Denial of tax treaty benefits: Blueprinting defence strategies for PE funds – A tax litigation perspective

When India amended its tax treaties with Mauritius (“Mauritius Treaty”) and Singapore (“Singapore Treaty”) in 2016 in order to provide for source-based taxation of capital gains on alienation of shares, it was expressly stated that this amendment would only apply prospectively. In other words, gains from the alienation of shares acquired prior to 1 April 2017 – when the amendment took effect – would remain taxable only in the state of residence of the shareholder. This “grandfathering” of existing investments was intended to protect the legitimate expectations of investors who had contributed their trust and capital towards the India growth story, with a specific tax impact in mind. Investors were therefore assured that treaty benefits would continue to remain available for grandfathered investments so long as the conditions for claiming such entitlement were fulfilled. 


However, in a disturbing development, the Income Tax Department (“Revenue”) has reopened assessments of several global fund houses (including notable PE firms) and retrospectively denied treaty benefits under the Mauritius and Singapore Treaties on the basis that these entities had indulged in fiscal evasion by means of treaty shopping, as their place of effective management was not, in fact, in Mauritius or Singapore. On that basis, the Revenue has denied tax treaty benefits, slapped substantial tax demands along with interest for prior assessment years, and levied penalties for under-reporting of income, in accordance with the provisions of the Income-tax Act, 1961 (“ITA”). 


In this article, we seek to analyse the Revenue’s actions, evaluate the parameters for determining treaty eligibility, discuss mitigation steps, and debate the practical challenges involved in responding to or challenging such actions for fund managers and investors. 

Key Takeaways:
  • Revenue has issued reassessment orders to several global PE/VC funds denying tax treaty benefits to grandfathered investments alleging treaty shopping through Mauritius and Singapore between AY 2013-14 and 2015-16
  • Substantial tax, interest, and penalty has been levied invoking judicial anti-avoidance principles based on a supposed lack of commercial substance in these jurisdictions
  • Funds confronted with reassessment orders may be forced to dip into reserves, rely on tax indemnity insurance, or invoke investor givebacks
  • Strong reliance on binding judicial precedent, departmental instructions, and textual interpretation of treaty language will be crucial in challenging reassessment orders
  • Funds will be expected to demonstrate ownership and control over funds, actual decision making by directors, and satisfy materiality thresholds to claim treaty benefits going forward
  • Future exits from grandfathered investments will witness greater Revenue scrutiny including reliance on GAAR and MLI-PPT if tax considerations drove a jurisdictional choice

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