The Madras High Court (High Court) in a recent judgment in T Rajkumar v Union of India ( 68 taxmann.com 182 (Madras)), has upheld the constitutional validity of Section 94A of the Income Tax Act, 1961 (IT Act), a provision which enables the Government of India to notify any country as a ‘notified jurisdictional area’ owing to lack of effective exchange of information with such country or territory. The High Court has also upheld the constitutional validity of Notification No 86/2013 dated 1 November 2013, issued by the Central Board of Direct Taxes (CBDT), which had notified Cyprus as a ‘notified jurisdictional area’ under section 94A of the IT Act (Notification).
Under the provisions of the Double Taxation Avoidance Agreement between India and Cyprus (Treaty), capital gains from the transfer of shares of an Indian company are exempt from tax in the hands of a Cypriot transferor. However, as an implication of being notified as a ‘notified jurisdictional area’ under Section 94A of the IT Act, payments made to a Cypriot resident on which tax is deductible at source under the IT Act are subject to withholding tax at least at the rate of 30%.
Three Indian purchasers (Petitioners) had entered into a Securities Purchase Agreement (SPA) with Skyngelor Limited a company based in Cyprus (Cypriot Company), to purchase 15,200 equity shares having a face value of INR 10 and 21,39,200 compulsorily convertible debentures of face value of INR 100 of New Kovai Real Estate Private Limited, an Indian company, for an aggregate consideration of INR 17.5 million.
The Petitioners did not withhold any tax on the consideration paid under the SPA as the Cypriot Company had transferred securities at less than face value. The income tax authorities passed orders under Section 201 of the IT Act treating the Petitioners as ‘assessee-in-default’ and sought to levy interest and penalty for their failure to withhold tax on the consideration paid. The Purchasers filed an appeal against the order issued by the Assessing Officer with the Commissioner of Income Tax (Appeals) and simultaneously moved the High Court, challenging the constitutional validity of Section 94A, the Notification and the press release dated 1 November 2013 issued by the CBDT which basically reiterated the implications of the notification of Cyprus as a ‘notified jurisdictional area’ (Press Release).
High Court Judgment
The High Court upheld the constitutional validity of Section 94A of the IT Act, the Notification and the Press Release and held that if the purpose for which the Treaty was entered into is defeated by a lack of exchange of information by one of the contracting states, such conditions would warrant the exercise of the power delegated under Section 94A of the IT Act. The High Court also commented that the Petitioners should have withheld tax on the consideration before making payment to the Cypriot Company and that the Cypriot Company should have then claimed a refund from the tax authorities.
Interplay between provisions of the IT Act and the Treaty
The High Court distinguished the judgment of the Supreme Court (SC) in Union of India v Azadi Bachao Andolan ((2003) 263 ITR 706 (SC)) (Azadi Bachao) where the SC had held that provisions of a tax treaty would operate even if they are inconsistent with the provisions of the Act. The High Court observed that this observation of the SC would result in inconsistent results if viewed in isolation. The High Court observed that Section 90(2) of the IT Act merely gives an option to the assessee to apply the provisions of the IT act or the tax treaty, whichever is more beneficial to him, and that this does not mean that one alternative is inconsistent with the other. The High Court also observed that Section 90 does not deal with inconsistency between the provisions of the IT Act and the tax treaty. The High Court thus observed that the principle, that treaty overrides the domestic law, laid down in Azadi Bachao, cannot be stretched to conclude that Parliament would not have the power to make a law in respect of matters covered by a treaty.
The High Court also observed that the Vienna Convention on Law of Treaties, 1969 (VCLT) obliges both the contracting parties to perform their obligations in good faith and that if one of the parties to a treaty fails to provide the necessary information, then such a party (in this case, Cyprus) would be in breach of the obligation under Article 26 of VCLT, as exchange of information is one of the purposes for which a tax treaty is entered into. The beneficiary of such a breach of obligation by one of the contracting states cannot invoke VCLT to prevent the other contracting party (India) from taking recourse to its domestic law, to address the issue.
Rationale for introduction of Section 94A
The High Court also perused the rationale behind the introduction of Section 94A and observed that Section 94A contains an anti-abuse provision, which was introduced in the IT Act pursuant to resolution passed by the G-20 to take action against jurisdictions which do not cooperate in exchange of information as per global standards. The High Court further observed that, Section 94A is the need of the hour for counteracting a lack of exchange of information, as many countries, such as Spain and Russia have also notified Cyprus as a ‘non-cooperative jurisdiction’, pursuant to which Cyprus had begun to cooperate in the exchange of information.
The implications of the notification of Cyprus as a ‘notified jurisdictional area’ under Section 94A, such as withholding at least at the rate of 30%, continues to remain in force, as the High Court has upheld the validity of Section 94A and the Notification.
It is peculiar to note that the tax authorities have challenged non-withholding of tax even when the transaction resulted in a capital loss to the Cypriot seller and thus, no taxable income arose in the hands of the Cypriot seller. This may impact deal negotiations going forward as not only does the availability of Treaty benefit seem grey, but also in cases where there is no income, withholding tax may be held to be applicable on a gross basis. Importantly, while the question relating to merits was not before the High Court, the High Court has also commented on the merits while deciding the constitutionality of Section 94A of the IT Act. Separate writ petitions challenging the order passed by the income tax authorities remain pending before the High Court, and one would have to wait till the disposal of these pending writ petitions to see the judicial view on the applicability of withholding tax in scenarios such as this, where the transfer of securities results in loss and no gains arise in the hands of a Cypriot transferor.