The Tale Of Two Capital Gains Tax Rulings!

There's good news and bad news for taxpayers on the capital gains front. The good- the Delhi HC allowed non-residents to avail of a lower rate of tax  at 10% on gains in off market transactions The bad- a recent Punjab and Haryana High Court has upset the precedent on sale of shares by promoters. Payaswini Upadhyay reports on the rulings and their impact.

The first case settles the much vexed issue of capital gains tax rate applicability on non residents. The case involves Cairn UK and pertains to a transaction that took place in 2009.  
At that point Cairn UK held a 64.68 % stake in Indian public listed company Cairn India. In an off market transaction, Cairn sold 2.29% of its stake in Cairn India to Mauritius based Petronas Corporation. It went to the tax department for a withholding certificate stating tax payable on capital gains is at the lower rate of 10% and not 20%. Section 112(1) of the income tax Act allows a taxpayer to pay tax at the rate of 10% before availing of indexation benefit. Cairn proposed to avail of this benefit and the benefit of foreign currency fluctuation under Section 48.
Revenue argued that the 10% rate is available only for resident investors as only they can claim indexation benefit. And if a lower rate is allowed, it would lead to a double benefit of foreign currency fluctuation and a lower tax rate of 10% on long term capital gains. Pranay Bhatia
Partner, ELP
"In that transaction, the real contention was whether Cairn UK- in addition to paying tax at a concessional rate of 10% is also eligible to claim the protection of foreign exchange fluctuation which otherwise a foreign investor is eligible to claim. The provisions of Section 112- which provide for this lower tax rate- state that if you’re a domestic investor, then you’re not entitled to any inflation adjustment. Therefore the tax department contended that as a foreign investor, you’re not entitled to foreign exchange fluctuation.”
To seek clarity on the rate of taxation, Cairn UK approached the Authority for Advance Rulings. The AAR made a first of its kind observation.
It said that the tax rate on long term capital gains arising out of an off-market sale of listed securities will differ between residents and non-residents. A resident taxpayer can index the cost of acquisition. For a non-resident, the cost of acquisition can be adjusted for currency fluctuations. It concluded that a non-resident cannot take a double benefit - of protection against foreign exchange fluctuation and a lower tax rate of 10%. Mukesh Butani
Managing Partner, BMR Legal
"The AAR was clearly inconsistent in its ruling because in an earlier case, it has clearly held that rate of tax should be 10% and this was not just one ruling but there were several rulings given by the AAR. Surprisingly the AAR changed its stance and started holding that the rate of tax should be 20%."
Aggrieved by AAR’s interpretation, Cairn filed a writ petition in the Delhi High Court. Last week, the court ruled in Cairn’s favor giving it the benefit of currency adjustments and a lower tax rate of 10%. The Delhi HC observed that if the legislature intended to deny a non-resident this double benefit, the Income Tax Act would have explicitly said so. Pranay Bhatia
Partner, ELP
"In last year’s budget, there was an amendment to say that if there is a gain on sale of unlisted securities, the gain will be taxed at 10% and domestic investors will not be allowed any indexation benefit and the foreign investors will not be allowed any foreign exchange fluctuation benefit. This is exactly the point that the Delhi HC is making. If there was an intent not to allow a foreign investor to take the benefit of foreign exchange fluctuation, there should have been a specific provision." Mukesh Butani
Managing Partner, BMR Legal
"I think the Delhi HC ruling is landmark as it settles a very important principle which was debated as a result of inconsistent rulings of the Advance Ruling Authority. More importantly, when non-residents exit or change their shareholding which triggers off capital gains on transactions- they need higher level of certainty. So I think this issue, in so far as the High Court as a judicial forum is concerned, has settled the debate."
This Delhi HC order will bring huge relief not only for Cairn UK but several other non-resident taxpayers. Chicago Pneumatic Tool is fighting a similar battle in the Bombay HC. Several cases are pending before various Tribunals. For now, taxpayers litigating this issue before the Tribunals can take advantage of this beneficial ruling by the Delhi HC.
Now, onto the bad news. For that, let’s go across to the Punjab and Haryana High Court for yet another first-of-its-kind view.
Last month, the Punjab and Haryana High Court held that if promoters are selling shares with management right the sale proceeds should be treated as business income
In 2005, the promoters of Excel Callnet sold their shares in the company under a Share Purchase Agreement to Pugmarks Interweb. The promoters offered the gains on this sale of shares to tax as long term capital gains. The tax department alleged that the transfer was not of a capital asset but was in fact transfer of the company’s business. It argued that the transaction should be taxed as business income as it is not a simple transfer of shares but in fact a transfer of control. The Chandigarh Tribunal accepted revenue’s view. Ajay Vohra
Managing Partner, Vaish Associates
"I think, so far as the individual is concerned, he had transferred a capital asset- namely shares of the company. It is nobody's case that the individual is in the business of promoting and selling ventures- it would become business income only in that situation. There is no such finding by the Assessing Officer. But if he has only sold the shares of the company and it is not is vocation to be promoting and selling ventures- I don't see how this can become business income."
But the Punjab and Haryana HC ruled it to be so and affirmed the ITAT’s judgment on grounds that
-  The share purchase agreement included not just the transfer of shares but also management rights
-  The promoters also transferred business assets such as employee database, products database, customer proposals in pipeline, customer data and contracts
-  A non-compete clause in the agreement prevented the promoters from entering a similar business for 2 years
-  The Share Purchase Agreement provided for specific clauses such as non-usage of brand, web domain, and non-solicitation of present and future employees of the Company
And so, the High Court concluded the transaction was a transfer of business and not just the transfer of shares. And upheld the tax department’s view to tax the gains as business income.
 
Daksha Baxi
Executive Director, Khaitan & Co.
"I think that there are several principles that need to be considered here, in the first place its piercing the corporate veil. When is a corporate veil permitted to be pierced? There has to be a specific or glaring and rare circumstance- one of which would be if the transaction on the face of it is sham. From the facts that are available in the order, it does not seem like it was a sham transaction. Therefore, it doesn’t seem to be a grave enough cause for the corporate veil to be pierced. The second principle that the SC established in the Vodafone judgment that a transaction has to be looked at and not looked through by dissecting the documents, which apparently or on the face of it is perfectly in order for such a transaction & the third thing is the distinction between a company as a corporate entity and a shareholder seems to have been completely done away with. A company owns the business & the shareholder owns the company, the company’s business does not automatically become the business of the shareholder. So this distinction also does not seem to have been respected and accepted in this order by the honorable court.” Ajay Vohra
Managing Partner, Vaish Associates
"I only hope that the department does not take a cue from such a decision and hold that in all cases where there is transfer of shares of a company - which results in transfer of control, transfer of ownership- they treat it as a transfer of business of a company and seek to tax it as business income instead of capital gains. I think it will be completely far fetched. In my understanding, this judgment is not correctly decided."
If the tax dept were to apply this principle laid down by the High Court, almost every promoter sale to private equity will become a business income transaction. Experts say that such an interpretation could create havoc as the clauses – based on which the Court has ruled the transaction as transfer of business- are standard to most share purchase agreements.
That brings me to the close of our two-in-one top story on capital gains- worried promoters and rejoicing non-resident investors! In Mumbai, Payaswini Upadhyay