The ITAT recently dismissed an appeal and slammed Cognizant India Private Limited (“Cognizant India”) for what it perceived as using a colorable device to evade taxes during its INR 190 billion share buyback exercise.
Cognizant (Mauritius) Limited (“Cognizant Mauritius”) and Cognizant Technology Solutions Corporations USA (“Cognizant USA”) held around 76% and 22% stake in Cognizant India respectively. The remaining 2% minor shareholding was also held by USA based entities.
In the year 2016, Cognizant India had entered into a scheme of arrangement to acquire all of Cognizant USA and a portion of Cognizant Mauritius shares, following the regulations outlined under Section 391 to 393 of the erstwhile (Indian) Companies Act, 1956 (“Companies Act”). The scheme was approved by Madras High Court on April 18, 2016 and accordingly, Cognizant India had purchased its 94,00,534 equity shares from its shareholders at the price of INR 20,297 per share for a total consideration of INR 190.80 Billion. In furtherance to the transaction, Cognizant Mauritius had become 99.87% shareholder in Cognizant India.
For the purposes of tax, Cognizant India treated the amount payable to its shareholders as capital gains under the provisions of the Income tax Act, 1961 (“IT Act”). Accordingly, it withheld capital gains taxes on the amounts paid to Cognizant USA and other USA based minority shareholders. With respect to amounts payable to Cognizant Mauritius, it claimed the capital gains tax exemption available under India-Mauritius Double Taxation Avoidance Agreement (“DTAA”). As a result, no taxes were withheld on these payments.
The Indian Revenue Authorities (“IRA”) initiated proceedings against Cognizant India by stating that the transaction contemplated in the scheme should be considered as capital reduction in terms of Section 100-104/402 of the Companies Act. This assertion implied that the payment made for the purchases of its own shares, using accumulated profits, should be viewed either as ‘distribution of dividends which entails release of assets of the company’ under Section 2(22)(a) of the IT Act or alternatively, as ‘distribution of dividend through capital reduction’ as defined in Section 2(22)(d) of the IT Act. In both the cases, Cognizant India ought to have paid dividend distribution tax (“DDT”) under the 115-O of the IT Act. The first appellate authority upheld the order of the IRA.
Cognizant India appealed against the said order before the ITAT. It contended that scheme, as approved by the High Court, had expressly provided that the provisions of Section 2(22) of the IT Act or 115-O of the IT Act are not applicable on the purchase of equity shares by the company from its shareholders. It had also contended that dividend is paid without any quid pro quo i.e. the company was free to distribute dividend on its own. However, in the instant case, consideration was paid by Cognizant India as per the terms of the contract pertaining to purchase of its own shares. It had also contended that scheme should be construed as judgment in ‘rem’ and, therefore, the IRA should be debarred from taxing the transaction.
The ITAT had held the release and distribution of a company’s assets in any form would be considered as ‘dividends’ for the purposes of Section 2(22) of the IT Act and that the word ‘distribution’ does not contain any aspect of quid pro quo or lack thereof. It held that share capital of Cognizant India had been reduced by around INR 9.40 crore, which is equivalent to 54.70% of the total paid-up capital. which establishes that the instant transactions is a capital reduction under section 2(22)(d) of the IT Act. It had also dismissed the arguments of Cognizant India pertaining to judgement in ‘rem’ by referring to the portion of the order of the High Court which clearly specified that no immunity from payment of taxes was granted to Cognizant India.
The ITAT reprimanded Cognizant India by holding that it is trying to deploy questionable strategy to somehow bring it under the ambit of capital gains for the purposes of engaging in treaty shopping. It held that the transaction was a colourable device intended to evade legitimate taxes.
Accumulated profits of the company are usually distributed as dividends or used for purchasing the shares back from the shareholders. As per the DDT regime, companies that distribute dividends are required to pay DDT at the effective rate of 20.56% on the gross dividends and there is no further liability on the shareholders. However, in case shares are bought back under the buy-back regime of the Companies Act, buy-back tax shall have to be paid by company at effective rate of 23.296%.
If a transaction falls outside the ambit of the aforementioned scenarios, then the primary tax liability would be shifted to shareholders. This has allowed the shareholders to structure their shareholding to claim tax treaty benefits by treating it as capital gains. In the instant case, the scheme specifically provided that the transaction was neither a buy-back of shares nor a dividend, based on which Cognizant India had claimed that the consideration should be taxed in the hands of shareholders, after providing tax treaty benefits. However, the ITAT considered the transaction in a holistic manner and decided to deny the benefits of tax treaty.
This will significantly impact companies planning to devise tax-efficient structures for their future corporate re-organizations. Going forward, tax authorities are likely to bank on this decision to minutely examine the business exigencies of such corporate restructurings Moreover, with other anti-abuse provisions like general anti-avoidance rules in their arsenal, the tax administrators are expected to be stricter in terms of their evaluation of a purposive transaction whereas the taxpayers have their tasks cut out! It is imperative they proceed with extreme caution, consider all relevant facts and ensure such transactions are driven by business exigencies rather than solely by tax- considerations.
 DDT under section 115-O of the IT Act is not applicable for any distributions made on or after April 01, 2020.