Benefit of India-Mauritius tax treaty - still a question mark?

Transactions involving India-Mauritius tax treaty have always been on the tax department's watchlist. In fact, the commercial arrangements comprising of capital gains tax exemption under India-Mauritius tax treaty have been questioned on umpteen occasions, including the landmark decision of Supreme Court in Azadi Bachao Aandolan[1]. Recently, the Authority for Advance Rulings (AAR)[2] pronounced two rulings of AB Mauritius group[3], fathoming the same question - taxability of capital gains in hands of Mauritian company arising on transfer of Indian company shares. Considering the specific facts in the two rulings, interestingly, the AAR allowed tax treaty benefit in one, while denying in the other. It is, thus, important to analyze the fundamentals of these rulings, as the issue seemed to have settled position post the Apex Court decision, and other rulings that followed.

In this write-up, we analyse peculiarities of these recent rulings, its key takeaways and imminent disruption that has been caused.

The chronicle of AB Mauritius

Two Mauritius companies (AB Holdings Mauritius-II and AB Mauritius) transferred the respective investments in the form of shares of two Indian companies to a Singapore group company. The moot question was on the taxability of the capital gains in India, in light of beneficial provisions of India-Mauritius tax treaty.

In one ruling, the AAR observed that Mauritian company possessed a valid tax residency certificate (TRC) from Mauritius tax authorities, had ongoing business of investment for almost 7 years, and was not a mere fly-by-night operator. The AAR placed thrust on the initial investment being done by Mauritian company out of its own resources, through proper banking channels, and had adequate documentation in place to demonstrate the same. For these reasons, the AAR held that the capital gains arising on the sale of Indian company shares would not be taxable in India under India-Mauritius tax treaty.

In the other ruling, while the Mauritian company possessed a valid TRC from Mauritius tax authorities, the AAR accentuated on the modus operandi at the time of the acquisition of shares by the Mauritian company. It was observed that neither the Mauritian company was able to demonstrate that the decision to purchase the Indian company shares was taken by it acting on its own behalf, nor the investment flowed from Mauritius to India. Taking entire fact pattern into consideration, the AAR held that Indian company shares did not actually belonged to the Mauritius company but to the US based holding company; hence Mauritius tax treaty benefit was denied to it.

Unprecedented approach

It is not the first, when tax administration has raised questions on eligibility of the capital gains tax exemption under the India-Mauritius tax treaty. In the year 1994 and 2000, the Central Board of Direct Taxes[4] issued two Circulars[5] respectively to clarify that TRC is sufficient evidence to accept residential status of Mauritius companies and its beneficial ownership of Indian shares, for granting capital gains exemption under the India-Mauritius tax treaty. Challenge to the constitutional validity of these Circulars was struck down by the Apex Court[6] in year 2003 and issue was decided in favor of taxpayers. Thereafter, many favorable judgments have been pronounced relying on the aforementioned Circular and Apex Court decision.

Indian court again got its handle on the India-Mauritius tax treaty in the year 2011, in the decision of Aditya Birla Nuvo[7] with a distinct perspective. In this case, the Bombay High Court observed that while the Mauritian company possessed a valid TRC, it had no shareholders rights in the Indian company which were actually being exercised by the US parent entity. With lack of adequate documentation and absence of shareholder participation, the High Court held that Mauritian company was a mere permitted transferee and was not the real owner of Indian company shares[8].

In case of AB Mauritius, the AAR analysed the same question (i.e. the real ownership of shares) but with a distinct prism. Rather than examining residential status/ beneficial ownership in the Indian company shares at the time of sale or whether Mauritian company exercised shareholder voting or dividend rights during the ownership of shares, the AAR went on to probe into factual matrix at the time of acquisition of Indian company shares. The initial investment decision maker, actual flow of funds from Mauritius to India, etc., were the factors considered relevant by the AAR to determine the real ownership and hence the eligibility to treaty benefit. Lack of documentation to substantiate facts, was negatively looked upon, regardless that such documentation was almost 15 years old and did not require retention (for these many years) under India or Mauritius statutes.

Unsettling the settled

In the backdrop of ongoing paradigm shift for adopting 'substance' as per OECD recommendations under Base Erosion and Profit Shifting (BEPS) initiative[9], India-Mauritius tax treaty was amended in May 2016, to insert Limitation of Benefit (LOB) clause, denying tax treaty benefit to a shell/ conduit company not meeting the LOB criterion. The amended India-Mauritius tax treaty also provided for grandfathering of capital gains exemption for shares acquired before 01 April, 2017.

With this grandfathering and prospective LOB requirement, prevalent perception was that litigation around Mauritian treaty benefit may get subdued. The AAR, however, in its recent rulings has not considered these aspects.

Conjoint analysis of the AB Mauritius rulings have raised brows on TRC being sufficient to prove beneficial ownership, and unsettling the principle laid out by the Apex Court. Call for more than decade old documents to justify the modus operandi at the time of investment in Indian shares may also be a reason to worry. These aspects are set to increase the tax scrutiny for investments, especially those made through Mauritius, and likely to beget further litigation on this issue, though against much acclaimed Government agenda of reducing litigation. Perhaps, it is time for Government to issue another circular to clarify its stance not to dive into these aspects for granting Mauritius tax treaty benefit and thus, put to rest the prophesized litigation on this front.

The taxpayers may decide to challenge the unfavorable ruling as the AAR may have gone beyond the Apex Court judgment which approved TRC as the acid test to claim treaty benefit. These rulings, at the least, fortify the gravity of maintaining robust documentation to claim the benefit of India-Mauritius tax treaty not only for the time of share sale, but also for the time of investment.

The article has also been co-authored by Rupal Maheshwari.