Walmart-Flipkart Deal: AAR Ruling May Impact Private Equity Exits, Experts Say

Just when the dust had settled on the issue of taxability of capital gains, the Delhi bench of the Authority for Advance Rulings has passed an order that is likely to impact foreign funds investing in India through the Mauritius route.

The ruling pertains to the taxability of capital gains arising from investments made by U.S.-based private equity firm Tiger Global Management LLC in the Singapore-based holding company of Flipkart India. In 2018, Tiger Global’s Mauritian arm sold more than 26 million shares in Flipkart Singapore to a Luxembourg entity and had approached tax authorities to claim capital gains tax exemption under the India-Mauritius double tax avoidance agreement.

After a close scrutiny of their management and control structure, the AAR arrived at an ‘inescapable conclusion’ that the Mauritian entities were set up only to derive benefit under the tax treaty. The exemption under the DTAA can only apply to direct transfer of an Indian entity’s shares, it said while denying the treaty benefits.

Experts said the ruling creates uncertainty among foreign investors who relied on the existing tax regime, which allowed treaty benefits on the basis of a tax residency certificate granted by the Mauritius government.

It also further complicates the relevance of tax treaties for indirect transfers. To reiterate, in this case, it was the shares of Flipkart Singapore that had changed hands and not Flipkart India.

There are not too many judicial precedents on availability of treaty benefits on indirect transfers, Dhruva Advisor’s Vaibhav Gupta said. In 2013, the Andhra Pradesh High Court in Sanofi’s case had upheld the benefits under India-France DTAA for an indirect transfer transaction, he said. ‘It will be interesting to see the outcome of the challenge to the AAR that Tiger Global is planning with the judicial authorities, Gupta said.

Impact On PE Exits

To plug tax leakages, India had amended the Mauritius treaty three years ago. A 10% capital gains tax was introduced for entities based in Mauritius on income arising from the transfer of shares of an Indian entity. Investments prior to April 1, 2017, however, were grandfathered, implying that capital gains tax won’t apply even if the shares were sold after this amendment.

This understanding has now been upended by the Delhi AAR bench, which lawyers said, will make exits expensive. It will also impact the internal rate of returns for private equity industry as they may now have to pay an “exit tax”, which can affect their returns.

According to Vivek Gupta, partner at KPMG, the order has created a precedent that gives a window to the tax department to evaluate each exit transaction minutely.

Explaining the impact on Mauritius-based investments into India, he said PE funds had generally factored in the scenario that sale of shares acquired prior to 2017 will be eligible for treaty benefits and hence, attract zero capital gains tax. There will be higher uncertainty or litigation on private equity exits, going forward, he said.

Authorities use the principle purpose test under the MLI to determine whether obtaining treaty benefits was one of the principle purpose of a tax arrangement. Based on the assessment, they can allow or deny tax benefits under the treaty.

BMR Legal’s Mukesh Butani said the ruling will tend to exert pressure on similarly structured PE deals, given its persuasive value. The AAR has diluted the grandfathering benefit of the renegotiated terms of the Mauritius treaty and has distinguished landmark decisions of the apex court rendered in the Azadi Bachao & Vodafone cases, he said.

M&A Deals: Higher Scrutiny

Another major impact of this order will be on the methods deployed by the tax department to scrutinise deals

Tiger Global had initially approached the Income Tax Department to seek a nil withholding certificate on transfer of shares. The tax department inspected the board minutes of the Mauritian entities, decision-making structure, financial control, including the authority to sign cheques beyond a particular threshold and beneficial ownership in the shares.

Based on these factors, it found that the real control and decision-making for the Mauritian entities was being exercised from the U.S., leading to a prima facie conclusion that the scheme was designed for avoiding tax.

Now armed with the “heads and brain test” and the precedent created by the AAR’s order, tax authorities will look to further scrutinise existing arrangements in order to find out the underlying intent behind such structures.

Tax authorities can demand more information about transactions than is currently required, Ravi Raghavan, partner at Majmudar & Partners, said.

Authorities can seek further details on origin of consideration invested in shares, authority and power of an entity to enter into agreements, board composition, bank account details, number of personnel employed, tax returns and email correspondences of an offshore entity investing into India through tax-friendly jurisdictions before allowing the beneficial provisions of a tax treaty, he said.

Raghavan said the order can’t be applied generally to all investment structures as each case has its own peculiarities. “It’s essentially based on specific facts relating to the ownership structure, financial control and management of the Mauritian entities.”

The AAR is a quasi-judicial authority appointed under the Income Tax Act to render decisions on tax consequences of certain transactions. Any ruling by the authority can be used as a ground by the tax authorities to further scrutinise transactions. While the law always allowed tax authorities to question tax structures, the possibility that they can go beyond the prevailing understanding has worried investors.