ECONOMIC Times carried a news item on the 18th April 2017-"Paris replacing Mauritius as tax haven, Citi alerts Finance Ministry." The tagline is a bit perplexing. France has one of the highest tax rates in the western world and it would not be proper to term it as a tax haven although there may be some aspects of its taxation regime that can be exploited by tax planners. It is true that till now all the financial skulduggery concerning Indian companies used to involve the usual suspect trios of Mauritius, Singapore and Cyprus and there was no particular necessity of paying close attention to tax treaties that India has with other countries, particularly for the purpose of tax planning. There have indeed been earlier reports that India's tax treaties with some western nations-France, Netherlands and Spain in particular have become popular with the tax planers following the clamp down on the three jurisdictions mentioned earlier.
The other interesting aspect of the article is that it is the Citi bank that is the apparent whistle blower. And the context is the P-notes- an instrument devised by FIIs putting money in India that allows these financial institutions to garner money from anonymous prospective investors. There have been many articles including that of yours truly pointing out the problems of investment through such a dense instrument. In fact, the NDA government appointed SIT, quoting from an earlier CBDT report pointed out that the instrument is capable of being misused by Indian investors for round tripping. This is against the avowed objective of the fight against black money.
According to a Bloomberg report Citi had got caught up in money laundering through Mexico and was fined by the Justice department of the USA. However, according to the ET news report, Citi apparently was of the view that allowing issue of p-notes through its office in Paris will be against the spirit of the provision. There is obviously something more than meets the eye here but not being privy to the discussions that it had with the ministry officials, it is not prudent to speculate.
Leaving aside the regulatory aspects of P-notes for the moment, one has to first understand why Mauritius used to be the most attractive destination for the FPIs. Under the erstwhile India-Mauritius tax treaty, the right to the taxation of capital gains arising out of alienation of shares in Indian companies used to lie with Mauritius. There was no taxation right for India. But that in itself will not increase the attractiveness of the jurisdiction concerned. On top of it, there should be no or minimal taxation of the income concerned in the other jurisdiction. In case of Mauritius, it had special rules for GBC1 companies and no capital gains was changeable to tax in the hands of such companies.
The relevant clause of article 13 relating to India-Mauritius tax treaty used to read as follows:
"4. Gains derived by a resident of a Contracting State from the alienation of any property other than those mentioned in paragraphs 1.2 and 3 Article shall be taxable only in that State."
Paragraphs 1, 2 and 3 used to deal with immovable property, PE property and ships and aircraft. Therefore all other types of capital gains including those arising from transfer of shares were covered by Article 13.4
As is well known, this state of affairs has now changed with the new protocol between India and Mauritius coming into force with effect from 1 st of April, 2017. The newly added paragraph 3A now states: "3A. Gains from the alienation of shares acquired on or after 1st April 2017 in a company which is resident of a Contracting State may be taxed in that State." There has been grandfathering of existing investments and a further concessional rate of 50% of the existing normal rate for capital gains arising up to 2019 has been provided subject to some limitation of benefits clause. These are not too difficult to comply with but that is beside the point here. For all investments after 1.4.2017, the new allocation of taxing rules will be operative.
Since similar provision was available in our tax treaty with Singapore and Cyprus, these treaties have also be amended on more or less similar lines with the result that more or less similar rules prevail in so far as taxation of capital gains arising from shares in Indian companies are concerned. Since p-notes are issued against the underlying shares of Indian companies, the provision relating to capital gains arising out of transfer of shares in an Indian company is the most relevant in this context. One may recall that at the time of the JPC(Ketan Parekh), there was an exercise as to the jurisdictions where the taxation right in respect of capital gains arising from alienation of shares of Indian companies were not retained. The treaties with Bangladesh, Brazil, Cyprus, Egypt, Indonesia, Mauritius, Syria, Tanzania, Thailand, UAE and Zambia did not deal separately with capital gains arising from shares. Some of these treaties have since been modified but countries such as France, Spain etc., were not in this list.
Since the ET report suggests that taxation of capital gains regime in the India-France tax treaty also confers similar benefits as was available under the erstwhile tax treaty with Mauritius, It will be instructive to study the article relating to capital gains in the India-France tax treaty. The article states as follows:
Article 14- India-France 1994 tax treaty
"1. Gains derived by a resident of a Contracting State from the alienation of immovable property, referred to in Article 6, and situated in the other Contracting State may be taxed in that other Contracting State.
2. Gains from the alienation of movable property forming part of the business property of a permanent establishment which an enterprise of a Contracting State has in the other Contracting State or of movable property pertaining to a fixed base available to a resident of a Contracting State in the other Contracting State for the purpose of performing independent personal services, including such gains from the alienation of such a permanent establishment (alone or together with the whole enterprise) or of such fixed base, may be taxed in that other Contracting State.
3. Gains from the alienation of ships or aircraft operated in international traffic or movable property pertaining to the operation of such ships or aircraft shall be taxable only in the Contracting State of which the alienator is a resident.
4. Gains from the alienation of shares of the capital stock of a company the property of which consists directly or indirectly principally of immovable property situated in a Contracting State may be taxed in that Contracting State. For the purposes of this provision, immovable property pertaining to the industrial or commercial operation of such company shall not be taken into account.
5. Gains from the alienation of shares other than those mentioned in paragraph 4 representing a participation of at least 10 per cent in a company which is a resident of a Contracting State may be taxed in that Contracting State.
6. Gains from the alienation of any property other than that mentioned in paragraphs 1, 2, 4 and 5 shall be taxable only in the Contracting State of which the alienator is a resident.''
It is clear that the India-France treaty provision in this respect is not identically worded as India's earlier tax treaty with Mauritius. In fact, there have also been a few disputes involving the capital gains article in the India-France tax treaty. Most important of these is the ruling of the AAR in Groupe Industriel Marcel Dassault [2011-TII-28-ARA-INTL] that got subsequently reversed by the decision of the Andhra Pradesh High Court in the case of Sanofi Pasteur Holdings SA [2013-TII-07-HC-AP-INTL]
Very briefly, the facts of the case were as follows.
Two French companies held shares in an Indian biotech company Shanta Biotech. These French Companies also held shares in another company incorporated in France called ShanH. The shares of the Indian company were later transferred to ShanH. Subsequently the shares of ShanH were sold to the taxpayer Sanofi Pasteur, another French company. The alienator companies sought advance ruling as to the taxability of these transactions in India arguing that since the transactions involved transfer of shares of a non-resident company to another non-resident company, there was no tax liability in India. The AAR conceded that looked at blandly, the transaction, the manner in which it was put through, would be taxable in France. However, the AAR held that the transaction was a part of a preordained scheme of tax avoidance and the real purpose of the transaction was the transfer of the Indian Bio-tech company. On a writ petition filed against the ruling of the AAR, the High Court of Andhra Pradesh in the case of Sanofi Pasteur reversed the finding relating to tax avoidance and indirect transfer of Indian assets. In that context, the High Court also examined the capital gains article between India and France and held that the scope and reach of Article 14(5) is;
"(a) the transaction must involve gains from alienation of shares [not being shares of the capital stock of a company, the property of which principally comprises, directly or indirectly of immovable property - Art.14(4)], representing participation of at least 10% in the company; and
(b) on indicators in (a) being satisfied, the gains derived from alienation of shares of such company may be taxed in the contracting State whereat the company is resident."
Since in this case, the transaction in issue involved a gain from alienation of ShanH shares by two French companies representing a participation of more than 10% in ShanH, a company registered and resident in France, the alienation was admittedly outside the scope of Article 14(4) and fell to be considered under Article 14(5). "The later provision in clear, unambiguous and in explicit terms allocates the resultant capital gains tax to France (the contracting State, whereat ShanH is indisputably a resident."
This was a case of transfer of shares of a French Company. The same rule will apply to transfer of shares of an Indian company also. Thus only if more than 10% shares in an Indian company is transferred, will India will have the right to tax the capital gains arising out of the same. In other cases, by virtue of Article 14(6), the capital gains will be taxable where the alienator is resident. Thus, if an FPI resident in France has shareholding of less than 10% in an Indian company and derives capital gains from their alienation, the right to tax the same lies with France and not with India.
This is thus an attractive proposition. However, one has also to take into account the treatment of the capital gains in France. In France, capital gains are generally deemed to be part of ordinary income and accordingly will be taxed at the general rate. It is also to be noted that a resident of France is liable to taxation on transfer of shares in whichever country these are held. This aspect has been discussed in the Sanofi Pasteur case as well. One of the reasons for the A.P High Court junking the theory of the Revenue was indeed the fact that by being subject to tax in France, the taxpayer stood to lose since the rate of taxation of capital gains is higher in France. The Court had, inter-alia held "the uncontested assertion by petitioners, that a higher rate of capital gains tax is payable and has been remitted to Revenue in France (than would have been the case, if liable under provisions of the Act), lends further support to the inference that ShanH was not conceived, pursued and persisted with to serve as an Indian tax-avoidant device…"
Therefore, prima-facie, if an SPV is formed in France for investing in Indian shares, the capital gains would normally be taxable in France unless of course such gains accrue to taxpayers that are not residents of France either. One does not know what structures are being adopted but news reports do suggest that some of the FPIs are setting shop in France.
In this connection, it is also important to remember that post 1st April, 2017, there is now a GAAR in India. GAAR will also override tax treaties. Therefore, unless there is some substance in such transactions, the same may be considered impermissible avoidance arrangement and the benefit of the treaty may be denied. However, the fear of such financial institutions regarding application of GAAR was allayed to some extent by the clarifications issued by the CBDT in January 2017 as follows:
"Q.4 Will GAAR provisions apply where the jurisdiction of the FPI is finalised based on non-tax commercial considerations and such FPI has issued P-notes referencing Indian securities? Further, will GAAR be invoked with a view to denying treaty eligibility to a Special Purpose Vehicle (SPV), either on the ground that it does not have its own premises or skilled professional in its own roll as employees?
A.4. For GAAR, the issue, as may be arising regarding the choice of entity, location etc., has to be resolved on the basis of the main purpose and other conditions provided under section 96 of the Act. GAAR shall not be invoked merely on the ground that the entity is located in a tax efficient jurisdiction. If the jurisdiction of FPI is finalized based on non-tax commercial consideration and the main purpose of the arrangement is not to obtain tax benefit, GAAR will not apply." [CBDT circular no 7 of 2017 dated 27/1/2017]
P-Notes issued by FPIs continue to be the weak point of tax administration. The volume of such instruments apparently went down after the revision of the India-Mauritius tax treaty. However, of late, it is being reported that the volume has picked up again. It may be recalled that the government appointed SIT had recommended in 2015 to tighten the regulations around P-Notes in the following words:
"It is clear that obtaining information on "beneficial ownership" of P notes is of crucial importance to prevent their misuse. SEBI needs to examine the issue raised above and come up with regulations where the "final beneficial owner" of P notes/ODIs are known.
The information of "beneficial owner" with SEBI should be in form of individual whose KYC information is known to SEBI. In no case should the KYC information end with name of a company. In case a company is the holder of P notes/ODIs, SEBI should have information of its promoters/directors who exercise effective control over the company. In case of Companies/Trusts represented by service providers like lawyers/accountants SEBI should have information on the real owners/effective controllers of those Companies/Trusts not end with name.
P notes are transferable in nature. This makes tracing the "true beneficial owner" of P notes even more difficult since layering of transactions can be made so complex so as to make it impossible to track the "true beneficial owner". SEBI needs to examine if this provision of allowing transferring of P notes is in any way beneficial for easing foreign investment. Any investor wanting to invest through P notes can always invest afresh through an Foreign Portfolio Investor (FPI) instead of buying from a P note holder."
Despite such warnings and despite the apparent willingness of the present dispensation to tackle the menace of black money as is evident from various initiatives taken so far, this is one area where the administration seems to be wavering. Let us see if the revelations made by Citi to the Ministry officials usher in any change in this regard.