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AAR or GAAR?!



Published on Sat, Apr 07 11:02, Updated at Thu, Jun 21 at 17:13
Source : CNBC-TV18   |   Watch Video :


This week's top story can be described in 3 pithy words- AAR YA GAAR. Payaswini Upadhyay explains the rest.

In 2008 & in 2010, the Board of Otis India put a buyback resolution to its shareholders- the majority ones being - Otis Elevators USA, Otis Elevators Mauritius, and Otis Elevators Singapore. On both occasions, only Otis Elevators Mauritius agreed to the buyback.

Subsequently, Otis India went to the Authority of Advance Rulings to answer two questions-

Should it withhold tax on the remittance of the buyback proceeds to Otis Mauritius
and whether Otis Mauritius would be entitled to treaty benefits on capital gains arising from the buy back.

The tax department argued against both these benefits being allowed.

  • It said that the buyback had been structured to avoid tax
    one because only Otis Elevators Mauritius had accepted the offer; had the  US and Singapore entities accepted it as well, their buyback gains would have been taxable in India under the US-India DTAA and conditionally taxable under India- Singapore DTAA
  • Two, it pointed out that Otis Elevator India stopped paying dividends after 2003. That�s when Section 115O that levies tax on dividend distributions became effective. And so, revenue argued, the buyback was a means of transferring reserves to the Mauritius entity and avoid payment of taxes under the Indo-Mauritius Treaty.

Otis India argued that the buyback decision was taken by its board and legally recognized under Sec 77a of the Companies Act. And as per the Income Tax Act, income arising from the buyback should be treated as capital gains entitled to Mauritius Treaty benefits.

But the AAR was not convinced. It ruled that Otis India's buyback scheme was devised to avoid tax. One, because the company offered no explanation as to why it paid no dividends after 2004. And two, because only the Mauritian entity had accepted the offer.

SR Wadhwa
Former Chief Commissioner, Income-Tax
"I regret I have not been able to persuade myself to agree to the judgment of the AAR in this case of Otis Mauritius. My reasons are- this appears to be a bona fide case of investment from Mauritius. This Indian company, to whom the investment came, was itself set up in India in 1953. The Mauritius company started investing in it 2000 onwards in small-small amounts by way of share capital. The investment has been correctly received here."
 
Vineet Agrawal
VP & Group Head- Direct Taxation
JSW Steel
"Once you are saying that dividend was not declared; tomorrow you can challenge a lesser dividend was declared. So who will challenge the commercial expediency and if entire profits are to be declared as dividend, then what is for growth; what for the appreciation of share value?"
 
Amrish Shah
Partner & National Leader- Transaction Tax
EY
"Yes they have not paid dividends- there is no debate on that but where were those profits utilized- they were ploughed back in the business. What is the additional profitability as a result of that- that could be the other issue." 
 
But the AAR concluded that the profits transferred by Otis India through the buyback, would fall under the definition of dividend under the Indo- Mauritius Treaty and were taxable under Article 10. And hence Otis India was required to withhold tax.

Vineet Agrawal
VP & Group Head- Direct Taxation
JSW Steel
"This is something like invoking GAAR- something like challenging the transaction and re-characterization of income. Companies can only, to avoid this kind of a transaction, they have to record in their Board meetings why they are declaring lesser dividends or they are not declaring any dividend at all. That's the only thing they can do."

Amrish Shah
Partner & National Leader- Transaction Tax
EY
"Documenting or not documenting on why dividend was not paid- if they had documented, would it mean that it was all fine? The very fact that it was used in business- nobody can deny that fact. The profitability earned as a result of that and taxation paid on it is all there."
 
It's not just Otis Mauritius whose income got re-characterized at the AAR last week. Another Mauritian entity's met with the same fate. In that order the unnamed parties are referred to as Z, V and S. Here's what they did.
 
V - an Indian entity transferred its rights to develop a plot of land to its subsidiary S.

Z- a Mauritius based company invested in S by purchasing equity and 0% compulsory convertible debentures. The debentures were convertible at Rs 4,447 per share at the end of 6 years from the first closing in November 2007. As per the Share Holder's agreement, in April 2010 and again in March 2011, V exercised a call option to purchase equity shares and compulsory convertible debentures from Z.

V then approached the AAR to determine whether gains arising from to Mauritius based Z from the sale of CCDs would be exempt from capital gains tax in India under Indo-Mauritius Treaty.

Revenue argued that the compulsory convertible debentures are ECBs- a debt carrying a fixed rate of return. Any gains earned on the sale would be interest taxable under Indo-Mauritius Treaty. It also said that the transaction is camouflaged as purchase of equity to avoid tax

Z argued that the sale of CCDs is a sale of assets and the premium it received is not interest income

An argument that the AAR did not buy. It said that the method laid down in the Share Holder Agreement between Z, V and S is akin to the way interest on an investment is calculated. And so it ruled that the appreciation in the value of the CCDs is payment of interest taxable under Article 11 of Indo-Mauritius Treaty.

Amrish Shah
Partner & National Leader- Transaction Tax
EY
"If you now look at the pricing formula from a foreign investor's perspective, you are required to do a DCF- both at the time of entry and at the time of exit. Now even if you had structured it as a fixed rate of return, if it was above the DCF price, you could not have paid that price because a resident was buying from a non-resident; so DCF becomes the cap. So where is the question in that situation to say that there is a debt type of an instrument. Let me put one more question- if they had converted into equity one Day 1 and sold the equity on Day 2, would it change its character overnight to say that now its an equity investment; subject to capital gains and no longer an interest. Or would it be still treated as income because it was converted a day before."

Vineet Agrawal
VP & Group Head- Direct Taxation
JSW Steel
"I think the decision is more or less in consonance with what has been so far held by the SC and various other HCs that convertible debentures are in the nature of debt till they are not converted into equity."

SR Wadhwa
Former Chief Commissioner, Income-Tax
"The ruling on compulsory convertible debentures seems to be an attempt, with great respect to the applicant, to treat the fixed consideration dependent upon the use of funds by the Indian company in the nature of capital gains. So that sort of attempt has not been approved by the Advance Ruling Authority which, I think, has been correctly done."
 
Taxability aside, the AAR ruling also stands out for the way it has applied the "look at" test to determine the substance of the transaction. Based on several rights that the agreements give to V, the AAR has concluded that the role of S is reduced to a puppet and that the relationship of parent and subsidiary between V & S is on paper; in reality they are one and the same entity. In saying so, the AAR relied upon SC's commentary on legal relevance of subsidiaries in the Vodafone case. The apex court had said that the decisive criteria is whether the subsidiary can perform its core activities without the parent's interference- in this case the AAR felt S couldn't. 

Amrish Shah
Partner & National Leader- Transaction Tax
EY
"The holding company has its own business -- it is not just that it is a pure holding company; it is an operating company. It is also holding this subsidiary. The investor was only interested in this single project otherwise it could have come in at the parent company level if he was interested in all the projects. How does a businessman attract investment if someone only wants to come in a particular project- the only was is to push it down into a subsidiary below you and attract investments there.  That part of the entire substance- there is no coverage in the judgment and so is that part of the substance to be ignored?"
 
The way the AAR has applied the look at test could have a bearing on how parent-subsidiary relations are viewed in future transactions as well. And though both these rulings are fact specific and not binding on other transactions, they will have a persuasive value in similar transactions. The learning, experts say, is to document the commercial reason for every decision that the Board makes so that at least the lack of it does not strengthen revenues claims. 

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