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of <h1>ITAT rules mutual fund units distinct from shares, capital gains exempt under India-Mauritius DTAA Article 13(3A)</h1> <h3>Emerging India Focus Funds, Apex Financial Services (Mauritius) Ltd. Versus ACIT, Circle Int. Tax 1 (2) (2), Delhi.</h3> Emerging India Focus Funds, Apex Financial Services (Mauritius) Ltd. Versus ACIT, Circle Int. Tax 1 (2) (2), Delhi. - TMI 1. ISSUES PRESENTED and CONSIDEREDThe core legal questions considered in the judgment are:Whether capital gains arising from the sale of units of equity-oriented mutual funds by a Mauritius-resident foreign company are taxable in India under Article 13(3A) or exempt under Article 13(4) of the India-Mauritius Double Taxation Avoidance Agreement (DTAA).Whether units of equity-oriented mutual funds should be treated as 'shares' for the purposes of Article 13(3A) of the India-Mauritius DTAA, thereby attracting capital gains tax in India.The applicability of the grandfathering clause for mutual fund units acquired prior to 1 April 2017.Whether the proportionate capital gains calculation based on minimum equity allocation (65%) is appropriate or the entire capital gain should be taxed.The correctness of interest levied under section 234B of the Income Tax Act, 1961.2. ISSUE-WISE DETAILED ANALYSISIssue 1: Taxability of capital gains on sale of equity-oriented mutual fund units under India-Mauritius DTAARelevant legal framework and precedents: Article 13 of the India-Mauritius DTAA governs taxation of capital gains. Article 13(3A) provides that gains from alienation of shares acquired on or after 1 April 2017 in a company resident in a contracting state may be taxed in that state (source country). Article 13(4) provides that gains from alienation of any property other than those specified in earlier paragraphs (including shares) shall be taxable only in the resident state.Precedents include Supreme Court rulings emphasizing strict interpretation of tax statutes and various tribunal decisions holding that mutual fund units are distinct from shares for DTAA purposes.Court's interpretation and reasoning: The Assessing Officer (AO) initially held that since the underlying assets of the mutual funds were equity shares, the capital gains should be taxable under Article 13(3A). The Dispute Resolution Panel (DRP) affirmed this view, relying on the doctrine of purposive construction, reasoning that units of equity-oriented mutual funds are akin to shares because:Equity-oriented mutual funds invest at least 65% of their corpus in equity shares.Income Tax Act provisions (Sections 10(38) and 112A) treat capital gains on equity shares and units of equity-oriented mutual funds similarly for exemption and tax rates.The legislative intent is to treat units of equity-oriented mutual funds as equivalent to equity shares to achieve the object of the law.The DRP relied on the purposive construction rule, citing Supreme Court precedent that statutes should be interpreted in a manner harmonious with their object. It concluded that the entire capital gains from sale of equity-oriented mutual fund units are taxable in India under Article 13(3A).Key evidence and findings: The AO and DRP relied on mutual fund asset allocation data showing minimum 65% equity investment, Income Tax Act provisions treating mutual fund units similarly to shares for tax purposes, and the legislative intent behind the DTAA amendments.Application of law to facts: The AO and DRP applied Article 13(3A) to the capital gains arising from sale of equity-oriented mutual fund units, treating them as gains from alienation of shares, and thus taxable in India.Treatment of competing arguments: The assessee argued that mutual fund units are distinct from shares under Indian law and DTAA, citing Securities Contract (Regulation) Act, 1956, Companies Act, 2013, and various tribunal decisions. It contended that Article 13(3A) applies only to shares, not mutual fund units, and that gains on mutual fund units fall under Article 13(4) and are taxable only in the resident state (Mauritius). The assessee also invoked Supreme Court rulings that tax statutes and treaties must be interpreted strictly and as per the plain meaning of terms.The Court observed that the DRP's purposive construction ignored the settled principle that treaties, including DTAAs, are to be interpreted primarily by the ordinary meaning of their terms unless ambiguous. The Court noted that 'shares' is not defined in the DTAA, and the meaning must be derived from Indian domestic law as a whole, not selectively from Income Tax Act provisions.The Court emphasized that mutual fund units and shares are distinct securities under Indian law: shares represent ownership in a company under the Companies Act, whereas mutual funds are trusts regulated by SEBI and the Securities Contract (Regulation) Act separately defines shares and mutual fund units as different securities.Conclusions: The Court concluded that for the purposes of the India-Mauritius DTAA, units of equity-oriented mutual funds cannot be treated as 'shares' and thus gains arising from their alienation do not fall under Article 13(3A). Instead, such gains fall under the residuary clause Article 13(4) and are taxable only in the resident state (Mauritius), exempt in India.Issue 2: Applicability of grandfathering clause for units acquired prior to 1 April 2017Relevant legal framework: Article 13(3A) applies only to shares acquired on or after 1 April 2017. Gains from shares acquired before that date continue to be exempt in India under Article 13(4) (grandfathering clause).Court's reasoning: The AO and DRP acknowledged the grandfathering clause but differed on whether it applied to mutual fund units. The assessee submitted detailed purchase and sale records showing units acquired prior to 1 April 2017, claiming exemption for gains on these units.The DRP directed the AO to verify the claim and grant exemption if substantiated, without making further enquiries from the assessee as per section 144C(8) of the Income Tax Act.Application of law to facts: The Court upheld the principle that gains on units acquired prior to 1 April 2017 should not be taxable in India under Article 13(3A), and accordingly, the AO was directed to allow exemption subject to verification.Issue 3: Proportionate taxation based on minimum equity allocationAO and DRP view: The AO initially taxed only 65% of the total capital gains, corresponding to the minimum equity allocation in the mutual funds, on the premise that only the equity portion is taxable under Article 13(3A).The DRP disagreed, holding that if mutual fund units are to be treated as shares, the entire capital gain is taxable, not just the proportionate equity component.Court's conclusion: The Court agreed with the DRP that once units are treated as shares for DTAA purposes, the entire capital gain on sale of such units is taxable in India under Article 13(3A), rejecting the AO's partial taxation approach.Issue 4: Levy of interest under section 234B of the Income Tax ActThe assessee challenged the levy of interest under section 234B. The Court did not elaborate extensively on this issue but noted it as a ground of appeal. Given the main appeal was allowed on merits, the interest levy would be consequentially impacted.3. SIGNIFICANT HOLDINGS'The Court concluded that for the purpose of the India-Mauritius DTAA, units of equity-oriented mutual funds cannot be treated as 'shares' within the meaning of Article 13(3A). The gains arising from alienation of such units fall under Article 13(4), which confers taxing rights exclusively to the resident state. Hence, capital gains arising from sale of equity-oriented mutual fund units by a Mauritius resident are exempt from tax in India.''The Court emphasized that the definition of 'shares' for DTAA purposes must be derived from the Indian domestic law as a whole, including the Companies Act, Securities Contract (Regulation) Act, and SEBI regulations, which distinctly classify shares and mutual fund units as separate securities.''The Court rejected the application of purposive construction by the DRP to expand the term 'shares' to include mutual fund units, holding that treaties must be interpreted according to the ordinary meaning of their terms unless ambiguity exists.''The Court upheld the grandfathering clause for units acquired prior to 1 April 2017, directing the AO to exempt gains on such units from taxation in India.''The Court agreed with the DRP that if mutual fund units were to be treated as shares (which they are not), the entire capital gain would be taxable and not just a proportionate amount based on equity allocation.''Accordingly, the appeal was allowed, setting aside the addition of capital gains income made by the AO and DRP, and holding that such gains are not taxable in India under the India-Mauritius DTAA.'
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