Where the sale price of CCDs issued by subsidiary company was linked to the holding period; CCDs were guaranteed by parent company; directors of subsidiary company had no powers of management; difference between the sale price and purchase price of CCDs held by Mauritian company was ‘interest’ and not ‘capital gains’ in terms of DTAA.

Where the sale price of CCDs issued by subsidiary company was linked to the holding period; CCDs were guaranteed by parent company; directors of subsidiary company had no powers of management; difference between the sale price and purchase price of CCDs held by Mauritian company was ‘interest’ and not ‘capital gains’ in terms of DTAA.

• The applicant (‘Z’) is a company incorporated in and tax resident of Mauritius. V Ltd. (‘V’) and S Ltd. (‘S’) are two Indian companies.

• ‘V’ is parent company of ‘S’ and company ‘S’ was engaged in developing a real estate project in India.
• The applicant, ‘V’ and ‘S’ jointly executed a Share Holders Agreement (‘SHA’) and Securities Subscription Agreement (‘SSA’).
• Pursuant to SHA and SSA, the applicant and ‘V’ invested in ‘S’. The applicant subscribed to equity shares and CCDs.
• As per SHA, CCDs were to be fully and mandatorily converted into equity shares after 72 months. The applicant had put option to sell certain shares and CCDs on specified dates to ‘V’ and ‘V’ had call option to purchase the said shares and CCDs from the applicant.
• The respective options were to be exercised prior to the mandatory conversion date. ‘V’ exercised its call option to purchase shares and CCDs from the applicant.
• The applicant contended that the capital gains arising from transfer was exempt from tax in India in terms of Article 13(4) of India-Mauritius DTAA. The contention of applicant was rejected by the Tax Department which held that:
• The concept of optional conversion rate was incorporated in SHA to compensate for normal interest from debentures. Only small portion of investment comprised equity shares and balance was CCDs. To characterise the gain to have arisen from transfer of capital assets was improper. ? For interpreting agreements, its essence as a whole should be considered and not merely their form. Relying on LMN India Ltd., in re (2008)5, CCDs recognised the existence of debt till repaid or discharged. The two agreements were entered into to camouflage the true character of income from interest on loan to capital gains.
• The applicant submitted that it was engaged in real estate business, but its only transactions in India were investment in ‘S’. Hence, alternatively, nature of income arising from the transaction should be business income.
• As per current FDI Policy, optionally and partly convertible debentures and preference shares are to be treated as ECB. Debentures recognise the existence of a debt. It does not cease to be so simply because they are redeemed by conversion to equity shares and not payment. Thus, ECB is contrived to look like CCDs convertible into equity. A transaction where the parties have a common intention not to create the legal rights and obligations which they give appearance of creating, is sham6. Since the rate of return was predetermined 6 years before the exercise of option, there was no commercial purpose. Accordingly, the transaction was designed to avoid tax by taking advantage of Article 13(4) of India-Mauritius DTAA. It was the applicant’s contention that:
• Investment through CCDs is not loan or advance and there is no lender-borrower relationship with ‘S’. Even if ‘S’ is assumed to be borrower, the consideration is received from ‘V’ for sale of assets. Any amount received over and above purchase price cannot be treated as interest7.
• Gains on sale of CCDs have arisen because of the value of the underlying assets, namely, equity shares.
• Applicant and ‘V’ are totally unrelated parties and hence, purchase of CCDs by ‘V’ cannot be regarded as redemption of CCDs.
• Since the tax benefit would result to only one, there is no reason for parties involved to share a common intention to create legal facade.

Ruling The AAR observed and ruled as follows:

 (i) Reliance placed on CWT v. Spencer & Co. Ltd. and Eastern Investments Ltd. v. CIT8, to contend that a CCD creates or recognises the existence of a debt, which remains to be so till it is repaid or discharged.

(ii) Article 11(5) of India-Mauritius DTAA, includes any type/form of ‘income from bonds and debentures’ within the ambit of ‘interest’. Purchase price under call option was linked to the holding period. While CCDs were not to carry any interest, they gave option of conversion into shares at a different price. Conversion of debentures into equity shares at the end of the specified period amounts to constructive repayment of debt. While calculating the purchase price the conversion rates vary, depending upon the period of holding of CCDs. This is nothing else but ‘interest’ within the meaning of section 2(28A) of the Income-tax Act and Article 11 of India- Mauritius DTAA.

 (iii) To ascertain true legal nature of the transaction, and to appreciate true nature of the consideration received, ‘look at’ test needs to be applied by examining substance of the transaction, inter se relationship of the parties and the transaction as a whole. While ‘S’ and ‘V’ were two independent juridical persons, ‘S’ did not exercise any power in managing its affairs. The management powers of the directors of ‘S’ were taken away through various clauses of SHA. ‘V’ was developing and running real estate business of ‘S’. ‘V’ was the guarantor of investment made by ‘Z’. ‘V’ acknowledged CCDs as debt. Thus, ‘V’ and ‘S’ were different only on paper, but otherwise they were one and the same entity. ‘V’ had de facto control and management over ‘S’. Therefore the argument that the sale of CCDs is not to the debtor but to a third party and hence, what is realised cannot be said to include interest, cannot be accepted.

(iv) Article 11 is a specific provision dealing with treatment of income from debt claims of every kind, whereas Article 13 deals with capital gains. ‘V’ and ‘S’ are one and the same. ‘V’ has paid fixed pre-determined return to the applicant. Hence, the amount paid by ‘V’ is towards the debt taken by ‘S’ from the applicant and therefore, appreciation in value of CCDs is ‘interest’ under Article 11.