|‘DTC won’t help tax transactions in Mauritius’|
|Friday, 27 January 2012 00:00|
Most assume that, had the Direct Taxes Code been in place, the Supreme Court would not have ruled in favour of Vodafone in its fight with the taxman—to that extent, it is believed that, once DTC and its General Anti Avoidance Rules (GARR) come into being, perhaps in the Budget, all future Vodafone-type transactions will be taxed. Satya Poddar, who is a partner at Ernst & Young’s tax and regulatory practice, argues this does not apply to transactions done out of Mauritius and Singapore, and that such transactions will remain until the tax treaties with these countries are modified. He also believes that, if the government wishes, it can renegotiate the treaties with both Mauritius and Singapore. Excerpts of an interaction with Sunil Jain:
Will the Direct Taxes Code, when it is implemented, make sure we don’t have a Vodafone-type situation again, where an overseas firm can sell an asset to another foreign firm in a foreign location and not pay tax even though the underlying asset is in India?
Even the Supreme Court says that if there was a provision in the Indian law for taxation of indirect transfers through shares, like that in the DTC, the transaction could have been taxed in India.
And this applies to all foreign transactions including firms located in Mauritius?
Without the DTC being in place, even if the buying and selling firms were located in New York, there would be no tax leviable in India, based on the Supreme Court judgment. The Mauritius route, by the way, is open to use even once the DTC comes in.
How is that?
There are two specific propositions in the DTC. One, it makes a share transaction taxable if the underlying Indian assets represent more than 50% of the value of the shares. This explicit provision takes care of the flaw in Section 9 of the Income Tax Act that the Supreme Court talked of. But, the transaction could still be exempt if the vendor is a Mauritius entity.
The second provision in DTC that can be used to attack a transaction like this is GARR, and it is important to understand what triggers GARR. In order to attract GARR, any transaction has to result in a tax benefit and it has to be either lacking in commercial substance, or constitute an abuse of the tax provisions.
The question is whether the setting up of a Holdco designed to take a tax benefit of the India-Mauritius treaty can be made subject to GAAR. The tax authorities have to prove that the holding company structure was lacking in commercial substance or that it is an abuse of the tax provisions. Given the extensive commentary made in the Supreme Court decision on the commercial purpose of holding company structures, I don’t think that they can be subjected to GAAR. However, there is a possibility that round-tripping investments via Mauritius—Indian entities taking funds to Mauritius and then bringing them back to India—would attract GARR.
So, you can tax all Vodafone-type transactions once DTC comes in, but not those via jurisdictions like Mauritius or Singapore with treaty exemption for capital gains.
Is the government aware of this?
Of course it is. In the Azadi Bachao Andolan case in 2004, the Supreme Court had hinted that if India had a GARR, the taxman could have attacked the transaction. Despite that, the government did nothing all this time. In my view, had there been a GARR in place, the Supreme Court would not have been as unequivocal as it has been in the Vodafone case. The tax demand in the Vodafone case was completely unanticipated, and brought in so much uncertainty and instability in the application of tax that the Supreme Court could not ignore this. Look at the last paragraph of the judgement, where it talks of a fiscal regime needing to be certain and stable. Had the GAAR been in the statute long enough, the companies would have been cognisant of the risks, and the tax demands would not have been seen to make the fiscal regime uncertain and unstable.
If Vodafone had been buying a telecom company whose underlying assets were based in the US (instead of in India), would the US taxman have collected taxes on it?
The US has recently introduced GARR provisions (for transactions lacking economic substance), but even without them, US residents are taxable on their capital gains from overseas transactions. However, if there is a transaction of the Vodafone type between two non-resident companies with the underlying assets in the US, the US does not tax the capital gains, except where the underlying assets are real estate. A few other developed countries also apply tax to indirect transfers, but only where the underlying assets are real estate.
Does this ruling bring in a level playing field between FII and FDI? After all, if FIIs from Mauritius don’t pay capital gains, why should FDI, and more so since this creates assets on the ground?
Perhaps that is one of the reasons why the Supreme Court ruled the way it did. The Indian tax regime for capital gains is lacking in consistency and neutrality in the treatment of different types of gains and of transactions in different jurisdictions. Every country has the right to tax or not tax transactions. But if a regime exempts certain type of transactions—FII from Mauritius, for instance—you can’t then try and attack other transactions in an unanticipated manner. You can have residence-based taxation or you can have source-based taxation but you can’t have a combination of the two, depending upon the whims and fancies of the taxman. There has to be consistency—if residents don’t pay taxes, is it appropriate to tax non-residents?
But the Bombay High Court said that since Vodafone signed lots of agreements in India—it wasn’t just the sale of shares in the Cayman Islands—a part of the transaction was taxable in India ...
Well, that’s what the Supreme Court struck down, it said you can’t break up a composite transaction into parts for taxation purposes. When you go to a doctor, you get some pills and you get a service, but you don’t break it up to tax each part separately—there are enough rulings on this in Indian courts.
So how do you tackle capital gains taxes after DTC comes in if firms are located in Mauritius and Singapore? Any Indian firm will now have Holdcos in these places to save on capital gains.
There are three types of transactions that need to be distinguished for capital gains tax. Domestic residents do not pay tax on long-term gains where the transaction attracts the Securities and Transactions Tax (STT). For non-residents, the application of tax depends on their place of residence. If they are residents of Mauritius (or Singapore), they remain exempt from tax, regardless of whether STT is paid. For residents of other jurisdictions without a treaty exemption, the gains from Holdco structures could become taxable once DTC is enacted. However, where Indian residents set up holding companies and engage in round-tripping transactions, then there is a possibility that they could be attacked by the taxman under GAAR. The government needs to review whether this disparate treatment of different types of capital gains so that it makes sense and is consistent with international best practices.
But can India renegotiate the treaties with Singapore and Mauritius?
Of course it can. The treaties are agreements, but not cast in stone for ever. Either government can give notice for their renegotiation.