Thursday, March 25, 2010

E*Trade Mauritius: Reaffirming legal form over economic substance



The Authority of Advance Rulings has issued its ruling in the matter of E*Trade Mauritius; and the Ruling essentially follows the decision of the Supreme Court in Azadi Bachao Andolan. The facts before the Authority were that the Applicant was a company incorporated in the Mauritius, and had been issued a Tax Residency Certificate by the Mauritius income tax authorities. The Applicant was a subsidiary of a company incorporated in the United States of America. The Applicant held shares in an Indian company, IL&FS Investsmart Ltd. It transferred its shares in the Indian company to another Mauritius company. Under domestic law, the gains from this transfer (gains arising through the transfer of a capital asset situate in India) would be chargeable under Section 9 of the Income Tax Act. Having a tax residency certificate in Mauritius, the applicant claimed the benefit of Article 13(4) of the Indo-Mauritius DTAA. Under Azadi Bachao, the applicant would clearly be entitled to the benefit of the DTAA; and the gains would be taxable only in the residence country, Mauritius.

The Revenue however contended before the AAR, that “there is scope and sufficient reason to infer that the capital gain from the transaction arises in the hands of the US entity which holds the applicant company. In other words, the beneficial ownership vests with the US company which according to the department has played a crucial role in the entire transaction. Though the legal ownership ostensibly resides with the applicant, the real and beneficial owner of the capital gains is the US Company which controls the applicant and the applicant company is merely a façade made use of by the US holding Company to avoid capital gains tax in India.” According to the Revenue, considering that the ‘real’ beneficiary was the US parent of the Mauritius applicant, the gains must be held to accrue to the US company. Under the relevant provision of the Indo-US treaty, the gains would be taxable in India. Contrary to this argument, the applicant contended that beneficial ownership is irrelevant in the context of Article 13 of the Indo-Mauritius treaty. Strong reliance was placed on Azadi Bachao.

The AAR analysed the decision in Azadi Bachao, and ruled, “…the Supreme Court found no legal taboo against ‘treaty shopping’ … if a resident of a third country, in order to take advantage of the tax reliefs and economic benefits arising from the operation of a Treaty between other countries through a conduit entity set up by it, the legal transactions entered into by that conduit entity cannot be declared invalid. The motive behind setting up such conduit companies and doing business through them in a country having beneficial tax treaty provisions was held to be not material to judge the legality or validity of the transactions.

The Revenue contended that where the incorporation of a Mauritius entity is merely a device or a sham, the ratio of Azadi cannot be applied. Again, the AAR clarified, once again on the basis of Azadi, that “… the word ‘device’ cannot be used ‘in any sinister sense’ and the design of tax avoidance by itself is not objectionable if it is within the framework of law and not prohibited by law. However, a transaction which is ‘sham’ in the sense that “the documents are not bona fide in order to intend to be acted upon but are only used as a cloak to conceal a different transaction” (per Lord Tomlin in Duke of West Minister) would stand on a different footing ….

In an earlier post discussing a recent English decision on lifting the corporate veil, Niranjan had stated that ‘sham’ is a legal concept which requires Courts to see what the legal substance of the relationship between the parties is. Courts are, however, not entitled to look at alleged ‘economic realities’ in deciding on the basis of allegations of sham. The AAR has held that the law in India after Azadi is the same, saying that “for acts or documents to be a ‘sham’, the parties thereto must have a common intention that they are not to create the legal rights and obligations which they give the appearance of creating…” Consequently, it was held that the Mauritius treaty would apply and the gains would not be taxable in India

While the decision does not contain any broad proposition of law beyond that which was already laid down in Azadi, it is significant for once again emphasizing that the ‘sham’ doctrine is a legal concept and not an economic concept. Further, the AAR has once again foiled the attempts of the Revenue to circumvent the ruling in Azadi by relying on McDowell’s case. Undoubtedly, McDowell’s case was decided by a larger Bench of the Supreme Court – that cannot be reason enough to supersede Azadi, which has elaborated on the true effect of McDowell. As the Bombay High Court had stated in Akshay Textiles, 308 ITR 401, and as once more clarified by the AAR, McDowell as interpreted and understood in Azadi is the law in India.

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