THE "stakeholders" who made presentation before the Shome committee, have welcomed the committee's report on indirect transfer. Amongst such stakeholders are of course those who sell post box companies in Mauritius and such other esoteric places. Such stakeholders will always seek loopholes so that the same can be exploited for fat fees. The question is whether the policy makers should bow to their demands. Going by media reports, the reaction to the committee's report amongst the revenue officers on the other hand has been negative. The committee not only went into areas like the legislative competence, constitutionality and such other no go areas, where even the Courts fear to tread, but it also pontificated a great deal on international taxation and the rules of the game and how by resorting to the retrospective amendment, India would be falling foul of the said rules.

We take the following comments and recommendation of the committee by way of example:

"4.15 Conflicts with the tax treaties (DTAAs) of India

Submission by the Stakeholders

India has entered into DTAAs with a number of countries. The DTAAs provide the right of taxation, inter alia, in respect of capital gains arising in the source country. Many DTAAs (e.g. the US, UK) provide the right of taxation to a source country as per its domestic law. However, by amendment of domestic law, India has expanded its tax base unilaterally which may not be respected by all treaty partners, possibly resulting in double taxation.''

In triangular cases, where all three countries involved (i.e. country of residence of seller, country of residence of the foreign company, and India where underlying assets are situated) may tax the same income arising from the transfer of shares of the foreign company. This may result in multiple taxation without tax relief in any jurisdiction.

In some cases, there would be treaty interpretation issues as the right of taxation to the source country is given in specific circumstances. For instance, on alienation of shares of a company, which is resident of a country, the country has the right of taxation of capital gains arising from such transfer.

The language of the treaties, by and large, cover only a direct transfer. Whether indirect transfer of shares of an Indian company are covered under the treaty or not, remains a question.

Whether the definition of the term "transfer" used in domestic law can be used to interpret the term "alienation" used in tax treaty is another issue . The domestic law uses the phrase "through transfer of a capital asset" which is much wider than the phrase used in a DTAA i.e. "from alienation of shares of a company". Also, the word "through" is different from the word "from", as explained in the first Report on GAAR.

Analysis

The then Finance Minister in his speech in Parliament on 10th May, 2012, at the time of announcement of Government amendments stated that the retrospective amendments related to indirect transfer shall affect mainly transactions in non-treaty countries and where they lead to double nontaxation.

The DTAAs entered into by India with other countries have different formulations for taxation rights on capital gains. These may be divided, mainly, into four categories-

(i) India has right of taxation of all capital gains as per its domestic law (e.g. US and UK);

(ii) India has right of taxation of capital gains arising on alienation of shares of an Indian company (in most treaties);

(iii) India has right of taxation of capital gains arising on alienation of shares of an Indian company only if the transferee is a resident of India (e.g.Netherlands);

(iv) India does not have right of taxation of capital gains arising on transfer of shares of an Indian company (e.g. Mauritius, Singapore, Cyprus).

Thus, these amendments would affect only those investors that come from a jurisdiction with which India does not have a tax treaty; or, where there is a tax treaty, India has right of taxation as per its domestic law under the treaty; or, India has right of taxation on alienation of shares of an Indian company.'' (Emphasis added)

From the text quoted above, it seems that the "stakeholders" had complained before the committee that the action of the Indian government in treating indirect transfer as giving rise to capital gains would lead to double taxation and hence should not be resorted to by the Indian government.

The subsequent ‘analysis' of the committee is befuddling. On the one hand, it says that there may be issues relating to interpretation as to whether the treaty covers indirect transfers. It then makes a perfunctory reference to the Finance Minister's remarks about the amendments to cover situations of double non-taxation. The committee ends up by saying that the amendments are useless in treaty situations.

It is not clear as to whether by referring to the FM's speech, the committee believes that the amendments should be restricted to cases of double non-taxation. It is obvious that the root of all the problems in the area of capital gains taxation of non-residents - the India-Mauritius treaty definitely promotes double non-taxation. The committee wants to save this treaty in particular as is evident from its report on GAAR. So, it could not be the intention of the committee that the proposed amendments should apply in such cases. Perhaps what it meant was that even in situation of double non-taxation, the proposed amendments should not apply because, according to the interpretation put by the committee the amendments will have no effect in treaty situations.

After giving two illustrations and quoting from Article 13, the committee then recommends as follows:

"In view of the above, in order to provide certainty to foreign investors, it may be clarified that where capital gains arising to a nonresident person on account of transfer of shares or interest in a foreign company or entity are taxable under section 9(1)(i) of the Act and there is a DTAA with country of residence of the non-resident, then such capital gains shall not be taxable in India unless

(i) the DTAA provides a right of taxation of capital gains to India based on its domestic law ; or

(ii) the DTAA specifically provides right of taxation to India on transfer of shares or interest of a foreign company or entity."

With due respect, a DTA does not and cannot provide a right of taxation based on a country's domestic law. A country always has absolute unfettered right to tax any which way it wants in terms of its domestic law. In fact, there is always a complex relation between domestic law and tax treaties. These do not function in isolation and independently of each other.

In this connection, it is important to examine the main purpose of a tax treaty. Apart from allocation of taxing rights over certain sources of income, a tax treaty serves no purpose. It does help in exchange of information but that is another issue. The domestic law can very well serve even the purpose of avoidance of double taxation. India has section 91, which allows for credit of taxes paid in a foreign country by an Indian resident as a credit from the taxes to be paid in India. Properly designed, a country's domestic law is sufficient to relieve double taxation. However, how the domestic law would be framed is the sovereign decision of the country concerned. Some countries might decide not to charge capital gains at all, some may charge at nominal rate while some others might charge the same at normal rate.

In this connection, it needs to be reiterated that a tax treaty cannot impose a tax. It is the domestic law that always imposes tax. Whether or not India should charge capital gains or not is a sovereign decision of the Indian government. Whether non-residents should be charged to capital gains or not is again a decision of the Indian Parliament. Whether the same rules should apply in the taxation of residents or non-residents is also a decision of the Indian Parliament. Whether the same rate should apply for long-term or short-term capital gains is again a decision of the Parliament. Whether the period of holding should be 6 months, one year or three years before an investment is considered long-term is also the sovereign decision of the Parliament. In the same vein, whether capital gains should be charged on indirect transfers is also a decision of the Parliament. Whether for signifying transfer ‘through' should be used or ‘from' should be used is again the decision of the Parliament.

A DTAA merely circumscribes the taxing rights of a State. So, the relevant question that is to be asked is not whether the DTAA gives taxing rights to India based on its domestic law but whether considering the fact that a state has unfettered taxing rights, what are the fetters put by the particular tax treaty. In this respect, each treaty has to be examined separately and no brad brush approach is possible.

Whether direct or indirect transfer should result in capital gains is not a subject matter of negotiation of tax treaties. The negotiators are interested in the allocation of taxing rights to the respective countries. Depending on the negotiating skills and the needs of the country, negotiators might agree on full right of taxation or partial right of taxation over this income head. Moreover, there is a variety of ways in which capital gains are taxed in individual countries. Even among OECD countries there is a wide variation. OECD commentary on Article 13 states as follows:

"2. Moreover, the taxes on capital gains vary from country to country. In some OECD member countries, capital gains are taxed as ordinary income and therefore added to the income from other sources. This applies especially to the capital gains made by the alienation of assets of an enterprise. In a number of OECD member countries, however, capital gains are subjected to special taxes, such as taxes on profits from the alienation of immovable property, or general capital gains taxes, or taxes on capital appreciation (increment taxes). Such taxes are levied on each capital gain or on the sum of the capital gains accrued during a year, mostly at special rates, which do not take into account the other income (or losses) of the taxpayer. It does not seem necessary to describe all those taxes.

3. The Article does not deal with above-mentioned questions. It is left to the domestic law of each Contracting State to decide whether capital gains should be taxed and, if they are taxable, how they are taxed …."

Relating to double non-taxation of capital gains which is the bane of India-Mauritius treaty, the OECD commentary in paragraph 21 states as follows:

"21. As capital gains are not taxed by all States, it may be considered reasonable to avoid only actual double taxation of capital gains. Therefore, Contracting States are free to supplement their bilateral convention in such a way that a State has to forego its right to tax conferred on it by the domestic laws only if the other State on which the right to tax is conferred by the Convention makes use thereof …"

Therefore, the recommendation of the committee that domestic law should provide that capital gains should not be charged in cases where there are tax treaties is not in order. The domestic law needs to be tough. Through its domestic law, India should charge capital gains, close loopholes and if, because of economic or other considerations, any relief has to be given, that may then be given through tax treaties. The reason is simple but needs to be hammered constantly - it is the domestic law that gives the power to tax, not the tax treaties. The domestic law therefore needs to be as strong as possible as otherwise even in non-treaty situations as also in domestic situations, Indian revenue will continue to lose.