Recently, the Revenue Department issued a guideline to the Foreign Revenue Investment Board [hereinafter “FIPB”], instructing them to reject foreign direct investment in the telecom sector from companies based in tax havens. The issue arose when Daltotrade Ltd., a Cyprus-based company, tried to raise its stake in Meta Telecomm, an Indian company. Under the India-Cyprus DTAA, Cyprus residents are exempt from capital gains tax in India, and the Cyprus laws do not impose any such capital gains tax. This enables double avoidance of taxation, which is something the Department seeks to avoid, which is why there is talk of the DTAA being amended accordingly. However, the fact that DTAAs with other countries like Mauritius have similar provisions makes this a larger issue than merely the DTAA with Cyprus. The issue here basically revolves around the meaning of ‘resident’ under a DTAA. The usual definition of resident in Indian DTAAs and under the Model Laws is: ‘For the purposes of this Agreement, the term ‘resident of a Contracting State’ means any person who, under the laws of that State, is liable to tax therein by reason of his domicile, residence, place of management, place of incorporation or any other criterion of a similar nature.’ Apart from the meaning of the terms ‘domicile’, ‘residence’, ‘place of management’ and ‘place of incorporation’, the more significant qualifying term in this definition is the phrase ‘liable to tax’. Even if one of the other four terms are satisfied, on a plain reading of the provision, it would not suffice, unless the satisfaction of the terms made the assessee ‘liable to tax’ in the Contracting State. However, there is a great degree of confusion as to the meaning of ‘liable to tax’. Logically, there are three possibilities: A person may not be covered by the tax net of a country (for instance, the U.A.E. does not tax individuals); the person may be covered by the law, but may enjoy an exemption is respect of certain income; and the person may be covered and be paying taxes under the law of that country. Which of these three cases does the term ‘liable to tax’ refer to? There seems to be a fair degree of judicial disagreement on this point, succinctly summarised by a reading of two conflicting decisions of the AAR in In re Mohsinally Alimohammed Rafik (1994) and Cyril Eugene Pereira v. C.I.T. (1999), and the 2003 decision of the Supreme Court in Azadi Bachai Andolan. Rafik endorsed the view that ‘liable to tax’ includes even the first scenario mentioned above. However, Pereira reconsidered this decision and concluded that being subject to tax liability is essential. The landmark decision of the Supreme Court in Azadi Bachao reconsidered these cases, and in conclusion, disagreed with the decision in Pereira. However, the precise nature of this disagreement is unclear. Azadi Bachao dealt with a situation where there was a specific exemption in respect of certain types of income for residents, and not when a certain class of residents was not subject to any sort of tax. Thus, the context was entirely different from that in Pereira, and the disagreement has not been reasoned out either. What makes a debate on this issue relevant today is the fact that, while the recent guideline may seem validated by the decision in Azadi Bachao, it is essential that a misreading of Azadi Bachao, as authority for propositions wider than what it actually said, should not affect decisions in important areas like foreign investment.
Another area where such a misreading is possible is the discussion of the decision on forum-shopping. While there seems to be a widespread belief that the Court gave a clean-chit to forum-shopping, an alternate interpretation of the decision seems equally tenable. The Court only says that a “hypothetical assessment of the ‘real motive’ of the assessee” is irrelevant for the purposes of determining residence. Now, this statement incorporates in it two qualifications: First, it precludes only a hypothetical assessment of real motives, and not a fact-based examination of the same. Thus, this statement would seem to suggest that if, on fact, it is proved that the motive for incorporation was tax evasion alone, it would be sufficient to lift the veil. However, it must be admitted that this interpretation of the statement goes against the general tenor of the decision, and would, in all probability, be incorrect. However, there is a second, and more significant, qualification which the statement definitely allows. Just before discussing the non-examination of motives of the assessee, the Court opined that, “(i)f the Court finds that notwithstanding a series of legal steps taken by an assessee, the intended legal result has not been achieved, the Court might be justified in overlooking the intermediate steps”. This means that if the independent entity has not, in fact, been created, the Court may be entitled to ignore the residence of this independent entity. Now, the corporate veil can also be lifted in cases other than when the creation of the new entity is for the sole purpose of avoiding tax liability. All that the decision in Azadi Bachao seems to do disallow is lifting the veil on the basis of motive for the creation of the entity. However, the decision is not authority for the proposition that the newly created entity will, in all cases, be considered independent, in ignorance of principles of corporate law. Thus, if, on facts, the new entity is considered the agent of the parent, or forms a single economic unit with the parent, the veil may still be lifted. It also seems to permit lifting the veil on grounds of injustice/inequity, which is an accepted basis in India.
It is these, and other interesting issues on the interpretation of DTAAs that are discussed by Mr. Sohrab E. Dastur in his recent piece. Apart from the two topics detailed above, he also sheds considerable light on issues like the effect of amendments to the Income Tax Act on the interpretation of a pre-existing DTAA, or amendments to a DTAA on pre-existing contractual arrangements. The article also contains a detailed exposition of the relation between the DTAA and the Income Tax Act, and the principles of interpreting tax treaties, providing an interesting insight into this fast-emerging area of law, with enormous commercial significance.
The article is available at http://www.itatonline.org/interpretation/interpretation17.php.