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

Background

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.

Decoding the legality of the reassessments

By virtue of section 90(4) of the ITA, tax treaty relief is only available to those taxpayers that have obtained a tax residency certificate (“TRC”) from the Government of their state of residence, establishing their “residence” in a treaty State. Mauritian investors had accordingly obtained TRCs from the Mauritius Revenue Authority (“MRA”) establishing their residence in Mauritius and thereby claimed treaty relief in respect of capital gains on sale of Indian shares in prior assessment years.

Tax authorities have the power to reopen assessments where they have information which suggests that income chargeable to tax has escaped assessment. Ordinarily, this power can be exercised beyond 3 years from the end of the relevant assessment year only if the Revenue has evidence which reveals that income in excess of INR 5 million has escaped assessment. The burden of proof is on the Revenue to establish that income had escaped assessment and to also demonstrate that the taxpayer had wilfully omitted to disclose material facts in relation to the escaped income at the time its assessment was originally completed.

It is unclear what evidence the Revenue has relied on to substantiate its claims of “treaty shopping” and “fiscal evasion”. Each tax treaty has its own self-contained definition “residence”. For instance, Article 4(1) of the Mauritius Treaty defines “resident of a Contracting State” to mean any person who, under the laws of that State, is liable to taxation therein by reason of his domicile, residence, place of management, or any other criterion of similar nature. Thus, if an entity is liable to tax in Mauritius under any of these criteria, it is considered tax resident in Mauritius for treaty purposes. Moreover, Circular No. 789 of 2000 issued by the Revenue (“Circular 789”) categorically states that foreign institutional investors and investment funds that are incorporated in Mauritius would be considered as “residents” of Mauritius in accordance with the Mauritius Treaty. It further clarified that wherever a TRC was issued by the Mauritian authorities, it would constitute sufficient evidence for accepting the status of residence as well as beneficial ownership for applying the Mauritius Treaty. In a press release issued on 1 March 2013, the Ministry of Finance confirmed that Circular 789 continues to be valid and effective, and that the Revenue cannot go behind a TRC and question an entity’s residential status.

A long line of judgements including the landmark Supreme Court decisions in Azadi Bachao Andolan¹ and Vodafone International Holdings² have also upheld the validity of Circular 789 and established that the Revenue has no power to “pierce the corporate veil” or look beyond a TRC issued by the MRA. These decisions have also held that absent an applicable limitation of benefits (“LoB”) clause in the treaty, factors such as the Mauritius company’s source of funds, control and management, or its activities could not impact treaty entitlement and such factors could not be “read in” to the Treaty. Put differently, the ‘motive’ with which an entity had been incorporated in Mauritius was wholly irrelevant and could not in any way affect the operation of the Treaty.

It appears therefore that the Revenue’s actions in denying the capital gains tax benefit under the Mauritius Treaty to grandfathered Indian investments are directly in contravention of binding judicial precedent. Furthermore, by virtue of section 119 of the ITA, Circular 789 is binding on the Revenue i.e., they cannot take a view that is contrary to departmental instructions and directions.³

Examining the foundations of a “substance over form” claim

In line with the OECD/G20 BEPS Project, Indian tax authorities have increasingly applied a substance over form approach in examining offshore structures, notwithstanding the ultimate legal validity of such an examination. A classical “substance analysis” involves the determination of an entity’s place of effective management (“POEM”) i.e., the place where key management and commercial decisions that are necessary for the conduct of the business of an entity as a whole are, in substance, made. While the Revenue has issued guiding principles for determining POEM under the ITA, these principles may not be strictly applicable in a cross-border context, in which residence is to be determined as per the terms of an applicable tax treaty.

Nevertheless, funds facing enhanced Revenue scrutiny for their jurisdictional choices will be expected to satisfy several parameters in order to establish “effective” residence and management in their claimed States of residence and thereby seek entitlement under an applicable tax treaty. In a nutshell, funds will be required to: (i) identify the persons who actually take key management and commercial decisions for the conduct of their business as a whole; (ii) establish that these persons, in fact, constituted their key managerial personnel (and not shareholders or delegated decision makers); and (ii) illustrate that these decisions were, in fact, taken in their claimed State of residence. A usual consequent step is to establish that they are not merely acting as agents or conduits of an ultimate beneficiary that either drives or derives the benefits of any Indian investment.

Funds claiming tax treaty benefits in respect of their Indian investments will be expected to satisfy the following key parameters in order to establish their “substance” in a treaty State:

• basis for funding investment in Indian assets: whether the source of investment was internal accruals, shareholder funds, external borrowings, or through back-to-back/ layered funding via multiple intermediate entities;
• fiscal independence: whether the fund had full, independent control over all bank accounts in its name in its claimed State of residence and discretion to utilize all moneys standing to its name as it saw fit without requiring prior approval from any person;
• manner of handling, receiving, and controlling exit proceeds: whether exit proceeds were actually received and effectively controlled by fund, unburdened by any contractual, legal, or economic arrangements such as back-to-back structures for upstreaming exit proceeds;
• duration and nature of operations: whether the fund has operated in its claimed State of residence for substantial periods; whether it has multiple investments in India or abroad; and whether its activities in that State have continued post divestment of Indian investments;
• decision making filters: identifying the directors of the entity, their place of residence, and their qualifications; the place and mode of conducting board meetings, the number of meetings conducted, the nature of decisions taken (routine/ordinary v. strategic/ policy) delegation of responsibility to board committees or other persons, manner of voting, recording of minutes and their content, signatories to board resolutions, including the degree of involvement by the fund’s immediate and ultimate shareholders in investing, managing, and divesting from its Indian investments;
• material presence thresholds: whether the fund had deployed significant assets and employees, derived substantial income, and incurred substantial expenses in its claimed State of residence on a standalone basis (to evidence the satisfaction of applicable LoB requirements) and as a proportion of its global assets, employees, income, and expenses;
• administrative filters: whether the fund owned or directly operated administrative/ office space in its claimed State of residence (and not merely relied on a third-party corporate management service) and whether its records (both corporate and tax) were ordinarily maintained there in accordance with applicable law.

Practical and commercial considerations for funds

Funds confronted by reassessment orders denying treaty benefits are likely to face several practical challenges in resolving them. The swiftest route for recourse would be to approach the jurisdictional High Court under Article 226 of the Constitution seeking a writ of certiorari quashing the orders passed by the Revenue. However, writ petitions under Article 226 are maintainable only on limited grounds and are subject to both the discretion of the Court and the rule of alternate remedy, which requires a claimant to exhaust the equally efficacious alternate remedy available under statute before invoking the extraordinary jurisdiction of a Constitutional Court.

The ITA contains its own appellate mechanism for challenging final assessment orders, but each appeal (to the Income-tax Appellate Tribunal) require a mandatory pre-deposit of 20% of the tax demanded before the appeal will be heard, which presents its own set of challenges.

From a commercial perspective, a reassessment order denying treaty benefits can quickly become a nightmare for all the stakeholders in an investment fund. Sponsors have a limited set of options that they can press into service when faced with a reassessment order.

Tax indemnity insurance. Whilst tax indemnity insurance no doubt offers the most comfort in that it largely ring-fences the fund from a long-drawn battle in court, such insurance is not always readily available. If insurance is not on the table, a sponsor will be compelled to fall back on investor giveback obligations or reserves or a combination of the two.

Investor givebacks. Giveback provisions are hotly contested, and investors will generally negotiate limits in terms of time and quantum. Although Indian sponsors sometimes get away with a bespoke time limit for tax-related givebacks, investors (particularly foreign institutional investors) are never happy to concede this and give in only when they are alerted to the sub-optimal nature of reserves. Further, they are likely to extract significant reciprocal concessions on other terms. If a giveback is enforced in practice, there are a host of administrative issues to deal with including timely receipt of funds, accounting for taxes suffered by investors, the inevitable trigger of the carried interest clawback, etc.

Reserves. Fund documents will generally permit the sponsor to create reserves to cater to future liabilities (including tax liabilities). Reserves, however, are the least preferred option for investors and sponsors alike. In practice, the creation of a reserve means that a portion of proceeds arising from the sale of investments is held back by the fund i.e., such proceeds are not distributed under the waterfall. As a result, it takes longer for the ‘clock to be stopped’ and the sponsor’s entitlement to carried interest will be delayed (if not entirely eliminated). Despite these obvious concerns, sponsors may elect to create reserves as it simpler from an administrative perspective when compared to givebacks.

The way forward for global funds investing in India

Offshore investors currently holding grandfathered investments are likely to view the reassessments with some degree of trepidation and future divestments by Mauritius and Singapore based investors are likely to attract deeper Revenue scrutiny. Adequate documentation and evidence of substance in these jurisdictions will become increasingly crucial in justifying a treaty claim, and investors should be mindful of where key commercial and management decisions are taken from. With India’sGeneral Anti-Avoidance Rule (“GAAR”) taking effect from 1 April 2018, the Revenue has been granted wide powers to recharacterize transactions and structures, including the power to deny benefits under a tax treaty, in all cases deemed to be “impermissible avoidance arrangements” i.e., arrangements the main purpose of which was to obtain a tax benefit, and which are uncommon, or abusive, or lacking in commercial substance, or not bona fide.

Moreover, with India’s ratification of the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent BEPS (“MLI”), several additional measures have been incorporated in India’s tax treaties to counter treaty abuse, prevent multinational tax avoidance, and prevent instances of double non-taxation. The principal purpose test (“PPT”) under the MLI prevents treaty benefits from being granted in cases where it is established that obtaining those benefits was one of the principal purposes of any arrangement of transaction that resulted in that benefit. The PPT is much broader in application than India’s domestic GAAR and it is likely that the Revenue will increasingly resort to it to exclude treaty benefits to entities that are, in substance, residents of a third jurisdiction. While the Mauritius Treaty is not covered under the MLI, the Singapore Treaty and several other tax treaties executed by India are covered under it. Singapore-resident investors in particular had made substantial investments into Indian equity prior to 1 April 2017 and it remains to be seen whether they will be able to successfully claim capital gains tax relief under the Singapore Treaty, which was amended on broadly the same terms as the Mauritius Treaty.

Multi-tiered investment structures across jurisdictions, especially those set up after 2012, may face an additional risk of denial of treaty benefits in case of exit at the level of an offshore holding entity, as the Revenue increasingly seeks to apply the indirect transfer rule to tax gains from offshore holdings deemed to derive substantial value from underlying Indian assets.

Investors cannot retroactively undo their Indian investments. Equally, the Revenue should respect the legitimate expectations of investors that have participated in Indian equities with a specific tax impact in mind. The bait-and-switch attitude adopted by the Revenue in reopening long closed assessments on grandfathered investments is guaranteed to erode investor confidence, tarnish the ease of doing business in the country, and frustrate the Government’s stated objective of limiting needless tax litigation.

¹ [2003] 263 ITR 706 SC.
² [2012] 341 ITR 1.
³ See KP Varghese v. ITO, [1981] 131 ITR 597 (SC) and Navnitlal Javeri v. KK Sen, [1965] 56 ITR 198 (SC).