The Corporate & Commercial Law Society Blog, HNLU

Tag: Taxation Law

  • Redefining Derivatives: India’s Speculative Turn on Futures And Options Taxation

    Redefining Derivatives: India’s Speculative Turn on Futures And Options Taxation

    BY TAPAS JOSEPH AND ADITYA S. NAIR, FOURTH-YEAR STUDENTS AT NUALS, KOCHI

    Introduction

    Up until the early 2000s, derivatives revolutionized spot and futures markets, disrupting natural market relationships and attracting regulatory scrutiny due to potential negative effects. This increased leverage made futures leading indicators. Derivative markets, employing futures and options, became pivotal for trading stock risks, with legally binding contracts specifying asset transactions. Future contracts involves buyer and seller being legally bound to the purchase and sale of a specific asset at a specific price by a certain time. On the other hand, options contracts involve the buyer being given a right but not a responsibility to buy or sell a specific asset at a specified price before a given time, where the seller is also bound to fulfil the buyer’s right if they choose to exercise it. The income derived out of futures and options (‘F&O’) trading has always been classified in the realm of non-speculative business income for levying tax. However, due to recent increase in the retail participant trade activity, there is a plan to move the F&O income to speculative business income under the Income Tax Act, 1961 (‘Income Tax Act’). This reclassification would put F&O transactions under deterrent tax laws and tax deducted at source (‘TDS’) which will harm the traders to one extent or the other by implementing a niggardly tax system.

    The Indian government’s proposed reclassification of F&O trading reflects growing concerns over unprecedented retail investor participation in derivatives. This regulatory shift aims to address potential systemic risks from unchecked retail F&O trading. Regulators worry that a major market correction could cause significant losses for retail investors, leading to widespread financial distress at the household level. This could have profound implications for market sentiment and economic stability. To mitigate these risks and ensure long-term market health, the government is considering reclassifying F&O trading income as speculative.

    What is Speculative Transaction?

    A speculative transaction is a transaction of purchase or sale of a commodity, being stocks and shares, and includes (section 43(5) of the Income Tax Act) a transaction that is not completed by the actual delivery of or by the transfer of the commodity.

    Section 43(5) defines ‘Speculative Transaction’ as a transaction in which a contract for the purchase or sale of any commodity, including stocks and shares, is periodically or ultimately settled otherwise than by the actual delivery or transfer of the commodity or scripts. For example, intra-day trading in shares could be one such kind of trade that comes under the head of speculative transaction.

    Understanding F&O Contracts in Financial Markets

    F&O are types of financial derivatives that enable traders to speculate on the price movements of an underlying asset without owning it. A futures contract binds the buyer to purchase and the seller to deliver the asset at a set price and future date. Conversely, an options contract grants the buyer the right, but not the obligation, to buy or sell the asset at a specified price by a certain date, while the seller is required to fulfil the contract if the buyer opts to exercise their right.

    Fiscal Implications for F&O Transactions

    An eligible transaction in respect of trading in derivatives referred to in Clause (ac) of section 2 of the Securities Contracts (Regulation) Act 1956 carried out in a recognized stock exchange is not a speculative transaction.

    Related to this, the Income Tax Act under section 43 (5) classifies F&O transactions as business income. This condition provides an exemption for trading in derivatives under clause (d). The section also includes subsection 5, which has clauses (a) to (e), and it specifically excludes speculative transactions. These include:

    • Hedging contract with respect to raw materials or merchandise.
    • Hedging contract with respect to stocks and shares.
    • Forward contract.
    • Trading in derivatives.
    • Trading in commodity derivatives.

    This makes trading under derivatives like F&O fall under the ambit of non-speculative business income, which is taxed under tax slabs based on the trader’s annual turnover.

    In essence, the profits from F&O trading are taxed like other business income, allowing taxpayers to claim deductions for expenses incurred, such as telephone bills, electricity bills, internet bills, etc.

    Prior to the addition of Clause (d) to the proviso of sub-section 5 of section 43, the Bombay High Court in Commissioner of Income Tax v. Bharat R. Ruia, determined that exchange-traded derivative transactions carried out by the assessee before January 24, 2006, were deemed speculative transactions. With the insertion of Clause (d) in section 43(5), an explanation was also introduced to define the term ‘Eligible Transaction’ as used in Clause (d). According to this explanation, only specific types of derivative trading transactions conducted on recognized stock exchanges are classified as non-speculative transactions. This was formalized by Notification No. S.O. 89(e) dated January 25, 2006. In this regard, from the date of Securities and Exchange Board of India (‘SEBI’), both Bombay Stock Exchange (‘BSE’) and National Stock Exchange (‘NSE’) were officially accorded recognition only for this particular purpose. Therefore, any derivative trades that were carried out in those exchanges and any others that may be entered in the future under the provision of this section are, in effect, non-speculative if they meet the conditions in the explanation of section 43 (5). These classifications apply to each of the transactions that satisfy the above conditions after January 25, 2006. The fact that for eligible derivative trades, there is a change of status from speculative to non-speculative is a major overhaul in tax and regulation.

    Analytical Assessment of Derivatives Taxation Reclassification: Implications for Market Participants

    F&O trading is considered a non-speculative business, and loss from its trading is allowed to be set against income from any other resource except salary income. This has been vividly described under section 71(2A) of the Income Tax Act.

    Unadjusted losses can be offset against income from other sources, except salary. Any remaining loss can be carried forward for up to eight years. In these subsequent years, the carried forward loss can only be offset against income under “Profit and Gains of Business and Profession.”

    Under section 73A, if a taxpayer incurs a loss from a speculative business transaction, they can only set off this loss against profits earned from other speculative business transactions. This means that a taxpayer cannot use a speculative business loss to offset gains earned from non-speculative business transactions, such as income from salaries, rent, or interest.

    In case a taxpayer is unable to set off the entire speculative business loss against profits earned from other speculative business transactions in the same financial year, they can carry forward the unabsorbed loss to the subsequent year. The unabsorbed loss from speculative business can only offset profits from similar transactions and be carried forward for four assessment years, as per section 73. This differs from non-speculative business losses, which can be carried forward for eight years.

    Examination of the Potential Impact on Market Behaviour and Investor Sentiment.

    The imposition of increased taxes on F&O trading could potentially reduce liquidity and trading volumes in these markets by dissuading active traders. While there are numerous drawbacks associated with such changes, they may also serve to influence market participants. For instance, the growing presence of retail investors in derivatives markets raises concerns about their vulnerability to significant losses during market corrections. Reclassifying F&O transactions as speculative could function as a deterrent, aiming to mitigate these risks and dissuade retail investors from exposure to substantial losses.

    However, there is also a risk that heightened taxes could redirect retail investors towards unregulated and potentially riskier investment alternatives. While these alternative channels offer the potential for greater profits, they operate outside the regulatory framework of traditional markets. This lack of oversight may expose retail investors to increased risks, potentially compromising their financial security. Institutional investors, who constitute a substantial segment of the F&O market, may reassess their strategies in response to these developments. The increased tax burden might influence their assessments of risk versus reward, altering market dynamics and potentially increasing volatility. Moreover, smaller market participants could face heightened operational costs and complexities as a result of these changes.

    Conclusion and a Way Forward

    The proposed reclassification of F&O transactions from ‘business income’ to ‘speculative income’ in India aims to protect retail investors but risks driving them to unregulated alternatives. To balance investor protection with market vitality, we propose:

    1) A tiered tax structure with lower rates for small investors and higher rates for large traders, curbing speculation while maintaining liquidity;

    2) Partial reclassification to a hybrid category, retaining some non-speculative tax benefits while introducing restrictions;

    3) Extending the loss carry-forward period beyond four years for speculative transactions. These amendments could foster a stable yet dynamic F&O market, ensuring fairness without unduly burdening traders. A robust regulatory framework remains crucial for maintaining transparency and investor confidence.

  • Extension Of ‘Angel Tax’ Provisions To Non-Residents: Is the Proposed Change Angelic Enough?

    Extension Of ‘Angel Tax’ Provisions To Non-Residents: Is the Proposed Change Angelic Enough?

    BY PURAVA RATHI, A SECOND-YEAR STUDENT AT NLIU, BHOPAL

    Introduction

    The Union Budget 2023, presented by Finance Minister Nirmala Sitharaman, proposed an amendment via the Finance Bill 2023 to Section 56(2)(vii-b) of the Income Tax, 1961. The amendment extends the applicability of the ‘Angel Tax’ to the funding received by privately held, unlisted companies from ‘non-residents’. This tax was previously levied only on the funding received from affluent ‘residents’ or high-net-worth individuals of the country. The provision was introduced in 2012 to mainly combat money laundering, corruption, and tax evasion. The imposition of such a tax is intended to increase transparency.

    However, due to its extension to non-residents, the proposed amendment is set to adversely impact the financing of start-ups, which has been showing a trend since 2022. Funding received by Indian startups has been showing a downward trend since 2022 and has plunged nearly 33% when compared to the previous year.

    This article intends to study the details of the proposed amendment and its impact on the start-up culture of the country. The apparent conflict pertaining to the calculation of the Fair Market Value (‘FMV’), between the Foreign Exchange Management Act, (1999) (‘FEMA’) and the Income Tax Act 1961 (‘IT Act’) has been highlighted. Moreover, the status of such a tax under different jurisdictions and initiatives taken by foreign governments to promote the start-up industry has also been put forth.  

    Details of the Provision and the Proposed Amendment

    Angel investors generally invest in firms where they see growth prospects. A corollary of the same is that they usually opt for convertible debt or ownership equity due to the unpredictability and volatility of the markets. This tax is imposed on the amount that startups receive while selling shares at a premium. When the shares of a company are sold at a higher share price than their FMV, the government taxes the excess income accordingly under the head of ‘Income from other sources’. This provision was introduced in 2012 because, then, the common practice was that of converting black money to white money by investing in shell companies. Therefore, its purpose was to mainly combat money laundering, corruption, and tax evasion.

    The introduction of such a provision was certainly a welcome move. However, there exists no mechanism to assess the genuineness of a transaction. As a result, due to the indistinguishability between bonafide and mala-fide transactions, these ventures suffer.  Therefore, the imposition of the same on finances raised from ‘non-residents’ might be detrimental to the growth of startups in India given that the government is majorly focussing on foreign direct investment, investment facilitation, and the ease of doing business in the Indian economy. 

    In this context, it is also pertinent to discuss certain exemptions from the applicability of the angel tax provided via the exemption notification of 2019. It stated that only ‘start-ups’ recognized by the Department for Promotion of Industry and Internal Trade (DPIIT) and whose total paid-up share capital and share premium after the issuance or intended issuance of shares, if any, do not exceed Rupees 25 Crores are eligible for the exemption. This is limited by the requirement that start-ups must not have invested in or would not invest in the class of assets that includes immovable properties, loans and advances, capital contributions to other entities, shares and securities, motor vehicles, or any other mode of transportation, jewelry, or any other asset class. Funds from non-resident investors shall not be included in computing the aforesaid threshold. However, it is expected that the exempted categories would also be amended soon to align them with the proposed amendment. 

    Implications of the Proposed Amendment

    Interestingly, the proposed amendment presents a dilemma for startup companies. This is because of the induced compulsion to raise shares at FMV. FEMA disallows the issuance of shares below the FMV and the IT Act taxes the amount raised in excess of the FMV. Therefore, startups are constrained to issue shares at the FMV.

    At a time when the startup industry is growing rapidly, with the most significant number of unicorns in India after the USA and China, this government initiative seeks to dampen the enthusiasm and growth prospects. The reason is that foreign investors are the major source of funding for start-ups in the country. India also provides for various schemes to promote and enhance the growth of startups. These initiatives include the Startup India Seed Fund Scheme, the Startup India initiative, and Startup Accelerators of MeitY Product Innovation and Growth (SAMRIDH). However, a provision like an angel tax may have an adverse effect on the advantages of these schemes. The growth of startups, as a result, may be impeded. An obvious outcome could also be apprehension amongst foreign investors due to the increased risk of litigation about the subjective valuation of the company, which is often challenged by tax officials. Due to the application of angel tax, these startups come under the close scrutiny of tax officials, since the excess amount is to be accounted for. The income tax provisions provide for a valuation mechanism for unquoted equity shares which permits the usage of net asset value (formula-based) or discounted cash flow approach as determined by a merchant banker. This creates subjectivity. A higher valuation is likely to be questioned by tax officials, and angel tax would be levied on the excess amount raised.

    Further, with the ambit of the ‘angel tax’ extended, startups would want to shift or establish their base in foreign countries where such tax restrictions are not applied. Such a move may also lead to ‘externalization’ which is the transfer of ownership to a holding company that is based in a conducive business environment in a foreign jurisdiction. This would further impact employment generation and the ease of doing business in the country. Therefore, it is hoped that the government will reconsider this proposed amendment given the complex consequences that are to ensue. 

    Position of ‘Angel Tax’ In Foreign Jurisdictions

    It is pertinent to note that angel tax is not a widely recognized concept in foreign jurisdictions. It is not surprising that such a tax, which disincentivizes funding for startups and the overall growth of the startup culture in the country, has not been adopted by other countries. 

    Canada

    In Canada, there is no specific angel tax provision, but there exist tax credits and incentives for investors who invest in certain types of companies, including startups. For example, the Canadian government offers the Scientific Research and Experimental Development (‘SR&ED’) tax credit to encourage investment in research and development. 

    Canada offers low business taxes for companies and a very good business climate. Total business tax costs here are by far the weakest among the G7 countries.
    Companies investing in Canada can benefit from a range of incentives and tax credit programs including the Global Skill Strategy, Accelerated Investment Incentive, and Innovation Superclusters initiative.

    Australia

    The Australian government, under its National Innovation and Science Agenda (NISA), provides for a ten-year exemption on capital gains tax for investments held as shares for more than 12 months. The scheme also provides for a 20 percent non‑refundable carry-forward tax offset on amounts invested in qualifying early-stage innovation companies (ESICs). Moreover, the country also provides capital gains tax exemptions to eligible foreign investors on their share of capital or revenue gains made under Venture Capital Limited Partnerships (VCLPs).  Such measures as providing tax offsets at the funding stage contribute to developing a healthy startup culture in the country.

    United Kingdom

    In the United Kingdom, the Enterprise Investment Scheme (EIS) and the Seed Enterprise Investment Scheme (SEIS) provide tax relief for investors. The UK has tried to maintain a congenial environment for attracting foreign direct investment. The country also imposes foreign equity ownership restrictions in a limited number of sectors. However, the UK’s decision to implement the improved National Security and Investment Act unfavorably affects the startup ecosystem in the country. The Act aims to investigate hostile foreign direct investment that threatens UK’s national security.  

    USA

    The USA does not have a central law for angel investments. However, it passed the Protecting Americans from Tax Hikes (PATH) Act of 2015 by amending Section 1202 of the Internal Revenue Code. This has made permanent a 100 percent exclusion from capital gains tax for any gains on long-term investments in qualified small businesses, up to 10 million dollars or ten times the original investment, whichever is greater.

    China

    China provides tax incentives to venture capitalists that invest at the seed capital stage. 70 percent of the investment amount can be offset against the taxable income of the venture capital enterprise for Corporate Income Tax (‘CIT’) purposes. Small businesses (whose annual income does not exceed RMB three million) have enjoyed a low CIT rate (2.5%) since 2020, up to a revenue of RMB one million. Small and Low-Profit Enterprises (‘SLPE’) are subject to a 20 percent CIT rate on 25 percent of their taxable income amount after the adjustment.  Therefore, the effective CIT rate for SLPEs is currently 5 percent. Because the SLPE evaluation is carried out at the entity level (instead of at the group level), small subsidiaries of foreign multinational enterprises (MNEs) in China can also benefit from these CIT cuts.

    Therefore, there do not exist any specific angel tax provisions in prominent foreign jurisdictions. These countries may serve as the perfect opportunity to escape the application of the angel tax provision, thereby leading to externalization, as discussed above. They function as tax havens, incentivizing the funding process for non-residents and subsequently benefiting the company.

    Conclusion

    In light of the above discussion, certain further amendments or notifications on the part of the government are expected to clarify the apparent conflict between the two laws. It is also imperative to consider that there already are various acts that govern and control these transactions in India, including the IT Act and FEMA. This raises pertinent questions as to the need for such a provision in the Indian context. Moreover, startups find it burdensome to bear the levy of this tax, as most of the funding received from non-residents goes into paying it. Since there are more unfavorable effects of the proposed amendment than favorable ones, it is imperative that the government reconsider the amendment before its implementation.

  • Cryptocurrency Taxation: Pigouvian Taxation Does Not Solve The Problem Of Tax Evasion

    Cryptocurrency Taxation: Pigouvian Taxation Does Not Solve The Problem Of Tax Evasion

    By Manas Agarwal, a fourth-year student at NLSIU Bangalore

    Introduction

    Cryptocurrency (‘crypto’) is an ideal example of the intersection between finance and technology. This is because technology makes crypto decentralized and unregulated, which gives rise to finance-related concerns. One such concern is taxation, and this is precisely the backdrop against which this article is set. The focal point of this article is the taxation of crypto that was put forth in the Union Budget of 2022-2023 (para 131). Consequently, the Finance Act, 2022 amended the Income Tax Act, 1961 (‘ITA’), with effect from April 1, 2022.

    Structurally, the article is divided into two parts. First, the author will critique the scheme of taxation of crypto prescribed under the ITA. Further, the author will flag some definitional issues in the present scheme of taxation. Second, the author will employ the law and economics framework of analysis to argue that the true purpose behind the present scheme of taxation is deterrence through negative externalities. Consequently, the author proposes to argue that the present scheme of taxation for cryptocurrencies is not sound either from a revenue maximization perspective or from the standpoint of addressing a negative externality.

    Issues pervading the taxation of crypto under the ITA

    The Finance Act 2022 inserted four components in the ITA:

    • The definition of Virtual Digital Assets (‘VDAs’) under Section 2(47A) of the ITA.
    • An explanation clarifying that VDA shall come under the definition of ‘property’ – section 56(2)(x) of the ITA.
    • Imposition of 30% tax rate on transfer of VDAs – Section 115BBH of the ITA.
    • Tax will be deducted at source for payment of consideration for the transfer of VDAs – Section 194S of the ITA.

    All these provisions pose policy challenges, including an increase in compliance costs. Compliance costs cover all costs that a taxpayer, as well as a third party, has to bear to comply with the tax law and other requirements of the tax authorities. Section 115BBH imposes a flat rate of 30 percent on the transfer of VDAs. This leads to an increase in compliance costs as; firstly, a flat tax rate obliterates the distinction between income from capital gains and business income. Under the ITA, the former is charged at a lower rate. However, in the new tax regime, a person will not be able to seek the benefit of a lower tax rate. Secondly, Section 115BBH does not allow setting off the loss from the transfer of VDAs against any other income.

    Additionally, Section 194S mandates every person (except those exempted) paying consideration in exchange for crypto to withhold tax at 1%. First, ‘Specified persons’ is one category that has been given certain exemptions from the section. Though the criteria to identify a specified user are elaborated on in the explanation, further information is required to assess who meets those criteria. This will increase compliance costs and also result in a decline in trading volume since users will stop dealing in crypto due to anonymity concerns. Second, the compliance costs will be significant in crypto-to-crypto transactions. This is because, a plain reading of the section suggests that firstly, both parties will have to deduct tax at the source, and secondly, the fair market value of the crypto will have to be ascertained to deduct the tax at the source.

    The real purpose behind the taxation of crypto is that of establishing control over virtual digital assets

    In this segment, the author, using different theories of taxation, argues that the government wishes to disincentivize crypto trading and crypto investment.

    i.   Tax as Revenue Maximization

    The first view reflects the traditional theory of taxation, which advocates that the purpose of taxation is revenue maximization so that public funding activities can be financed.[1] Hence, this view will advocate that due to the large trading volume of crypto, it can serve as a good source of revenue. However, if revenue maximization is the purpose, then the existing scheme of taxation of crypto is not optimal. This can be understood through Adam Smith’s canons of taxation. The second and third canons, the canons of certainty and simplicity, state that the levying of taxes should be certain, non-arbitrary, and convenient for the taxpayer (pages 36-37). Moreover, the fourth canon states that the difference between the amount in the public treasury and the amount recovered as tax should be minimal (pages 36-37). In other words, costs such as the salary of tax officers, the costs of legislation, etc. must be minimal. Net revenue equals administrative costs and compliance costs subtracted from gross tax revenue.[2]

    As mentioned above, the prohibition on setting off losses from crypto (Section 115BBH) and the onerous Tax Deducted at Source (‘TDS’) requirements (Section 194S) increase the compliance cost. Furthermore, vagueness in the definition of VDAs and a lack of a coherent mechanism for the valuation of fair market value will increase the administrative costs of litigation, appeals, and explainers. Hence, the goal of revenue maximization will remain unachieved because of the high compliance costs.

    ii.  Tax as Negative Externality

    The central argument of Modern Monetary Theory is that sovereign governments face resource constraints, not financial constraints. Hence, the theory advocates that the traditional mechanism of first imposing taxation and then spending on public financing is outdated and works only in times of commodity-based money. With the introduction of fiat money, there is now a mechanism in which the government spends first and imposes taxation later.[3] This is because, unlike non-state actors which use the currency, the state issues it. Hence, revenue maximization is not the sole purpose of taxation.

    One such purpose is Pigouvian taxation. Pigouvian taxation is used to minimize the deadweight loss in cases where the society faces a deadweight loss due to the private cost being less than the external cost. For instance, pollution imposes external costs on society that are not borne by the private actor, the polluter. Hence, a tax is imposed on the polluter to ensure that, while deciding how much to pollute, the polluter internalizes the external costs (for example, carbon tax, plastic tax)[4]. The author argues that the present system of crypto taxation is an example of Pigouvian taxation.

    The Indian regulatory landscape has been hostile towards crypto. For instance, Section 8 of the Banning of Cryptocurrency and Regulation of Official Digital Currency Bill, 2019 states that direct/indirect mining, generating, holding, selling, dealing in, disposing, and issuing are declared offenses and can have penal consequences. Furthermore, all these offenses are non-bailable and cognizable in nature (sections 8(1) and 12(1). However, this staunch opposition does not extend to Central Bank Digital Currency (‘CBDC’), which is a digital token recognized as a legal tender (para 111). The exclusion of ‘Indian currency’ from the ambit of section 2(47A) of the ITA saves CBDC from falling within the definition; otherwise, it would have also been treated as a VDA under the ITA. This is because even private digital currencies fulfill the three roles of money (store of value, medium of exchange, and unit of value). Hence, the elephant in the room is not the ‘digital’ nature of private crypto but the lack of government control over it. This happens because; first, unlike CBDCs, private crypto is not easily traceable, and hence monitoring, reporting, and surveillance is difficult, and; second, unlike CBDCs, crypto operates independently of financial intermediaries such as banks, as crypto is only dependent on the demand and supply in the market (pages 38, 42). Hence, the central bank loses control in addressing concerns such as inflation because crypto is independent of the monetary measure of interest rates.

    The government will justify control through taxation because decentralization and (pseudo) anonymity present in the crypto transaction make crypto a tax haven. Furthermore, there have been numerous instances of crypto being used to finance terrorist activities and in money laundering. Therefore, people who illegally deal in crypto impose external costs on society (if there is an increase in criminal activities and the focus of the State is on preventing such activities, then there might be a resource crunch due to which the welfare activities of the State are compromised). Hence, a high tax rate will act as a deterrent, and the external costs due to crime will be internalized. Therefore, crypto taxation represents a Pigouvian tax.

    However, characterizing crypto taxation as a Pigouvian tax by itself is insufficient. This is because a cardinal principle of taxation is neutrality. It means that taxation should not be used to distort consumer choices, and consumers should be allowed to make a decision based on welfare and/or economic reasons. However, one might argue that Pigouvian acts as an exception to neutrality since it establishes an equilibrium between private costs and social costs. Though this is true, the exception is not being drawn in the present case. This is because the issues concerning tax evasion, illicit activities, etc., and the imposition of a Pigouvian tax as a solution to these issues do not have a direct correlation. Under the ITA, the prominent mode of filing returns is based on self-assessment (sections 139, 140A) where taxpayers must assess their tax liability themselves based on factors such as (i) income, (ii) taxable income, (iii) head of income, (iv) concessions, (v) exemptions, and (vi) TDS. Self-assessment helps to address the case of crypto taxation because of the anonymity coupled with high compliance costs. Furthermore, techniques of summary assessment, (section 143(1)) regular assessment (section 143(2)), and re-assessment (section 144) are not adequate to receive taxation on crypto because crypto acts independently of banks and financial institutions and posits a cloud of anonymity. Moreover, it can be said that the probability of self-assessment and third-party reporting is indirectly proportional to the compliance costs and directly proportional to the probability of detection of tax evasion. As stated before, compliance costs are high and the probability of detection is low in a crypto transaction, thus, a model of Pigouvian taxation for crypto by itself is not the optimal solution.

    Conclusion

    The present scheme of crypto taxation suffers from various policy concerns. This is because Sections 115BBH and 194S of the Indian Tax Act raise compliance costs, and hence cryptocurrency taxation is not optimal for revenue maximization. Furthermore, using crypto taxation as Pigouvian taxation is not helpful, because the issue of tax evasion, illicit activities, and the solution of levying a Pigouvian tax, do not have a direct correlation. This is further aggravated by the low probability of detection because of self-reporting. Hence, (a) the present taxation of crypto under the ITA does not solve the fintech issue of tax evasion due to anonymity inherent in the technology used in crypto and (b) the taxation of crypto does not achieve the goal of either revenue maximization or Pigouvian taxation.

    [1]Beverly I. Moran, ‘Taxation’ in Mark Tushnet, and Peter Cane (eds), The Oxford Handbook of Legal Studies (OUP 2012) 377.

    [2] ibid.

    [3] L. Randall Wray, Modern Money Theory: A Primer on Macroeconomics for Sovereign Monetary Systems (2nd ed, Palgrave Macmillan 2015).

    [4] ‘Environmental Taxation’ in James Mirrlees (ed), Tax By Design (OUP 2010)231.

  • The Mitsui & Co. Challenge: Time to Rethink the Retrospective Tax Amendment?

    The Mitsui & Co. Challenge: Time to Rethink the Retrospective Tax Amendment?

    By Aarushi Srivastava and Ridhi Gupta, second-year students at RGNUL, Patiala

    INTRODUCTION

    After Cairn and Vodafone, the latest instance of a company initiating investment arbitration proceedings against a hefty amount demanded under India’s infamous retrospective taxation regime, is Earlyguard Ltd., a British subsidiary of the Japanese behemoth, Mitsui & Co. The 2,400-Crore tax is being charged over a transaction that took place in 2007, consisting of the sale of Earlyguard’s shares of Finsider International Co., a UK domiciled company which had a 51% stake in Sesa Goa. Earlyguard treated the capital gain properly and in accordance with taxation rules prevalent then, but despite that, the company was served with a tax notice. Thereafter, it initiated arbitration proceedings, before the Permanent Court of Arbitration, under the India-UK Bilateral Investment Treaty.

    Previously, Vodafone, as well as Cairn, have won arbitration cases against retrospective taxation by India and its violation of bilateral investment treaties in international tribunals. However, instead of honouring the arbitration awards of INR 75 Crore and INR 8842 crore respectively, the Indian Government(hereafter Government) has challenged both these awards. In the case of Cairn, the Government stated that it never agreed to arbitrate the dispute, despite it sending a judge to the tribunal. While in Vodafone’s case, the Government has filed an appeal before the Singapore appeals court, stating that it has the sovereign right to taxation and no private individual can decide on it.

    RETROSPECTIVE TAX AMENDMENT

    The origin of the retrospective tax can be traced back to 2007, when Vodafone was taxed by Indian tax authorities. In the case of Vodafone International Holdings B.V. v. Union of India & Anr., the Supreme Court ruled in favour of the telecom company by stating that, “tax laws must be strictly construed and the provision of income tax must not be expanded to impose tax on any exchange that was otherwise untaxable.” It was to override this judgement that the then Government introduced the Finance Bill, 2012 to amend the Income Tax Act, 1961 with retrospective effect, returning the onus of payment to Vodafone.

    1. Fair and Equitable Treatment in Investment Treaties

    Article 1(a) of the Draft Convention on Protection of Foreign Property has influenced various countries to incorporate the principles of fairness in international dealings. The meaning and substance of fair and equitable treatment (“FET”) has been laid down in various arbitral awards such as Biwater Gauff Ltd. v. United Republic of Tanzania and Rumeli Telekom AS v. Republic of Kazakhstan. The following concepts have emerged under the scope of FET :

    • Prohibition of manifest arbitrariness in decision making, that is measures taken purely on the basis of prejudice or bias without a legitimate purpose or rational explanation;
    • Prohibition of denial of justice and disregard to the fundamental principles of due process;
    • Prohibition of targeted discrimination on manifestly wrongful grounds of gender, religion, race or religious belief.;
    • Prohibition of abusive treatment of investors, including coercion, duress and harassment; and
    • Protection of investors’ legitimate expectations arising from a government’s representation and balancing the same with host State’s right to regulate in public interest.

    The introduction of the retrospective tax amendment was a direct violation of the FET under international law. Firstly, the Government had no rational reason to introduce the amendment, other than the motive to reverse the Supreme Court judgment. Secondly, the due process of law was disregarded as all the dealings were based on the India-UK Bilateral Treaty, which is silent on taxation, except in cases where already an international or domestic legislation provides for the tax. Thirdly, the investors, at the time of making the dealings with India in all the cases, Vodafone (2007), Cairn (2006-07) and Mitsui (2007) could not legitimately expect the Government to enforce a tax on these dealings after a period of 5-6 years, as there was no such representation or intention shown by the Government.

    Expropriation means the act of nationalising or taking away money or property, especially for public use without payment to the owner, or through illegal measures. Expropriation could be direct, where an investment is nationalised or directly expropriated, or indirect, through state interference without effect on legal title. Under International law the property or assets of an ‘alien’, i.e., a person from another state must not be expropriated, without adequate compensation. The India- UK Bilateral Treaty states under Article 5(1) that the investments of an investor shall not be expropriated except for a public purpose regulating economic activity on a non-discriminatory basis and equitable compensation. However, in all the aforementioned dealings, the Government enforced the tax regime neither for a public purpose to regulate economic activities nor for the purpose of equitable compensation, and thus, the retrospective tax is a direct violation of the ‘very law’ i.e. the treaty governing all these dealings.

    There have been cases where Tribunals have considered tax measures as indirect expropriation. In the EnCana v. Ecuador, the Tribunal held that, from the perspective of expropriation taxation is in a special category, only if a tax law is punitive, extraordinary or arbitrary, issues of indirect expropriation would be raised. It was held that, in the absence of a specific commitment from the host state, the foreign investor has neither right nor any legitimate expectation that the tax will not change perhaps to its disadvantage, during the period of investment. Further, the Tribunal in Feldman v. Mexico held that a tax measure may amount to expropriation, where the investor had an acquired right with regard to which the tax authorities behaved arbitrarily through a sufficiently restrictive nature.

    The act of the Government of enforcing retrospective taxes on its investors was, thus, not only against the FET but also an act of expropriation. To begin, the amendment was introduced arbitrarily without any consultation with the investors or regard to the India-UK Treaty. Further, the investors had no legitimate expectation that the tax regime would change to their disadvantage and that the tax authorities would function in such a restrictive nature.

    POSSIBLE NEGATIVE OUTCOMES

    When the amendment was introduced in 2012, the then-opposition party, BJP, raised its voice against it and criticized the government. However, years after coming into power, there have  been no attempts from its side to remove the amendment. Instead, tax notices have been sent to companies, their assets have been seized, and the taxation regime has been defended in the arbitration proceedings. This shows the unwillingness of the present Government to discontinue with the tax amendment of 2012.

    However, the Government’s disregard to the arbitral awards will not prevent investors to fight tooth and nail to enforce these awards. Cairn Energy, for instance, is leaving no stone unturned to monetize the award. The company has successfully got the award registered in countries like the US, the UK, France, the Netherlands and Singapore, in order to further the process of enforcing the award against overseas Indian assets. This would mean that Cairn can seize Indian assets in these countries, if India fails to pay the amount. The company can enforce the award in over 160 countries that have signed and ratified the 1958 New York Convention on the Recognition and Enforcement of Foreign Arbitral Awards. Cairn has also filed a lawsuit in New York to declare Air India, the national carrier, as an alter ego of the Indian Government. If Cairn does get successful in enforcing the award, this will set precedent for other companies facing the same issue of retrospective taxation. This might lead the country having to lose a significant number of its overseas assets in the future. As a result of which, India’s investment environment can be perceived in a negative light, having a toll over its future investment dealings.

    Since the amendment was introduced, there has been zero revenue collection under it, rather it has resulted in substantial amount of losses in foreign direct investment (FDI) and foreign institutional investors (FII). The FII’s invest huge amounts of money in India that provides a great boost to the economy.  The investors, while investing in a country take close notice of the existing legal framework and then decide on investment. A consistent legal environment is not ‘much’ that the investors expect a country to give, as it is a part of minimum standard of protection of foreign investments under customary international law. However, with all these initiations against India’s retrospective tax regime and yet no reconsideration by the Government, the investors would not legitimately expect a consistent scenario of taxes in India, and they may fear any future amendments that could again impair their rights.

    CONCLUSION

    India was ranked 63rd in the Ease of Doing Business Rankings, 2020 which is indeed a development for India, however, due to the hasty 2012 amendment, the country has been attracting negative attention lately. Not only is the retrospective law against the FET and way of expropriation but also, it can act as a major discouragement for investors globally, who would have otherwise been interested in making investments in India. With two major judgements against the Government, its high time for the Government to look back and revise its arbitrary amendment. It is ironical, that though the present Government has always promoted international trade and business, it has failed to address this major hindrance to international dealings. The retrospective tax amendment should be done away with, in order to regain the trust of the investors and ensure a secure environment for investments in India.

  • Jurisdictional Defect Beleaguering the Assessment Proceedings under Income Tax Act, 1961

    Jurisdictional Defect Beleaguering the Assessment Proceedings under Income Tax Act, 1961

    By harshita agarwal and raj aryan, third-year and fourth-year students at ms ramaiah college of law, bangalore and llyod law college, respectively

    It is well-settled under Section 232(9)(c) of the Companies Act, 2013, that after a merger between two or more entities, all the legal proceedings in the name of blending entities pending or arising before the effective date of the deal will be enforced against the name of the blended entity. Any legal proceedings initiated against the blending entities individually would be considered void ab-initio. Surprisingly, Income Tax Appellate Tribunal, New Delhi (“Delhi ITAT”) recently in the case of Boeing India Pvt. Ltd (Successor v. Acit Circle- 5(1), New Delhi on 17 August 2020 (“Boeing India case”) came across the same issue wherein the Assessing Officer (“AO”) as per above law erred in taking into consideration that after a merger no legal proceedings can be initiated against the name of blending company which have lost its existence after the merger.                                                                          

    In this blog, the authors critically analyse the issue of whether the jurisdictional defects in the later stages of the proceedings can be remedied under the law in the light of the Boeing India case. Further, the authors analyse whether proceedings under Section 144C of the Income Tax Act, 1961 (“the Act”) can be initiated on the ambivalence of jurisdictional validity of the assessment order.

    Factual Matrix of the Case

    Boeing India Pvt. Ltd.(“BIPL/Appellant”) notified its merger with Boeing International Corporation India Private Limited (“BICIPL”) to the Regional Director. The effective date of this scheme was 15.02.2018. On 10.04.2018 the Appellant apprised the AO that the BICIPL was dissolved and all the legal proceedings after the merger will be initiated or transferred in the name of the BIPL. Further, on 19.10.2018 the Transfer Pricing Officer (“TPO”) under Section 92 CA(3) of the Act drafted an order determining the arm’s length price of the international transaction of BICIPL with its Associated Enterprise in the name of the Appellant. But later the AO issued the draft assessment order in the name of a non-existent company i.e., BICIPL. On appeal to the Dispute Resolution Panel (“DRP”), it turned the deaf ear to the Appellant’s appeal. Aggrieved by the DRP order, the Appellant approached the ITAT Delhi claiming that there exists a jurisdictional defect in the draft assessment order. In this case, the Tribunal strived to discuss whether the jurisdictional defects can be remedied under assessment proceedings of Section 144C of the Act . 

     Understanding the legal anatomy of Section 144C assessment proceedings 

    Firstly, while referring to any issue before DRP, the procedure embodied under Section 144C of the Act needs to comply. Under Section 144C(1) of the Act, the AO needs to frame the draft assessment order in the name of the ‘eligible assessee’. The draft assessment order constitutes the foundational structure before inbounding into further procedural aspects under the Act. For better clarity, it is pertinent to note the definition of the eligible assessee. The definition is under Section 144C(15)(b) in accordance to which an ‘eligible assessee’ is any person whose variation of income or expenses arises as a consequence of the TPO’s order passed under Section 92CA(3). As per the definition outlined above, the eligible assessee before the merger was BICIPL. However, after the merger, it is BIPL. In the instant case, the AO defaulted in addressing the concerned person, thereby causing a jurisdictional defect.

    The DRP obviated that the defect can be remedied in the further proceedings under the Act. However, the DRP’s order under Section 144C(5)  lacked legal standing as firstly, Section 144C(3) specifies that the final assessment order needs to be drafted based on the draft assessment order. Secondly, Section 144C(2) narrows down the order of DRP as according to this sub-section, once the draft assessment order has been framed then the immunity to accept or change it lies in the hands of the assessee only. In other words, the AO’s power to make further changes in the draft assessment order is inhibited. While drawing reference to the above contention, reliance can be placed in the case of Turner International Pvt. Ltd v. DCIT wherein the Hon’ble High Court ruled that failure in complying with Section 144C(1) will make the whole final assessment proceedings void. The act of the AO outbroke the foundational structure of Section 144C, thereby making the entire proceedings null and void.

    Remedying the jurisdictional defect under Section 144C

    In the second contention of remedying the jurisdictional defect under Section 144C of the Act, it is pertinent to ponder over the question of whether all the procedural mistakes can be remedied under the Act. For this, it is necessary to first understand the comparative analysis of jurisdictional defects between the initial stages and later stages of the proceedings. 

    To understand the comparative analysis of the jurisdictional defect between the initial stages and later stages of the proceedings under the Act, it is pertinent to canvass the ruling of Sky Light Hospitality LLP v. Acit (“Sky Light Hospitality LLP case”) to distinguish the procedural matter in the beginning and later stages of the proceedings. In this case, the AO committed a mistake by issuing notice under Section 148 of the Act, under the name of the non-existent company. Based on the above facts, the Delhi High Court ruled that the procedural mistakes at the beginning of the proceedings can be cured under Section 292B, as it does not form the root of the matter. The Delhi ITAT in Boeing India case construed that the Sky Light Hospitality LLP case was distinguishable to the instant case as in the above case the procedural defect happened at the initial stages of the proceedings, thereby not affecting the root of the proceeding. However, where the defect occurs at the later stages of the proceedings, the mandatory requirement to complete the assessment proceedings under Section 144C of the Act is contravened, thus vitiating the final proceedings in-toto.

    In this case, the draft assessment order has not been treated as a mere irregularity but as incurable illegality . The reference to the above can be drawn from the case of The Asst. Commissioner Of Income v. Vijay Television Private Ltd. wherein the court held: “Section 292B of the Act cannot be read to confer jurisdiction where none exists.” Further, the Circular No.179 dated 30 September, 1975 has limited the scope of Section 292B of the Act to rectify the mistakes of notices, the return of income, assessment, summons, or other proceedings only if they are in substance form and do not deviate from the intent or purpose of the Act. The jurisdictional defect is outside the intent of the Income Tax Act, 1961, thereby excluding such defect from Section 292B of the Act.

    In other words, the basis of refusal to remedy the jurisdictional defect lies in the context that Section 292B can be invoked only when there subsists technical irregularity in the order but not in the stance where there exists wrong jurisdiction. Thus, this made it clear that the jurisdictional defect cannot be cured under Section 292B of the Act. 

    Conclusion

    The enforceability of law demands the requisite of valid jurisdiction. To invoke the provisions of any law in India, a person is required to satisfy all the jurisdictional requirements set down by the laws in India. The failure of valid jurisdiction will allow the courts or tribunals to repudiate the validity of any order, plea, petition, or any case. The Delhi ITAT’s stern response to the jurisdictional defect under Section 144C (1) of the Act envisaged that jurisdictional defect cannot be sustained by any court in India. This even implies to all the authorities and regulatory bodies in India. This case had further drawn light on the procedural mistakes in the assessment proceedings that can be cured under Section 292B of the Act and the procedural mistakes in the assessment proceedings that cannot be cured under Section 292B of the Act by differentiating them as procedural mistakes at the initial and later stages of the assessment proceedings.

    The second loophole that subsists in this case was the lack of independence of DRP. The DRP, in this case, intentionally supported the Department Representative in the procedural mistake under Section 144C (1) of the Act even after being acquiescent to the fact that there was a jurisdictional defect in the draft assessment order. This connotes that the DRP overlook the procedural irregularities of the case, which can affect the tax adjudication in India. It is a need of an hour that even DRP should look into technical intricacies of the case before adjudicating any dispute.

  • Desolated Future Of Investments In India- Disregarding The Vodafone Verdict

    Desolated Future Of Investments In India- Disregarding The Vodafone Verdict

    By Shobhit Shulka, second-year student at MNLU, Mumbai

    India is an attractive destination for foreign investment. However, given the hitherto arbitration regime in the country and uncertainty in smooth enforcement of awards in India, foreign companies are becoming more skeptical about investing in India. Even at a time when the judiciary has been more supportive of arbitration, the government has continued to be incredulous of the practice. The issue has  been further aggravated recently by the Solicitor General of India when he refused to accept the award given by the Permanent Seat of Arbitration in the case of Vodafone International Holdings BV v. The Republic of India (‘Vodafone Judgment’). This post briefly discusses the judicial trend on this issue and analyses the consequences of this orientation by the government towards arbitration.

    In a unanimous decision, The Permanent Seat of Arbitration ruled on 25th September 2020 that the Indian income tax authorities had violated the guarantee of fair and equitable treatment under the Bilateral Investment Treaty (‘BIT’) signed with the Netherlands, by retrospectively amending the law to demand Rs. 22,000 crores from Vodafone.The judgement seemed to bring the infamous retrospective tax battle to a close, however, closure is still uncertain. After the declaration of the award, India as a state had two options: 1) To accept the award and close this long pending matter which would suit India’s contention of it being a better place to do business, with a tax-friendly regime for business incorporators and foreign investors. 2) Challenge the award at another international forum and not implement the award as decided by the arbitral tribunal. At this juncture, the government seems more inclined towards the second option, which was affirmed bythe Solicitor General’s comments. However, this might have a severe impact on India’s tax friendly regime and would disincentivise investors and businesses to invest in India, at a time when the deteriorating economic conditions are in desperate need of such investments.

    Background of the case

    In May 2007, Vodafone bought a 67% stake in Hutchinson Telecommunications (‘Hutchinson’)for an $ 11bn deal, this included the mobile business and other assets of Hutchinson in India. In September that year, the Indian Government raised a demand of about 8000 crores in capital gains and withholding tax from Vodafone saying the company should have deducted the tax at source before making a payment to Hutchinson. Vodafone moved the Bombay High Court which ruled against Vodafone. It then appealed against the order in the Supreme Court, which ruled Vodafone’s interpretation of the law as the correct one and ruled that it did not have to pay any taxes. In an ideal world, the matter would have ended then and there. However, that same year the then Finance Minister came with a proposal to amend section 9(1)(i) of the Income Tax Act and retrospectively tax such deals. The Bill passed the onus on Vodafone to pay the taxes. The Government circumvented the effect of the apex court’s judgment by resorting to retrospective legislation and created an unpredictable and unstable business environment. Vodafone then challenged the amendment under the India-UK BIT and the India-Netherlands BIT. The arbitral award was announced in Vodafone’s favour, finding the Indian government in violation of section 4(1)of the India-Netherlands BIT.A BIT is an agreement between two sovereign states for the protection of investors and businesses from one state to another. The government’s stand has been that tax matters do not come under the purview of BITs. The retrospective law allowed the indirect transfers of Indian capital assets even if the transfer was a sale. Thus, the argument from the government has been that they should challenge the award under the tax treaty because it questions the sovereign right of the government. This award negates India’s general position that tax disputes do not come under the ambit of investment treaties. The Indian Revenue department has thus raised objections over the arbitral award coming under the purview of the BIT and not under the tax treaty.

    Options that India has to challenge the infamous award

    India stands at a tricky crossroad here as challenging this award seems very unreasonable as the dispute has already been ruled against India by the Supreme Court and then the arbitration tribunal. However, the government’s contention here is that the award seems to challenge its sovereign right to tax and would impact other cases against the government.

    Vodafone too cannot enforce its victory and will have to approach Indian courts again, because India does not recognise any foreign court in a commercial dispute that questions the state’s sovereign right to intervene. The Apex Court in State of West Bengal v. Keshoram Industries held that if the terms of an arbitration treaty are inconsistent with India’s sovereign laws, a court will not give effect to such treaty. This has resulted in the lapsing of 70 BITs between foreign governments and India which has lapsed since 2016 and is not being renewed. India’s latest bilateral investment deals, such as the India Belarus BIT in 2018 and the India Brazil BIT in 2020, have largely omitted from their domain, measures relating to taxes or compliance of tax obligations. In the future, India may negotiate vigorously to integrate such exclusions into bilateral investment treaties.

    Uncertainty of investment regimes in India

    Unless new agreements have been negotiated between India and the related transaction states, new investments in India between foreign investors and the country will cease to gain BIT security. Current investments related to BITs with ‘sunset provision’,which means that the treaties may continue such as, the India Netherlands BIT that specifies, for investments made before the termination, substantial provisions may continue to extend for fifteen years after the termination.  Several of India’s other deals, such as those with the United Kingdom and Mauritius, have identical ‘sunset’ provisions.

    However, this uncertainty could affect India’s business with global powerhouses such as the European Union (‘EU’).Talks aimed at reaching a free trade agreement between the EU and India (which may include investor rights provisions) were started in 2007 but allegedly reached a deadlock in 2013.India, even after a request from EU officials, is hesitant so far to briefly expand its BITs with EU countries to fill the gap with any new agreements. The consequence of the termination of these bilateral agreements is not limited to investment into India but by India too. As westbound investment by Indians rises, Indian investors are increasingly looking at BITs to secure their investments and provide have a roadmap to seek any violations in host countries of the promised safeguards. India’s woes, however, are not limited to uncertainties in trading regimes. The dismissal of an international arbitral award may also have a detrimental effect on the future of investments in India.

    What this means for future investments in India

    New York Convention awards were enforced in India through the Arbitration and Conciliation Act, 1996 (‘Arbitration Act’). Before this, India’s arbitration was afflicted by setbacks, lack of clarification on the grant of temporary relief, no finality on arbitral awards owing to court requests for setting aside, and a belief that arbitrators were not always unbiased and neutral. Though major cities in India may take several more years to become common international arbitration seats such as those in Singapore or Paris, India is becoming an arbitration-friendly jurisdiction.However, refusalto accept such awards by the government could have a severe impact on such ambitions.

    An international investment usually includes a trade arrangement (‘Investment Contract‘) between the foreign investor and the host state. Investment arrangements, either before domestic courts or regulatory tribunals or by international arbitration, allow for dispute settlement. Refusing to accept an international arbitration award will disincentivize the investors. Investors will start contemplating on investing in India as any dispute arises the government of such countries might not comply with the international order, putting the investors to losses. It creates a hindrance in the ease of doing business in such countries and thus discourages them to make any investments to indulge in any form of funding

    The way forward

    The Government has 90 days to file an appeal in Singapore, as the seat of the dispute was in Singapore. At a time when India is in desperate need of investments due to its deteriorating economic conditions, it seemed like it would accept the award and make India seem like a country where foreign investors have a remedy under International Law. However, quixotically enough the government is inclined to challenge the award further, with a slim chance of overturning the award. This could have a severe impact on investor confidence in India and could adversely affect foreign direct and indirect investments in India.

  • India Mauritius Double Taxation Avoidance Treaty: Assessing AAR Decision Implications

    India Mauritius Double Taxation Avoidance Treaty: Assessing AAR Decision Implications

    By Anupriya Nair, A fourth-year student at NALSAR, Hyderabad

    On 26 March 2020, The Authority for Advance Ruling, New Delhi (‘AAR‘) in the case of  Re Tiger Global International II Holdings, Mauritius  denied the capital gains tax exemption pertaining to the indirect transfer of shares of Indian companies under the India Mauritius Double Tax Avoidance Agreement (‘DTAA‘). The ruling was a result of a favourably designed DTAA  which allowed Mauritius-based companies selling Indian shares to benefit from the exemption, and to promote tax avoidance practices involving the repositioning of investments into India via Mauritius-based shell entities.

    This article examines the economic implications of the AAR decision in light of the uncertainty brought about by COVID-19. The ruling in the instant case brings forth a substantial shift in practice with regard to the interpretation of the DTAA and will have a lasting effect on international investment relationships with India.

    Brief Facts of the Case

    The applicants in Re Tiger Global International II Holdings, Mauritius, comprising of Tiger Global International II, III, and IV Holdings (‘TGM’), were part of a tripartite structure of private companies which engaged in long term investment activities undertaken for the purpose of gaining capital returns. These three companies are residents of Mauritius for taxation purposes pertaining to the DTAA.

    The applicants invested in Flipkart (Singapore) between 2011-2015 which attributed a significant value of its shares to India as a result of its investment in various India-based companies. The three Mauritian taxpayers subsequently transferred a portion of their Flipkart (Singapore) shares to Fit Holdings S.A.R.L.(Luxembourg) . This sale was a consequence of a larger transaction involving Walmart’s acquisition of a majority stake in Flipkart (Singapore).

    Initially, the applicants approached the Revenue Tax authorities (‘Revenue’) in August of 2018 under Section 197 of the Income Tax Act 1961 (‘IT Act’) seeking a ‘nil’ withholding certificate in relation to the aforementioned transfer. The request was denied on grounds of ineligibility arising out of lack of independence and control and the Mauritian applicants held in the transaction in question.

    Subsequently, the applicants approached the AAR under Section 245Q (1) of the IT Act in order to determine whether the transaction would be taxable under the existing DTAA.

    Breaking Down the AAR Ruling

    The AAR’s ruling, after consideration of the factual matrix of the case, upheld the ruling of the Revenue. It was held that the share transfer transaction in question was an investment strategically designed for tax avoidance purposes. The AAR made the following key observations:

    • Since the financial statements of the applicant revealed that Flipkart (Singapore) was their only recorded investment, it was concluded that the transaction was an exploitation of the DTAA that Mauritius specifically shared with India.
    • The operating structure within which the transaction was to function, although not held to be a definite indication of tax avoidance, reflected an intention to exploit the benefits of the DTAA. This was termed as an ‘inescapable conclusion’ by the Court.
    • The role of Charles Coleman (a US-resident) over the entirety of the TGM group structure, as a director, beneficial owner, and applicant appointed signatory of bank cheques, gave the AAR reason to believe that the real control and management of the business was not situated in Mauritius but in the USA. Determining the ‘head and brain of the Companies’ as opposed to the daily affairs of business activity was a deciding factor in this aspect.
    • The AAR concurred with the Revenue to conclude that the holding-subsidiary structure in combination with the USA-based control and management of the business was indicative of the intention of applicants to exploit the DTAA as ‘see through’ entities.
    • Since the transaction involved the share transfer of Flipkart (Singapore) which only procured a substantial value of its company from India, and not an Indian company, the DTAA was held to be inapplicable and the applicants ineligible to claim benefit under the premise of the investment.

    Exploring the Implications of the decision

    Economic Implications

    There is an air of uncertainty and impermanence that surrounds the present state of economic affairs owing to the pandemic. The AAR ruling in the instant case will deter investors from engaging with the Indian market. Mauritian investors were operating under the premise that all existing investments up to March 31, 2017 have been grand-fathered (protected) and exits/shares transfers beyond this date will not be subject to capital gains tax on exit. However, exit plans for Mauritian entities were constricted by virtue of amendments in the convention between India and Mauritius for the avoidance of double taxation and fiscal evasion with respect to taxes on income and capital gains. The denial of treaty benefits, despite the existence of the grandfathering rule, is likely to attract ramifications on future exits by start-up investors who have routed money from tax havens.

    The added rigidity in the parameters for the exemption of tax under DTAA will encourage international investors to move their investments to alternate routes and investment destinations. This can cause severe implications on an economy already on the brink of recession owing to the pandemic.

    Context-Specific Approach

    The context-centric approach adopted by the AAR may mark a shift in the analysis of claim for benefits with respect to tax treaties in the future. A key take-away from the ruling is the increased relevance placed in the examination of substance matter of the parties involved in the DTAA. Further, the holistic perception of the transaction was deemed indispensable, wherein the roles of not only the sale of the shares, but rather the purchaser/buyer involved were also analysed. The intention behind the transaction was also determined by careful perusal of the structure, credibility, conduct, ownership and control of the business.

    This level of specificity in the analysis of the transaction leads to the question of the possible arbitrariness in future AAR rulings due to the broadening of scope of analysis made available to them. In the instant case, the AAR found one of the purposes of the transaction arrangement to be for obtaining tax benefit, failing the Principal Purpose Test. However, despite the AAR having utilised the aforementioned test, it was not explicitly mentioned in the ruling, leaving scope for wider analysis/interpretation of operational structure and consequently, easier deconstruction of DTAA in the future.

    An Uncertain Future

    The CBDT Circular No. 789/2000 clarifies that the tax residency certificate (TRC) issued by the Mauritian Tax Authorities would constitute sufficient evidence of residency as well as beneficial ownership of the Mauritian entity for application of the tax treaty. Further, the landmark ruling of the Hon’ble Supreme Court in the case of Vodafone International Holdings B.V. wherein the apex court unequivocally found that the language of the IT Act was inadequate to tax offshore indirect transfers, upholds the eligibility to claim benefits under the treaty (grandfathering rule).

    It is therefore essential to understand that the ruling in the instant case was rooted in the scrutiny of the specificities of the factual matrix presented before the AAR and is not to be held as the conclusive and settled jurisprudence on the DTAA between the two countries. Although it is an important AAR ruling, it is important to consider its position in jurisprudence in light of the above-mentioned circulars and judicial pronouncements. The primary relevance of this judgement lies in its dissonance from this previously deep-rooted position of law.

    This discord in the position of law created by this ruling will create an uncertainty in the mind of investor. Further, the way in which the standard treatment of indirect transfer of shares with respect to capital gains exemption will be affected by the current AAR ruling with Tiger Global is unpredictable. We can only wait and observe the way in which issues surrounding the economic impact, grandfathering clause and principle purpose test will be addressed when Tiger Global moves to Delhi High Court to challenge AAR’s decision.