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The original position of law, first set out in Azadi Bachao Andolan, that a tax residency certificate is conclusive and sufficient proof of residency to avail the benefits of a double tax avoidance agreement has been unsettled by recent jurisprudence in India, writes Megan Sequeira.
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IT is a basic rule of the law of taxation that unless otherwise expressly provided, income cannot be taxed twice. Accordingly, as under Section 90 of the Income Tax Act of 1961, the Union government is permitted to conclude double tax avoidance agreements (DTAA) with other countries to prevent such double taxation.
India has signed such treaties with over 94 countries, including Singapore, and is planning to sign more in the future.
A tax residency certificate (TRC) is a document issued by a person's country of residence that certifies their tax residency status. As inserted by the Finance Act of 2013, Section 90(4) of the Income Tax Act necessitated a TRC for a non-resident to be given benefits under a DTAA.
However, this has been considered a procedural requirement and does not override Section 90(2) of the Act, which allows the taxpayer to avail of treaty benefits.
Therefore, taxpayers are allowed to determine their residency to claim benefits under a tax treaty through methods other than a TRC.
“India has signed double tax avoidance treaties with over 94 countries, including Singapore, and is planning to sign more in the future.
The requirement of a TRC is, however, only in cases of investments made before April 1, 2017 (based on the amended treaty provisions), as affirmed in a recent judgment by the Bombay High Court in the case of Bid Services Division (Mauritius) Limited.
This is in consideration of the fact that investments made before April 1, 2017 are grandfathered from the application of the domestic General Anti-Avoidance Rule (GAAR) in the individual treaties.
In the instance of the Indo-Mauritius DTAA for example, investments made after the given date will also be subject to the added limitation of benefits clause whereby a resident of Mauritius is deemed to be a shell or conduit company if its total expenditure on operations in Mauritius is less than ₹27,00,000 (Mauritian rupees 1,500,000) in the immediately preceding 12 months.
The original position of law, first set out in the Azadi Bachao Andolan case, is that a TRC is conclusive and sufficient proof of residency to avail the benefits of a DTAA.
However, this has been a contentious position over the years and has recently become subjudice, given the Supreme Court's stay on the Order of the Delhi High Court in January 2024.
In the Azadi Bachao case, which was a public interest litigation (PIL) challenging a circular issued by the government of India, the issue that came up before the Supreme Court was whether a TRC is conclusive proof of residency or whether it can be re-assessed.
The circular issued by the Indian tax authorities clarified that a Mauritian-issued TRC was sufficient evidence to accept the status of residence of a person as a Mauritius tax resident to enjoy the benefits of the Indo-Mauritius DTAA.
The challenge against the circular was that such a certificate cannot be conclusive. In fact, this interpretation would encourage treaty shopping and allow easy fraud to take advantage of the treaty. The Delhi High Court accepted this rationale and quashed the circular.
The Supreme Court reversed this judgment and observed that one of the principles that must be condoned keeping in mind the long-term development of the economy is treaty shopping.
It held that the circular was a clear articulation of the substance of the treaty with Mauritius itself. Following this decision, courts consistently applied the TRC as conclusive evidence to determine the taxpayer's residency.
“Taxpayers are allowed to determine their residency to claim benefits under a tax treaty through methods other than a TRC.
Given that the circular was a direct extension of the Indo-Mauritius Tax Treaty, the rationale stood justified in terms of this case. However, this judgment was then used as a precedent applied consistently by tribunals and courts in the context of all DTAAs in India.
Amendment of the Income Tax Act and subsequent events
The Income Tax Act was later amended in 2013 (with retrospective effect from 2012) to specify that a TRC was a mandatory precondition to claim a tax benefit under Section 90.
It was also clarified that although the submission of such a certificate is necessary, it is "not a sufficient condition" to claim benefits under a tax treaty. This turned the position of law set forward by Azadi Bachao Andolan on its head.
Shortly after, due to the backlash and frenzy of panic among investors, another clarification was issued by the government of India stating that contrary to any interpretations of the previous guidance, a TRC is conclusive proof of residency and the tax authorities in India will not go behind the certificate to investigate one's residency. However, tax officers continued to doubt the conclusiveness of the TRC.
The issue has come up for debate before the courts several times since, most recently in Blackstone Capital Partners (Singapore) VI FDI Three PTE Ltd. versus CIT. In this case, as the opening paragraph dictates, the core issue was whether the tax authorities could question the tax residency certificate issued.
The Delhi High Court returned a finding in favour of the TRC amounting to conclusive proof, upholding decisions of the Supreme Court in Azadi Bachao Andolan, Vodafone International Holdings BV versus Union of India, CIT versus JSH (Mauritius) Ltd, Sanofi Pasteur Holding SA versus Department of Revenue, Ministry of Finance, and several others.
However, on appeal, the Supreme Court stayed its decision, allowing the issue to become sub-judice again.
On April 1, 2017, the GAAR was made effective to, amongst other reasons, deny tax treaty benefits if the 'main purpose' of the arrangement or transaction was to claim artificial tax benefits.
The power under GAAR can be said to be in addition to the rationale of the Supreme Court judgment in the case of McDowell & Co. Ltd which permits denial of tax benefits in cases involving colourable devices or dubious methods.
India introduced the GAAR provisions under its municipal law to essentially codify the doctrine of 'substance over form', i.e., the intent and purpose of an arrangement are taken into consideration irrespective of the legal structure.
It is pertinent to note that the date of applicability is aligned with the protocols in the Indian tax treaties (such as the India–Singapore tax treaty), providing a carve-out for investments made before April 1, 2017.
Under the GAAR, an arrangement is considered an 'impermissible avoidance agreement' (IAA) if the main purpose of the arrangement is to obtain a tax benefit and the arrangement:
This is commonly called the four sins test, and the commitment of even one sin indicates that such agreement will not fall under the treaty.
In 2019, the Indian government also ratified the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (BEPS) which deals with anti-abuse situations under tax treaties.
“The original position of law, first set out in the Azadi Bachao Andolan case, is that a TRC is conclusive and sufficient proof of residency to avail the benefits of a DTAA.
The BEPS allows the application of the Principal Purpose Test (PPT) which permits the denial of tax treaty benefits in certain cases. The BEPS could override all Indian jurisprudence to date.
BEPS Action 6 is aimed at the prevention of tax treaty abuse to prevent instances of treaty abuse and treaty shopping arrangements, arising out of the extensive network of tax treaties (3,000 to 4,000 treaties in force worldwide).
The Indian government is applying the PPT clause of the BEPS as a temporary measure to prevent treaty abuse. This is while it enters into bilateral renegotiations for several double-tax treaties.
For instance, on March 7, 2024, India and Mauritius signed an amendment to the DTAA to include the PPT test. However, investments made before April 1, 2017 have been grandfathered and, therefore, domestic GAAR principles do not apply to such investments.
So the question of the requirement of the TRC and the conclusive nature of such evidence remains for all investments created before 2017.
The GAAR provisions and the PPT apply to identify whether a transaction is a sham or a part of a series of pre-ordained steps to avoid taxation. They do not specifically deal with how one should view a single transaction not routed through any other entities, wherein a claim of treaty benefits is made based on the residency of the investor.
However, given that the GAAR provisions and the PPT adopt a look-through approach to identify whether a transaction is for tax avoidance purposes, one can advocate that such an approach should also be adopted in identifying the residency of an assessee.
The amended treaties now include a limitation of benefits clause as well, whereby the residency of a company is put into question based on its operations and expenses in the relevant country in the immediately preceding year.
However, given the grandfathering provisions, the limitation of benefits clause is not applicable to investments made before April 1, 2017.
The sole reliance on a TRC allows the possibility of treaty shopping. By not actually carrying out operations in the tax-haven country but simply acquiring a TRC, investors are afforded an easy opportunity to avoid taxation on investments made in India.
The problem with this sole reliance was explicated by a Canadian Court, in Neil Berry McFayden versus The Queen (200 DTC 1426). In this case, the taxpayer sought to take advantage of the Canada–Japan Tax Treaty which would make his income taxable only in Japan.
“The circular issued by the Indian tax authorities clarified that a Mauritian-issued TRC was sufficient evidence to accept the status of residence of a person as a Mauritius tax resident to enjoy the benefits of the Indo-Mauritius DTAA.
He was asked to file proof that he was a resident of Japan, which he did by submitting a Japanese tax form entitled "Certificate of Residency of Japan", stating that he was a resident of Japan under Article 4 of the treaty.
The court, however, held that this certificate was weak and should be given very little weight. The rationale observed was that although the certificate was issued by the authorities, there was no evidence to state they had full knowledge of the taxpayer's circumstances during those years or the parameters of law in the area of income tax, but simply the conclusion of residency.
Since there was no reasoning for the conclusion or evidence about the expertise of the official issuing the certificate, the TRC was not sufficient and much less conclusive evidence of residence to benefit from a treaty.
Further, it is important to note that residence for treaty purposes is distinct from residence under domestic law. A country cannot be bound by another country's evaluation of the facts on which residence is based.
An instance of a possible treaty abuse through the sole reliance on a TRC can be highlighted in the case of Radha Rani Holdings versus ADIT.
In this case, although a resident of India possessed 99 percent of the company's shareholding while a Singaporean resident held only 1 share, the issuance of a TRC by the Singaporean taxation authorities significantly played into the decision of the income tax appellate tribunal that the company's control and management would be in Singapore and that it would not be a resident of India.
Citing Azadi Bachao Andolan, the tribunal found that the TRC submitted was conclusive proof of residency.
In Azadi Bachao Andolan itself, while the Supreme Court of India admitted that treaty shopping might be a necessary evil, it also stated that whether treaty shopping should continue and for how long, is a question best left to be decided by the executive.
Given India's active steps in signing the Multilateral Convention to Implement Tax (MLI), which is particularly aimed at the prevention of tax treaty abuse, it seems that the time has come to disallow this no-longer necessary evil and take away the conclusive nature of the TRC.
The Place of Effective Management (POEM) is the place where key management decisions are taken. It is an internationally recognised test to determine the residential status of a company incorporated in a foreign jurisdiction and has commonly been used to interpret residence to claim treaty benefits.
The Central Board of Direct Taxes (CBDT) issued detailed guidelines vide circular No. 6 of 2017 for the determination of the POEM. One of the factors in ascertaining the POEM could then be the TRC itself.
The presence of a TRC does not foreclose the possibility of an entity being a resident of both contracting States. Under tax laws, a company may have more than one residence, as held in Unit Construction Co Ltd versus Bullock.
By Circular 1 of 2003, the CBDT clarified that where a person other than an individual is a resident of both contracting States, it shall be deemed a resident of the contracting State in which the POEM is situated (in reference to the Indo-Mauritius Treaty).
In SMR Investments Ltd versus DDIT, the assessee was a company incorporated in Mauritius with two shareholders (Suresh Rajpal and Mavis Tse Rajpal, who respectively hold 99 percent and 1 percent of the share capital), similar to the shareholding in Radha Rani.
“On April 1, 2017, the GAAR was made effective to, amongst other reasons, deny tax treaty benefits if the 'main purpose' of the arrangement or transaction was to claim artificial tax benefits.
It earned some capital gains by selling the shares it held in an Indian Company. The Indo-Mauritius DTAA provided that capital gains would only be taxable in the State of which the alienator is a resident.
The company claimed that the gains were exempt from tax in India as a TRC had been issued by the Financial Services Commission of Mauritius. However, the assessing officer sought to tax the gains maintaining that the assessee was a resident of India.
It was found that the company was resident in both countries. However, since the POEM was situated in India, capital gains were liable to be taxed in India. The tribunal found that a mere TRC may not be the conclusive determinant of the residential status of the Mauritius company. It may be essential to substantiate the residential status based on the POEM.
A TRC is only granted to companies after a detailed analysis by one of the contracting State authorities. Disregarding such a certificate by the Indian revenue authorities could then be contrary to the principles of sovereignty under international law and can go against the purpose of the treaty itself.
However, especially when both countries are signatories to the MLI, it is clearly in the interest of both contracting States to adopt a 'look-at' approach so as to stop tax avoidance and work towards a healthy economy.
An argument can also be made to the effect that by choosing to grandfather investments before 2017 in the recent amendments to the DTAAs and, therefore, protecting such investments from the limitation of benefits clause, the Indian executive has made a clear-cut decision to let the TRC remain conclusive.
This argument can also be easily rebutted: the conclusive nature of the TRC was a judicially introduced concept. The executive even went so far as to attempt to reverse this position by the amendment in 2013, although the later clarification allowed its sufficiency due to the frenzy created among investors.
This brings us to the second and foremost challenge: foreign investors will now have to establish that they are residents of a foreign jurisdiction in substance and not merely by producing the residency certificate.
This should not pose too much of a challenge: while the executive was forced to allow the sufficiency of the TRC in 2013 in its clarification due to the panicked investment pull-outs, this frenzy was justified by the sudden amendment from the prevailing position of law.
Now, in 2024, investors not only have a sufficient warning about such sham transactions and treaty abuse but given that the MLI is a global initiative, a clarification on the non-conclusive nature of the TRC for investments made before 2017 will not cause an equivalent panic and pull-out of investments.
“In fact, given that the discussion is only relevant to investments made before 2017, it should not have any severe impact on the economy as all further investments are already subject to the amended domestic GAAR provisions.
In fact, given that the discussion is only relevant to investments made before 2017, it should not have any severe impact on the economy as all further investments are already subject to the amended domestic GAAR provisions.
A last challenge: an adverse ruling from the Supreme Court may trigger reassessment proceedings on foreign investors where tax authorities have reasons to doubt the residency of the taxpayer. This may have negative consequences on foreign investment in India as well as the growth of the economy.
This too can easily be resolved: in the interest of public policy and efficiency, such changes can be introduced only on a prospective basis for taxation to be paid in the current financial year onwards, thereby avoiding any reassessment procedures.
In conclusion, while Azadi Bachao Andolan and its aftermath have significantly shaped the landscape of tax residency determination and treaty interpretation in India, post-BEPS, given the shift towards mutually agreed procedures to determine residency, it is unlikely that past precedents and authorities will guide questions of treaty eligibility.
Although the initial stance had accorded conclusive weight to TRCs, sole reliance on such certificates has been criticised for potentially facilitating treaty shopping and tax avoidance schemes.
“It is important to note that residence for treaty purposes is distinct from residence under domestic law. A country cannot be bound by another country's evaluation of the facts on which residence is based.
Moreover, the introduction of GAAR and the principal purpose test under BEPS Action 6 signifies a shift towards examining the substance of transactions instead of form. Alternative tests such as the POEM offer a more nuanced approach to residency determination.
While the objective of these agreements and rules is to curb treaty abuse, they also pose challenges and uncertainties for taxpayers and investors. Therefore, striking a balance between preventing abuse and facilitating legitimate cross-border transactions remains a complex endeavour.
