Taxation of Mergers Aquisitions
Updated: Jun 2, 2020
Karthik Ranganathan Associates
Gains earned from sale of CCDs in a Joint Venture are capital gains and not interest income.
The Delhi High Court (Delhi HC) has very recently held in the case of Zaheer Mauritius vs. Director of Income-tax (International Taxation) II [(2014) 47 taxmann.com 247 (Delhi)] that the gains earned by an entity situated in Mauritius by the sale of Compulsorily Convertible Debentures (CCDs) held in an Indian Joint Venture Company (JV Co.) to the Indian JV Partner shall be treated as capital gains and not as interest income even though the terms of calculating the sale consideration is dependent upon the accumulated fixed rate of return of the CCDs. By this, the entire gains earned by the Mauritian entity (the taxpayer) will be tax exempt in India due to the India Mauritius tax treaty and whereas, classifying the same as interest income would result in 20% withholding tax (WHT) by the Indian JV Partner as per the Indian Income-tax Act, 1961 (the Act) since interest income is taxable according to the laws of India/ Mauritius.
The matter reached the Delhi HC by way of a writ petition against the order of the Authority for Advance Ruling (AAR) which held that the gains earned by the taxpayer is in fact accumulated interest income and not capital gains and therefore, requires withholding tax by the Indian payer. The AAR also held that the investment in the JV Co. was actually a loan provided to the Indian JV Partner by the taxpayer which can be understood if the corporate veil of the JV Co. is lifted to show that the JV Co. and the Indian JV Partner are one and the same. The AAR further held that the entire transaction was to avoid Indian taxes.
On a separate note, since the orders of the AAR are not appealable, only writ petitions before the jurisdictional High Courts can be filed against such orders by the aggrieved parties. The Supreme Court in the case of Columbia Sportswear Co. vs. DIT, Bangalore (2012) 346 ITR 161 held that only writ petitions under Article 226 of the Indian Constitution have to be filed before the jurisdictional High Courts against the orders of the AAR and no Special Leave Petitions should directly be filed under Article 136 of the Indian Constitution before the Supreme Court.
Facts of the case
Vatika Limited (Vatika or the Indian JV Partner) is into the business of developing and dealing of real estate. It owned a land which was meant for developing a cyber park near Gurgaon. Vatika had set up a 100% subsidiary named SH Tech Park Developers Private Limited (the JV Company). The taxpayer is a company incorporated in Mauritius namely, Zaheer Mauritius which is into the business of investing in Indian real estate companies.
The taxpayer, Vatika and the JV Co. entered into Share Subscription Agreement (SSA) and Shareholder Agreement (SHA) by which the taxpayer will have shareholding to the extent of 35% in the JV Co. by investing INR 1 Billion (INR 100 Crores) in five tranches by way of subscribing to 46,307 equity shares and debentures worth INR 880 Million (approx). Among other rights given to the parties to the JV, the SSA also gave call option to Vatika to purchase all the above securities from the taxpayer and put option to the taxpayer to sell to Vatika during the determined period.
Separately, Vatika entered into a Developments Rights Agreement (DRA) with the JV Co. by which all the rights to develop the cyber park, rights to transfer the same post completion and to enjoy all incidental rights including the right to retain the sale proceeds were given to the JV Co. In short, the JV Co stepped into the shoes of Vatika vis-a-vis the development and transfer of the cyber park was concerned.
In April 2010, Vatika partly exercised the call option whereby the all the CCDs were purchased by Vatika from the taxpayer and equity shares to the extent of 22,924. The consideration paid by Vatika to the taxpayer for exercising such option was INR 800 Million. The remaining equity shares to the extent of 23,383 were retained by the taxpayer.
To avoid any tax dispute in the above exercising of call options by Vatika, the taxpayer approached the income tax department (the revenue) to provide a NIL withholding tax certificate under section 197 of the Act on the consideration received by the taxpayer for the sale of the CCDs. The tax department passed an order stating that the entire gain on the transfer of the CCDs is interest income as per section 2(28A) of the Act and Article 11 of the India Mauritius tax treaty and should be subject to WHT at the rate of 20% (plus surcharge and cess) as per the Act.
Against such order the taxpayer approached the AAR for an advance ruling that the entire gains should be treated as capital gains in the hands of the taxpayer and by applying the India Mauritius tax treaty it was exempt from Indian taxes.
The AAR, in short held that:
The entire gains earned by the taxpayer was interest income as per the Act and the tax treaty and therefore, liable to WHT in India
By lifting the corporate veil of the JV Co. it is understood that Vatika and the JV Co. are one and the same entity. The entire investment in the JV Co. by the taxpayer is nothing but a loan granted by it to Vatika and the whole structure and transactions are a sham.
The entire transaction is nothing but a devise to evade Indian taxes
Aggrieved by the order of the AAR, the taxpayer filed the present writ petition before the Delhi HC.
Arguments of the Taxpayer
The taxpayer argued that there was no debtor and borrower relation between it and Vatika. The CCDs were held as capital assets by the taxpayer and therefore, the transfer of the same should only result in capital gains. According to India Mauritius tax treaty the gains were exempt from tax in India. The understanding of the AAR that the agreements entered by the taxpayer, Vatika and the JV Co. are a loan transaction, disguised as an investment in CCDs is erroneous. Further, the understanding of the AAR that Vatika and the JV Co. are a single entity and the JV Co. has been created only for the purpose of avoiding Indian taxes is incorrect.
Arguments of the Revenue
The Revenue argued that the writ petition was not maintainable before the High Court as the order passed by the AAR was a reasoned one and not perverse. On merits, the revenue argued that the entire transaction was nothing but an External Commercial Borrowing (ECB) which can be understood from the structure. It further argued that the taxpayer was entitled to a fixed rate of return which got accumulated over the duration of the investment and therefore, the gains earned by the taxpayer were interest simplicitor and subject to tax in India.
Judgment of the High Court
The High Court in its judgment first tried to ascertain the basic nature of CCDs i.e. whether it can be treated as capital asset or not. While the court was convinced that CCDs per se are debt instruments and the return on such instruments are certainly interest income, the court held that not all type of incomes that is earned through such instruments can be treated as interest income as per section 2(28A) of the Act. The court held that if CCDs are to be treated as capital assets then any gains earned by transfer of such capital assets will only be capital gains and not as interest income. Likewise, any loss made by transfer of such capital assets is capital loss and not business loss or loss from other sources. The court held that had these CCDs been transferred to a third party then any gains made by the taxpayer would certainly be capital gains. The entire controversy arose because the CCDs were transferred to Vatika and therefore, the AAR is of the view that this is a disguised loan transaction.
The court appreciated some of the facts such as, the investments were to be made in various tranches by the taxpayer which was approximately INR 200 Million in each tranche and during each investment the taxpayer would receive certain number of equity shares and CCDs of the JV Co. All the CCDs were convertible into equity shares after a period of 72 months (i.e. six years) but the taxpayer also had the option of conversion of some of the CCDs after certain specific period like 48 months, 54 months and 60 months. The court extracted certain relevant clauses from the SHA which held that if the taxpayer exercised its put option or if Vatika exercised its call option before the determined period then the taxpayer would get back its investment amount plus accrued return plus equity payment. The court held that this method of calculation of repayment was what held by the AAR as interest payment and not capital gains since the consideration is dependent upon the rate of return.
However, the Delhi HC held that merely because the mode of calculation was dependent on a fixed rate of return the same cannot be treated as interest income. The court rightly pointed out that such payments would happen only if Vatika wanted to buy the CCDs from the taxpayer or if the taxpayer wanted to exit from the JV. Had the taxpayer 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 JV Co. Merely because the taxpayer wanted to exit in the middle of the determined period will not make the gains as interest income.
The court also held that the taxpayer had the right to sell the options to third parties also in which case it would have been taxable as capital gains. Further, the court held that either the taxpayer held the CCDs or Vatika held the CCDs, the JV Co. was bound to convert them into equity shares after the determined period which goes to shows that the instruments are only capital assets.
On the second point of the AAR that the JV Co. and Vatika are a single entity, the court painstakingly referred to various clauses of the SHA and SSA to show that Vatika had limited powers in various decision making processes in the JV Co. and in various situations the Affirmative Vote of the taxpayer was required to approve a decision. This shows that Vatika and JV Co. were independent and the former did not have absolute control over the latter. Further, the Board of Directors had a mix of both Vatikas and the taxpayers nominee directors. Further, Vatika had to refrain from any decisions pertaining to developments rights of the cyber park which only proves that Vatika and JV Co. were distinct entities. Therefore, the court held that there was no need to lift the corporate veil and treat Vatika and JV Co. as a single entity.
The court also relied on the Foreign Direct Investment (FDI) policies and Reserve Bank of India (RBI) guidelines to show that it was permissible for the taxpayer to invest in the CCDs and the same was treated at par with equity investment which is a capital asset. Therefore, CCDs could not be treated as ECBs as ECBs had separate guidelines and procedures.
On the tax evasion aspect decided by the AAR, the court held that if the payments are treated as interest payments it will only benefit Vatika as the same is deductible against its taxable income. The court relied on the Vodafone judgment of the Supreme Court and held that only look at approach has to be adopted and the structure of the taxpayer has to be respected if the same is for commercial reasons. The court concluded by holding that it was a genuine commercial venture and the legal nature of the instrument of CCDs should not be ignored.
It is a classic case to demonstrate that the terms of the agreements such as SHA and SSA are extremely important for tax purposes. Interestingly, both AAR and the Delhi HC relied on the agreements to arrive at their conclusions. The AAR held that the payments made are interest income since the sale consideration was based on the rate of return as mentioned in the agreement. The court also relied on the same agreement to distinguish the conclusion of the AAR and especially, to hold that the JV Co. and Vatika were separate entities.
As of now, the revenue does not have powers to re-characterize any payments from one kind to the other like in the present case. Such powers are only found in the General Anti Avoidance Rules (GAAR) which unless deferred will come into force from April 1, 2015. Of late, many of the decisions of the AAR are based on substance over form concepts, unfortunately, some of which are an overreach.
Merely because the CCDs were sold back to the JV Partner (i.e. Vatika) in this case, the AAR held that it is an interest payment which appears to be incorrect given the fact that in JV Agreements usually the other JV Partner has pre-emptive rights to buy the remaining interest from the exiting JV Partner. Such re-characterization of capital gains into interest income is unwelcome which will have a bearing on several FDIs in the country which are in the form of JVs given the sectoral caps restrictions.
On the other hand, as per India Mauritius tax treaty, interest includes premiums on the underlying debt securities! The fact that the sale consideration on exercising the call option by Vatika was determined based on the fixed rate of return on the CCDs created a reasonable doubt in the mind of the AAR to re-characterize the capital gains as interest income. A clause stating that the sale consideration at the time of exit by the taxpayer will be determined at such time may have avoided these confusions.
As far as time taken to decide the matter is concerned (which is key to foreign investors), section 197 application (Nil WHT certificate by the revenue) has taken four months time. The AAR has decided in little over a years time and the Delhi High court has decided the case in two years and four months time which is relatively a shorter time span in India! Now, one has to wait and see whether the revenue will take up this matter to the Supreme Court under Article 136 of the Constitution to have finality in the matter.
This article was originally published at Karthik Ranganathan Associates.