Emerging jurisprudence surrounding entitlement to treaty benefits in India

Mukesh Butani
BMR Legal Advocates, New Delhi
mukesh.butani@bmrlegal.in

Akshara Rao
BMR Legal Advocates, New Delhi
akshara.rao@bmrlegal.in

Introduction

Foreign investors are experiencing increased scrutiny from the Indian tax administration on the ‘beneficial ownership’ (BO) test, particularly when investments in Indian capital markets are made from tax-friendly jurisdictions.[1] Separately, the Indian market regulator, the Securities and Exchange Board of India (SEBI), has sought BO details from several foreign portfolio investors (FPIs).[2] This phenomenon has gathered momentum since India replaced its 25-year-old law on dividend distribution tax (DDT) by reintroducing a withholding mechanism. In addition, over the years, SEBI has been continuously strengthening its BO test with stricter know-your-customer (KYC) and compliance requirements to prevent round tripping of foreign direct investment (FDI). Despite the fact that the concept of BO continues to be undefined under the Indian statute and despite limited tax jurisprudence, foreign investors face the threat of being denied treaty benefits if the tax office disagrees with them.

Amidst this growing friction, a significant judgment was pronounced by the Delhi High Court (the ‘Court’) on 30 January 2023. In the case of Blackstone Capital Partners (Singapore) VI FDI Three Pte. Ltd[3], the Court reassured the foreign investors that a valid Tax Residency Certificate (TRC) is sufficient for treaty claims. Following the established law[4], the Court quashed the reassessment proceedings initiated by the tax office.

This case adds to the existing jurisprudence that upholds a TRC as a valid document for treaty entitlement. However, this does not provide certainty to investors as the relevance of such jurisprudence is diluted post-incorporation of the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (MLI) and the domestic anti-avoidance rules (the General Anti-Avoidance Rules or GAAR). Under the current framework, a taxpayer must satisfy comprehensive BO tests to be eligible for treaty benefits.

This article discusses the Delhi High Court judgment and provides analysis of the sufficiency of the TRC in light of the principal purpose test (PPT) introduced under the Organisation for Economic Cooperation and Development (OECD)-led MLI framework and in the context of the domestic GAAR. It observes that, in the context of the current framework, a TRC will not be sufficient and taxpayers must take further precautions to avoid scrutiny by the tax office.

The Delhi High Court provides reassurance on the validity of a TRC for treaty claims

Factual background

The taxpayer is a Singapore tax resident who acquired shares in an Indian entity (Agile Electric Sub Assembly Private Ltd) in 2013, which it sold in 2015. By virtue of Article 13(4) of the India–Singapore tax treaty (prior to its amendment in 2017), the taxpayer claimed that the gains earned from the sale were taxable only in Singapore. It buttressed its treaty claims based on the TRC issued by the Inland Revenue Authority of Singapore (the ‘IRA Singapore’).

Despite making the requisite disclosures when filing its returns, the Indian tax office issued a notice for reassessment on 2 December 2022, providing reasons for the reopening of the case. As per the tax office’s notice, an ‘open source enquiry’ was conducted, which revealed that the source of the investment funds and management of the affairs (of the Singapore investor) were conducted by its US holding company.

The Court’s reasoning

The Court held that a TRC is sufficient evidence to claim treaty eligibility and to establish tax residence status and legal ownership. It held that the tax office must accept the position and cannot look beyond the TRC. The Court reached this conclusion after making the following observations:

• Indian Statute[5] clarifies that a non-resident with a TRC is eligible to claim treaty benefits;
• circulars[6] issued by India’s apex tax administration, the Central Board of Direct Taxes (CBDT), clearly provide that a TRC will constitute sufficient evidence for accepting the status of residence, as well as the satisfaction of the beneficial ownership condition under the treaty;
• the Supreme Court upholding the validity and efficacy of the administrative circulars in the cases of Azadi Bachao Andolan[7] and Vodafone International Holdings B.V.[8], observed that what is unacceptable is the use of ‘artificial devices’ to avail of the treaty benefits, resulting in double non-taxation and that a certificate of residence is conclusive evidence;
• the High Court emphasised a press release[9] by the CBDT, which states that the TRC certificate is sufficient evidence to show residence and beneficial interest/ownership; and
• the High Court reiterated that the taxpayer has a valid TRC from the IRA Singapore, evidencing that it is a tax resident of Singapore and is eligible to claim tax treaty benefits. Holding that the TRC is statutorily the only evidence, and because the IRA Singapore has granted a TRC to the petitioner after its detailed analysis of the documentation, the Indian tax office’s disregard for such processes would be contrary to international law.

The judgment relied heavily on the CBDT circular and the past judgments of the Apex Court. This jurisprudence allows a taxpayer to claim treaty benefits by merely producing a TRC and restricts the tax office from looking beyond it.

However, this only stands true under the current framework. With the introduction of the PPT and GAAR, the tax office can look beyond a TRC and question the substance of a transaction. The scope for scrutiny is broad under these new provisions.   

The current framework surrounding treaty claims

Foreign investors must note that the Delhi High Court judgment, and the supporting jurisprudence, pertain to financial years prior to 2017–18. The courts have been clear that the TRC is sufficient evidence, however, this is limited to investments made up until 1 April 2017. This was affirmed in a recent judgment by the Bombay High Court in the case of Bid Services Division (Mauritius) Limited[10], wherein it was observed that the limitation of benefits (LOB) clause under the India–Mauritius tax treaty (which contains the PPT), is applicable only for investments made until 1 April 2017. The Bombay High Court affirmed that a TRC is sufficient only until the said date.[11]

Several developments in international tax and municipal tax law have altered this jurisprudence, making it more comprehensive. The introduction of the PPT and GAAR are two such developments that an investor must be mindful of to avoid scrutiny.

Applicability of the PPT

On 7 June 2017, India signed the MLI, along with more than 65 countries. Then, on 25 June 2019, India deposited the instrument of ratification, along with its final position in terms of covered tax agreements (CTAs), reservations, options and notifications under the OECD’s multilateral framework. As a result, the MLI entered into force in India from 1 October 2019 and its provisions influence India’s tax treaties from the financial year 2020–21 onwards.

The MLI is applied alongside the existing tax treaties, modifying their application to implement the base erosion and profit shifting (BEPS) measures. Article 6 of the MLI provides for the modification of the CTAs, which includes the following preamble text: ‘Intending to eliminate double taxation with respect to the taxes covered by this agreement without creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance (including through treaty-shopping arrangements aimed at obtaining reliefs provided in this agreement for the indirect benefit of residents of third jurisdictions).’

To ensure harmony between the treaty and municipal law, Section 90 of the Income Tax Act 1962 (‘the Act’), which grants statutory validity to tax treaties, was amended by the Finance Act of 2020, making it applicable from the financial year 2020–21 onwards.  

The PPT can be triggered to deny treaty benefits if at least one of the following elements is found in a transaction:

• the presence of a benefit arising from the relevant treaty;
• it being reasonable to conclude that obtaining that benefit was one of the principal purposes of the transaction that resulted in that benefit; or
• it is contrary to the object and purpose of the relevant provisions of the treaty.

The commentary on Article 29 (entitlement to benefits) of the 2017 OECD Model Convention defines the term ‘benefit’ as including all limitations, for eg, a tax reduction, exemption, deferral, or refund on taxation imposed on the source state, the relief from double taxation, and the protection afforded to residents and nationals, or any other similar limitations. Further, it also proposes a broad interpretation of the terms ‘arrangement or transaction’, ie, to include any agreement, understanding, scheme, transaction, or series of transactions, whether or not they are legally enforceable. These terms also encompass arrangements concerning the residence qualification and include steps that those entitled to treaty benefits may take to establish residence.

Further, the reference to ‘one of the principal purposes’ means that obtaining benefits under a tax treaty need not be the sole or dominant purpose. The PPT can be invoked even if one of the principal purposes is to obtain a tax benefit. Interestingly, it’s a more stringent test than that under the domestic GAAR law, discussed below.

Applicability of the domestic GAAR

India introduced the GAAR provisions under its municipal law to essentially codify the doctrine of ‘substance over form’, ie, the intent and purpose of an arrangement are taken into consideration irrespective of the legal structure. Historically, India has experienced few judicial decisions on the matter[12]; some held that the legal form of transactions could be dispensed with, and the real substance of the transaction could be considered while applying the taxation laws, while others have held that the form is to be given sanctity. To settle this debate, the GAAR provisions were introduced through the Finance Act 2012, under Chapter X-A of the Act. These provisions were made applicable from 1 April 2017. It is pertinent to note that the date of applicability is aligned with the protocols in the Indian tax treaties (such as the India–Singapore tax treaty), which incorporated the provisions of the MLI, providing a carve-out for investments made prior to 1 April 2017.

Under the GAAR provisions, an arrangement is considered an ‘impermissible avoidance agreement’ (IAA) if the main purpose of the arrangement is to obtain a tax benefit and the arrangement: 

• creates rights, or obligations, which are not ordinarily created between persons dealing at arm's length;
• results, directly or indirectly, in the misuse, or abuse, of the provisions of the Act;
• lacks commercial substance; or
•  is carried out by means, or in a manner, which are not ordinarily employed for bona fide purposes.

If the arrangement satisfies at least one of the above tests, it will suffice to invoke the GAAR. The notion of tax benefit for the purposes of the GAAR refers to any benefit arising either out of a treaty claim or otherwise. The scope of ‘tax benefit’ is defined very widely. It encompasses, inter alia, a reduction, deferral of tax, increase in a refund, reduction of taxability, reduction in total income, an increase in loss, etc. The main purpose test is presumed to be satisfied even in situations where part of an arrangement confers a tax benefit.[13]

Finally, a non-obstante clause results in the over-arching nature of the law, including those conferring treaty benefits. However, it has been clarified that the GAAR will not be invoked if a taxpayer satisfies the LOB clause under a tax treaty.[14] India’s domestic law thrusts the onus on the taxpayer to demonstrate that transactions, including treaty benefits, do not result in a tax benefit.

The way forward for foreign investors

The implementation of the PPT and GAAR will make the existing jurisprudence surrounding treaty entitlement less material for investments, especially for those made after 1 April 2017. This is because a TRC merely establishes the legal structure and does not suffice to verify the existence of the substance of an arrangement.

Considering the increased scrutiny by the tax office, a taxpayer must exercise caution in structuring their tax affairs. A taxpayer must ensure proper documentation, keeping in mind the essence of the current framework. This is to say that the documents must be capable of supporting the substance and commercial rationale. As a precaution, a taxpayer must ensure that they satisfy the PPT and GAAR independently. Therefore, the documentation must support that the transaction/arrangement was undertaken without the sole purpose of securing a benefit as a result of the tax treaty and that the arrangement satisfies the ‘four sin tests’ under the GAAR.

Since the incorporation of these provisions, there has been little to no jurisprudence surrounding them. Therefore, the conditions of the PPT and GAAR, coupled with the lack of jurisprudence, provide the tax office with ample scope to initiate enquiries. A taxpayer must rethink their transactions and structuring in light of the importance associated with the substance over form principle under the new paradigm. A focus on prevention is the way forward for investors.