High Court interprets word ‘substantially’; lays down 50% threshold limit for indirect transfer of capital assets

Gains arising from sale of a shares of a company incorporated overseas, which derives less than 50 per cent of its value from assets situatedd in India would not be taxable under section 9(1)(i), read with Explanation 5 thereto.

Facts:

The issue that arose for consideration of the High Court was: Whether the sale of shares of an overseas company which derives only a minor part of its value from the assets located in India could be deemed to be situated in India by virtue of Explanation 5 to section 9(1)(i)?

The High Court held in favour of assessee as under:

1)A plain reading of Explanation 5 to section 9(1)(i) suggests that it was always the intention of the Legislature that an asset, which derived its value from assets in India, had to be considered as one, which was situated in India. The clear object of section 9(1)(i) was, inter alia, to cast the net of tax also on income which arose from transfer of assets in India, irrespective of the residential status of the recipient of the income. Explanation 5 introduced a legal fiction for the limited purpose of imputing that assets which substantially derive their value from assets situatedd in India would also be deemed to be situated in India;

2)It is trite law that a legal fiction would be restricted to the purpose for which it was enacted. The object of Explanation 5 was not to extend the scope of section 9(1)(i) to income, which had no territorial nexus with India, but to tax income that had a nexus with India, irrespective of whether the same was reflected in a sale of an asset situated outside India. There would be no justification to read Explanation 5 to provide recourse to section 9(1)(i) for taxing income which arises from transfer of assets overseas and which do not derive bulk of their value from assets in India.

3)In this view, the expression 'substantially' occurring in Explanation 5 would necessarily have to be read as synonymous with 'principally', 'mainly" or at least 'majority'. The 'United Nations Model Double Taxation Convention between Developed and Developing Countries' and the 'OECD Model Tax Convention provide that the taxation rights in case of sale of shares are ceded to the country where the underlying assets are situated only if more than 50 per cent of the value of such shares is derived from such property.

4)In view of the above, gains arising from sale of a share of a company incorporated overseas, which derives less than 50% of its value from assets situated in India would certainly not be taxable under section 9(1)(i), read with Explanation 5 thereto.

5)Thus, in the instant case, even if the transaction had been structured in the manner as suggested on behalf of the Revenue, the gains arising to the shareholders would not be taxable under Section 9(1)(i), as their value could not be stated to be derived substantially from assets in India. – DIT (International Taxation) v. Copal Research Ltd., Mauritius [2014] 49 taxmann.com 125 (Delhi)