Tax Tangles in the Walmart-Flipkart Deal: Are the Courts Leaning Towards a New Trend?

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Investor sentiment took yet another hit after the Authority for Advanced Ruling (“AAR”) rejected the application filed in the Walmart-Flipkart deal for tax exemptions under the DTAA (India Mauritius Double Tax Avoidance Agreement). The investor faith is dissipating amidst the pandemic induced economic slug. This is also coupled with the uncertainty circling changes in the FDI policy. All in all, these issues may deter investors from future investments in the Indian start-up ecosystem.

The Mauritius arm of USA based private equity firm Tiger Global Management LLC (“Tiger Global”) sold more than 26 million shares in Singapore based Flipkart. This transaction pertained to the acquisition of Flipkart by Walmart through its Luxembourg-based entity FIT Holdings SARL. The deal valued at Rs. 14,500 crores in 2018. Tiger Global had approached tax authorities for claiming capital gains tax exemptions under the DTAA.

The AAR rejected the application and relied on the ‘substance over form principle’. It scrutinized the management and control of the Mauritius entities. It held that the ‘heads and brains of the company’ are in the USA based parent company. The entities seeking exemption were not resident in Mauritius but resident in the USA. It is pertinent to note that Tiger Global possessed Tax Residency Certificates (“TRC”) issued by the Mauritian Government.

Relevance

The Supreme Court decision in Union of India v. Azadi Bachao Andolan had clarified that TRC submission shall be enough evidence to claim treaty benefits under the DTAA. Further, in Vodafone International Holdings B. V. v. Union of India & Anr, the Supreme Court accepted TRC as conclusive evidence for determining residency as well as beneficial ownership for applying the tax treaty.

D. B. Zwirn Mauritius Trading No. and Ardex Investments Mauritius Ltd. are some of the AAR rulings where TRC was further considered and treaty benefits to the respective applicants were then allowed in line with the Supreme Court’s decision. But, the recent ruling of the AAR in the case of AB Mauritius and now Tiger Global, along with the observations made by the Bombay High Court in Indostar Capital v. CIT seems to show that TRC is losing its significance due to the importance given to the ‘substance over the form’ principle.

Double Taxation Avoidance Agreements – Background

Double Taxation implies taxation of the same income twice. Taxation may either be on a source basis or a residency basis. The former means that tax is payable in the country where income has been generated. Whereas the latter means tax is payable in the country wherein the recipient of the income resides irrespective of the source of income. Investors are dissuaded from transactions taxed in both countries since this reduces their returns significantly. Thus, countries enter into agreements to avoid such double taxation and to extend tax benefits for investment and growth.

Scope of the DTAA

As held in Vodafone International Holdings B. V. v. Union of India & Anr, the scope of the Indo-Mauritius DTAA is based on two fundamental principles – the Westminister principle and the Ramsay principle.

The Westminister principle (evolved in the case of Commissioners of Inland Revenue v. His Grace the Duke of Westminster) states that “given that a document or transaction is genuine the Court cannot go behind it to some supposed underlying substance”. The English Courts referred to this principle as “the cardinal principle”. It is the task of the Court to learn the legal nature of the transaction. While doing so, it has to look at the entire transaction as a whole and not to adopt a dissecting approach.

The Ramsay principle states that a device of colorable nature has to be ignored as a financial nullity (evolved in the case of W.T. Ramsay Ltd. v. Inland Revenue Commissioners). An extension of the Ramsay principle was in the case of Furniss (Inspector of Taxes) v. Dawson. In this case, the Court reconstructed the transaction on the premise that the inserted step should have a business purpose, except deferment of tax.

Tax Planning v Tax Avoidance

While the law prohibits tax avoidance and tax evasion, tax planning is a legitimate practice. The Hon’ble Calcutta High Court in the case of Hela Holdings Pvt. Ltd. v. Commissioner of Income-tax and Another distinguished between tax evasion and tax avoidance. The Court held that tax evasion is the result of things such as illegality, suppression, misrepresentation, and fraud. Whereas, if the observation is that tax which would otherwise be payable by the assessee is not payable as a consequence of designing the transaction in a particular manner, with the primary purpose of non-payment of tax only, it amounts to tax avoidance. Such determinations are a result of the facts and circumstances of the case.

Furthermore, in the Vodafone International Holdings B. V. v. Union of India & Anr, the Apex Court laid down the ‘corporate business purpose’ test for distinguishing between tax avoidance (pre-ordained transaction) and tax planning (investment to take part in India). This test reiterates the ratio decidendi of the Dawson case and distinguishes tax planning from tax avoidance.

The Court further laid down certain factors, consideration of which determines the intent of a company. They are as follows:

  • duration of time during which the holding structure existed;
  • the period of business operations in India;
  • generation of taxable revenue in India during the period of business operations;
  • timing of the exit; and
  • continuity of business on such exit.

It is in the aforesaid context that the AAR examined the case in point.

Legal Context of the Deal

This exemption is applicable where the seller is a company resident in Mauritius. This provision is also referred to as the grandfathering clause. Tiger Global had claimed tax-benefits under this clause.

To learn residency, the control and management of an applicant are examined. The AAR held control and management to mean the ‘head and brain’ of the applicant companies and not the power over day-to-day affairs. In other words, the power to make important decisions must lie with the applicant company. Furthermore, on ascertaining the legal nature of the whole transaction, the AAR found Tiger Global as a mere see-through entity of its parent group. Moreover, Tiger Global did not make any foreign direct investments in India. It also did not perform any other activities other than the purchase and sale of Flipkart’s shares. This established that the primary purpose of the routing through the Mauritius wing was to avoid payment of tax and thus, qualified as tax avoidance.

The AAR further reasoned that benefits under the DTAA (both original and amended) contemplated extending the benefit of residency-based taxation for shares of a company resident in India. Since the instant case dealt with the sale of shares of a Singapore based company the provisions were not applicable.

Implications of the AAR ruling

The ruling has a three-fold effect:

Firstly, the ruling creates uncertainty in the investment market. This is because the investors rely upon the existing tax regime according to which tax residency certificates issued by the Mauritius Government were adequate for claiming treaty benefits. This ruling will also exert pressure on transactions structured similarly. Moreover, investors had begun to believe that acquisition of Indian companies via Mauritius and Singapore was covered under the grandfather clause of the renegotiated DTAA.

Secondly, there will be detailed scrutiny beyond the legal form of such entities into the management and control.

Thirdly, a fresh impetus to litigation based on the bona fides of transactions routed through such jurisdictions is likely.

Conclusion

Tax Residency Certificates seem to be losing their importance. There is a growing focus towards ‘substance over form’ principle in such cases. There will be greater scrutiny of the bona fides of transactions in the days to come. The vigilance of the regulatory bodies is a welcome move from a nationalistic perspective. But, the ruling has been further challenged in the High Court. Such a trend will hurt the returns of private equity firms and make their exits expensive.


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