2014 (8) TMI 9 - HC - Income Tax

Court rules gains from sale of Compulsorily Convertible Debentures as capital gains, not interest. Corporate veil not lifted.

Zaheer Mauritius Versus Director of Income Tax (International Taxation) -II

The court allowed the writ petition, setting aside the AAR's ruling. It held that the gains from the sale of Compulsorily Convertible Debentures (CCDs) ... Lifting up of corporate veil - Whether the AAR was correct in holding that the corporate veil ought to be lifted and that the JV Company and Vatika were essentially the same entity – Held that:- The JV Company was to be managed as a joint venture between the petitioner and Vatika and the JV Company was not an alter ego of Vatika alone - the affairs of the JV Company were to be managed separately and distinctly from that of Vatika - The reading of the agreement as a whole clearly indicates that the petitioner was entitled to participate in the management and affairs of the JV Company, not only by appointing its nominee directors but also by ensuing independent auditors and an independent Asset Manager - the affairs of the JV Company were to be managed independent of Vatika - when the corporate veil of the JV Company is lifted, Vatika and the JV Company were essentially one and the same entity to be wholly erroneous and not warranted. Whether the amount paid/payable by Vatika in excess of the amount invested by the petitioner would be ‘interest’ within the meaning of Section 2(28A) of the Act and Article 11 of the Indo –Mauritius DTAA – Held that:- It cannot be read to mean that the petitioner was only entitled to a fixed return on the investments made by it in the equity and CCDs issued by the JV company - the CCDs held by the petitioner would mandatorily be convertible into equity shares and the petitioner would be entitled to the benefits that would accrue to an equity shareholder in respect of the equity shares issued by the JV Company on conversion of the CCDs - merely because an investment agreement provides for exit options to an investor, would not change the nature of the investment made - It also cannot be ignored that the options were granted to the investor as well as to Vatika - it is essentially a joint venture agreement and it is common in any joint venture agreement for the co-venturers to include covenants for buying each-others’ stakes - Although, the SHA enables the petitioner to exit the investment by receiving a reasonable return on it, and in that sense it is assured of a minimum return, it cannot be read to mean that the CCDs were fixed return instruments, since the petitioner also had the option to continue with its investment as an equity shareholder of the JV Company - The rights with regard to options as well as additional rights under Article 11 of the SHA were the mutual rights and obligations between Vatika and the petitioner and not the JV company - The JV Company would in any event, whether the options were exercised inter se Vatika and the petitioner or not, convert the CCDs into equity shares on completion of 72 months from the First Closing Date. Agreement structured for the purpose of avoiding tax or not – Held that:- If the gains are considered as payment of interest by Vatika, as is contended by the Revenue, it would also mean that the quantum of interest is a deductable expenditure in the hands of Vatika - it would be erroneous to conclude that the whole transaction had been structured to ensure avoidance of tax on income – Relying upon Vodafone International Holdings BV v. Union of India and Anr. [2012 (1) TMI 52 - SUPREME COURT OF INDIA] - Court must look at the entire transaction as a whole and not adopt a dissecting approach - the court cannot start with the question of whether the transaction is a tax saving device, but should instead apply the “look at test” to ascertain its true legal nature. There is sufficient commercial reason for the petitioner to have routed its investment in the real estate project through equity and CCDs - The pre-mature exit options as recorded in the SHA and the minimum return assumed by Vatika on its investment are clearly commercial agreements between the parties - These would not change the legal nature of the transaction entered into between the parties - The terms of the arrangements between Vatika and the petitioner reveal that the JV was a genuine commercial venture, in which both partners had management rights - The call and put options were defined commercial options capable of being elected by the parties –there is no reason to ignore the legal nature of the instrument of a Compulsorily Convertible Debenture or to lift the corporate veil to treat the JV Company and Vatika as a single entity – Decided in favour of Assessee. Issues Involved:1. Taxability of gains from the sale of equity shares and Compulsorily Convertible Debentures (CCDs) under the Double Taxation Avoidance Agreement (DTAA) between India and Mauritius.2. Classification of gains from the sale of CCDs as 'interest' under Section 2(28A) of the Income Tax Act, 1961.3. Determination of whether the transaction between the petitioner and Vatika was a genuine investment or a disguised loan.4. Applicability of the corporate veil doctrine to treat the JV Company and Vatika as a single entity.5. Allegation of tax avoidance through the structuring of the transaction.Detailed Analysis:1. Taxability of Gains from Sale of Equity Shares and CCDs:The petitioner, a Mauritius-based company, challenged the Authority for Advance Ruling (AAR) decision that gains from the sale of equity shares and CCDs were not exempt from capital gains tax in India under the DTAA with Mauritius. The petitioner argued that these gains should be treated as capital gains and thus exempt from Indian taxation as per Article 13(4) of the DTAA.2. Classification of Gains from Sale of CCDs as 'Interest':The AAR held that gains from the sale of CCDs constituted 'interest' under Section 2(28A) of the Income Tax Act and Article 11 of the DTAA. The petitioner contended that the AAR erroneously classified the gains as interest, despite the absence of a debtor-creditor relationship between Vatika and the petitioner. The petitioner maintained that CCDs were capital assets, and gains from their sale should be treated as capital gains, not interest.3. Genuine Investment vs. Disguised Loan:The AAR concluded that the transaction was essentially a loan disguised as an investment in shares and CCDs, warranting the lifting of the corporate veil. The petitioner argued that the AAR's conclusion was incorrect, emphasizing that the CCDs were held as capital assets and the transaction was a genuine investment. The court analyzed the terms of the Securities Subscription Agreement (SSA) and Shareholder's Agreement (SHA) and found that the agreements provided for genuine investment options, including call and put options, and did not solely assure a fixed return.4. Corporate Veil Doctrine:The AAR's decision to lift the corporate veil and treat the JV Company and Vatika as a single entity was challenged. The court examined the SHA and found that the JV Company was managed independently, with both Vatika and the petitioner having significant management rights. The court concluded that the JV Company and Vatika were not a single entity, and the corporate veil should not be lifted.5. Allegation of Tax Avoidance:The Revenue argued that the transaction was structured to avoid tax. The court referred to the Supreme Court's judgment in Vodafone International Holdings BV v. Union of India, emphasizing the 'look at' principle to ascertain the true legal nature of the transaction. The court found that the petitioner had commercial reasons for structuring the investment through equity and CCDs, and the transaction was a genuine commercial venture. The court held that there was no basis to conclude that the transaction was solely designed to avoid tax.Conclusion:The court allowed the writ petition, setting aside the AAR's ruling. It held that the gains from the sale of CCDs were capital gains and not interest, and the transaction was a genuine investment, not a disguised loan. The court also found no justification for lifting the corporate veil to treat the JV Company and Vatika as a single entity. The parties were left to bear their own costs.