Saturday, August 6, 2011

Developments in Taxation: Constitutionality of Service Tax; and Tax Planning through the "Mauritius Route"



The Bombay High Court has, in the past few weeks, decided two important issues: one pertaining to direct taxation, and the other to indirect.

A Division Bench headed by Justice D.Y. Chandrachud has upheld the constitutional validity of service tax on renting of immovable property, as reported by Legally India. The arguments raised by the Petitioners were primarily that a “service” tax on renting of immovable property was in substance a tax on land and building, and was within the competence of the State Legislature under Entry 49, List II. The Union of India, on the other hand, contended that a tax on land and building (Entry 49, List II) was different from a tax on income arising from land and building, and on services pertaining to land and building. It was further contended that as long as there was no transgression into List II, it was open for Parliament to artificially define a taxable “service”.

Insofar as this challenge is concerned, the issue really turns on the scope of Entry 49. In Assistant Commissioner of Urban Land Tax v. Buckingham & Carnatic Co., [1970] 1 SCR 268, it was held that to fall under Entry 49, List II, two tests must be satisfied. First, the tax must be directly imposed on land/buildings. Secondly, the tax must bear a definite relation to the land and buildings. In the case of tax on renting of immovable property, the tax may be one bearing a definite relationship to land/buildings, but is the tax really imposed directly on land and buildings? Further, in State of West Bengal v. Kesoram Industries, (2004) 10 SCC 201, the Supreme Court also clarified the earlier decision in India Cements v. State of Tamil Nadu, and in this context observed, “There is a clear distinction between 'tax directly on land' and 'tax on income arising from land'.” A tax on renting of immovable property would perhaps be closer to the latter, and not the former.

On the direct tax front, a bench headed by Justice J.P. Devadhar had cast doubts on the efficacy of the “Mauritius route” in tax planning, in Aditya Birla Nuvo v. Union of India. The Court appears to have read down the judgment of the Supreme Court in Azadi Bachao Andolan. The facts are summarized by ITAT Online thus:

Idea Cellular Ltd, an Indian company, was set up as a joint venture company pursuant to a JV agreement between AT&T Corp, USA, and the Birla Group. As provided by the agreement 49% of Idea Cellular’s equity was allotted to AT&T Mauritius, being 100% subsidiary & “permitted transferee” of AT&T, USA. Though the shares were allotted to AT&T Mauritius, all rights of voting, management, right to sell etc were vested in AT&T USA (subsequently known as “New Cingular Wireless Services Inc, USA” (“NCWS”). Subsequently, Tata Industries was inducted as a joint venture partner in Idea Cellular. Thereafter, 50% of the shares of Idea Cellular held by AT&T Mauritius were sold by AT&T Mauritius to Aditya Birla Nuvo (nominee of the Birla group) and 100% of the shares of AT&T Mauritius (which held the balance 50% of the shares of Idea Cellular) were sold by NCWS to Tata Industries. Aditya Birla Nuvo obtained a NOC u/s 195(2) permitting it to remit the sale consideration to AT&T Mauritius without TDS. The Court had to consider the validity of three proceedings initiated by the AO (i) Order u/s 163 treating Aditya Birla Nuvo as agent of NCWS USA on the ground that though the transferor was AT&T Mauritius, the gains from sale of the Idea Cellular shares was taxable in the hands of NCWS USA, (ii) Order u/s 163 treating Tata Industries as agent of NCWS USA on the ground that though the shares of AT&T Mauritius were purchased, effectively the underlying shares of Idea Cellular were purchased and (iii) Notice u/s 148 asking NCWS to file a return in respect of the gains arising from (indirect) transfer of the Idea Cellular shares…

The essential question, in the words of the Court, was “whether the ICL shares were owned by AT&T Mauritius or by NCWS (USA).” The Revenue contended that the shares were owned by NCWS (USA), and not by the Mauritius company. It was contended by the assessee that the shares were owned by the Mauritius company, and an enquiry as to the “real” ownership would amount to lifting the corporate veil over a company which had a tax residency certificate in Mauritius. This (the assessee argued) was not permissible in view of the Supreme Court decision in Azadi Bachao Andolan.

The Court distinguished Azadi, by holding that in Azadi, the ownership of shares itself was not in issue. In the present case (the Court reasoned), It is AT&T USA which has subscribed to and owned 49% equity shares (later on reduced to 32.91%) of the JVC under the JVA. It is at the instance of AT&T USA the shares subscribed were issued in the name of its 100% subsidiary as a permitted transferee. It is AT&T USA as a shareholder of the JVC, entered into a Shareholders Agreement wherein the shareholding was reduced with the induction of the Tata Group.  It is AT&T USA which has agreed with the other joint venture partner that irrespective of issuance of the shares in the name of a permitted transferee, all rights relating to those shares including the right to sell the shares shall vest in AT&T USA. Therefore, in the facts of the present case, where the investments are made by AT&T USA and not by AT&T Mauritius, the ratio laid down by the Apex court in the case of Azadi Bachao Andolan (supra) would not apply…” Casting doubts on the effectiveness of structuring investments through “permitted transferees”, the Court held “Once it is prima facie established that the investments in the shares of the JVC were made by AT&T USA and the allotment of shares in the name of AT&T Mauritius was as a permitted transferee of AT&T USA, then the fact that AT&T Mauritius held a Tax Residence Certificate issued by the Republic of Mauritius and that certificate was valid on the date of sale of ICL shares would become wholly irrelevant. Since the shares of the JVC were subscribed and owned by AT&T USA as a joint venture partner and AT&T USA had agreed to sell the shares of ICL along with AT&T Mauritius to Indian Rayon by a Sale and Purchase Agreement dated 28th September 2005, the amount of sale consideration received by AT&T USA through AT&T Mauritius would be taxable in the hands of the AT&T USA (now represented by NCWS).





9 comments:

Anonymous said...

Post this decision, what is the best jurisdiction to structure investment inflows, from a tax perspective? Can the Mauritius route be used, any ideas for getting around this judgment?

vswami said...

On the mentioned development re.-conctitutionality of Service Tax:

On the first blush, in one's perception, the arguments of both sides seem to have been primarily confined to / mainly focused on the question whether or not it was, having regard to the overriding constraint in the Constitution, within the power of the Central Government to levy 'service tax' on rent from immovable property/land and building. In other words, arguments on the crucial question whether, and why a pure and simple letting out of ‘the property’, which entails/or includes no element of ‘service’ within its ordinary, as well as its strict legal connotation (de hors any 'deeming'), so as to be justifiably regarded as 'service' and be subjected to tax on that premise does not seem to have been sufficiently stressed, as warranted. Should that be so, or even otherwise, perhaps, this is an aspect on which the 'experts' active in the field would be obliged to apply their mind, after a close study of the entire Court judgment, and come out with ideas on the scope left, if any, for pursuing the ongoing battle against such or similar levy. For this purpose,it might be worth examining, for getting at useful clues,the specific provisions of the Income-tax Act, as also the long line of court decisions, on a related issue, howsoever remote that be. That is, - whether or not income from pure and simple letting out of ‘property’, for a rent, has the characteristics of ‘business’ so as to be taxed as ‘business income’, or as income under other heads – ‘house property’ or ‘other sources'.

Mihir Naniwadekar said...

@Anonymous: I dont think it is impossible to point out the "best" jurisdiction which will work in each and every situation. And yes, the Mauritius route can be used; though it will be better if in substance the investment is made by a Mauritius-based entity. The Court has frowned on this arrangement of "permitted transferee" being a Mauritius company, when all the incidents of ownership vest in the American parent. I dont think that this judgment can be read as implying that in all cases, Mauritius-based transactions would suffer.

@vswami: The issue of whether mere renting is a service or not was indeed argued before the High Court. The problem, is, let us assume for a moment that mere renting is not a service. U/E 97, however, as long as no List II/III entry is transgressed, Parliament has the power to define "service" in any way it wants. (In a sense, the analogy is to the real income principle - by statute, it is open for Parliament to override the real income theory. So too, by statute, Parliament can override the fact that in common parlance, mere renting may not be a service.

vswami said...

".....as long as no List II/III entry is transgressed, Parliament has the power to define "service" in any way it wants."

I personally see no logic, in the suggested view of the expert columnist: as, otherwise, what follows is - the Parliament is supreme, hence can bypass the very basic original idea in having 2 separate entries, by so changing the otherwise accepted/acceptable meaning (for other purposes e.g.I TAX) of 'service', within its dictionary or legal meaning.

As to the analogy of 'real income',I think it makes more sense to bear in mind- the age old distinct concepts of - 'earned' and 'unearned' income. However, as I said,a truly detailed study and examination with a fine toothed comb of the lines of reasoning adopted in the regime of I TAX is called for.

I have in the back of my mind a very old court case (was it a Gift tax case - Getti Chettiar?)wherein the SC ruled that a co-owner (HUF?)cannot be regarded to have effected any 'transfer' - (despite the very wide meaning given per statutory definition), -if he relinquishes his rights in favour of the other co-owners.(May be, one can find such view taken in partnership cases as well)

vswami said...

A Rider: If the proposition sought to be canvassed, namely, - the Parliament is 'omnipotent' and has unlimited powers /competence to make any enactment as it likes - were to be accepted, then, in one's perception,that would make a nonsense of those plethora of cases where the constitutional validity of any number of enactments have been / still continue to be challenged on the ground of - 'ultra vires'; I am open to correction, if this observation is void, with no substance.

For more thoughts: REF. the Blogs:

EARLIER POSTs-
10TH MARCH
http://vswaminathan-swamilook.blogspot.com/2011/03/levy-of-service-tax-if-at-all-justified.html

15th Mar
http://vswaminathan-swamilook.blogspot.com/2011/03/constitutional-law-amendment-of.html

Anonymous said...

Will respond in detail to the points: but just one question- if parliament had levied a "Parliamentary Tax on renting of immovable property" instead of a "Service tax on renting of immovable property", would that still be subject to a competence-based challenge? If not, why does the fact that parliament chose something to be defined as a "service" matter? Today, a gift tax is levied as a tax on income from other sources - is that on its own grounds enough to challenge the validity of the tax?

To my mind, the nomenclature of the tax is irrelevant: one needs to ask (a) what is the nature of the tax, in substance; (b) is a tax of that nature covered under List II? In the case of the impugned tax, the nature of the tax is not something which can be called a tax on land and buildings. No other List II entry would be transgressed, either.

Anonymous said...

Also, regarding your rider: the position is that if a law does not fall within entries 1-96 of list 1, then unless and until a law falls within lists 2 or 3, it shall be deemed to fall within entry 97 list 1. In each and every case where a central act was struck down on grounds of competence, it was because the same was referable to a specific entry in list 2. As stated in the previous comment, I'l post a more detailed reply: meanwhile, pl. let me know if there is any specific entry in list 2 where you think the impugned levy falls under?
-Mihir

vswami said...

It is heartening for me to note that my brief but quick comments, primarily intended to provoke a 'lively' and 'purposeful' debate, has set in motion and met with some result. It is my earnest wish, and is more desirable, that it is kept going/ alive through a greater participation by, apart from (Mr?)'Anonymous', others having exposure or experience in dealing with the complexities of the 'Constitution'(admitting, to be true to myself, to be one not at all profoundly ‘equipped’ so as to profess to be one of them).
I have only one suggestion: While on this subject, one may usefully have a look at the lines of reasoning, though mutually varying, adopted by courts - the last one reported is in itatonline @ - "Service tax is payable on Sale of SIM cards, no sales tax – even if Sales tax is wrongly paid, Service Tax is payable – Supreme Court"

vswami said...

Sorry!It should be read: 'taxguru' (in place of 'itatonline')