While going through the recent judgements of the Income Tax Appellate Tribunal (“ITAT”), I came across this interesting decision issued by the Mumbai bench of ITAT in relation to transfer of shares of a company called Century Enka Limited (“CEL”), wherein the ITAT has given certain guiding principles as to what is meant by a reorganization of the business or arrangement which are relevant for claiming the tax benefits under the Double Taxation Avoidance Agreement (“DTAA”) entered between India and the Netherlands.

Facts of the case

This case is between Accordis Beheer BV (“AB”) and Director of Income Tax, Mumbai (“DoIT”). AB held 38.24 % of shares in CEL and had tendered certain portion of its holding through a High Court approved scheme of arrangement under which CEL had bought back the shares resulting in capital gains of INR 58.64 crores to AB.

AB, upon a claim being raised by the income tax authorities cited Article 13(5) of the India-Netherland DTAA and contended that the capital gains is not taxable in India, which was not acceptable to the authorities. Accordingly, the parties went to the ITAT for its ruling. While we shall review the other contentions of the party later, I would like to firstly apprise you as what constitutes Article 13 of the DTAA. This article relates to the capital gains earned by the resident members of either state.

The said article from the DTAA is given below for ready reference:

“5. Gains from the alienation of any property other than that referred to in paragraphs 1, 2, 3 and 4 shall be taxable only in the State of which the alienator is a resident. However, gains from the alienation of shares issued by a company resident in the other State which shares form part of at least a 10 per cent interest in the capital stock of that company, may be taxed in that other State if the alienation takes place to a resident of that other State. However, such gains shall remain taxable only in the State of which the alienator is a resident if such gains are realised in the course of a corporate organisation, reorganization, amalgamation, division or similar transaction, and the buyer or the seller owns at least 10 per cent of the capital of the other…”

The income tax authorities (referring to the bold section above) held that since the company in question, i.e. CEL, is based in India, the shares tendered under the buyback were more than 10% of the capital stock and the shares were transferred to an Indian resident, again CEL, the transaction was taxable in India.

However, AB in its contentions held the non-applicability of the said provisions referring to the same article (the one underlined above) contended that the capital gains had arisen due to the corporate reorganization scheme under the approval of the High Court and hence the taxability of the transaction is in Netherland, the state of its residency.

ITAT’s decision

The decision of the ITAT in the said case depended primarily on two factors a) would the transaction of buyback of CEL constitute “reorganization”, and b) would it also be a scheme of “arrangement” qualifying for the DTAA.

As there is no definition of the term reorganization, the ITAT has relied on the definition as provided in the Dictionary of Accountants which defines reorganization as a major change in the financial structure of a corporation or a group of associated corporations resulting in alterations in the rights and interests of security holders; a recapitalization, merger or consolidation. Based on the facts, ITAT held that in the current scenario there has been no major change in the financial structure of CEL which have resulted in the alteration of the rights of AB. AB still enjoys the same rights as the shareholders and of course the share capital of CEL has come down marginally due to the buyback of shares.

Further, the ITAT referring to section 390 of the Companies Act, 1956 held that the term arrangement would refer to a reorganization of the share capital of the company caused due to consolidation of shares of different classes, or by the division of shares into shares of different classes or by both those methods, which clearly was not the case in the current matter.

The ITAT also held that the entire scheme as approved by the High Court was clearly an exit route provided to AB as the buyback of shares by CEL was provided only to non-residents and the cancelation of shares post buy back didn’t result in a significant change in the financials of CEL and hence AB’s transfer of shares in the present fact pattern did not amount to “reorganization” under Article 13(5) of the DTAA. It further said that AB is not eligible to the exception provided for in the DTAA and, hence, is taxable on the buyback transaction.

Conclusion

While we are aware that any decision of the Appellate Tribunal is binding only on the parties and the Income tax authorities concerned to the said matter, we should note that this is an important decision wherein reliance has been placed on the terms reorganization and arrangement and ITAT has been very strict with AB even though it has agreed that a buy back under the court approved route is not a colorable device. While this ruling would be a guiding principle for residents doing business in either of the States, it should be kept in mind that any further amendments to the Income Tax laws would change the scenario, till then all transactions need to keep this ruling in mind.