Tax Hotline August 04, 2014

Delhi High Court Upholds Mauritius Route: CCD Transfer On Exercise Of Option Taxed As 'Capital Gains'

  • Transfer of a ‘Compulsorily Convertible Debenture’ to a third party taxable as ‘capital gains’ and not ‘interest’;
  • Provision of exit options does not change the nature of the investment and does not allow re-characterization;
  • FDI Policy allowing for CCD investment would be enough rationale for FDI through the route;
  • ‘Look at’ principle followed and benefits under the India-Mauritius tax treaty upheld on sale of CCDs.

In a landmark decision, the Delhi High Court (“Court”), in the case of Zaheer Mauritius v. DIT1, has set aside the ruling of the Authority for Advance Rulings (“AAR”) in Z, In re:2 (Please click here for our hotline on this ruling) and has held that income arising from the sale of Compulsorily Convertible Debentures (“CCDs”) on exercise of a call option by a Mauritian resident company can be characterized only as ‘capital gains’ and not as ‘interest’ and that such income should not be taxable in India owing to the benefits provided under the India-Mauritius Double Taxation Avoidance Agreement (“DTAA”).


Zaheer Mauritius Limited (“Petitioner”) is a Mauritius resident company that is engaged in the business of investment into Indian companies engaged in the construction and development business. Vatika Limited (“Vatika”) is an Indian company inter alia engaged in the development and dealing of real estate. SH Tech Park Developers Private Limited (“JV Company”) is an Indian private limited company and a wholly owned subsidiary of Vatika.

Vatika was the owner of a tract of land in Gurgaon, Haryana which was proposed to be developed as a cyber park (“Land Parcel”). In order to garner investment for this project, in August, 2007, the Petitioner agreed to acquire 35% ownership interest in the JV Company by way of subscription to a combination of zero coupon CCDs (compulsorily convertible after 3 years from first closing) and equity, evidenced by a Share Subscription Agreement (“SSA”) and a Shareholders’ Agreement (“SHA”). The SHA recorded the relationship between the Petitioner, Vatika and the JV Company, including matters relating to transfer of interest amongst each other and management. The SHA also provided for a call option for Vatika, which if exercised prior to 3 years from first closing, the Petitioner would be entitled to the value of the investment plus a fixed return. However, if the call option was exercised after the expiry of 3 years, the price would include an ‘equity component’ equal to 10% of the project value. Likewise, a put option was given by Vatika to the Petitioner to sell to Vatika all the aforementioned securities after the expiry of 5 years from first closing for a price which would also include the above mentioned ‘equity component’.

Further, in November, 2007, Vatika and the JV Company entered into a Development Rights Agreement by which Vatika transferred the exclusive development rights, entitlements and interest in the Land Parcel to the JV Company. In 2010, prior to completion of 3 years from the first closing, Vatika exercised the call option and purchased the CCDs from the Petitioner in multiple tranches. Vatika approached the tax officer for a nil withholding certificate for the income earned contending that it was exempt from tax in India under the India-Mauritius DTAA. The tax officer, however, rejected the application and asked Vatika to deposit the withholding tax on this transaction. The Petitioner subsequently approached the AAR for an advance ruling on the issue.

After hearing the Petitioner’s case, the AAR re-characterized the income arising on such disposition as interest income and not capital gains income on the basis that a CCD is in the nature of a debt till conversion and income arising from a CCD should be considered interest income, regardless of the fact that the income has arisen on sale. Aggrieved by such finding, the Petitioner challenged the ruling before the Court by way of a writ petition.


Before the Delhi High Court, the Petitioner contended that the AAR had failed to appreciate that there was no debtor-borrower relationship between Vatika and the Petitioner while concluding that the income was in the nature of ‘interest’. On this basis, it was urged that the CCDs were held by the Petitioner as ‘capital assets’ and gains arising on their transfer should only be treated as ‘capital gains’. Further, the Petitioner also used this rationale to oppose the AAR’s finding that the transaction in question was a loan in disguise and used the terms of the SHA to question the AAR’s lifting of the corporate veil and finding that Vatika and the JV Company were in fact a single entity.

On the other hand, the revenue opposed the admission of the writ petition on jurisdictional grounds contending that the AAR’s ruling was ‘reasoned’. Further, the revenue strongly contended that the transaction was essentially in the nature of an External Commercial Borrowing (“ECB”) since the Petitioner was entitled to receive a fixed rate of return and the duration of the investment would determine the quantum of return receivable. On this basis, the revenue argued that the transaction was modelled in this manner solely for the avoidance of tax.


The Court, after hearing all contentions put forth by the parties, arrived at the following conclusions:

No fixed return owing to options: The Court noted that the AAR had relied on the provisions providing for the call/put options in the SHA to arrive at the conclusion that the Petitioner would receive a fixed rate of return. After an analysis of the SHA, the Court rejected this finding and held that the call/put options were only options available to the contracting parties and that the mere provision of exit options in an investment agreement would not change the nature of the investment. The Court noted that it is common in any joint venture agreement for the parties to include covenants for buying each other’s stake and although the SHA enabled the Petitioner to exit the investment by receiving a reasonable return, the same could not be read to mean that the CCDs were fixed return instruments, since the Petitioner also had the option to continue as an equity shareholder of the JV Company (after conversion).

No single entity owing to separate control and management: The Court also noted that the AAR had ruled that Vatika and the JV Company were in essence a single entity on the basis of a finding that Vatika had all management and control over the JV Company’s business. After perusing material provisions of the SHA concerning composition of the board, board meetings, quorum, voting, affirmative vote items, auditor appointment, related party transactions, bank accounts etc. of the JV Company, the Court rejected this finding of the AAR. The Court noted that the Petitioner was entitled to nominate directors on the board of the JV Company and at least 1 director nominated by the Petitioner was required to constitute valid quorum. Further, the Court noted that all vital decisions required the consent of both the Petitioner and Vatika. The Court also noted that Vatika was refrained from influencing decisions involving the transfer of development rights over the Land Parcel and that all related party transactions were to be on an arm’s length basis. On the basis of the above, the Court concluded that the affairs of the JV Company were to be managed independent of Vatika and that they could not be held to be a ‘single entity’ through lifting of the corporate veil.

No tax avoidance owing to commercial rationale: Finally, the Court considered the contention as to whether the transaction was modelled for the avoidance of tax. The Court noted that the FDI Policy3 allows 100% Foreign Direct Investment (“FDI”) in the construction and development industry under the automatic route subject to conditions as to minimum built-up area, capitalization etc. Further, it was noted that CCDs were recognized as equity instruments under the FDI Policy as long as they are fully and mandatorily convertible into equity shares. Consequently, the Court held that since Government policy allowed for the Petitioner to invest in a project of the requisite size/nature by way of CCDs and since the policy with regard to ECBs had other conditions, there was sufficient commercial rationale in the fact that the Petitioner found CCDs as the most appropriate route for the investment. Further, the Court held that if the income would be considered ‘interest’, the same would be deductible in the hands of Vatika which would be erroneous. On this basis, relying on the ‘look-at’ principle laid down by the Hon’ble Supreme Court in Vodafone4, the Court held that the entire transaction must be looked at as a whole without adopting a dissecting approach and therefore, held that the present transaction cannot be held to have been structured for the avoidance of tax.


In a welcome decision, the Court has reversed a much criticized decision of the AAR wherein it had indulged in an overzealous use of judicial anti-avoidance. As upheld by the Hon’ble Supreme Court in Azadi Bachao Andolan5 and Vodafone6, the form of a transaction must be respected as long as the same is justified by commercial rationale and a wide re-characterization by a court or tribunal should not be permissible. Further, in the absence of thin capitalization rules and prior to the General Anti-Avoidance Rules (“GAAR”) coming into effect in India where certain criteria would need to be fulfilled, a broad re-characterization of debt into equity and vice versa is not in accordance with accepted principles of tax law in India. Further, two separate entities cannot be considered to be the same as long as any element of the separation in their control and management is proven. In the present case, the Court has analyzed the SHA in detail and has looked at certain key factors such as board composition, quorum requirements, affirmative rights on vital matters etc. to determine control and management which may be looked upon as indicative factors for such determination in the future. Since the Court has emphasized on the commercial rationale involved in the present case, it is to be seen if demonstration of such rationale should be considered sufficient to avoid the rigours of the GAAR as well once made applicable.

Most importantly, the Court has upheld the principle that the mere existence of exit options under an investment agreement will not change the nature of the investment. The existence of a call/put option in respect of all securities is common in respect of most deals undertaken by private equity investors and is usually designed to provide downside protection besides other exit options. This decision will therefore, serve as a respite for private equity investors whose exits through options have been questioned by the tax authorities.

This decision has given much needed clarity that although a debenture is a debt instrument, a transfer of a debenture to a third party can only result in ‘capital gains’ and not interest income. One may assume that the same logic may be applied to redemption of a debenture since this would result in a ‘transfer’ as well, even though a debtor-creditor relationship is existing between the parties. If the spirit of this decision is respected by the tax authorities going forward, this may serve as a respite to the real estate industry where investment by way of private debt is commonplace. Further, the recognition of the Court that investment in Indian real estate by way of CCDs under the FDI Policy is a commercially viable structure, to escape the rigidities of the ECB Guidelines, would act as a positive spur for real estate investment into India

Finally, as a major relief for investors holding Indian investments through Mauritius based companies, the Court has upheld the validity of the ‘Mauritius route’ once again as enshrined by the Hon’ble Supreme Court in Azadi Bachao Andolan7 and Vodafone8 and by the CBDT through various circulars and notifications9. Since the Court has noted that the Petitioner is engaged in the business of making investments into India in the present case, it has impliedly endorsed the fact that the establishment of an entity in Mauritius for such purpose would have sufficient commercial rationale and that the entity would be eligible for benefits under the India-Mauritius DTAA.

Sriram Govind & Rajesh Simhan

You can direct your queries or comments to the authors

1 W.P.(C) 1648/2013 & CM NO.3105/2013.

2 (2012) 345 ITR 11 (AAR – New Delhi).

3 Press Note 2 of 2005 issued by the Department of Industrial Policy & Promotion

4 (2012) 6 SCC 613.

5 (2004) 10 SCC 1.

6 Supra.

7 Supra.

8 Supra.

9 Circular No. 789 of 2000; Circular No. 1 of 2003; Press Release for Notification dated March 1, 2013.

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