Taxes (CBDT) had issued Circular No. 789 dated 13 April 2000 (Circular 789) stating that the ‘Certificate of Residence’ issued by Mauritian authorities will constitute sufficient evidence for accepting the status of residence and for availing treaty benefits. This exemption is a classic example of double non-taxation as there is no concept of taxing capital gains in Mauritius. Thus, in order to address this situation, India has signed a Protocol with Mauritius on 10 May 2016 (Protocol) to, inter-alia, amend Article 13 of the DTAC and insert a limitation of benefits (LOB) clause, i.e. Article 27A, in the DTAC.
Taxation of capital gains on shares
The Protocol amends Article 13 of the DTAC and provides that from 1 April 2017, a Contracting State 1 has the right to levy tax on capital gains accruing to a resident of the other Contracting State from alienation of shares acquired on or after 1 April 2017 in a company, which is resident of the Contracting State levying such tax. In consonance with Government of India’s promise to grant stability in tax matters, the said amendment has been made effective from 1 April 2017 and a grandfathering provision has been introduced to exclude shares acquired before 1 April 2017. It has been further agreed that during the transition period from 1 April 2017 to 31 March 2019, capital gains will be taxable at a beneficial rate of 50% of the tax rate applicable on such gains in the Contracting State where the company, whose shares are being alienated, is situated provided that conditions of the LOB clause are satisfied.
Insertion of Limitation of Benefits clause
The newly inserted Article 27A of the DTAC, being the LOB clause, stipulates that benefit of the beneficial rate will not be available to a shell/ conduit company 2. Article 27A(3) of the DTAC creates a deeming fiction that a company whose expenditure on operations in the Contracting State, in which it is resident, is less than Mauritian Rupees 1,500,000 or INR 2,700,000, as applicable, in the immediately preceding 12 months from the date of the gain arising, will be deemed to be a shell/ conduit company.
Article 27A(4) of the DTAC states that a company will be deemed not to be a shell/conduit company if it is listed on a recognized stock exchange of the Contracting State in which it is a resident.
SC ruling in Azadi Bachao.
Let us now understand the significance of these amendments in context of Supreme Court’s (SC) ruling in Union of India and Anr. vs. Azadi Bachao Andolan and Anr.3 (Azadi Bachao).
In Azadi Bachao, validity of Circular 789 was challenged on the ground of the same being ultra vires of Section 90 of the Income Tax Act, 1961 (IT Act) (Power of central government to enter into agreement with foreign countries or specified territories) and Section 119 of the IT Act (CBDT’s powers to issue instructions to subordinate authorities). The SC upheld the validity of Circular 789 and ruled that it did not amount to impermissible delegation of legislative powers.
The SC, while holding that the residency certificate issued by Mauritian authorities was to be taken as a conclusive proof of residency for applying the DTAC, also made inter-alia the following observations: (i) the DTAC was not ultra vires of Section 90 of the IT Act merely on account of its susceptibility to ‘treaty shopping’ by residents of ‘third countries’; (ii) though the words ‘sham’ and ‘device’ were loosely used in connection with incorporation under Mauritius laws, these words could not be used to nullify a legal situation; and (iii) permission to lift corporate veil could not be sought under the garb of ‘sham’ or ‘device’
The Protocol provides clarity and introduces new safeguards to counter treaty abuse. Introduction of the LOB clause in the DTAC imposes an additional condition to avail benefits of the DTAC and does not alter the stand taken by the SC in Azadi Bachao. Further, the introduction of the grandfathering provision has put in the necessary safeguards to ensure that the said amendments to DTAC do not result in outflow of investments made prior to 1 April 2017.