Summary of events

On 8th October, 2003 the Supreme Court of India released a landmark judgment (dated 7th October 2003) which will have international repercussions on the financial markets. Legal experts in the field the world over were awaiting the judgment not merely because of the newly acquired importance of India as a fund destination (and the consequent tax benefits and certainty which would flow from a favorable order) but because several countries are facing similar issues about tax treaties. This judgment is expected to be cited in courts the world over for the interpretation of double tax treaties.

A Public Interest Litigation was filed in the Delhi High Court challenging the validity of the circular in public interest. The Delhi High Court struck down the circular on various grounds. The court also found that the treaty gave rise to tax evasion and encouraged the existence of Mauritius as a tax haven and passed adverse comments about the treaty itself. The High Court order was challenged by a consortium of Mauritius based companies called the Global Business Institute (represented by the law firm P.H. Parekh & Co., before the Supreme Court of India) and also by the Government of India (represented by the Attorney General of India). After extensive arguments, the Supreme Court passed a judgment upholding the circular and reversing the findings of the Delhi High Court on all counts. The order brings the much needed certainty back into investments coming from Mauritius which had gone down from 35% of inflows over the past decade to only 5% of inflows over the past 6 months.

The past decade has seen substantial investments into India via Mauritius because of a favorable tax treaty with the country. In early 2000 some tax officers started questioning some foreign financial institutions to prove their residence of Mauritius. This preliminary investigation resulted in a huge uncertainty for foreign investors and funds which approached the finance ministry. The government therefore, to quell uncertainty and a cataclysmic outflow of funds, issued a circular (No. 789 of 2000) on 13^th April 2000 clarifying that a certificate of residence issued by the Mauritius authorities should be taken as sufficient evidence of residence of Mauritius. The circular clarified that "wherever a Certificate of Residence is issued by the Mauritian Authorities, such Certificate will constitute sufficient evidence for accepting the status of residence as well as beneficial ownership for applying the DTAC accordingly". This circular was issued pursuant to the Double Tax Avoidance Convention between India and Mauritius which states that the determination of residence of a ‘person’ of Mauritius shall be made according to the laws of Mauritius where such person is liable to tax.

People’s Union for Civil Liberties (an NGO) and a retired income tax officer, Mr. Jha, filed a writ petition before the Delhi High Court challenging the validity of the circular issued by the Central Board of Direct Taxes ("CBDT"). By an order dated 31^st May 2002 the Delhi High Court quashed circular 789 of 2000 and held that the circular was ultra vires Section 90 of the Income Tax Act which allowed treaties only for the purpose of avoiding double tax not for encouraging trade and investments (as was provided in the Preamble of the Treaty). It was further held that since Mauritius charged no capital gains tax there was no question of ‘double’ taxation. It was also held that the circular took away the discretion of the income tax officer in determining the residence of a person and that right granted by statute could not be taken away by a mere circular. The High Court even decided what was not part of the arguments and stated that "Treaty shopping which amounts to abuse of the Indo Mauritius Bilateral treaty, may amount to fraudulent practice and cannot be encouraged." The High Court order thus raised uncertainty amongst foreign investors regarding their tax liability in relation to their investments in India.

On 4^th October 2002, the Global Business Institute Ltd. ("GBI"), filed a Special Leave to Petition ("SLP") before the Supreme Court of India through M/s P.H. Parekh & Co., appealing against the Delhi High Court order. GBI, is a company incorporated under the laws of Mauritius, comprising of international investors, asset managers, management companies, banks, custodians, lawyers, accountants industry/professional associations and practitioners in the financial services sector. Although GBI was not a party before the Delhi High Court, the Supreme Court allowed it to make the petition against the order since it was a person aggrieved by the order. The Government of India and the CBDT being the respondents in the proceedings before the Delhi High Court had also filed a similar appeal before the apex court.

The SLPs filed by GBI and the Government of India, were heard together. Amongst other grounds, both SLPs challenge the power of the Indian income tax officers to question residency of a Mauritius entity since determination of such residency is the sovereign right of the Mauritius government. It is analogous to the issue of a passport of a foreign country, which unless forged should be taken as sufficient proof of citizenship.

After hearing both sides for several weeks the court finally pronounced its judgment on the 7^th October 2003 reversing the order of the Delhi High Court. The rationale for the Supreme Court order in brief is as follows.

• The charging section of the IT Act (sections 4 and 5) are made subject to the Act and therefore also to S. 90. The Agreement therefore prevails over the Income Tax statute. Unless the treaty gives away something which the Income Tax Act charged, the treaty would be meaningless.
• The circular would prevail even over the IT Act as per the terms of S. 90(2) of the IT Act.
• The circular falls within the provisions of the Section and is not ultra vires S. 119.
• "If in the teeth of this clarification, the assessing officers chose to ignore the guidelines and spent their time, talent and energy on inconsequential matters, we think that the CBDT was justified in issuing ‘appropriate’ directions vide circular No. 789, under its powers under Section 119, to set things on course by eliminating avoidable wastage of time, talent and energy of the assessing officers discharging the onerous public duty of collection of revenue."
• The argument that the treaty itself is beyond Section 90 of the Act "deserves short shrift" merely "on account of its susceptibility to treaty shopping on behalf of the residents of the third countries".
• Liability to pay tax is not the same thing as actual payment of tax. Therefore one does not need to pay tax so long as one is liable to pay tax in Mauritius. "It is, therefore not possible for us to accept the contentions so strenuously urged on behalf of the respondents that avoidance of double taxation can arise only when tax is actually paid in one of the Contracting States."
• Treaty shopping – "It is urged by the learned counsel for the appellants, and rightly in our view, that if it was intended that a national of a third State should be precluded from the benefits of the DTAC, then a suitable term of limitation to that effect should have been incorporated therein." The Mauritius treaty is contrasted with the Indo-American treaty which specifically provides for such a term. The court rhetorically asks (referring to third country residents) "can they be denied the benefit on some theoretical ground that treaty shopping is unethical and illegal?"
• The court states that if there are abuses such as reported by the Joint Parliamentary Committee of Indian residents misusing the treaty for manipulation of the stock market etc. then the legislature and the regulator are free to take appropriate steps.
• Treaties are a result of political bargaining and there are several considerations behind entering into such agreements. "In developing countries, treaty shopping is often regarded as a tax incentive to attract scarce foreign capital or technology…In this respect, it does not differ much from other similar tax incentives given by them, such as tax holidays, grants, etc."
• "The loss of tax revenues could be insignificant compared to the other non-tax benefits to their economy." Such practices might appear to be evil but "are tolerated in a developing economy, in the interest of long term development."
• The court found that not every attempt at tax planning is illegitimate. Citing an authority the court endorsed "The legal right of a taxpayer to decrease the amount of what otherwise would be his taxes, or altogether to avoid them, by means which the law permits, cannot be doubted." The court should not be guided by the assessee’s real motive and must deal with what is tangible in an objective manner.
• We are unable to agree with the submission that an act which is otherwise valid in law can be treated as non-est merely on the basis of some underlying motive supposedly resulting in some economic detriment or prejudice to the national interests, as perceived by the respondents.

The Court has thus endorsed the treaty and the circular and has refused to interfere in what is essentially a legislative and executive function.

PS. The Court’s use of Macbeth strategically and sardonically is amusing.