2.1 The AO, based upon the Public Announce-ment [PA] made by HSBC Securities and Capital Markets (India) Private Limited [HSCI] and HSBC Violet alongwith persons acting in concert [PACs] [the Acquirers] under the provisions of the SEBI Takeover Code and the Share Purchase Agreement between Infrastructure Leasing & Financial Services Limited [IL&FS] and HSCI dated 16th May, 2008 [IL&FS Share Purchase Agreement] drew attention to the fact that one of the conditions precedent to the IL&FS Share Purchase Agreement was completion of the E*Trade Share Purchase Agreement between ETM & HSBC Violet dated 16th May, 2008.
The AO also drew attention to the statement in the PA under the Reasons for the Offer and Future Plans that pursuant to the substantial acquisition, the acquirers will be in control of the management of the target company. The acquirers propose to reconstitute the Board of Directors of the target company upon completion of the offer formalities.
It is worth noting that upon the acquisition of shares by the Acquirers from IL&FS and ETM under both the abovementioned agreements, the acquirers’ shareholding in IIL would amount to 73.21%, besides the acquisition of shares from other minority shareholders.
2.2 The AO rejected the contentions of the ETM based upon Article 13(4) of the DTAA and drew the following inferences and held as follows :
a. “It is inferred that the transaction is prima facie, liable to Income Tax in India. E*TRADE, by reason of this transaction has earned income liable for Capital Gains Tax in India as the income was earned towards sale consideration of transfer of its business/economic interests, in favour of the acquirers.”
b. “Like most other taxing jurisdictions, the Indian Income Tax Act follows the twin basis for taxation, (i) based on residence or domicile and (ii) based on source of income. While Indian residents are taxed on global income under Section 5(1), non residents are taxed only on the income, which has its source in India under Section 5(2). The non-residents should have either received or deemed to have received the income in India or the income should have arisen or accrued in India or should be deemed to have accrued or arisen in India. The deeming provision is enumerated in section 9 of the Income Tax Act. It is the submission of the Revenue that the income or capital gains of E*TRADE is deemed to have accrued or arisen in India and therefore, it squarely falls within the ambit of Section 9 and is hence chargeable to Income Tax.”
c. “The question that arises for considera-tion in the present case is
(i) what was the subject matter of the transaction;
(ii) whether the subject matter can be said to be a capital asset;
(iii) whether the transaction involved transfer of a capital asset situate in India.
(i) The subject matter of the present transaction between the acquirer and E*TRADE is nothing but transfer of interests, tangible and intangible, in Indian company in favour of the acquirer and not an innocuous acquisition of shares of some Mauritian Company.
ii) From the facts and material available as of now, it is demonstrable that a strong prima facie case is made out to show that the transaction entered into by the Acquirer amounts to transfer of capital asset situated in India. The above transfer is a transfer of a capital asset and not merely a transfer simpliciter of controlling interest ipso facto in a corporate entity. It is :
a) A transfer of a bundle of interests;
b) Substitution of the Acquirer as a successor in interest;
c) Transfer of Controlling Interest in an Indian Company; and
d) Transfer of Management Rights
iii) Mode of transfer of an asset is not determinative of the nature of the asset.
Shares in themselves may be an asset but in some case like the present one, shares may be merely a mode or a vehicle to transfer some other asset(s). In the instant case, the subject matter of transfer as contracted between the parties is not actually the shares of a Mauritian Company, but the assets situated in India. The choice of the acquirer in selecting a particular mode of transfer of these right enumerated above will not alter or determine the nature or character of the asset.
It is seen that E*TRADE Mauritius Limited, a limited company formed under the laws of Mauritius is a subsidiary of E*TRADE’ Financial Corporation, a company incorporated under the laws of the State of Delaware, USA. The very purpose of entering into agreements between the two foreigners is to acquire the controlling interest which one foreign company held in the Indian company, by other foreign company. This being the dominant purpose of the transaction, the transaction would certainly be subject to laws of India, including the Indian Income Tax Act.
d. Prima facie on the basis of details available on record and submissions of the applicant, it is seen that the Capital Gains have accrued in India. The transaction is not a transaction merely of shares but is a transaction which is not covered under article 13(4) of the India-Mauritius DTAA. Also it may be mentioned here that this application is an application for tax deduction at source and not an assessment proceeding.”
Thus, the AO ignored ETM’s submissions based on Article 13(4) of the DTAA and decided to tax the capital gains u/s. 9(1) of the Act.
2.3 Accordingly, the AO directed HSBC Violet to deduct tax at source @ 21.11% on gross payments to be made to ETM. This was the Order u/s. 197 which was subject matter of the writ petition before the Bombay high court.
3. Findings and observations of the DIT(IT) in his order u/s. 264
3.1 Pursuant to the order of the High Court on 26.9.2008, ETM filed a revision petition u/ s. 264 with the DIT(lT) on 3.10.2008, urging the DIT(IT) to quash / set aside the Order of the AO u/s. 197. The ETM submitted as follows:
a) The applicant is a company incorpo-rated in Mauritius and holds a Tax Residency Certificate issued by the competent authority of that country.
b) Consequent to that, Circular No 789 issued by the Board is applicable to the facts of the case, and
c) As a corollary to the above two facts, capital gains earned from the sale of shares of the Indian Company IlL, would not be taxable in India in view of Article 13(4) of the Indo-Mauritius Tax Treaty.
3.2 The DIT(IT), in his order u/s. 264 dated 1st January, 2009 essentially upheld the Order of the AO but on different grounds. However, the DIT(IT) directed the AO to substitute the quantum of the capital gains by the net amount of capital gains instead of gross sales consideration adopted by the AO in his order u/s. 197. He further upheld the rate of tax @ 21.11% as against tax rate of 10% sought by ETM as per proviso to section 112. The findings and observations of the DIT(IT) are summarised in the following paragraphs.
3.3 On the basis of the enquiries made and information gathered by the DIT(IT) from the public domain, mainly through Internet, the DIT (IT) noted and observed as under:
(i) The CAI was incorporated in November 2000 in the State of Nevada, USA. It holds various investments in equity shares and manages corporate cash and investments on behalf of ETFC.
ii) Dilemma of the Managerial Spectrum : The DIT noted the composition of Board of Directors of CAI (about Two Directors), ETFC (10 Directors), ETM (5 Directors) and IlL, before sale of shares by ETM (17 Directors).
iii) The DIT (IT) further noted that certain key personnel from ETFC, USA and group companies were deputed to the Indian Company IlL, including the MD & CEO of Indian Company, who prior to joining IlL was employed with ETFC USA as its Vie-President Finance-Capital Markets and who was also on ETM’s Board for some period. He noted that these key personnel were neither shareholders in ETM nor its employees nor its Directors except one person. The DIT(IT) concluded from these facts that ETFC, the ultimate parent company of ETM, was exercising the rights available to a Shareholder in appointment of Directors in the Indian Company and the management of the Indian company through deputation of its senior managerial personnel. It may be noted that ETM declined to furnish the aforesaid information on the ground that they were not concerned as the matter relates to ETFC whom it did not represent and the DIT(IT) obtained the information from the public domain through Internet and the Indian Company.
iv) Intricacies of the Financial Conundrums: The DIT(IT) noted, observed and concluded as follows:
a) ETM was incorporated in October, 2004. In November, 2004 it entered into Share Purchase Agreements (with 3 Companies) for purchase of share in IlL i.e. from a Mauritian Company, a Japanese Company and IL&FS, aggregating to 48.80 Lakhs shares.
b) IIL, the investee company, was a party to a Share Purchase Agreement under which it undertook to furnish an Annual Certificate to the US parent ETFC under the US tax laws in relation to its status as Passive Foreign Investment Company as per section 1297 of the US Internal Revenue Code.
c) Thereafter, between December 2005 to November 2006, ETM acquired GDRs issued by IlL and thus increased its holding in IlL to 37.67%, which exceeded the holding of the Indian Promoter namely IL&FS of 29.36%. ETM further acquired shares by an open offer increasing its shareholding in IlL to 43.85% at a Total Cost of Rs. 494.38 Crores.
d) The DIT(IT) noted from the Bank Statements of ETM that these funds were contributed either by CAlor ETFC. He further noted that in some cases dividends due to ETM were remitted to E*Trade Securities (HK) Ltd., as an associate company of ETFC.
e) He further analysed the Bank Statements of ETM for the year ended 31.12.2005, 31.12.2006 & 31.12.2007 and based on his analysis he concluded that not only the funds for investments have been completely sourced from the parent companies but even their allocation in the accounts of ETM are not clear and dividends received from IlL have been remitted as reimbursement of excess funds.
f) Accordingly, the DIT (IT) came to a conclusion, that “The Financial element was routed through the Mauritian entities whereas the management of those routed funds invested in the Indian Company was ensured by” deputation of senior key personnel from ETFC and group companies.
g) The DIT(IT) has extracted relevant information from Annual Report of IlL for FY 2004-05, Prospectus dated 13th July, 2005 issued by IlL and Public Announcement of offer to the equity shareholders of IlL by ETFC dated 7th October, 2006 to arrive at an inference that “This ingeniously planned affair appears to have been conceptualised by and between both the Groups i.e. IL&FS, the Indian Promoter Group and E Trade Group, USA in the year 2004 itself when E* Trade made its first investment in the Indian company. The Mauritius subsidiary was set up in October, 2004. Some of the disclosures made in the Annual Report of IlL for the Year 2004-05, in the Prospectus and in the appointments of MD & CEO as well as deputationists indicate and prove this inference.”
h) Based on the above discussions, the DIT(IT) concluded as follows:
“Three issues emerge from the entire discussion above, one which is certain that there existed a Permanent establishment of the parent company, ETFC in terms of Article 5 (2) (l) of the India-US Tax Treaty, and the second one, that whether a permanent establishment of the Mauritian company, ETM existed would depend on further enquiries. It is a fact that Mr. James Leslie Whiteford was director in ETM from October 2004 till May 2008 and was also MD & CEO in I1L from May 2007 to May 2008 when ETM thought to divest its 43.85% stake in IlL. The discussions in respect of the managerial and financial aspects throw light in that direction to some extent. Another situation may emerge where the comingling of assets and management of the Indian company by persons from US company and their activities in India may lead to their carrying on business of the US entity in India and the Mauritian entity is simply a facade. At this moment, the evidence captured indicates such a possibility but more evidence is surely needed to hold so. The fact of direct exercise of rights available to a shareholder and remittance of dividend received from IlL immediately after the receipt thereof coupled with deployment of ETFC’s senior personnel on deputation and with the Board of Directors in the Indian company IlL, is a clear indication for such a possibility.”
4. Taxpayer’s Response
4.1 The taxpayer challenged the inquiries made to ascertain the facts and circumstances by contending that this amounts to exercise of jurisdiction under Section 263 of the Act and not under Section 264. It was asserted that the DIT(IT) can make enquiry only concerning the record of the proceedings which were before the AO and grant relief to the taxpayer in light of the legal position on the subject matter of the revision petition.
4.2 The DIT(IT) repelled the said contention of the tax payer as follows:
a) The High Court had observed that all the contentions available to both the sides are kept open to be raised before the revision authorities;
b) The statutory provisions empower the Revision Authority to make such enquiry or cause such enquiry to be made and pass such order thereon, as he thinks fit. However, the order passed under Section 264 should not be prejudicial to the assessee. Explanation 1 to Section 264 defines what should not be considered as prejudicial to the assessee. There is no mandate in the section that whatever relief is sought for by the assessee must be allowed to him.
(c) The assessee has contended that under Section 264, the revision authority is required to rectify the order of the AO for just and equitable relief. Such a mandate is not discernible from a reading of Section 264 of the Act.
5. Applicability of Circular 789 and Supreme Courts decision in Azadi Bachao Andolan’s case
5.1 The taxpayer’s main argument was that in view of Tax Residency Certificate issued by the Mauritius Revenue Authority, it is a tax resident of Mauritius. Accordingly, it claimed to be entitled to the benefit available under Article 13(4) of the Treaty, as per Circular 789 issued by the CBDT and the judgement of Hon’ble Apex Court in the case of Azadi Bachao Andolan reported in (2003) 263 ITR 706.
5.2 The DIT (IT) repelled the taxpayer’s argument in the following words:
a) “The facts and circumstances discussed above leave the question wide open whether the said Treaty would at all apply here. Assuming for a moment – though not admitting that it is so, it is a fact that Circular 789 was issued to provide that where a Tax Residency Certificate is issued by the Mauritian Revenue Authority, the provision of India-Mauritius Tax Treaty should be given effect to. That situation does not exist in the present case and needs further examination.”
b) “The explanation of the applicant was also called for especially in the context of judgement dated 14th October 2008 of the Hon’ble Apex Court in the case of Commissioner of Central Excise vs. Ratan Melting & Wire Industries 2008 (231) ELT 22 (SC). The applicant, inter alia, replied vide letter dated 15th December 2008 that the above referred decision has no impact or effect on the validity, applicability, and maintainability of the CBDT Circular No 789.”
c) “The moot question is whether India-Mauritius Tax Treaty would apply on the given facts or India-US Tax Treaty would be applicable in the light of overwhelming facts indicative of the ownership of shares resting with the US Company. These complex issues which do not admit solution through doctrinaire or straight jacket formula cannot be decided in these summary proceedings. Since ETM is regularly assessed to tax by the ADIT (IT) -3 (2), Mumbai, these issues can be examined in greater detail in the course of regular assessment and be decided therein.”
6. Decision of the DIT(IT)
6.1 The DIT(IT) citing the following High Court Decisions held that provision of the section 195 of the Act is only for the tentative deduction of income-tax subject to regular assessment and the rights of the parties are, not adversely affected in any manner and that the orders u/s. 195(2)/ 197 are not conclusive and they do not pre-empt the tax department from passing appropriate assessment orders:
a) CIT vs. Tata Engineering and Locomotive Company Limited [2000] 245 ITR 823 (Bom)
b) CIT vs. Elbee Services Private Limited [2001] 247 ITR 109 (Born).
6.2 Based on the above discussions, the DIT(IT) crystallised the following three issues for decision:
1. Whether tax should be deducted from the gross sale consideration received on the sale of shares of the Indian company, IlL by the Mauritian company ETM ?
2. Whether such capital gains are exempt from tax in view of the benefit available under Article 13(4) of the India- Mauritius Tax Treaty in view of Circular 789 issued by CBDT and ratio of the Hon’ble Apex Court in the case of Azadi Bachao Andolan reported in 263 ITR 706?
3. What would be the rate of tax, if the gains are to be taxed ?
6.3 The DIT(IT) decided the above issues as follows:
a) Tax should be deducted from the net amount of capital gains instead of gross sale consideration as adopted by the AO. He thus reversed the direction of the AO on this point and granted partial relief to the taxpayer.
b) It can not be said at this stage that capital gains have arisen to the Mauritian entity, ETM and not to the US entity and much is left to be looked into as apparent does not appear to be real. There are enough flaws, defects and discrepancies in the claim of the applicant which need to be explained by it before the claim of the applicant can be accepted. In view of the same, in so far as this finding of the AO is concerned that capital gains are made by ETFC, at this stage, no interference is called for.
c) Following the Mumbai Tribunal’s decision in the case of BASF Aktiengesellschaft vs. Deputy Director of Income tax (International Taxation) [2007] 12 SOT 451/110 TTJ (MUM.) 741, the DIT (IT) held that proviso to Section 112would not apply in the case of long term capital gains arising on account of sale of shares of a listed company and consequently, the rate of tax on long term capital gains computed under the first proviso to section 48 would be 20 per cent.
d) In view of the above, the DIT(IT) ordered that an amount of Rs. 18.94 lakhs be returned to the taxpayer and a sum of Rs. 24.31 crores be deposited with the AO.
7. Analysis
7.1 It appears that the DIT(IT) has virtually lifted the corporate veil of ETM to ascertain the beneficial ownership of such capital gains and in order to bypass the application of the Indo-Mauritius DTAA. It may be pointed out here that the concept of beneficial ownership is applicable to Article 10 (Dividends) and Article 11 (Interest) and not to Article 13 of the Treaty in respect of Capital Gains.
7.2 The matter will be finally decided by the AO in the regular assessment proceedings wherein the taxpayer would have opportuni ty to furnish all such facts, documents, explanations and legal submissions as may be appropriate in its case and the tax department would also be able to make such further inquiries and collect such further evidence as it may deem necessary. However, the AO is unlikely to adopt a line different from that of his superior. Hence, the matter may be tested in successive appeal proceedings.
7.3 In the meantime, the tax officers, in appropriate cases, are likely to use this precedent, depending upon the facts and circumstances of each case, to deny the benefit of Article 13(4) of the DTAA to Mauritius entities resulting in protracted litigation and it may impact flow of investments through Mauritius.
7.4 In view of this precedent, such investors and their investment and tax advisors would be well advised to take proper precautions to ensure that there is substance in the operations of the Mauritius entities and that financial transactions are routed through Mauritian entities and not directly with other group entities Iaccounts. The recording of the transactions in the books of accounts and their documentation should be done very meticulously and various financial disclosures to various regulatory authorities are well thought out and vetted by the tax advisors.
7.5 It is important to note that from the orders of the High Court it appears that the Taxpayer did not vehemently urge its case based on the CBDT’s Circular No. 789 and the decision of the Supreme Court in Azadi Bachao Andolan’s case (Supra). Had it been so, perhaps the decision of the High Court could have been different, even in a case involving summary proceedings u/s. 1971 195(2).
7.6 The DIT(IT) has relied upon the SC’s decision in the case of Ratan Melting and Wire Industries (Supra) to rebut the tax payer’s reliance upon the aforesaid CBDT Circular No. 789. In Ratan Melting’s case, the SC held that Circulars and instructions issued by the Central Board of Excise and Customs are no doubt binding in law on the authorities under the respective statutes, but when the Supreme Court or the High Court declares the law on the question arising for consideration, it would not be appropriate for the Court to direct that the circular should be given effect to and not the view expressed in a decision of this Court or the High Court. So far as the clarifica tions I circulars issued by the Central Government and State Govern-ments are concerned, they represent merely their understanding of the statutory provisions. They are not binding upon Courts. It is for the Court, and not for the Executive, to declare what the particular provision of a statute says. Further, a circular which is contrary to the statutory provisions has really no existence in law.
The DIT(IT) ought to have appreciated that the legal validity of the said CBDT Circular No. 789 has been upheld by the SC in unequivocal terms in Azadi Bachao Andolan’s case (Supra) and it is not a case where the court has held that the said circular is contrary to the statutory provisions. Thus, in our view, Ratan Melting’s case has no application in respect of the validity and the binding nature of the said Circular No. 789.
7.7 Media reports appearing at the point in time when the said Circular No. 789 was issued, suggest that the same was issued keeping in mind the then prevailing economic conditions, fiscal situation, position of the forex reserves and the need to attract foreign investments into the country, both FDI as well as FII investments. In addition, in view of notices being issued/inquiries being made by the revenue authorities to/with Mauritius-based FIls and investors, a huge hue & cry was made by such investors severely impacting the stock markets adversely as well as the fear of negatively impacting the inflow of the foreign investments into the country leading to issuance of the said circular by the CBDT, probably under political pressure. The veracity of this statement cannot be verified and it is in the realm of speculation.
To ensure that the decision of E*Trade Mauritius’s case does not create uncertainty in the minds of the FIls’ and the Investors coming through Mauritius and such other jurisdictions, it would be perhaps in the fitness of things that Political leadership, Revenue authorities in both the countries, Investors and Tax Advisors put their heads together to find a viable and acceptable solution to the issue. This would help in removing the uncertainties from the minds of the investors and also in avoiding protracted litigation.
7.8 The moot point is whether in respect of a matter which has been concluded and settled by the SC and which under Article 141 of the Constitution becomes the law of the land, is it open to the revenue authorities to reagitate the matter for some reason or the other?
7.9 There is no doubt that the provisions of India Mauritius DTAA have been used for Treaty shopping and may cause loss of revenue. Treaty Shopping has been clearly upheld by the Supreme Court in Azadi Bachao Andolan’s case. A more appropriate course of action would be for the political leadership to take a firm stand in the matter to renegotiate the treaty about which we have been hearing for a long time but there is no real action on the ground.
7.10 In view of the experience in Vodafone’s case and E*Trade Mauritius’s case, the tax payer would be well advised to submit to the tax authorities requisite facts, documents and information during such summary proceedings as well as regular assessment proceedings in order to avoid antagonism and protracted litigation because the tax authorities are now becoming more tech savvy and are able to gather lot of relevant information available in the public domain through Internet or from the filings with the regulatory authorities in domestic/foreign jurisdictions.
