The Interconnect

Is Tax Steering the Wheel of Deals…?

Ketan Dalal (Managing Partner, Katalyst Advisors LLP)
Mar 14, 2019


2018 was a significant year for mergers and acquisitions in India, given the merger of Vodafone India and Idea Cellular, Walmart’s acquisition of 77% stake percent stake in India’s largest online retailer Flipkart, announcement of HUL-GSK India deal, and several other transactions. Whilst deal activity is likely to remain muted till elections, post that, there is a strong likelihood of revival of deal activity.

However, there are several uncertainties in the tax and regulatory space which have become road blocks in overall deal consummation. Usually, whilst tax considerations are a part of any deal, recently tax considerations have become even more relevant, particularly because of significant uncertainties and consequent tax risks; much of it is attributable on account of introduction of GAAR provisions, as well as special anti-avoidance provisions like section 56(2)(x) and section 50CA dealing with transactions undertaken below the fair market value.

Further, there are some legacy issues also, which are serious deal roadblocks. A classic (and very important) example of tax considerations in a deal scenario is the case of capital gains tax and withholding requirement under the Income Tax Act, 1961 (‘ITA’) upon exit of a non-resident shareholder; especially in case of a seller from erstwhile treaty friendly jurisdiction (say Mauritius or Singapore), and this ‘Interconnect’ article seeks to focus on this aspect.

Mauritius/ Singapore as favoured tax jurisdictions:

As per the FDI statistics released by the Ministry of Commerce & Industry[1], FDI in India (April 2000 to December 2018) from Mauritius and Singapore accounts for a whopping 32% and 19% respectively, which put together is almost one half of the entire FDI inflows in India since 2000!

Let’s first look at the development of Mauritius and Singapore as favoured tax jurisdictions. The tax treaties with Mauritius and Singapore provided relief to such foreign residents on capital gains upon transfer of Indian securities. Thus, when India opened the doors to foreign investment, Mauritius (and later Singapore) became favourite jurisdictions for channelling investments in India.

However, transactions involving Mauritius or Singapore treaties have always been on the radar of the tax department. The tax department perceived such jurisdictions as treaty abuse by letter box companies and thus, started issuing tax notices/ demands. Concerned about its impact on the Indian economy (majorly from an FDI angle) the CBDT issued a circular[2] to the effect that the tax department would accept ‘certificate of residence’ (issued by the Revenue Authorities in Mauritius) as a valid proof of residency for availing treaty benefits. The case of Union of India vs Azadi Bachao Andolan[3] is a classic example, where the tax department questioned the availability of capital gains exemption under the India-Mauritius Treaty. The Apex Court ruled in favour of taxpayer and allowed the claim of treaty benefit by stating that a Tax Residency Certificate (‘TRC’) is a valid proof for establishing residency of a jurisdiction to claim treaty benefits.

Even before the above Apex Court judgement, TRC was always considered as valid proof for claiming such tax/ treaty benefits. It is important to point out (in the context of beneficial capital gains clause in the Mauritius and Singapore treaties) that the Government was keen to attract foreign investments (including through tax benefits) in the larger economic interest at the relevant point in time (in 1991, India was faced with a serious foreign exchange crisis). However, in spite of having bestowed the benefit, there is (and has always been) still a sense of reluctance on part of the tax administration to allow tax benefit of Mauritius/ Singapore treaties by challenging their residency. This issue was again addressed by a press release[4] stating that the TRC would be accepted for evidencing the tax residence under the tax treaty and the tax authorities would not go beyond the TRC to examine the residential status. Further, the press release also reiterated that Circular No. 789 would continue to be applicable.

On the other hand, to prevent (so-called) treaty abuse and curb revenue loss, the Indian Government (in 2016) entered into a protocol with the Mauritius and Singapore Governments to amend the respective tax treaties. The said amendments basically gave taxation rights to India on alienation of shares by a Mauritius/ Singapore resident acquired on or after 1st April 2017 while simultaneously grandfathering investments acquired prior to 1st April, 2017. Also, in respect of such capital gains arising during the transition period from 1st April, 2017 to 31st March, 2019, the tax rate was limited to 50% of the domestic tax rate of India, subject to the fulfilment of the conditions in the limitation of benefits article in the respective treaties.

Deal scenario:

Usually in a deal scenario, involving share purchase wherein the seller is a non-resident and is a Mauritius/ Singapore resident, the seller should logically pay no capital gains tax in India (for the grandfathered cases) by availing the treaty benefits. However, under the ITA, the liability to deduct taxes is on the buyer and accordingly, the buyer needs to be convinced about the (non) taxability of the seller, otherwise the buyer might end up deducting higher taxes and the seller would have to claim refund (or the deal may not conclude at all).

One way to address the above issue is by way of an application by the buyer to the tax department (u/s 195 of the ITA) or by the seller to the tax department (u/s 197 of the ITA) seeking certificate for Nil/ lower withholding. Usually, there is a lot of resistance at the ground level, as tax officers usually do not accept TRC as a conclusive proof of tax residency (and consequent treaty benefit), and in most cases, do not issue a NIL/ lower withholding certificate. Many times, because of such tax uncertainties, deals have collapsed or have led sub-optimal/ uncertain scenarios and thereby have muddied the deal waters!

Since obtaining Nil/ lower withholding certificates has been a significant challenge for both the buyer and the seller, the buyer on the basis of certain ‘representations’ from the seller, (in some cases) may agree to not withhold taxes. Incidentally, apart from the general representations, specific representations by a Mauritius/ Singapore seller that often find place in a deal agreement usually include: Seller holds valid TRC issued by the Revenue Authorities in Mauritius/ Singapore, Seller is eligible to claim treaty benefit under the respective tax treaty, etc.  Alternatively, or additionally, the buyer may require indemnities, or at times, may even ask for insurance against tax exposures. On the basis of the representations, indemnities and/ or insurance given by the seller, the buyer could be persuaded not to withhold taxes.

As far as tax indemnities are concerned, one key issue is the stage that triggers the indemnity clause i.e. will it be the assessment order or will it be the tax demand? What about situations where assessment order is contested in appeals?  Further, issues like computing indemnity amount, determining indemnity period, inclusion of interest/ penalty, etc. fuel the complexities. At times, the buyer may even require the seller to deposit the agreed indemnity amount (or a percentage thereof) or the buyer may keep a part of the consideration (holdback) in an escrow account maintained either in India/ overseas for protection against any default risk. As far as insurance is concerned, it has its own limitations and challenges; the major one being the premium amount (usually in percentage of deal value), whether there should be inclusion of interest/ penalty, etc. These issues have serious implications and are potential deal breakers.

It would be obvious that such tax uncertainties can, and do, hold up transactions (specifically involving investment from Mauritius and Singapore jurisdictions) and lead to endless discussions on representations, negotiations on tax indemnities, deposits of disputed amounts in escrow, tax insurance, etc. which are very complicated to resolve and take months of negotiation, and many times, have led to sub-optimal results for the buyer and seller both.

Such transactions have an important part to play in a country’s economic activity and in the interest of ease of doing business, a specific clarification from CBDT for accepting TRC for withholding purposes or an extension of the existing circular 789 to withholding provisions would help clear the deal waters so that tax considerations do not steer the wheel of deals!

This article has been co-authored by Darshan Khandhar.

[2] Circular No. 789, dated 13th April, 2000.                  

[3] [2003] 263 ITR 706 (SC)

[4] dated 1st March, 2013

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