MLI SERIES ANTI-TAX AVOIDANCE MEASURES FOR CAPITAL GAINS: ARTICLE 9 OF MLI

This article in the on-going series on the Multilateral Instrument (MLI) focuses on Article 9 of the MLI, which brings in anti-tax avoidance measures related to capital gains earned by sale of immovable property through indirect means.

A break-up of the various DTAAs signed by India, whether or not modified by the MLI, appears later in this article along with what a Chartered Accountant needs to keep in mind in the post-MLI scenario. However, the first requirement is to understand the provisions and what changes have been brought about by them. Owing to a multitude of options and different ways in which they can apply, the language of Article 9 of the MLI is quite difficult to decipher, leave alone explain. Therefore, we have attempted to simplify the provisions with the help of a story, a narrative that can provide a basic understanding about the concepts. The reader should refer to the respective DTAAs and the application of the MLI on those DTAAs before forming any opinion.

1. ‘The Story’
Mr. A is a wealthy Australian businessman with interests in real estate around the world, including India. He wants to sell shares in an Australian Company and therefore approaches his tax consultant, Mr. Smart, to get an opinion on his tax liabilities. Here is the transcript of a conversation between Mr. A and Mr. Smart:

Mr. A – Hi, did you calculate my taxes on the sale of shares?

Mr. Smart – Yes, I did. And for your information, we also have to pay tax in India.

Article 13(4) reads: ‘Income or gains derived from the alienation of shares or comparable interests in a company, the assets of which consist wholly or principally of real property referred to in Article 6 and, as provided in that Article, situated in one of the Contracting States, may be taxed in that State’.

Mr. A – Ah! Though I know that I will get credit for those taxes paid against my Australian taxes, but I do not want the hassle of paying tax in another country. Is there any way out? You said that the company should derive value wholly or principally from the immovable property. Could we plan in a manner that we contribute other assets, shortly before the sale of the shares, to overcome this? That would dilute the proportion of the value of the shares that is derived from immovable property situated in India. For example, if my company has a total asset size of AUD 100, which currently includes AUD 90 of immovable property in India, the gain on the sale of such company’s shares would be taxable in India. However, just before such sale, can I infuse AUD 100 in the company and park it in a fixed deposit? Then, the share of immovable property in my company’s value will be reduced to 45% and the transaction of such sale of shares would be taxed only in the state of incorporation of the company (Australia) and not in the state where the immovable property is situated (India).

Mr. Smart – Where the businessman leads, the taxman follows! Well, this planning might have worked if you would have come to me before 1st April, 2020. Knowing that many taxpayers plan their affairs in such a manner, the India-Australia Treaty has to be read along with the Multilateral Instrument which now reads as follows:

As per clause (a), keeping money in a fixed deposit or any other asset for a short period of time would not work. If at any point of time during the preceding 365 days (period threshold), your company majorly derives value (proportion threshold) from immovable property situated in India, then the sales of shares would be taxable in India (source country).

Mr. A – Oh! Oh! They have plugged this loophole. I also see that in clause (b) comparable interest has been added. Does that mean that even if I hold immovable property in LLP, partnership firms, trust or any other similar forms, selling of those shares would also be under the ambit of India’s (source country) taxation?

The same is true with MLI. You have various options on the menu. Whenever a country notifies that MLI should be applied to its treaty with another country, it is only if the other country reciprocates equivocally would their treaty be read with MLI (sit together). Similarly, even when the countries have decided that the treaty position will change, they still have options to not change all clauses and selectively they can choose and pick their options (eat together the same food).

Mr. A – Ok, that sounds delicious. What kind of options the countries have in case of such transaction of shares having underlying immovable property in another country?

Further, Article 9(1) provides a choice for inclusion / exclusion of the comparable interest condition [vide para 6(c)], whereas Article 9(4) makes comparable interest an integral and inseparable part of it. A country can select Article 9(4) or Article 9(1), but both cannot exist at the same time as they are alternatives to each other.

The Articles read as follows:
Article 9(1)
‘Provisions of a Covered Tax Agreement providing that gains derived by a resident of a Contracting Jurisdiction from the alienation of shares or other rights of participation in an entity may be taxed in the other Contracting Jurisdiction provided that these shares or rights derived more than a certain part of their value from immovable property (real property) situated in that other Contracting Jurisdiction (or provided that more than a certain part of the property of the entity consists of such immovable property (real property):

Article 9(4)
‘For purposes of a Covered Tax Agreement, gains derived by a resident of a Contracting Jurisdiction from the alienation of shares or comparable interests, such as interests in a partnership or trust, may be taxed in the other Contracting Jurisdiction if, at any time during the 365 days preceding the alienation these shares or comparable interests derived more than 50 per cent of their value directly or indirectly from immovable property (real property) situated in that other Contracting Jurisdiction.’

Mr. A – So only two options to choose from. That is not so complex.

1. Where both countries choose to apply the 365-day period threshold coupled with value threshold at a standard 50% under Article 9(4), then in such a case the more flexible option for anti-tax avoidance tests under Article 9(1) would not apply. [Article 9(8)]

2. However, even after choosing to apply Article 9(4) as above, a country may choose not to apply Article 9(4) to treaties with certain select countries. [Article 9(6)(f)] In that case, nothing changes for treaties with these countries and the treaty reads as it was pre-MLI.

3. Where no such reservation is made as per the above option, Article 9(4) applies. However, the countries need to choose which exact provision does Article 9(4) apply to in their existing Covered Tax Agreements. [Article 9(8)] If the other country also cites the same provision, then the language of the existing provision between treaties of both countries changes as per Article 9(4).

4. In the case where the same provision is not notified by the other country, even then Article 9(4) applies – as the countries have already agreed to apply it as per point No. 1 above. But in such a case, the wording of Article 9(4) would supersede the existing provisions of the Covered Tax Agreement to the extent it is incompatible with the present text of the Agreement. Thus, for example, if the Covered Tax Agreement at present cites a period threshold of only 60 days, as both countries have accepted to apply article 9(4), but not notified the same provision, the 365-day threshold will supersede the 60-day threshold.

5. Now, consider a situation where the countries notify that they do not want to apply the more flexible options under Article 9(1) to their treaties; and have also chosen not to apply the provision as per Article 9(4) – then in such a case there will be no change at all in their treaty language due to the provisions of Article 9 of the MLI. [Article 9(6)(a)] In essence, the anti-tax avoidance tests would not be part of the treaty.

6. Even where a country has chosen to apply Article 9(1), it can make a choice of applying only one of the anti-tax avoidance mechanisms, i.e., either the time threshold test or the comparable interest condition; or both. [Para 9(6)(b) to (e)] The other country can also make a similar choice and only the matching choices will get implemented. Thus, where a country chooses to apply both mechanisms, but the other country chooses to apply only the time threshold test, then only the time threshold test gets matched.

7. To the extent the choices made in respect of either or both of the mechanisms matches between both countries, the countries next need to specify which provision under their Covered Tax Agreement stands modified. [Article 9(7)] If the provision specified by both countries does not match, then the treaty language stands unchanged. Thus, even after choices have been made as per Article 9(6), such choices would apply only if the same provisions are earmarked by both countries for applying the changes.

So, as I said earlier, it is like even if the countries decide to sit at one dinner table, they can still reserve their right to not eat certain food items from the menu.

Mr. A – Gosh! That’s one dinner party I don’t want to be invited to. That’s too much to take in one day. As many of my friends the world over have properties in India, can you send me a note on the application of Article 9 with respect to India?

3. Applicability to transactions
Finally, what are the points to be taken care of by a Chartered Accountant while reviewing the application of Article 9 of the MLI to specific transactions? These are as under:

a. Review of transaction – Check whether foreign company’s shares derive value from Indian immovable property? If yes, then the transaction falls in the scope of this Article.
b. Review of respective DTAA – Check whether India’s DTAA with country of residence has various thresholds for attribution of taxation rights of such shares in India. If yes, whether the transaction meets the threshold?
c. Review of MLI – Check whether the country of residence has notified the application of Article 9. If yes, then apply the provisions as per the matching principle explained above. Synthesised text2, if available, could be used for ease of interpretation.

4. Authors’ remarks
1) A country-specific example (that of Australia) has been taken here to make the article practical and easy to understand. Specific country positions need to be understood for in-depth analysis.
2) Definition ambiguity: Immovable property is not defined by the DTAA and by MLI only additional description provided as real property; therefore, one needs to see the definition of immovable property / real property from domestic law.
3) Article 9(6) has given various combinations of reservations to the countries, thereby providing flexibility but also leading to complexity when applying the provision.
4) MLI’s position qua India indicates that most Contracting Jurisdictions have opted out of this Article, thereby choosing to stick to the existing position.
5) A Chartered Accountant while issuing a certificate u/s 195 on the payment made by a buyer, needs to consider the Act, DTAA and MLI in combination before considering the final tax liability.

CONCLUSION

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2 https://incometaxindia.gov.in/Pages/international-taxation/dtaa.aspx – select
DTAA Type as Synthesised text