KPMG FLASH NEWS. Background. Facts of the case KPMG IN INDIA. 27 August 2012

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1 KPMG FLASH NEWS KPMG IN INDIA Buy-back of shares by an Indian company from a Mauritian company is not a tax avoidance scheme. Further there is no capital gain tax under India- Mauritius tax treaty 27 August 2012 Background Recently, the Authority for Advance Rulings (the AAR) in the case of Armstrong World Industries Mauritius Multiconsult Ltd. 1 (the applicant) held that the proposed buy-back of shares by an Indian company from a Mauritian company is not a tax avoidance scheme and it is not liable to capital gains tax in India under the India-Mauritius tax treaty (tax treaty) in view of Article 13(4) of the tax treaty. Further, the AAR held that the capital gain transaction is not exempt under Section 47(iv) 2 of Income-tax Act, 1961 (the Act) since the entire share capital is not held by the applicant or its nominees. Further, the proposed buy-back is an international transaction between related parties and income arises out of it, therefore, the transfer pricing provisions of the Act are applicable to the applicant. 1 Armstrong World Industries Mauritius Multiconsult Ltd (AAR No of 2011) - Taxsutra.com 2 Capital gains shall not be levied on any transfer of a capital asset by a company to its subsidiary company, if the parent company or its nominees hold the whole of the share capital of the subsidiary company, and the subsidiary company is an Indian company. Facts of the case The applicant is a fully owned subsidiary of Armstrong World Industries Limited, UK (Armstrong UK). Armstrong UK in turn is a fully owned subsidiary of Armstrong USA. The applicant was incorporated in Mauritius in the year 1999 and it is a tax resident of Mauritius. Armstrong World Industries India (Pvt) Limited (Armstrong India) was incorporated in India in the year 1999 as a fully owned subsidiary of Inarco Ltd., an Indian company. Inarco Limited was engaged in the business of production of textile machine parts and floorings. Armstrong UK, through the applicant, was holding 50 percent of the share capital in Inarco Limited. Pursuant to a scheme of amalgamation, approved by the Bombay High Court, the flooring business of Inarco Limited was transferred to Armstrong India. In consideration of that transfer of business, Inarco Limited was allotted 360,000 shares of the value of INR 10 each in Armstrong India.

2 Subsequently, Inarco Limited s share capital was reduced 3 from INR 7.2 million (divided into 72,000 equity shares of the value of INR 100 each) to INR 3.6 million (divided into 36,000 equity shares of the value of INR 100 each) by cancelling of 50 percent of its share capital. As consideration, Inarco Limited transferred to the applicant 360,000shares of INR 10 each of Armstrong India. These arrangements were all made after getting the relevant statutory approvals. Currently, the applicant is holding percent of the shares in Armstrong India. The other 0.03 percent of the shares therein is held by Armstrong UK. Armstrong India is proposing to buy-back 4 90,025 shares from the applicant out of the 360,000 shares held by it. The proposed buy-back is for commercial reasons and it was a justified step. By the proposed buy-back, capital gains would arise to the applicant which would be taxable under the Act. However, the applicant relying on Section 90(2) of the Act read with Article 13(4) of the tax treaty contended that the capital gains can be taxed only in Mauritius and not in India. The pictorial presentation of the entities and their shareholdings is depicted below: Legends of the diagram Position after transfer of flooring business to Armstrong India by Inarco Ltd for consideration of 360,000 shares of INR 10 each in Armstrong India Position after cancellation of 50 percent of share capital of Inarco Ltd and transfer of 360,000 shares of INR 10 each in Armstrong India to the applicant by Inarco Ltd. Proposed buy-back of 90,025 by the applicant of shares in Armstrong India Issues before the AAR Whether capital gains arising to the applicant on buy-back of shares in Armstrong India are taxable under the Act read with tax treaty? Whether transfer of shares in the course of proposed buy-back of shares is exempt from tax in India in the hands of the applicant, in view of the provisions of Section 47(iv) of the Act? Whether the proposed buy-back of shares attracts the transfer pricing provisions of Section 92 to 92F of the Act? Tax department s contentions The applicant is a shell company created in Mauritius to acquire the shares in the Indian company. The investment was made from USA or from UK and hence the tax treaty of either of the countries could be applied. Therefore, the applicant could not claim the benefit of the tax treaty merely relying on the Tax Residency Certificate (TRC) and the whole scheme was designed for non-payment of capital gains tax in India. Even currently, the applicant has not disclosed all the facts and an investigation into the facts was necessary. Further Section 47(iv) of the Act is not applicable to the present case since the conditions specified therein are not fulfilled. Since income arose to the applicant and the transaction falls under Sections 92 to 92F of the Act, the transfer pricing provisions are applicable to the present case. 3 In accordance with Section 100 of the Companies Act, In accordance with Section 77A of the Companies Act, 1956

3 Applicant s contentions The series of transactions were commercially dictated and the original scheme had been approved by the Bombay High Court. The shares had been held bona-fide as investment. Further, the proposed buy-back of shares was based on sound commercial considerations and was a bonafide transaction. Even if the original capital might have flowed from USA or UK, the coming into existence of the applicant as an investor in the year 1999 cannot be ignored. Alternatively, the buy-back was not a transfer for the purpose of Section 45 of the Act since it was excluded from the operation of Section 45 of the Act by Section 47(iv) of the Act. Sections 92 to 92F of the Act had no application, since capital gain is not taxable under the Act. The ruling rendered in the case of RST 5 requires reconsideration since the interpretation placed therein on Section 47(iv) of the Act, is not in consonance with the legislative intent. Section 47(iv) of the Act has to be read as conferring benefit in three situations as follow: When the parent company holds the whole of the share capital of the subsidiary, When the nominees of the principal hold the whole of the share capital of the subsidiary and When the principal and the nominee together hold the whole of the share capital of the subsidiary. AAR ruling Non-taxability of capital gains under Article 13(4) of the tax treaty The tax department has not disclosed adequate material to justify a finding that the applicant or its principal has resorted to the devising of a scheme for avoidance of tax. It may be the fact that the applicant was incorporated in Mauritius and the investment made through it was for acquiring shares in Indian company to take advantage of the tax treaty. However, this cannot be a ground to discard the claim of the applicant for benefit under the tax treaty as laid down by the Supreme Court in the 5 In re RST [2012] 206 Taxman 477 (AAR) case of Azadi Bachao Andolan 6. On the facts available in the present case, the applicant is entitled to the benefit of the tax treaty. Once it is held that the applicant is entitled to invoke the tax treaty, Article 13(4) of the tax treaty is attracted and therefore, the capital gains could be taxed in Mauritius alone. The argument that it is not actually taxed in Mauritius and hence the tax treaty cannot have application, cannot also be accepted in view of the decision of Azadi Bachao Andolan. Accordingly, the capital gains arising out of the proposed buy-back of shares is not taxable in India in view of Article 13(4) of the tax treaty. Taxability of capital gains under Section 47(iv) of the Act The wording in Section 47(iv) of the Act is the parent company or its nominee. There appears to be no justification in reading or as and to hold that when a principal and its nominee hold the whole of the share capital, that case will also come within the ambit of the provision. Assuming that there is a lacuna as contended by the applicant in the present case, it is for the legislature to deal with that situation. Relying on the case of Rowlatt. J. in Cape Brandy Syndicate 7, the AAR held that in interpreting a taxing statute, it is not for the Court to supply an omission, even if there be one. Accordingly, following the ratio of the AAR ruling in the case of RST, the proposed transaction is not exempt by virtue of Section 47(iv) of the Act. However in light of the ruling on the above issue, the ruling on this issue has no efficacy. Applicability of transfer pricing provisions In the present case, there is an international transaction between related parties and income arises out of it. Similar reasoning in the case of Castleton Investment Limited 8 has been adopted in the present case. Accordingly, the transfer pricing provisions under Sections 92 to 92F of the Act are attracted to the present case. 6 Union of India v. Azadi Bachao Andolan [2003] 263 ITR 706 (SC) 7 Rowlatt. J. in Cape Brandy Syndicate v. IRC [(1921) 1 KB 64] 8 Castleton Investment Limited [2012] 24 taxmann.com 150 (AAR)

4 Our comments The AAR in the present case relying on the Azadi Bachao Andolan has upheld the applicability of India- Mauritius tax treaty and held that buy-back of shares by an Indian company from a Mauritius company is not liable to capital gains tax under the India-Mauritius tax treaty. Recently, the AAR in the case of A Ltd 9, based on the facts of the case held that the buy-back scheme resulting in buying back of the shares held by a Mauritian shareholder is as a colourable device for avoiding payment of dividend distribution tax. The AAR held that the scheme can only be treated as a distribution of profits (i.e. dividends) by a company to its shareholders which does not attract Section 115-O of the Act. Accordingly, the payments were held to be taxable as dividend under Article 10 of the tax treaty and also under the Act. The AAR also held that the transfer pricing provisions are applicable to the applicant relying on its earlier decision in the case of Castleton Investment Limited. Even though the ruling of the AAR is legally binding only on the parties involved in a particular case, the ruling would have a persuasive value in similar matters before the Indian tax authorities and Courts. 9 A Ltd. (AAR No. P of 2010 dated 22 March 2012)

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