BACKGROUND
Setting aside the ruling of Authority for Advance Ruling (“AAR”), Delhi High Court (in its judgment given on July 30, 2014) in the case of Zaheer Mauritius Limited vs. Director of Income-tax (International Taxation), has held that gains earned by a Mauritian resident entity by the sale of Compulsorily Convertible Debentures (“CCDs”) on exercise of a call option can be characterized only as ‘capital gains’ and not as ‘interest’. Therefore, in light of the provisions of India-Mauritius Double Taxation Avoidance Agreement (“DTAA”), entire gains earned by the Mauritian entity will be tax exempt in India.
PREFACE
DTAAs have played an important role in facilitating foreign investment in India and Mauritius having emerged as one of the largest sources for foreign investment.
According to Article 13 (4) of DTAA entered into between India and Mauritius, gains derived by a resident of a contracting state from the alienation of any property will be taxable only in that state. Therefore, if a Mauritian company earns capital gains in India, then such income from capital gains is not eligible to be taxed in India and capital gains arising from the sale of securities in India by a Mauritian resident are taxable only in Mauritius.
Typically, hybrid instruments like CCDs, convertible preference shares etc, of Indian companies which are subscribed by the foreign investors have a put and call options as typical exit routes in respect thereof which are designed to provide downside protection (i.e. the use of an option or other hedging instrument in order to limit or reduce losses in the case of a decline in the value of the underlying security).
An option contract gives the buyer the right, but not the obligation to buy/sell an underlying asset at a pre-determined price on or before a specified time. A put option gives the holder of securities the right to sell a specified number of securities at a specified price within a specified time to a specified buyer, which buyer is contractually obliged to acquire the securities in question. A call option, on the other hand, gives the holder of securities the right to buy a specified number of securities at a specified price within a specified time from a specified seller, which seller is contractually obliged to dispose of such securities.
In the aforesaid background and due to the ruling of AAR3 given on March 21, 2012 (in which the AAR re-characterized the income arising on sale of CCDs pursuant to exercise of such options as interest income and not capital gains income), issue had arisen as to whether the sale proceeds realized on the sale of CCDs by way of a put / call options (having predetermined conversion / redemption rates) were of nature of capital gains or did they include a component of income by way of “interest” under the Income Tax Act, 1961 or the DTAA?
If the gains earned were of capital gains then the same will be tax exempt in India in light of provisions of Article 13 to the India – Mauritius DTAA. But, if the gains were of the nature of interest income, then the same would result in 20% withholding tax to be paid as per the Indian Income-tax Act, 196. Interest income is taxable according to the laws of India/ Mauritius as per Income Tax Act and Article 11 of the DTAA.
FACTS OF THE CASE (IN BRIEF)
Zaheer Mauritius Limited, the applicant is a company incorporated under the laws of Mauritius and is a tax resident of Mauritius. Pursuant to a securities subscription agreement (“SSA”) and a shareholders agreement (“SHA”), it invested alongwith Vatika Limited, an Indian company, in SH Tech Park Developers Private Limited (“SH Tech Park”), another Indian company, which is a wholly owned subsidiary of Vatika Limited.
The aforesaid investment was made by Zaheer Mauritius Limited by subscribing to equity shares and CCDs of SH Tech Park. As per the terms of SHA, CCDs were to be fully and mandatorily converted into equity shares at a particular price after the expiry of 72 months from the investment date. Prior to the said mandatory conversion date, pursuant to a call option right, Vatika Limited could purchase the said shares and CCDs from Zaheer Mauritius Limited in which Zaheer Mauritius Limited would get its investment value plus a fixed return for the investments made by it.
Vatika Limited exercised the said call option and purchased the entire stake (including CCDs) held by Zaheer Mauritius Limited in SH Tech Park for a particular consideration. Vatika Limited approached the tax officer for a nil withholding certificate for the income earned contending that it was exempt from tax in India under the India-Mauritius DTAA. However, the Tax officer held that the gains on the transfer of equity shares and CCDs would be treated as interest, and that tax at 20% (plus applicable surcharge and education cess) should be withheld.
Zaheer Mauritius filed an application before the AAR to obtain a ruling on whether the gains arising on the sale of CCDs were exempt from capital gains tax in India under Article 13(4) of the IndiaMauritius DTAA.
AAR re-characterized the income arising on such disposition as interest income and not capital gains income holding that a CCD is in the nature of a debt till the time it is converted into shares and any income arising on account of a CCD should be considered as interest income under article 11 of DTAA, regardless of the fact that the income has arisen on account of sale of such CCDs to a party thereby denying exemption in respect of capital gains under the DTAA.
The AAR inter alia observed and ruled that: a) a ‘CCD’ was inherently, in the nature of a debt instrument which continues to remain so, till the time the debt was repaid; b) while the income derived from sale of equity shares would fall under capital gains; CCD being a debt instrument, the income derived from its sale would be treated as interest falling within the meaning of section 2(28A) of the Income Tax Act as well under Article 11 of the DTAA with Mauritius. c) The conversion of debentures into equity shares at the end of the specified period at the conversion price amounted to constructive repayment of debt. Therefore, there was a debt and what was paid under the SHA was an interest towards that debt.
CONTENTIONS OF THE TAX PAYER
The AAR had failed to appreciate that there was no debtor-borrower relationship between Vatika and the Petitioner while concluding that the income was in the nature of ‘interest’. The transaction entered into was an investment in shares and CCDs, and not a loan transaction.
The method of payment would not determine the character of payment but it was the quality of payment that was decisive of its character. The CCDs were held by Zaheer Mauritius as a capital asset and the transfer of these investments was liable to be treated as capital gains, and was accordingly exempt under Article 13(4) of the DTAA.
CONTENTIONS OF TAX DEPARTMENT
In order to compensate normal interest income from debentures, the concept of optional conversion rate had been incorporated in SHA, which actually was a loan and interest thereon. The SHA and SSA were entered into to camouflage the true character of income from that of loan and interest, by calling it capital gains. Debentures recognize the existence of a debt.
As per the FDI Policy of India, optionally and partly convertible debentures and preference shares were to be treated as an external commercial borrowing (“ECB”) Based on this argument, the tax department contended that under the SHA / SSA, ECB was contrived to look like CCDs convertible into equity and the legal character of CCD as a debt did not change.
SHA which gave fixed rate of return and the applicable rate for call option which was to be exercised 6 years later were all predetermined. The transaction clothed as a purchase of equity and CCDs, was ‘sham’, designed for avoidance of tax and to take advantage of the Article 13.4 of the DTAA with Mauritius to claim exemption from capital gains.
JUDGMENT OF DELHI HIGH COURT
Though CCDs per se are debt instruments and the return on such instruments are certainly interest income, not all type of incomes that is earned through such instruments can be treated as interest income under the Income Tax Act. If the CCDs been transferred to a third party, then any gains made by the taxpayer would certainly be capital gains.
Merely because the mode of calculation was dependent on a fixed rate of return the same cannot be treated as interest income. The court pointed out that such payments would happen only if Vatika Limited wanted to buy the CCDs from Zaheer Mauritius Limited or if Zaheer Mauritius Limited wanted to exit from SH Tech Park. Had Zaheer Mauritius Limited continued to hold the CCDs beyond 72 months, all the CCDs would have been converted into equity shares and thereby, becoming an equity investment in the SH Tech Park and which showed that the CCDs were only capital assets. Hence, merely because the SHA provided an exit option to Zaheer Mauritius Limited would not change the nature of the investment made and could not be read to mean that the CCDs were fixedreturn instruments.
The Court noted that in accordance with the foreign direct investment guidelines, CCDs were the most appropriate route for Zaheer Mauritius Limited for routing investments in an Indian company. In such circumstances, it ought not to be readily inferred that the entire structure of the transaction was designed solely for the purposes of avoiding tax.
On this basis, relying on the ‘look-at’ principle laid down by the Hon’ble Supreme Court in the case of Vodafone International Holdings BV v. Union of India4 , the Court held that the entire transaction must be looked at as a whole without adopting a dissecting approach and therefore, held that the present transaction could be held to have been structured for the avoidance of tax.
CONCLUDING COMMENTS
By reversing a much criticized judgment of AAR in this case in which the AAR had re characterised debt into equity on the grounds of tax avoidance and sham arrangement, the Delhi High Court’s decision on this case is surely a welcome move (from tax perspective) for foreign investors who have subscribed to CCDs of Indian companies with optionality clauses as exit route. This decision has given much needed clarity that although a debenture is a debt instrument; a transfer of a debenture to a third party can only result in ‘capital gains’ and not interest income.
About Bulwark Solicitors
Bulwark Solicitors is a law firm pioneered by Solicitor Chirag Sancheti and Advocate Deep Shridharani. The firm has expertise in the areas of both Litigation and non-Litigation. Under the non-litigation Law practice, the firm practices in the areas of Corporate Law, Intellectual Property Law, Bankruptcy & Insolvency Law, Competition Law, Real Estate and Conveyancing and DTAA Advisory. Further, under Corporate Law area, we practice Company Law, Securities Law, Mergers and Amalgamations, Private Equity and Venture Capital Investment Transactions, Legal Due Diligence and Foreign Exchange Management Law.