Will Otis ruling render buy-back otiose?

The concept of buy-back has long been in vogue in the US, Canada, the UK and other places. In India, it was introduced in 1999 after the Companies Act 1956 permitted an Indian company to repurchase its own shares. Currently, buy-back of equity shares is permitted up to 25 per cent of the paid-up equity shares and 25 per cent of the paid equity capital and free reserves. Post buy-back, the debt-equity ratio should not exceed 2:1.

With the insertion of buy-back in the Companies Act, the Income-Tax Act 1961 was amended to provide for exclusion of share buy-back from the definition of dividend. Separately, a mechanism for computation of capital gains on buy-back was provided. With the amended provisions in the ITA, the income from buy-back was characterised as capital gains. The exemption is possible in India under the favourable tax treaties that grant capital gains exemption on transfer of shares of an Indian company. In the absence of a favourable tax treaty, it was possible to claim exemption under ITA itself if the buy-back took place by a subsidiary from shareholders holding 100 per cent stake in the subsidiary. These tax advantages have been questioned by two recent rulings of the Authority for Advance Ruling in the case of Otis Elevator India and RST Germany. Though the AAR ruling is not binding on other assessees, in practice an adverse inference of these two decisions may be drawn by tax authorities.

In the first ruling, the exemption of capital gains under the India-Mauritius Tax Treaty was denied to a tax resident of Mauritius. This case concerned buy-back of shares by an Indian company from its Mauritius shareholder. In deciding the issue, the AAR emphasised two facts: Non-declaration of dividend by Otis India since 2003, that is, since the introduction of dividend distribution tax in the ITA; and non-acceptance of buy-back by other major shareholders of Otis India who are tax residents of the US and Singapore. With these facts in view, the AAR concluded that the buy-back was a tax avoidance mechanism. The authority disregarded the legal form of the buy-back and treated it as a distribution of dividends. It held that the dividend will be taxable in India under Article 10 of the India-Mauritius Tax Treaty. The proposal in the Finance Bill 2012 to introduce the General Anti-Avoidance Rules has created some uncertainty on inbound structures through a Mauritian intermediary holding company. The AAR, however, has invoked the anti-avoidance principles before the GAAR becomes law.

In the second ruling, the exemption was denied to a company wholly holding shares in an Indian subsidiary by itself and through nominees, and relying on the provisions of section 47(iv) of the ITA. According to section 47(iv), any transfer of shares by a holding company to its wholly-owned Indian subsidiary is disregarded and thereby exempt from capital gains tax. It requires the parent company or its nominees to hold 100 per cent shares in the subsidiary. The AAR interpreted the “or” to mean that the entire share capital of the subsidiary should be held either exclusively by the parent company or exclusively by nominees; it did not admit a situation where the shares are held by both. With this interpretation, only a company where the entire share capital is exclusively held by two or more nominees can benefit from section 47(iv).

The ruling has not considered the Gujarat High Court's observation in the Chunilal Khushaldas (93 ITR 369) case that asset held by the nominee of the assessee can be regarded as held by the assessee. The AAR also held that specific provisions in section 46A of ITA dealing with computation of buy-back would apply regardless of any exemption generally available on transfer of shares by the holding company to its 100 per cent Indian subsidiary. The tax authorities also argued that there is no transfer in the case of buy-back as after a buy-back, shares do not exist. This argument was not discussed by the AAR.

The two AAR rulings discussed above may cause hardship for buy-backs done until now, particularly when the investors acted bona fide and the Mauritian structures were respected by the Indian Supreme Court. The investor community, which has brought prosperity to our economy in many ways, would certainly expect the authorities to include appropriate safeguards in the GAAR provisions, thereby providing certainty to structures that are already in place or transactions already carried out.

Geeta Ramrakhiani is Senior Manager and Anita Nair is Deputy Manager, Deloitte Haskins & Sells.