Vol. 7 Issue 4.

4 About BMR Advisors | BMR in News | BMR Insights | Events | Contact Us |

April 13, 2012 Feedback

AAR holds that gains from the sale of debentures are in the nature of interest and liable to tax under the IndiaMauritius Tax Treaty
The Authority of Advance Ruling (AAR) in a recent ruling has held that gains arising from sale of Compulsorily Convertible Debentures (CCDs), ie, the appreciation in the value of CCDs, is in the nature of interest and hence, liable to tax in India under Article 11 of the India-Mauritius Tax Treaty. Facts of the case The Applicant, Z, is a company incorporated in Mauritius and a tax resident of Mauritius. Z along with V Ltd (V), an Indian company, invested in S Ltd (S) to undertake development of a real estate project in India. V set up S as its subsidiary on July 4, 2007 and subscribed to 10,000 shares of face value Rs 10 each (9,999 held by V and 1 held by its nominee). Vide a Shareholders Agreement (SHA) dated August 7, 2011 and based on the representations, warranties and indemnities provided by V and S, Z agreed to invest in S and the manner of investment was set out under the Securities Subscription Agreement (SSA) dated the same day, August 11, 2007. The commercial agreement between the parties, as articulated in the SHA, was that V, which had developed and is developing large projects in its real estate business would transfer the development rights of certain projects to S. Upon transfer of these rights, Z will invest in equity shares and zero percent CCDs in S. The terms of the CCDs were as under: CCDs were mandatorily convertible at the end of 6 years from the first closing date. Prior to the mandatory conversion and upon specified dates from the first

BMR in association with Infraline energy is organizing a Conference & Interactive Workshop on Successful EPC Contracting in India

Taxand Access Getting the Deal Through Tax on Inbound Investment 2012 Taxands Global Guide to M&A Tax. Click here to view media commentary. Taxand voted Top Tax Planning Advisor in 32 countries in ITRs 2011 poll. Click here to view article. Taxand conducted Global Survey 2011 Taxand the CFO. Click here to view full research findings. PERE together with Taxand produced the 2011 global guide to tax, advising on real estate investment opportunities. Click here to view guide.

BMR Advisors has been rated as a Tier 1 firm according to International Tax Review , World Tax Guide 2012 for the fifth consecutive year. BMR Advisors is ranked fourth most

closing, Z was given a put option to sell specific number of CCDs or shares to V and a call option was also given to V to purchase the said shares or CCDs from Z. 3 nominees of V and 2 nominees of Z became directors on the Board of S, with one of the nominee of V being appointed as Chairman, without the right to a casting vote. On April 8, 2010, V exercised its call option under the call option agreement dated September 4, 2009 pursuant to which V purchased certain equity shares and CCDs from Z. Based on the above facts, the Applicant sought an advance ruling on whether the gain arising to the Applicant on sale of CCDs and shares would be in the nature of capital gains and hence, exempt from tax in India having regard to paragraph 4 of Article 13 of the India-Mauritius Tax Treaty. Revenues contention The Revenue contended that a small portion of the investment comprised shares and the rest was in the form of CCDs and hence, to characterize the gains as having arisen on account of transfer of a capital asset is improper. The agreements viz, the SHA and SSA were entered into to camouflage the true nature of income from that of a loan and interest to capital gains and the Revenue contended that the essence of the agreements as a whole needs to be taken into account while interpreting the agreements and not merely the form. The Revenue also contended that the varying conversion rates depending upon the period of holding were incorporated in the agreement to compensate for the interest income typically payable on debentures and hence, the substance of the instrument was loan and income thereon would be in the nature of interest . The Revenue also contended that the investment by the Applicant was structured as a CCD by way of the SHA and SSA to get around the end use restrictions on foreign debt ie, External Commercial Borrowings. However, that would not change the legal character of CCDs, which continue to remain as debt and more so in view of the predetermined fixed rate of return, applicable rate for call option, etc. Accordingly, the Revenue applying the principle laid down by the Supreme Court in the case of B C Srinivasa Shetty [1] contended that where the common intention of the parties is not to create legal rights and obligations which it gives the appearance of creating, the transaction is then a sham. The Revenue also contended that there was no commercial rationale to determine the conversion ratio based on the period of holding or to guarantee a minimum rate of return whether the company made profits or not. Hence the transaction clothed as purchase of CCDs and equity was a sham designed for avoidance of tax. Without prejudice to the above, the Revenue, on the basis that the SHA and SSA were signed in India and that one of the directors on the board of S was a

active financial advisor for India in Thomson Reuters Mid-Market Insight . BMR Advisors is ranked second Most Active Transaction Advisor (Private Equity) according to the Venture Intelligence League Table for the first quarter of 2011 BMR wins India Case of the Year, and Best Use of the Internet awards at 5th International Tax Review Asia Awards, 2010. BMR is ranked Tier 1 in ITRs World Tax 2011 guide, to the Worlds leading tax firms. BMR is rated Great Place to Work 2010; Great Place to Work Institute

Kalpesh Maroo Prerna Mehndiratta Priyanka Sahi Shilpi Jain

Mukesh Butani, New Delhi +91 124 339 5010 mukesh.butani@bmradvisors.com Rajeev Dimri, New Delhi +91 124 339 5050 rajeev.dimri@bmradvisors.com Gokul Chaudhri, New Delhi +91 124 339 5040 gokul.chaudhri@bmradvisors.com Bobby Parikh, Mumbai +91 22 3021 7010 bobby.parikh@bmradvisors.com Abhishek Goenka, Bangalore +91 80 4032 0100 abhishek.goenka@bmradvisors.com Sriram Seshadri, Chennai +91 44 4298 7000 sriram.seshadri@bmradvisors.com Sumeet Hemkar, Singapore

representative of the Applicant, argued that the income arising to the Applicant was in the nature of business income since the Applicant was engaged in real estate business and its only transaction in India was the investment in S.

+65 6408 8004 sumeet.hemkar@bmradvisors.com

Applicants contention The gain arising to the Applicant was on transfer of securities and hence in the nature of capital gains. Accordingly, the gain would be exempt from tax in the hands of the Applicant under paragraph 4 of Article 13 of the India-Mauritius Tax Treaty. The Applicant contended that it had invested in equity and CCDs of S and the CCDs could not be held to be in the nature of loans and advances in the absence of a lender -borrower relationship between the Applicant and S. Further, even if S were to be treated as a borrower, the consideration received by the Applicant was from sale of assets to V and the purchase price was based on the terms of the SHA. Accordingly, the income earned by the Applicant from sale of securities could not be treated as interest. The Applicant also contended that the Applicant was an investor and had no place of business in India. The signing of the agreements in India would not constitute a permanent establishment of the Applicant. The Applicant contended that it is a well settled principle that a holding company and a subsidiary are considered as separate legal entities and the business of the subsidiary is not undertaken by the holding company[2] . Accordingly, the purchase of CCDs by V from the Applicant cannot be construed as redemption of CCDs by S. The Applicant contended that it is not a related party of V and as unrelated parties, they could not share a common intention to create a legal facade since benefit in ones hands would not result in any corresponding benefit in the hands of the other. Further, since payment by V to the Applicant cannot be claimed as interest by V, the Revenue also cannot argue that part of the consideration received must be regarded as interest received by the Applicant. Further, if the transaction was that of a loan, as contended by the Revenue, the Applicant would not have made additional equity payment, have representation on the board and participate in decision making as a shareholder. Ruling of the AAR The AAR relying upon the definition of debentures and judgments under various legislations, held that CCDs create or recognize the existence of a debt, which remains to be so, till it is repaid or discharged. The AAR while concluding as above also relied on the Supreme Court judgment of CWT v Spencer & Co [3] and

Eastern Investment Ltd V CIT [4] and concurred with the view that discharging of the debt by way of issue of shares does not change the character of the liability, which continues to remain as a debt. As regards the nature of the sale proceeds received by the Applicant on sale of shares and CCDs to V, the AAR based on the following consideration, held the same to be in the nature of interest: The definition of interest under the Income Tax Act, 1961[5] (Act) as well as under paragraph 5[6] of Article 11 of the India Mauritius Tax Treaty include within its ambit any income that becomes payable on a debenture; The mode of computation of the sale proceeds, provided for in the SHA, interalia included accrued return, applicable rate which was in the range of 20 to 30 percent depending upon the period of holding of the securities. Based on this, the AAR observed that calculation of price payable for acquiring the investment was almost entirely dependent on the period of holding of the investment and hence the AAR was inclined to think that the manner of computation was akin to computing interest on an investment. Further in relation to the CCDs, the AAR held that the lack of return on CCDs was compensated by an option to convert at different prices, depending upon the period of holding the CCDs and hence that would constitute interest under paragraph 5 of Article 11 of the India-Mauritius Tax Treaty [7] . In addition to the above, the AAR also held as under: Reliance on the decision of Supreme Court in the case of Sahara India Savings and Investment Corpn Ltd[8] was misplaced. The Applicant could not rely upon the ratio of this judgment to contend that CCDs were in the nature of investment and cannot be treated as loans and advances since in the said judgment the bonds and debentures were of an approved nature and the judgment was in the context of Interest Tax Act, 1974. In relation to the contention of the Applicant that the look at provisions should be applied to the transaction to ascertain the true legal nature of the transaction[9] , the AAR after observing the terms of the SHA and the SSA, held that though S and V were independent juridical entities, S exercised no powers in managing its own affairs and it was de-facto under the control and management of its parent entity, V. The AAR observed that it was V who was developing and running the real estate business of S, V was the guarantor to the investment made by Z and it was V (and not S) that acknowledged the CCDs as debts. Therefore, applying the principles upheld by the Supreme Court in the case of Vodafone, the AAR held that the acknowledgment of debt with the commitment to pay is factually on V and the role of S is reduced to a puppet of V. Accordingly, the AAR overruled the argument of the Applicant that the sale of CCDs is not to the debtor but to the third party and hence, could not qualify as interest.

Based on the above, the AAR held that Article 11 which deals with treatment of income from debt-claims of every kind, is a specific provision applicable to the present case instead of Article 13 which deals with gains from alienation of any property. Further, on the basis that V and S are one and the same, the payment by V is clearly towards the debt that was taken by S from the Applicant. Accordingly, the appreciation in the value of CCDs is clearly payment of interest and liable to tax under Article 11 of the India-Mauritius Tax Treaty.

BMR comments
In this ruling, the AAR held that the consideration received by the Applicant on sale of CCDs would qualify as interest under the provision of the Act and the IndiaMauritius Tax Treaty notwithstanding the arguments of the Applicant that CCDs would qualify as capital asset and the gain on sale should be treated as capital gains. In order to arrive at this conclusion, the AAR has relied upon the definition of interest which includes income from debt-claims of every kind. The interesting feature of this ruling is that the AAR, in the absence of anti-abuse rules under the extant laws, has applied the look at provisions to disregard the legal form of the transaction. The AAR after reviewing the terms of the SHA and SSA held that since the management and control of S was in the hands of V, V and S are the same person and hence, the payment to the Applicant was indeed by the debtor thereby qualifying as interest. While concluding the AAR also seems to suggest that the exemption under the India-Mauritius Tax Treaty would not be available in case of capital gains that arise on sale of equity shares. Implications under the General Anti Avoidance Rules (GAAR) The GAAR provisions are proposed to be introduced vide Finance Bill, 2012 effective April 1, 2012. The GAAR provisions allow the Indian Revenue authorities to disregard an impermissible avoidance arrangement if it inter alia lacks commercial substance and has been set up for merely claiming a tax benefit. In the present context, the proposed GAAR provision not only empowers the Indian Revenue Authorities to look through an arrangement but also allows them to disregard an accommodating party or treating any other party as one and the same person. Accordingly, what the AAR has sought to conclude in this ruling by applying principles of substance over form, lifting of corporate veil, etc, would be powers that would become available to the Indian Revenue Authorities by way of legislation if the proposed GAAR provisions become law in case a transaction qualifies as an impermissible avoidance arrangement. Position under DTC Under the DTC, the definition of interest is on the same lines as the definition under the Act and to that extent DTC also includes within the ambit of interest any

amount payable in any manner in respect of a debt. Additionally, the DTC contains detailed provisions related to GAAR similar to the provisions proposed to be introduced by the Finance Bill, 2012 and this would once again lead to greater scrutiny.

____________________________________
[1] 128 ITR 284

Vodafone International Holdings BV (334 ITR 1) (SC)

88 ITR 429

20 ITR 1

Interest" is defined under section 2(28A) to mean interest payable in any manner in

respect of any moneys borrowed or debt incurred (including a deposit, claim or other similar right or obligation) and includes any service fee or other charge in respect of the moneys borrowed or debt incurred or in respect of any credit facility which has not been utilized

Under Article 11 of the India-Mauritius tax treaty, the term interest is defined as "interest"

as used in this Article means income from debt-claims of every kind whether or nor secured by mortgage and whether or not carrying a right to participate in the debtors profits, and, in particular, income from Government securities and income from bonds or debentures, including premiums and prizes attaching to such securities, bonds or debentures. Penalty charges for late payment shall not be regarded as interest for the purpose of this Article.

Relying on In re AAR 769, the AAR held that the payout would also constitute interest

under section 2(28A) of the Act

321 ITR 371

Vodafone International Holdings BV (334 ITR 1) (SC)

Disclaimer: This newsletter has been prepared for clients and Firm personnel only. It provides general information and guidance as on date of preparation and does not express views or expert opinions of BMR Advisors. The newsletter is meant for general guidance and no responsibility for loss arising to any person acting or refraining from acting as a result of any material contained in this newsletter will be accepted by BMR Advisors. It is recommended that professional advice be sought based on the specific facts and circumstances. This newsletter does not substitute the need to refer to the original pronouncements.

Quality tax advice, globally

www.taxand.com Contact US | Archives

BMR Advisors | 22nd Floor | Building No. 5 | Tower A | DLF Cyber City | DLF Phase III | Gurgaon 122 002 Tel: +91 124 339 5000 | Fax: +91 124 339 5001
The information contained in this communication is intended solely for the use of the individual or entity to whom it is addressed and others authorized to receive it. This communication may contain confidential or legally privileged information. If you are not the intended recipient, any disclosure, copying, distribution or action taken relying on the contents is prohibited and may be unlawful. If you have received this communication in error, or if you or your employer do not consent to email messages of this kind, please notify us immediately by responding to this email and then delete it from your system. No liability is accepted for any harm that may be caused to your systems or data by this message. Unless related to BMR business, the opinions, conclusions and other information contained within this email are those of the sender alone and do not necessarily constitute those of the Firm.

Copyright 2012, BMR Advisors. All Rights Reserved

In case, you do not wish to receive this newsletter, click here to unsubscribe

[1] 128 ITR 284

[2] Vodafone

[3] 88 ITR 429 [4] 20 ITR 1

[5] Interest" is defined under section 2(28A) to mean interest payable in any manner in respect of any moneys borrowed or debt incurred (including a deposit, claim or other similar right or obligation) and includes any service fee or other charge in respect of the moneys borrowed or debt incurred or in respect of any credit facility which has not been utilized [6] Under Article 11 of the India-Mauritius tax treaty, the term interest is defined as "interest" as used in this Article means income from debtclaims of every kind whether or nor secured by mortgage and whether or not carrying a right to participate in the debtors profits, and, in particular, income from Government securities and income from bonds or debentures, including premiums and prizes attaching to such securities, bonds or debentures. Penalty charges for late payment shall not be regarded as interest for the purpose of this Article. [7] Relying on In re AAR 769, the AAR held that the payout would also constitute interest under section 2(28A) of the Act [8] 321 ITR 371 [9] Vodafone International Holdings BV (334 ITR 1) (SC)