26 August 2014 | Volume 7 Issue 8
Indirect transfer on sale of shares taxable in India only if 50% of the total value of global assets derived from Indian assets

The Finance Act, 2012, introduced tax on indirect transfers with retrospective effect from 1962. The Income Tax Act, 1961 (the Act) provides that transfer of shares or interest in a company or entity registered/incorporated outside India shall be chargeable to tax in India if the value of such shares is substantially derived from assets located in India. However, the word 'substantially' had not been defined under the Act, which has not only created uncertainty and ambiguity in its interpretation but also resulted in challenges in global restructurings.

In a recent judgement of Delhi High Court in case of DIT vs Copal Research Limited, Mauritius & Ors
[1] wherein the court explained the meaning of the term 'substantially' used in the context of indirect transfers. It was held that gains arising from the sale of a share of a company incorporated overseas which derives less than 50% of its value from assets in India would certainly not be taxable under Section 9(1)(i) of the Act.

Facts of the case
  • Copal Partners Ltd, Jersey (CPL Jersey), held 100% shares in Copal Research Ltd, Mauritius (CRL Mauritius)
  • CRL Mauritius, in turn, held 100% of the shares in both, Copal Research India Pvt Ltd, India (CRIPL India) and Copal Market Research Ltd, Mauritius (CMRL Mauritius). CMRL Mauritius, in turn, held 100% of the shares in Exevo Inc, USA (Exevo USA). Exevo US, in turn, held 100% of the shares in Exevo India Pvt Ltd, India (Exevo India).
  • Approximately 67% of the shares in CPL Jersey were held by Copal Group shareholders and the remaining 33% (approximately) were held by banks and financial institutions.
  • The Copal Group and Moody Group (non-resident companies) entered into the following Share-Purchase Agreements:
    • Transaction I: CRL Mauritius sold its entire shareholding in CRIPL India to Moody's Cyprus Ltd (Moody's Cyprus)
    • Transaction II: CMRL Mauritius sold its entire holding in Exevo USA to Moody's Analytics Inc US (Moody's USA)
    • Transaction III: Copal Group shareholders sold their 67% holding in CPL Jersey to Moody's Group UK Ltd (Moody's UK)
A diagrammatic representation of these facts is shown below:
  • An application was filed with the Authority for Advance Rulings (AAR) to determine whether Transaction I and Transaction II are chargeable to tax in India, the head under which the said transactions would be taxed, the year and head under which the deferred consideration would be taxed and the applicability of withholding tax.
  • The AAR concluded that the said transaction shall not be chargeable to tax in India.
  • It was also held that the deferred consideration was a part of the full consideration and as such would be taxable under the head, Capital Gains.
  • Aggrieved by this, the Revenue filed a writ before the Delhi High Court.
Key issues before the High Court
  • Whether the transactions for sale of 100% shareholding in CRIPL India and Exevo USA (i.e. Transactions I and II) are designed prima facie for avoidance of income tax under the Act?
  • Whether the transactions resulting into direct/indirect transfer of two underlying Indian subsidiaries are taxable in India?
In the following paragraphs, we discuss the above issues and the ruling of the High Court. 

Revenue's contention
  • The transactions for sale of shares of Exevo USA and CRIPL India must be viewed in conjunction with the sale of shares of CPL Jersey to Moody's UK as contemplated under Transaction III. All three transactions (i.e. Transactions I, II and III) were essentially parts of a single transaction.
  • In order to avoid the incidence of tax, the sale of the businesses and interests of the Copal Group to the Moody Group was structured in a manner so as to exclude two separate transactions for sale of shares of CRIPL India and Exevo USA and hence there was no taxability in India.
  • Separate sale transactions in respect of shares of CRIPL India and Exevo USA (i.e Transactions I and II) were executed one day prior to the sale of shares of CPL Jersey (i.e Transaction III). The gains arising from the sale of shares of CPL Jersey in the hands of Copal Group shareholders would be taxable under the Act (due to non-availability of India-Mauritius DTAA benefits) as the shares of CPL Jersey would derive their value substantially on account of the value of the assets situated in India (namely shares of Exevo India and CRIPL India).
  • The entire structure of investments to hold the companies in India has been evolved with the sole objective of avoiding tax and the intermediary companies in Mauritius had been incorporated only with a view to avoid tax at the time of sale in future.
  • Companies/subsidiaries of Copal Group are in fact shell companies and CRL Mauritius and CMRL Mauritius are actually non-operative since their revenues are generated from within the Copal Group.
 Taxpayer's contention
  • Both CRL Mauritius and CMRL Mauritius held Category-I Global Business Licences (GBL) and the financial statements of both companies indicated that the companies had earned substantial revenue from provision of services.
  • The India-Mauritius DTAA does not include a Limitation of Benefits (LOB) clause and therefore it was not open for the Revenue to contend that the said companies should be denied treaty benefits.
  • The applicant submitted that had the shareholders of Copal Jersey directly transferred their holdings to Moody Group, the Moody Group would have obtained only 67% of the holding in the Indian subsidiaries. However, this was not the commercial intention as the Moody Group wished to be the 100% owner of the Copal subsidiaries. Therefore, different transactions were entered into.
  • Further, the banks and financial institutions that held 33% shares in Copal Jersey also participated in the dividends that were distributed from the funds received from the sale proceeds of Transactions I and II. This would not have been commercially viable if the overall transaction had been structured in the manner as suggested by the Revenue i.e. a simpliciter sale of 67% shares of Copal Jersey by the Copal Group shareholders.
 High Court's ruling
  • Indirect transfers are taxable in India only when the shares derive a substantial value from the Indian asset. In the given case, the shares of Copal Jersey earned a value of USD 93.5 million whereas the consideration from the Indian subsidiaries was USD 28.53 million only.
  • The objective of inserting Explanation 5 was not to extend the scope of Section 9(1)(i) of the Act to include income which has no territorial nexus with India, but rather to tax income having nexus with India irrespective of whether the same was reflected in a sale of an asset situated outside India. The expression 'substantially' occurring in Explanation 5 would have to be read as synonymous to 'principally', 'mainly' or at least 'majority'. Explanation 5 having been stated to be clarificatory in nature must be read restrictively.
  • Reference was made to the OECD Model Tax Convention on Income and on Capital to add a persuasive and not conclusive value and it was mentioned that the taxation rights in case of sale of shares are ceded to the country where the underlying assets are situated only if more than 50% of the value of such shares is derived from such property.
  • Reference was also made to the Shome Committee Report and the Direct Tax Code, 2010, where both had considered the term 'substantially' to be a threshold of 50% of the total value derived from assets of the company or entity.
  • The High Court found that there was adequate commercial rationale behind Transactions I and II and rejected the department's contention that they were carried out for the purpose of tax avoidance.
  • The High Court upheld the conclusion of the AAR that gains arising from the transaction shall be chargeable to tax in India only if the Indian assets contribute to its value by more than 50%.

[1] DIT (Int. Tax) vs Copal Research Limited and Others [W.P. (C) 2033 / 2013 & other connected matters]
SKP's Comments
This is certainly a welcome and awaited ruling on the taxability of indirect transfers. Based on this ruling, the High Court has set a 50% threshold to the word 'substantially', thereby providing some certainty to a presently vague term. The investor community was waiting for such a clarification by the new government in the recent Union Budget. Such favourable verdicts will surely help reinforcing the confidence of foreign investors in India. Another positive indication is that the courts are not willing to indiscriminately pierce the corporate veil, and the onus would lie on the Indian Revenue authorities to successfully prove that piercing the corporate veil is warranted.
However, it is pertinent to note that the Delhi High Court has not considered the amendment in the revised DTC Bill, which had reduced the threshold from 50% to 20%.

It will be interesting to see the treatment of such transactions by the courts once the General Anti-Avoidance Rules (GAAR) come into play.

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