ITAT

Dividend Distribution or Reduction of Share Capital: DDT’s Long Shadow on Cognizant

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Dividend Distribution Tax (‘DDT’) – abolished in April 2020 – was one of the most contested taxes in India as it taxed dividends in hands of companies which distributed dividends. Making companies liable to pay dividend tax was opposite to widely followed classical system of dividend taxation wherein dividends are taxed in the hands of shareholders. The various questionable policy reasons for introduction of DDT aside, DDT also created incentives for companies to find innovative ways to put money in the hands of its shareholders without declaring dividends. One such alternative way was buyback of shares. The alternate means of transferring money in hands of shareholders has been questioned in various cases, most recently and prominently in the Cognizant ruling by ITAT Chennai – currently under appeal before the Madras High Court – where Cognizant was held liable to pay DDT of Rs 19,000 crores (appx.). I look at ITAT’s decision and analyze whether ITAT has imposed tax liability on Cognizant based on persuasive reasons or otherwise.  

Scheme of Amalgamation and Tax Payments  

M/s Cognizant Technology Solutions India Pvt Ltd. (‘assessee’) purchased its own shares from non-resident shareholders under a ‘Scheme of Amalgamation & Compromise’ sanctioned by the Madras High Court under sections 391-393 of the Companies Act, 1956. The scheme was sanctioned in April 2016, when DDT was still in force. The result of the scheme and buyback of shares by the assessee was that the shareholding of its Mauritius based shareholders increased while that of the US-based shareholders decreased. Thus, a significant capital base of the assessee moved to Mauritius because of the scheme. Though the assessee maintained that its reasons for restructuring were corporate structure streamlining, improving earnings per share, reduce fluctuations in terms of foreign currency fluctuations, and improving overall capital structure of the company.  

After approval of the scheme, in Financial Year 2016-17, assessee bought back 94,00534 equity shares of face value of Rs 10 each from its shareholders at a price of Rs 20,297/ per share. Assessee deducted TDS before making payments to the US -resident shareholders since their capital gains arose in India but did not withhold tax for its shareholder resident in Mauritius because the transaction was not liable to tax in India as per the India-Mauritius DTAA.

Revenue’s Arguments for Levy of DDT 

The Revenue’s contention was that the consideration paid by assessee to its own non-resident shareholders comes within the ambit of Section 2(22)(a)/2(22)(d) of the IT Act, 1961 and the assessee is liable to pay DDT under Section 115-O of the IT Act, 1961.  

Section 2(22)(a) of the IT Act, 1961 defines dividend to include any distribution by a company to its shareholders to the extent of accumulated profits of the company, whether capitalized or not, whether such distribution entails release by the company all or any part of the assets of a company. Section 2(22)(d) further includes within the definition of dividend any distribution made to the shareholders by a company on reduction of its share capital to the extent company possesses accumulated profits. 

Revenue Department’s argument was that the sum paid by the assessee after approval of its scheme by the High Court was akin to distribution of accumulated profits by a company to its shareholders, whether capitalized or not, and was taxable under Section 2(22(a), IT Act, 1961. Alternatively, the Revenue Department argued that the consideration paid by the assessee on purchase of its own shares was akin to distribution of accumulated profits on reduction of its share capital and was taxable under Section 2(22)(d), IT Act, 1961. Either way, the Revenue Department’s argument was that the consideration paid was on reduction of share capital amounted to dividend as defined under IT Act, 1961 and was thus taxable under Section 115-0 of the IT Act, 1961. 

Assessee Resists Levy of DDT 

One of the assessee’s arguments was that Section 2(22)(a)/2(22)(d) are not attracted in the impugned case since distribution of profits would imply absence of quid pro quo. While in the current case there was an offer by the company and acceptance by the shareholders and therefore there is no ‘distribution’ of profits in the true sense. Further, the provisions require that the reduction of capital should be co-terminus with distribution of profits, while in the impugned case the reduction was a result of scheme approved by the High Court. ITAT rejected both prongs of the argument: first, it noted that distribution does not require quid pro quo or lack thereof, only requirement is that the payment and disbursal of profits should be made to more than one person; second, the ITAT held that the assessee is trying to assign a hyper-technical meaning to ‘reduction of share capital’ and to attract Section 2(22)(a)/2(22)(d), it is immaterial if the reduction is a result of the scheme or otherwise. 

Assessee’s second argument was that once the scheme was approved by the High Court, the approval operated in rem and was binding on the Revenue Department. The scheme could not be re-characterised by the Revenue Department to levy taxes on the assessee. The ITAT clarified that the approval of the scheme is subject to the condition that it does not grant immunity to the assessee from payment of taxes. Also, the High Court in approving the scheme only acts an umpire to note if the conditions prescribed under the statutory provisions have been met. Finally, the ITAT clarified that the Revenue Department is not seeking to recharacterize the scheme but merely analyse its tax implications. And assessee cannot legitimately argue that the scheme once approved by the High Court excludes the applicability of IT Act, 1961.   

Assessee further contended that the reduction of its share capital was sui generis under Sections 391-393 of Companies Act, 1956 and not under Section 77. Thereby, it was taxable only via buyback tax provided under Section 115QA, IT Act, 1961. Section 115QA included only buyback of shares under Section 77A in its scope and included all other forms of buyback in its scope only from 2016 onwards. The assessee’s contention was that its buyback was not under Section 77A but under Sections 391-393 and thus the transaction was not taxable under Section 115QA. ITAT dismissed assessee’s categorization of its transaction and held that no buyback of shares can take place solely under Sections 391-393 and the buyback is necessarily read with section 100-104. Thus, no buyback of shares can take place under Sections 391-393 alone. Finally, ITAT concluded that all forms of buyback – except under Section 77A – are included in the definition of dividend since they entail release of assets of a company. And since assessee’s buyback – by its own admission is not under Section 77A – the distribution of consideration is covered by the definition of dividend.     

Use of ‘Colorable Device’ by Cognizant 

ITAT was clear and unambiguous in its conclusion that the assessee adopted a colorable device to evade taxes. ITAT noted that the ‘real intent’ of the scheme was to artificially shift the capital base of the company to Mauritius. The other reasons cited by the assessee to streamline corporate structure, increase earnings per share were discounted by ITAT. Further, ITAT noted, assessee was wished to evade taxes by resorting to buyback under general provisions instead of specific provisions, since latter would have triggered their liability to tax. Thus, ITAT concluded:

Therefore, from the facts of the present case, it is undoubtedly clear that the scheme as such is only a colourable device intended to evade legitimate tax dues. Such colourable devices which do not have any commercial purpose can be excluded for physical nullity and the AO empowered to ‘look through’ rather ‘look at’ the transactions. This is further established by the fact that there is no commercial nexus between the company activities and Mauritius and this fact has been specifically dealt by the lower authorities. (para 43)

The cumulative factors led ITAT to conclude that the scheme amounted to distribution of accumulated profits, the consideration paid amounts to dividend under Section 2(22)(a)/2(22)(d) read with Section 115-O and thus is taxable under the IT Act, 1961. 

‘Tax Exemption’ Enjoyed by Cognizant

Another fact, though should have been irrelevant, was found germane to the issue by ITAT. The ITAT noted that the assesee had enjoyed ‘tax exemption’ of Rs 30,000 crores (appx) as the assessee has accumulated profits of Rs 33,000 crores (appx) and has not declared interim dividend since 2006-07. (para 31) The assumption in this statement is that the assessee by not declaring dividends was enjoying tax exemption, since under DDT regime, tax was payable by a company only on declaration of dividend. The fact that wasn’t articulated by ITAT was that DDT was introduced to disincentivize companies from declaring dividends and encourage them to invest their profits in growth of the companies. So, fulfilling the objective of DDT amounted to enjoying a tax exemption? Also if the taxable event under DDT is distribution of dividends, and a company chooses not to distribute dividends, how does it amount to a company enjoying ‘tax exemption’? It is at best a case of tax planning. A company can choose not to declare dividend if it feels it will add to its tax liability. The decision not to declare dividend hardly amounts to ‘enjoying’ a tax exemption. Whether the impugned buyback of shares amounts to distribution of dividends should have been interpreted on its own terms, rather than making prior dividend policy of the assessee relevant to determine its tax liability.  

Conclusion 

ITAT relied heavily on the facts to characterize assessee’s transaction as a colorable device intended to evade tax under the IT Act, 1961. The use of general provisions of Sections 391-393 instead of specific provision of Section 77A to buyback its shares, hyper technical interpretation of reduction of capital and distribution of profits, all were interpreted against the assessee to term the scheme as a colorable device intended to evade DDT. The factual matrix – as captured in ITAT’s decision – certainly doesn’t seem to favor the assessee and even the definition of dividend is wide enough to include the distribution of profits – even if as part of buyback – under the scope of DDT. Whether the arguments and facts are argued and interpreted in a different manner in the High Court and whether any other factors are considered in determining the tax liability of assessee will be known soon. 

But, ITAT seems to have stacked the odds against assessee especially by making it prior dividend policy relevant to the impugned case. However, ITAT’s decision is heavily reliant on the interpretation of the definition of dividend which inter alia includes distribution of profits, a stipulation which is certainly fulfilled in the current case. The assessee’s arguments that there was quid pro quo and thus there was no distribution of profits, and that reduction of share capital was a result of the scheme and not co-terminus with distribution do not hold much water. The assessee’s arguments come across as ‘hyper-technical’ as ITAT rightly pointed out. It is to be seen whether assessee adopts alternate or additional arguments in the High Court.              

Citing DIN in Communication is Necessary: ITAT, Chandigarh

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Income Tax Appellate Tribunal, Chandigarh (ITAT) in its recent decision[1] followed the decisions pronounced by the Delhi High Court and the Bombay High Court which had held that quoting DIN in the body of communication issued by the Income Tax Department is mandatory by strictly interpreting CBIC’s Circular. ITAT held that the Income Tax Department cannot take recourse to Section 293B, IT Act, 1961 and argue that the error of not quoting the DIN does not affect the validity of the communication. 

Facts 

The brief facts of case are: the assessee filed its return of income and the relevant assessment proceedings were completed. But subsequently after search proceedings in the assessee’s premises were completed, the Assessing Officer (‘AO’) stated that some of assessee’s income had escaped assessment due to assessee’s failure to fully and truly disclose certain materials. AO added additional income and passed a reassessment which was challenged by the assessee. One of the grounds of challenge before ITAT was that the AO did not follow the prescribed procedure, the assessment order was not uploaded on the e-filing portal of the assessee and was communicated via courier without mentioning the DIN. The ITAT noted that the ground relating to not mentioning the DIN was the heart of the matter and adjudicated on it on priority. And ITAT’s ruling on the said issue proved crucial to assessee’s success in the case. 

Arguments 

The arguments on the issue of DIN were simple: the assessee argued that not quoting DIN in the communication issued by the Income Tax Department was contrary to CBIC’s Circular and thus liable to be struck down. The assessee elaborated that DIN was mentioned in the demand notice, but not in the reassessment order. And both the notice and order are required to be issued under different provisions of the statute, are separate communications and thus require their own DIN. In essence, the assessee’s case was that omission to cite DIN in the body of the reassessement order was fatal and in direct contravention of the CBDT’s Circular and thus should be struck down. 

The Income Tax Department tried to justify the non-citation of DIN in the body of assessment on various grounds, two of which included: first, that the demand notice and assessment order were not two separate communications and thus the latter did not require a separate DIN; second, that the omission of DIN can be saved by Section 292B, IT Act, 1961. Section 292B states that any return of income, assessment, notice, summons or other proceedings issued or purported to have been issued under the provisions of IT Act, 1961 shall not be invalid merely by reason of any mistake, defect, or omission if such communication is in substance and effect in conformity with or according to the intent and purpose of IT Act, 1961. 

ITAT’s Decision 

ITAT cited the CBDT Circular and arrived at the prudent conclusion that the CBDT Circular was clear in its mandate that the Income Tax Department shall not issue any communication without generating a DIN and quoting it in the body of the communication. No relaxation is provided in the Circular except when manual communication may be issued with prior approval of the Principal Commissioner. The ITAT also noted that the CBDT Circular clearly provided that in the absence of adherence to the conditions prescribed, it shall be presumed that the communication is invalid and deemed to have never been issued. 

The reassessment order, the ITAT held, was issued contrary to the conditions prescribed in the CBDT Circular, i.e., it did not cite the DIN in its body nor did it adhere to the conditions prescribed for issuing manual communication. Thus, it held the impugned communication to be invalid. 

ITAT did not accept any of the Income Tax Department’s arguments. It held that while the demand notice and the subsequent assessment order were part of the same assessment proceedings and their close connection cannot be denied. However, the demand notice is passed under Section 156, IT Act, 1961 while an assessment order is passed under Section 143 read with Section 147 of the IT Act, 1961. And more importantly it noted that no exception was provided in the CBDT Circular regarding issuance of successive communications to the same assessee, on the same date and regarding the same assessment year. ITAT concluded that: 

Therefore, in the instant case, we find that assessment order and notice of demand are two separate communications qua the assessee and carry separate physical existence and identity, even though issued on the same date by the same Assessing officer pertaining to same assessment year and therefore, necessarily have to carry separate DIN on the body of the said communications. In view of the admitted position that there is no DIN on body of the assessment order (even though there is DIN on body of the notice of demand), the same will continue to be non- compliant with paragraph 2 of the CBDT Circular no. 19/2019 and carry the same consequences in terms of paragraph 4 of the CBDT Circular and will be held as invalid and never been issued. (para 21) 

The Income Department was not allowed to take recourse to Section 292B as the ITAT relied on the relevant precedents to state that the language used in the CBDT Circular did not leave room for any alternate view or leeway and the said Circular is binding on the revenue as per Section 119, IT Act, 1961. The ‘phraseology’ used in paragraph 4 of the CBDT Circular which states that a communication shall be treated as never issued was relied on to conclude that Section 292B was inapplicable to the impugned case. 

Conclusion 

The ITAT’s decisions follow what is now a growing body of jurisprudence on the issue with several High Courts and ITATs deciding that not quoting DIN in the body of communication is fatal to the communication and contrary to CBDT’s Circular. The ITAT in this decision reiterates the earlier decisions with the additional input that demand notices and assessment orders cannot be treated as a single communication and are separate orders requiring their own DIN. As I stated in my recent post on ITAT Chennai’s decision on the same issue, decisions that strictly interpret CBDT’s Circular are welcome and hold them the Income Tax Department to standards that itself has prescribed for its officers.  

[1] M/s SPS Structures Ltd v The DCIT Central Circle-1, Chandigarh TS-791-ITAT-2023. 

Tax Residency Certificates Cannot be Questioned: ITAT Delhi Pronounces Two Similar Decisions 

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The Income Tax Appellate Tribunal (‘ITAT’), New Delhi pronounced two decisions on 10 and 11 August 2023 and in both of them it reiterated one of the core observations of Supreme Court in the Azadi Bachao Andolancase[1], i.e., Indian Revenue officials cannot go beyond behind the Tax Residency Certificate (‘TRC’) issued by competent authorities of another jurisdiction. Further, the ITAT held that mere allegations of tax evasion and use of conduit companies are not sufficient to deny an assessee benefits under the Double Taxation Avoidance Agreement (‘DTAA’) unless the allegations are backed by cogent evidence. 

Introduction

In the Sarva Capital case[2], the issue before the ITAT was taxability or otherwise of capital gains from sale of equity shares under Article 13(4) of the Indo-Mauritius DTAA. The assessee was a non-resident corporate entity incorporated under the laws of Mauritius and a tax resident of Mauritius. During its business, assessee purchased equity shares in Indian companies and in the assessment year in question sold those equity shares and made capital gains. The assessee offered the income from sale of equity shares as capital gains but claimed exemption under Article 13(4) of the Indo-Mauritius DTAA. 

In the Sarva Capital case, the Assessing Officer denied assessee benefits under DTAA by stating various reasons which inter alia included that tax residency certificate issued by Mauritius is not sufficient to establish its residency if the substance proves otherwise. Additionally, the Assessing Officer argued that the assessee was not the beneficial owner of the income, it was just a conduit and had no commercial rationale for incorporation in Mauritius to argue that the substance proves that the assessee was incorporated in Mauritius only as part of a tax avoidance arrangement and thus was not entitled to benefits under the DTAA.    

In a similar set of facts, in the Leapfrog Financial case[3], the ITAT had to adjudicate if the assessee was entitled to benefit of Indo-Mauritius DTAA for income from capital gains derived from sale of shares. The assessee was a non-resident corporate entity incorporated under the laws of Mauritius and a tax resident of Mauritius. The assessee sold certain unlisted shares of a company and claimed that the resultant long-term and short-term capital gains were exempt from taxation under Article 13(4) of the Indo-Mauritius DTAA. 

And just like in the Sarva Capital case, in the Leapfrog Financial case too, the Assessing Officer denied the assessee benefit of tax exemption under the Indo-Mauritius DTAA by claiming that the assessee had been interposed as an entity only for the purpose of deriving benefits under Indo-Mauritius DTAA and for tax avoidance purposes. The Assessing Officer applied the doctrine of form over substance to deny assessee tax benefits under the DTAA and proceeded to tax it under domestic law. 

Against decision of the Assessing Officer in each of the cases, the assessees approached the ITAT Delhi which overruled the Assessing Officers in both cases to decide in favor of the assessees. 

Tax Evasion Allegations and Tax Residency Certificate 

In the Sarva Capital case, while deciding the residency status of the assessee, the ITAT relied on the Azadi Bachao case and the recent decision of the Delhi High Court in Blackstone Capital case[4] to reiterate that tax authorities in India cannot go behind the tax residency certificate issue by competent tax authorities of other jurisdictions and that the tax residency certificate is sufficient to claim not only legal and residential ownership but also treaty benefits. The ITAT concluded that the Assessing Officer committed a ‘fundamental error’ in denying DTAA benefits to the assessee despite the fact that the assessee possessed a valid tax residency certificate. (para 15)

 In the Leapfrog Financial case, the ITAT made similar observations and stated that Indian tax authorities cannot go beyond the tax residency certificate issued by another jurisdiction. It cited observations of the Supreme Court in the Azadi Bachao Andolan case to conclude that Revenue authorities cannot question the assessee’s residential status and entitlement to treaty benefits. (para 16) In this case, the ITAT specifically questioned the Assessing Officer’s allegations that the assessee was a conduit company and noted that despite making such allegations there is nothing on record to show the Assessing Officer invoked provisions under Chapter XA, i.e., GAAR provisions of the IT Act, 1961. The ITAT concluded:

Thus, in our view, the reasonings of the Assessing Officer to treat the assessee as a shell/conduit company to deny the benefits under India Mauritius tax treaty is without any substance as they are not backed by any credible evidence. (para 13)  

Conclusion 

 The above discussed ITAT Delhi decisions reiterate a fundamental aspect of international tax jurisprudence that was unequivocally laid down by the Supreme Court in the Azadi Bachao Andolan case, i.e., Indian tax authorities cannot question the veracity and authenticity of the tax residency certificate issued by competent authorities of other jurisdictions. While there is little to find fault with the ITAT decisions on this point, the fact that Assessing Officers can and continue to ignore the ratio of Azadi Bachao Andolan case in their attempt to deny DTAA benefits to assessees is not a great example of efficient and rigorous tax governance. And, as the ITAT rightly pointed out in the Leapfrog Financial case, if there is merit of allegations of tax avoidance by the assessee, then the Assessing Officer should not hesitate to apply GAAR provisions. Else, allegations of tax avoidance and that the Mauritian company of the assessee is used as a conduit for investments are merely empty rhetoric and not specific allegations backed by concrete evidence.  

[1] Union of India v Azadi Bachao Andolan (2004) 10 SCC 1. 

[2] Sarva Capital LLC v ACIT ITA No. 2289/Del/2022. 

[3] Leapfrog Financial Inclusion India (II) Ltd v ACIT ITA Nos. 365 & 3666/Del/2023. 

[4] Blackstone Capital Partners (Singapore) VI FDI Three Pte Ltd v ACIT 2023/DHC/000634.  

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