What did the court actually rule?
The Supreme Court ruled that foreign investors cannot rely solely on a Tax Residency Certificate (TRC) to claim tax benefits under a Double Taxation Avoidance Agreement (DTAA). The court held that tax authorities are entitled to examine the commercial substance of overseas investment structures while assessing treaty claims.
The ruling also clarified that such examination is not barred merely because the investment was made before April 1, 2017 – the date from which India’s General Anti-Avoidance Rules (GAAR) formally came into force.
What do terms like DTAA, commercial substance and GAAR mean?
DTAA (Double Taxation Avoidance Agreement) is a tax treaty between two countries that decides which country can tax an investor’s income and prevents the same income from being taxed twice.
Commercial substance means that an investment structure has real business activity in the country where it claims tax residence, such as employees or operations, and has not been set up only to claim tax benefits.
GAAR (General Anti-Avoidance Rule) allows the Indian tax department to deny tax benefits if a structure is created mainly to avoid tax and lacks commercial substance. What does this SC ruling change?
The ruling changes the long-held comfort that possession of a valid TRC by itself is sufficient to secure treaty benefits. The court made it clear that a TRC is necessary but treaty protection can be denied if the underlying structure does not show commercial substance.
What does this mean for FPIs? Who could be impacted now?
The ruling has implications for private equity exits routed through Mauritius, Singapore and Cyprus, which have historically been the preferred routes for several foreign entities to invest in India. This is particularly relevant to legacy investments where tax authorities dispute the commercial substance of the overseas holding entities.
Are these concerns only limited to PE firms? What about other FPIs?
The concerns are not limited to private equity firms. FPIs trading in Indian equity derivatives through Mauritius and Singapore are also closely watching the ruling.
Even after the Mauritius and Singapore treaties were amended, FPIs are spared tax on their derivative profits. Post the Tiger Global ruling, there may be a lurking fear that some FPIs lacking substance could be asked to pay tax on derivative earnings.
“Currently, the position being adopted is that India-Mauritius DTAA is amended only to tax capital gains on the sale of ‘shares’ and does not cover F&O transactions,” said Uday Ved, Tax Partner, KNAV. “Whereas this position may remain the same with respect to India-Singapore DTAA, the observations and comments of SC with respect to TRC and the substance issue may change the tax position.”
How does treaty history fit into this context?
The India-Mauritius DTAA went through a major shift in 2016. Before 2016, the treaty followed a residence-based taxation system, under which capital gains were taxable only in the investor’s country of residence. Since Mauritius did not tax capital gains, investors effectively paid no tax on exits from Indian investments.
To address this, India and Mauritius amended the treaty in 2016, moving to a source-based taxation-a system where capital gains are taxed in the country where they are earned.
How do the pre-2017 and post-2017 era work?
Investments made after April 1, 2017, are taxable in India on exit. Investments made before April 1, 2017 were expressly grandfathered and remained exempt from capital gains tax in India, said Harshal Bhuta, Partner, P. R. Bhuta & Co Grandfathering means protecting older investments from new tax rules.
Why hasn’t the market reacted to this ruling so far?
This is because the ruling does not automatically change the taxation framework for FPIs. Foreign portfolio investors continue to be taxable on capital gains, similar to domestic investors. There is also no change in the post-2017 regime, under which capital gains on direct transfers of listed shares are taxable in India irrespective of treaty provisions.
While there is also no impact on the taxation of derivative profits earned by FPIs, the worry here is that the commercial substance in these jurisdictions could be questioned by tax authorities and the availability of treaty benefits may be denied. That’s why the market is not too bothered about the ruling.