On August 14 2014, in DIT v Copal Research Limited,(1) the Delhi High Court held that there was sufficient commercial rationale to enter into the transactions in question and that these were not entered into in order to avoid tax. The court further held that gains arising from the sale of a share of a company incorporated overseas which derives less than 50% of its value from assets situated in India is not taxable under Section 9(1)(i) of the Income Tax Act 1961, read with Explanation 5 thereto.
Three transactions were undertaken:
- Transaction 1 – shares of COPAL Research India Private Limited were sold by COPAL Research Limited, Mauritius to Moody's Group Cyprus Ltd.
- Transaction 2 – shares of Exevo Inc, United States were sold by Copal Market Research Limited, Mauritius to Moody's Analytical, United States.
- Transaction 3 – 67% of the shares of COPAL Partners Limited, Jersey were sold by individual shareholders to Moody's Group UK Ltd.
In all three transactions, in addition to a fixed consideration, deferred consideration in the form of an earn out was payable.
Applications were filed before the Authority for Advance Ruling (AAR) in relation to the first and second transactions; the AAR duly held that capital gains arising out of the transactions were not liable to tax in India. Further, the AAR held that the earn-out would also be a part of the consideration. Consequently, Moody Analytical and Moody Cyprus were not obliged to deduct tax.
Aggrieved by the AAR's ruling, the Income Tax Department filed writ petitions before the Delhi High Court. The Income Tax Department argued that the commercial understanding between Copal Group's shareholders and Moody UK was that the entire business and interest of the Copal Group would be transferred to the Moody's Group, and the same was effected by the three transactions. Thus, with the transfer of shares of Copal Jersey, the business and the downstream subsidiaries would also be transferred to the Moody's Group.
The Income Tax Department also argued that but for the separate sale transactions in respect of shares of COPAL Research India and Exevo – which were executed a day before the sale of the Copal Jersey shares – the gains arising from the sale of the Copal Jersey shares would have been taxable under the act, as the Copal Jersey shares would have derived their value substantially on account of the value of the assets situated in India. The sale of COPAL Research India shares and Exevo shares was effected in order to avoid this tax.
The assessee held that there was a commercial rationale for the sale of the shares of COPAL Research India and Exevo, as those companies represented holding interests in Indian companies and Moody's had insisted on acquiring the entire capital of those companies.
The Delhi High Court had to consider whether "the two transactions in question – for sale and purchase of COPAL Research India Private shares and Exevo shares are designed prima facie for avoidance of income tax under the Act".
The court ruled that the effect of the first and second transaction was that the consideration received was distributed as dividends and was ultimately received as dividends (from the chain of downstream subsidiaries) by the individual shareholders, banks and financial institutions.
If the transaction had been structured as contemplated by the Income Tax Deparment (ie, simplicitor sale of Copal Jersey shares), these commercial results would not have been achieved. The Moody's Group would not have acquired 100% direct control over COPAL Research India and Exevo, but would have acquired only 67% of the economic interest. In addition, the banks and financial institutions holding 33% of the shares would not have received their share of the consideration.
Thus, the Income Tax Department's contention was not sustainable, since it would not achieve the same commercial results.
Therefore, the court held as follows:
"In view of our conclusion that the commercial transaction as structured could not be structured at the Jersey level and the sale of shares of Exevo-US and CRIL at Mauritius level cannot be stated to be without any commercial reason but only to avoid tax, it is not necessary to examine whether the gains arising in the hands of the Copal Group Shareholders from sale of shares of Copal-Jersey would be exigible to tax assuming that the shares of Exevo-US and CRIL had not been transacted at the Mauritius level."
Even if the transaction was structured as stated by the Income Tax Department (ie, the sale of Copal Jersey shares), there would still be no tax incidence, as only a fraction of the value of the Copal Jersey shares were derived indirectly from the value of the shares of COPAL Research India Private and Exevo US.(2)
Explanation 5 to Section 9 introduced a legal fiction for the limited purpose of imputing that assets that substantially derive their value from assets situated in India must also be deemed to be situated in India. The goal of Explanation 5 is not to extend the scope of Section 9(1)(i) of the act – which has no territorial nexus with India – but to tax income that has a nexus with India, irrespective of whether this is reflected in the sale of an asset situated outside India.
Based on the expert committee report, the United Nations Model Double Taxation Convention between Developed and Developing Countries and the Organisation for Economic Cooperation and Development's Model Tax Convention on Income and Capital, it was concluded that gains arising from sale of shares in a company incorporated overseas which derives less than 50% of its value from assets situated in India are not taxable under Section 9(1)(i) of the act, read with Explanation 5 thereto.
The Delhi High Court's decision is useful in cases where the value derived from Indian assets is less than 50%. The decision has defined the term 'substantial' to be at a threshold of 50%. The current draft of the Direct Taxes Code (released for public comment) provides for a threshold of 20%; the government must issue definitive guidelines in this regard. However, the Andhra Pradesh High Court decision in Sanofi Pasteur Holding SA(3) continues to apply where the seller is entitled to the benefit under the applicable tax treaty.
For further information on this topic please contact Ranjeet Mahtani or Divya Jeswant at Economic Laws Practice by telephone (+91 22 6636 7000), fax (+91 22 6636 7172) or email (email@example.com or firstname.lastname@example.org).
(2) The value in relation to assets held by Copal Jersey outside India was $93,509,220. Of that amount, $28,530,435.8 (ie, 67% of the fixed consideration paid for acquiring COPAL Research India Private and Exevo ) was value from the assets located in India.