Substance + Treaty = Not taxable in India
The Taxman proposes, Court disposes and SANOFI wins round 2 of its battle with the Indian Tax Department. The Andhra Pradesh High Court announced its decision in favour of Sanofi on Friday – but before we get to that...let’s jog your memory!
Once upon a time in France (2006), ShanH, a wholly owned subsidiary of Merieux Alliance (MA), bought an 80% stake in Indian Pharmaceutical Company Shantha Biotechnics. Over the years two other investors, including GIMD bought into ShanH. In 2009 MA and GIMD sold their shareholding in ShanH to French Pharma giant Sanofi. The Indian Tax department said this transfer of a major shareholding in an Indian asset was subject to withholding tax in India. Sanofi argued the transaction was the transfer of shares of a French company and hence not taxable in India. Any capital gains would be taxable in France as per the Double Tax Avoidance Treaty. The Authority for Advance Rulings (AAR) disagreed. It said since ShanH had no other business or assets beside Shantha shareholding, what was being transferred by the transaction was the underlying assets, business and control of the Indian company. The transfer of shares of ShanH was a scheme for tax avoidance and must be ignored. The AAR relied on a purposive construction of the DTAA not a literal one. The matter went to the Andhra Pradesh High Court and on Friday the High Court announced a decision in favour of Sanofi. It ruled that ShanH is an independent corporate entity, with substance and not a mere nominee of MA and GIMD, nor a tax avoidance device. There is no warrant for lifting the corporate veil. Any capital gain arising from a transaction in ShanH shares is taxable by France under the DTAA. Last year’s retrospective amendments have no impact on the interpretation of the DTAA. It’s an important verdict and to understand its implications better I have with me Rohan Shah of ELP, the law firm representing Sanofi.
Doshi: Let’s look at this from two points of views - (a) the issue of taxability of indirect transfers and substance and (b) the approach to tax treaties. The first point - what do you make of the court deciding that this company incorporated in 2006 to purchase shares up to 80 percent shareholding of Shantha Biotechnics is the company that had substance?
Shah: Obviously, the approach on this is fact specific. They have looked at a series of facts including the tenure of the holding, the nature of the participation and various other factors. All of that was placed before the court. So in the facts of this case, they have come to a view that ShanH was not merely a nominee or a conduit. Therefore, it had substance. Now, that was critical because the entire earlier proceeding which is AAR and also before the assessing officer - they took a view that ShanH ought to be ignored. If ShanH is ignored and the transaction of sale of its shares is ignored then what we have is a sale of Indian shares and therefore it could be taxed. So the moment they have taken a view that ShanH is a substantial entity, it has a commercial rationale - the logic that then follows is that this is a sale of shares of a French company between two other French companies and this transaction ought to be taxed in France. So, very fact specific, but I think the larger message is that you can have SPVs, you can have investing companies who sole holding its shares in an Indian company. But if that company is a credible holder, it participates in the business then there is no reason to lift the corporate veil and you have to honour this entity for what it is. So from that perspective, I think it is very important judgment.
Doshi: Can you explain to me why or how the court arrived at the decision that it is a credible owner because I think it is not difficult to see why revenue thought that a company that’s been in existence for just three years and who is only holding is an 80 percent stake in an Indian asset, is a company that is in a sense being used to avoid having to pay tax in India. I am just trying to understand what are the specific factors that led to the establishment of substance?
Shah: We don’t have the benefit of the judgment as yet. What we have is a summary. But from the facts from what our pleadings were, quite clearly we pointed out that setting up investment subsidiary is in fact the way in which the companies did a lot of investments even prior in point of time. Setting up these companies were important from the perspective of containing risk because you are going into a new country, you have certain exposures. In the three years in question, the board, the manner in which it participated, the nature of technical inputs which came in, the flow of knowledge which effectively would have happened. A series of facts in the nature and quality of the participation is what we had pleaded to say. If you see it in terms of the nature of this participation, quite clearly, this was an investment company, it was active and it has now taken a decision to effectively divest.
Doshi: How would you contrast the manner in which the Andhra Pradesh High Court or at least your pleadings when it comes to substance, in this case, with the way in which the Supreme Court determines substance in the Vodafone case?
Shah: I think they pretty much seem to have treaded the same path. As I said, today, we don’t have the complete judgment. But this whole situation of how you recognise an entity as having the necessary commercial substance and how you distinguish it from something which is set up purely for a tax purpose? This tenure of holding also of three years - what you are really trying to avoid and what courts are going to get riled at is you create an entity today, buy shares and you offload them in a matter of another four weeks or so. Quite clearly any, any such setup leans more towards a sense of this is done for a tax purpose because there doesn’t seem to be anything else. But when you have a reasonable period of holding, when you have a clear nature of engagement, the courts have lent in favour of saying this is a substantial entity. So while we don’t have the detailed reasoning, both Vodafone and this judgment have gone on the factor of saying just because it is an SPV, just because it only holds the shares of one Indian company - that’s not the reason to discard it. You have to dig deeper. If you find substance then we have to recognise that.
Doshi: The other important aspect in this case was how it approached tax treaty interpretation. I understand that your lawyer’s arguments were that if there was any capital gain to be taxed under the double tax avoidance agreement between India and France that it would fall to France to apply any capital gains tax and the court seems to have upheld that. Can you explain to us what this means for our tax treaties are interpreted?
Shah: The first issue which is critical for me is the primacy that has been accorded to tax treaties. Section 90 secures a certain position for tax treaties - that’s an important part of our statute and these treaties are ultimately sovereign agreements which are bilateral. So what the court has effectively said is if there is a treaty then the treaty provisions need to be administered. In the facts of this particular case they said under article 14(5) of this treaty, if we had the nature of transaction that we did namely more than 10 percent of the equity of the company in question was being sold then in terms of the provisions of the tax treaty, since the sale of shares was happening was of a French company, it is France alone who would have had the right to tax. It is very important in this case. They have not said there is no tax. What they have said is there will be a tax but that tax will not be imposed by India; it will be imposed by France in terms of the DTAA. So, the situation here is they have restored the privacy of the treaty and under the treaty, they have recognised that this would be taxable in France. The Indian tax authority attempted a look through, they want to tax us on the basis of the underlying assets - there also an argument was made that the only time that the French treaty allows us to look at the underlying asset is where the primary assets is immovable property which is article 14(4) and this is not such a case. It does not fall within 14(4). Therefore, in this case, there is no look through which is permitted which also the court seems to have accepted.
Doshi: The court has taken a position on the retroactive amendments enacted by the Finance Bill last year, would that not in a sense have influenced the way the court looks at this transaction?
Shah: What the court has said is that the retroactive amendment has no impact on your interpretation of the DTAA.
Doshi: Can you explain to me why would a treaty position be un-impacted by a retroactive amendment if the retroactive amendment requires for all indirect transfers in which category this would fall to be taxed in India?
Shah: The retroactive amendment effectively comes to a position of saying that this nature of transaction ought to be taxed. Once you come to that position the question is another provision of the act tells you that in relation to transactions which occur between country A and country B, we have however decided and given that a statuary impact to say irrespective of what the act is saying under this treaty this particular income will be taxed in the jurisdiction that we have decided. Therefore is this taxable? The judgment does not say it is not taxable. However having considered the treaty it then says it ought to be taxed in France. So the issue here is not whether you are taxable or not. Being taxable which country ought to impose the tax is the question which has been answered and to that extent the retrospective amendment does not impact the treaty.
Doshi: If the Supreme Court were to view this a transaction that was a sham transaction undertaken only to avoid tax as the revenue seems to be arguing and if they were to ignore ShanH or pierce through that corporate veil then irrespective of what the treaty says, the retroactive amendment would require this transaction to be taxed in India, have I understood that correctly?
Shah: We have several leaps of faith. Firstly, in terms of whether it will go to the Supreme Court, secondly whether the Supreme Court will see it as a sham, etc.
Doshi: I am only hypothetically asking. There are two issues here, there is the treaty and there is an indirect transfer issue right?
Shah: We have to talk of two separate fact profiles. If you had the fact profile that you have in this case where you have an entity of substance and you have a tax treaty, it will be treated as this judgment says, not to be taxed in India. If however you neither have treaty protection and you have an entity which is not of commercial substance and is set up for tax avoidance, the consequence will be you will be taxed in India.
Doshi: How many transactions that are currently under scrutiny, Vodafone, Sanofi like transactions that are currently under scrutiny enjoy tax treaty protection? I am just trying to understand how many of them will gain from what the Andhra Pradesh High Court has said?
Shah: Three categories, Vodafone type transaction and no treaty protection, then you have a series of transactions which have treaty protection, but of those only few of them have the provisions which are similar to 14(5) of the Indo-French treaty. Those which do will of course directly be impacted by this judgment. Those situations where you have treaty protection but you don’t have a similar provision, then provision is decided in terms of what that treaty provision says.
Doshi: I suppose that is as detailed a breakdown as we can do without having the benefit of the details of the judgment. So, may be we will have you back once we are able to go through the judgment, but for now congratulations and thanks very much for joining us.