In a recent case of Assistant Director of Income Tax v Maersk Line UK Limited.1, the Income Tax Appellate Tribunal, Kolkata (“ITAT”) held that distribution of dividends by an Indian subsidiary to its foreign parent company immediately prior to sale of the subsidiary cannot be termed as a colorable device or sham transaction even though it would be tax advantageous in terms of reduced capital gains on the sale of shares by the parent company. Also, the receipt of the dividends by the parent company cannot be re-characterized as sale consideration for sale of shares in the hands of the parent company.
Maersk Line UK Limited (formerly known as P&O Nedlyod Limited, UK) is the taxpayer. The ultimate holding company of the taxpayer was Royal P&O Nedllyod NV. In August 2005, AP Mollar Maersk Group (“Maersk Group”) under the process of business reorganization acquired all the shares of Royal P&O Nedllyod NV. Subsequently, on March 28, 2006 the taxpayer sold all the shares of its wholly owned Indian subsidiary i.e. Nedllyod India Pvt. limited (“NIPL”) to the Indian subsidiary of Maersk Group i.e. Maersk India Pvt. Ltd. (“Maersk India”).
However, just before the taxpayer i.e. Maersk Line UK Limited sold its shares in NIPL to Maersk India, NIPL distributed substantial dividends to the taxpayer (being its parent company) out of its reserves and surplus. Dividend distribution tax (DDT) was paid on the dividends distributed and therefore, there was a reduction in the net asset value (NAV) of the shares of NIPL leading to reduction in the sale consideration to be received by the taxpayer.
As per an RBI Circular,2 sale of unlisted shares by a nonresident to resident shall be at a value which is lower of the valuations obtained in two different valuation reports. Accordingly, the taxpayer being a nonresident obtained these reports on March 27, 2006 and March 29, 2006. However, before receiving the second valuation report, the taxpayer sold the shares of NIPL on March 28, 2006. The sale of shares was made at the valuation based on the first valuation report. Although the prescribed procedure under the above mention RBI Circular was bypassed, there were no adverse consequences as incidentally; the NAV of shares under both the valuation report was same.
In its income tax return for the Assessment Year 2006-2007, the taxpayer declared its income as gains from sale of shares of NIPL by adopting the reduced per share NAV leading to a reduced capital gains.
The Assessing Officer (“AO”) on scrutiny construed the distribution of dividends by NIPL just before sale of its shares as a colorable device only to reduce capital gains for the taxpayer considering that the DDT is less than the capital gains tax. Accordingly, the AO recalculated and taxed the taxpayer’s gains by adopting per share NAV without considering the reduction in the net-worth due to distribution of dividends.
The taxpayer challenged the order of the AO before the Commissioner of Income Tax (Appeals) (“CIT(A)”). The CIT(A) decided in favor of the taxpayer holding that declaration of dividends just before the sale of shares was not sham or colorable device. The order of the CIT(A) was challenged by the Revenue before the ITAT.
Issues before the ITAT
The issues before the ITAT were as follows:
- Whether capital gains for taxpayer should be computed based on the actual sale consideration received.
- Whether payment of dividend by NIPL to the taxpayer just before change in its ownership is sham and a colorable transaction.
Contentions before the ITAT
Revenue contended that the distribution of dividends by NIPL to the taxpayer just before sale of NIPL shares is a colorable device only to reduce the sale consideration to that extent and thereby reducing capital gains tax. Therefore, the declaration of dividends should be ignored but be added to the sale consideration received by the taxpayer.
Further, the Revenue argued the factual matrix indicate that there was an urgency shown in the declaration and payment of dividend by NIPL to the taxpayer by violating the procedure prescribed by the RBI which establishes the culpable state of mind of the taxpayer. The Revenue relied on the Hon’ble Supreme Court’s decision in McDowell & Co Ltd vs CTO3 which states that “Tax Planning may be legitimate provided it is within the framework of law. Colourable devices cannot be part of tax planning …..”
The taxpayer argued that the dividend distribution by NIPL were made out of the reserves and surplus eligible for distribution and such distribution of dividends just before change in its entire shareholding was not different from a distribution of dividends by a company out of its surplus cash funds in normal course.
Decision of the ITAT
The Kolkata ITAT recognized the legitimate need for dividend distribution by NIPL by considering that if dividends were not distributed then the surplus money in the nature of undistributed profits to the shareholders would have changed character as capital appreciation of the shares value. Hence, the calculation of capital gains based on sale consideration received as per reduced net worth of NIPL post dividend distribution was held to be correct.
The ITAT, while upholding the order of the CIT(A), applied the law laid down in the decision of Union of India v Azadi Bachao Andolan4 which says that every action or inaction on the part of the taxpayer which results in reduction of tax liability to which he may be subjected in future, is not to be viewed with suspicion and shall not be treated as a device for avoidance of tax if the act is legitimate and genuine.
The ITAT also discussed the principle laid down in Snook v London and West Riding Investments Ltd.5 wherein it is stated that for acts or documents to be a ‘sham’, all the parties thereto must have a common intention that the acts or documents are not to create legal rights and obligations which they give the appearance of creating. In light of the above case and the facts, the ITAT held that distribution of dividends cannot be termed as a ‘dubious’ method to evade taxes since dividend distribution is a bonafide exercise and is not intended to be used as a cloak to conceal a different transaction. Hence, merely because distribution of dividend was leading to tax saving for the taxpayer on sale of NIPL shares, it was not considered to negate the effect of the lawful and legitimate action of distribution of dividend by NIPL.
Further, the ITAT very pragmatically nullified the Revenue’s contention about the procedural discrepancy in determining the price at which the shares were sold on the premise that there was no adverse consequence as the valuations in both the valuation reports were the same.
The tax planning involved in the above case law was that, had there been no distribution of dividends by NIPL to the taxpayer before the sale of shares of NIPL, the cash surplus that was available for dividend distribution would have been added to the sale consideration and the capital gains tax would have been higher. Instead, the taxpayer preferred to declare dividends to itself on the cash surplus before the sale and NIPL paid DDT on such distribution. The effect being, the rate of DDT (approx. 12.5% as applicable for AY 2006-07) was much lesser than the capital gains tax (approx. 20%) by 7 to 8 percent. This resulted in a tax saving of INR 9.4 million for the taxpayer as mentioned in the facts. The ITAT held that such tax planning was within law and there was nothing illegitimate in it.
This decision is of significant importance on two counts. First, as held by the ITAT such declaration of dividends just before the sale of shares is well within law and any measure taken by any taxpayer to reduce its taxes within the framework of law is permissible.
The second is of some more interest, the rate of capital gains tax on sale of unlisted securities by a non-resident (not being a company) or a foreign company has been reduced to 10% in the Finance Act, 2012. Therefore, the above type of tax planning would have no flare to reduce taxes as the capital gains tax (10%) is lesser than the DDT (approx. 17% as of now). However, it has been in debate whether the term ‘unlisted securities’ as used in section 112(1)(c)(iii) of the Income-tax Act, 1961 would also include shares of private limited companies given the fact that ‘securities’ as defined under the Securities Contracts (Regulation) Act, 1956 includes only freely marketable securities. If it is construed that the shares of a private limited company are not freely marketable given the restrictions on sale of shares of a private limited company under the Companies Act, 1956, then the concessional rate of 10% of capital gains tax would not be available on sale of shares of private limited companies and therefore, the above type of tax planning would be warranted as capital gains tax would be 20% instead of 10%.
It is worth noting that the both NIPL and the Indian company which acquired the shares are private limited companies!
That said, it would be worth waiting for such an issue to reach an appropriate judicial forum to get clarified whether the 10% concessional capital gains tax would also be available on sale of shares of a private limited company by a non-resident person or a foreign company.