Judgment affirms validity of investment structures

By Joyjyoti Misra and Arjun Rajgopal, Khaitan & Co

Tax structuring of investments through jurisdictions having beneficial double taxation avoidance agreements (DTAAs) with India have been used by both financial and strategic investors into India. These structures, though supported by international and domestic law, have long been a thorn in the side of the tax authorities in India. Recently, Delhi High Court reversed the decision of the Authority for Advance Rulings (AAR) in the matter of an investor, Zaheer Mauritius, and held that income from the sale of compulsorily convertible debentures (CCDs) pursuant to the exercise of a call option cannot be characterized as interest income but must be classified as capital gains and hence the benefit of the India-Mauritius DTAA cannot be denied to the investor.


The investor, who was a tax resident of Mauritius, invested in Indian construction and property development companies. A real estate developer, Vatika Limited, owned land and proposed to develop it through a subsidiary called SH Tech Park Developers Private Limited.

Joyjyoti Misra
Joyjyoti Misra

The investor entered into investment agreements (IAs) with Vatika and the subsidiary to invest to acquire a 35% stake, constituted by a mix of CCDs and shares in the subsidiary, which would thus become a joint venture company (JVC). The IAs also recorded the inter se rights of the investor and Vatika in the management and operation of the JVC.

The IAs also provided a call option to Vatika and a put option to the investor relating to the investor’s securities. The options were exercisable within a specified time frame at a price determined by a computation method contained the IAs, which contemplated a fixed rate of return over time along with an equity payment equal to 10% of the project value and assets. Vatika partly exercised its call option and purchased some of the investor’s securities.

The investor, in the course of this, applied to the tax authorities for a certificate of “nil” withholding tax on the grounds that the investor’s resultant income was in the nature of capital gains and was therefore not taxable in India as per the India-Mauritius DTAA. The tax authorities responded that the income was in the nature of interest on a debt and that it should be taxed accordingly. The authorities also alleged that the JVC and Vatika could be treated as one and that the investor’s investment in the JVC’s CCDs was in fact a loan to Vatika.

The AAR subsequently upheld the position of the tax authorities. Further, the AAR called the entire transaction a sham structured to avoid tax in India. The investor challenged this ruling before Delhi High Court.

High court judgment

The court reversed the AAR’s ruling and made some important observations in its judgment on the matter.

Arjun Rajgopal
Arjun Rajgopal

The court recognized that a CCD creates a debt obligation until it is discharged or converted and this would imply that amounts paid by the issuer to the holder would usually be in the nature of interest. However, the court went on to say that the expression “interest” may not apply to all gains received by a debenture holder. If a CCD is transferred in a secondary sale as a capital asset, the gains arising would be capital gains. In this case, the CCD’s nature (as debt or equity) would have no bearing on the nature of the gains.

On the allegation that the transaction was essentially a loan to Vatika, the court stressed that while the amount of return on the CCDs was fixed, it was payable as an option and was not an obligation on Vatika, implying it wasn’t a loan. Further, the IAs showed that the investor had specific management rights in the JVC. Therefore the implication that the JVC was merely an alter ego of Vatika was incorrect. The court held that this transaction did not merit lifting the corporate veil.

The court observed that commercial reasons emanating from the foreign direct investment policy and Reserve Bank of India regulations partly accounted for the structure of the transaction. The court also looked at the principles laid down in the Supreme Court’s Vodafone judgment in 2012, observing that the transaction should be viewed as a whole.

The court concluded that there was no reason to ignore the legal nature of the CCDs as an instrument and that the corporate veil need not be lifted, therefore reversing the AAR’s ruling.

This judgment vindicates the investor’s investment structure, which resembles most private equity and venture capital investments in India. The decision also upholds the basic tax law principle that the form of the structure must be respected unless it can be established that the dominant purpose behind the transaction is tax avoidance.

Joyjyoti Misra is an associate partner and Arjun Rajgopal is a senior associate at Khaitan & Co. Views of the authors are personal and should not be considered as those of the firm.


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