Acknowledgement: BMR Advisors
Abhishek Singh [firstname.lastname@example.org]
Arvind Ray [email@example.com]
The Income Tax Act, 1961 (“Act“) has incorporated a scheme of advance ruling with a view to avoid and reduce disputes on the issues concerning assessment of income-tax liability concerning non-residents (and also specified categories of residents). The applicant for advance ruling can avoid expensive and time consuming litigation on any question of law or fact that might arise from normal income-tax assessment proceedings. The Authority for Advance Ruling (“AAR“) has delivered a significant ruling on 27 August 2012. The ruling brings settlement compensation paid in overseas lawsuit within the purview of the Act and makes it taxable in India. The advance ruling clarifies the legal position that even if a lawsuit proceeds abroad and under a foreign law the compensation received by virtue of settlement will be taxable in India if the cause of action arises in India. This can have significant and wide ranging impact on compensation claims against Indian companies outside India.
Brief Facts of the Case:
The shares of an Indian Company (“IC“) were listed on the Indian stock exchanges, while its American Depository Receipts (“ADR“) were listed on the New York Stock Exchange (“NYS“). The IC share prices plummeted suddenly and dramatically in the market due to an admission by its former Indian chairman that the accounts prepared as of 30 September 2008 contained some misstatements. Aggrieved by this, several lawsuits were filed against IC, the Indian arm of the IC’s auditors (“Indian Auditors“) and the foreign arm of IC’s auditors (“Foreign Auditors“), in the United States claiming damages. All the lawsuits were consolidated in accordance with the Rule 23 of the Federal Rules of Civil Procedure (“FRCP“, civil procedure rules followed by the US courts) and a class action, on behalf of the holders of ADRs, against the IC, Indian Auditors and Foreign Auditors was permitted to be filed.
The class action was settled outside the court. Under the US procedures, out of court settlements have to be approved by the US court. Under the proposed settlement, IC agreed to pay $ 125 million to the Qualified Settlement Fund (“QSF“) to be administered by QSF’s lead counsel for distributing the compensation to those qualified to participate in the class action (“Authorized Claimants“). Indian Auditors and Foreign Auditors together agreed to pay $ 25 million to QSF.
Under the terms of the settlement approved by the court (“Approved Settlement“), IC and Indian Auditors had to first deposit the settlement amount in a segregated account in India. Thereafter, the amount deposited by IC and Indian Auditors had to be transferred to an initial escrow account in New York after the initial preliminary approval of the settlement by the Court. On the other hand, the Foreign Auditors had to first deposit its share of the settlement amount in an initial escrow account in New York. After the final approval of the settlement by the US court, the settlement amount lying in the initial escrow account was to be transferred to the final escrow account to be treated as QSF. Thereafter, it had to be distributed to the Authorized Claimants.
The IC, Lead Counsel of QSF, Indian Auditors and Foreign Auditors filed separate applications for advance ruling on issues regarding chargeability of tax on payment of settlement amount under Section 195 of the Act. Section 195 of the Act mandates an Indian party, to deduct taxes while making any payment to a non-resident, which is taxable under the Indian law. Here, is a brief summary of issues raised in that applications and the decision of the AAR:
Ruling of AAR
|Whether the amount payable under the Approved Settlement is chargeable under section 195 of the Act? If so, at what point in time and at what rate income tax is required to be deducted under section 195 of the Act?||Settlement amount payable is a sum chargeable under section 195 of the Act. The IC is required to deduct tax at the rate of 30% when the settlement amount moves from the segregated account to the initial escrow account.|
|Whether the amount payable by Indian Auditors and Foreign Auditors under the Approved Settlement will be regarded as sum chargeable under the provisions of the Act, and whether the Indian Auditors and the Foreign Auditors are obligated to withhold the applicable taxes prior to transferring the funds to QSF? In addition to the withholding the taxes at the time of transfer to the initial escrow account, are the Indian Auditors and the Foreign Auditors obligated to take into account the chargeability of the settlement fund when the QFS distributes it to Authorised Claimants? Whether section 195 of the Act will apply to the QSF when it distributes the Settlement Fund to the Authorised claimants?||The amount payable to the settlement fund by Indian Auditors and Foreign Auditors will be regarded as sum chargeable under the provisions of the Act, and the Indian and Foreign Auditors are compelled to withhold taxes prior to transferring the funds to QSF. For the purpose of deduction under section 195, the Indian Auditors and Foreign Auditors are not obligated to take into account the chargeability of the settlement fund when the funds are distributed to the authorized claimants by QSF. Further any issues involving deduction of tax by QSF at the time of distribution of the fund to the Authorised Claimants is a subject matter for the US tax authorities in the, and once the tax is deducted on the fund as a whole, the obligation of QSF will end under the Act. The deduction of tax will be at the rate of 30%.|
Here is a summary of the reasoning provided by the AAR:
Nature of payment by IC, Indian Auditors and Foreign Auditors
The applicants contended that the payment of settlement amount is a waiver, release and discharge of the applicants in the class action or compensation for forbearance to sue. The attempt here was to make a distinction between receiving funds in lieu of the right to sue and receiving compensation post trial. However, the AAR rejected this contention and held that it is not a case of forbearance to sue or waiver of the right to sue. The suits filed in the US were for damages or compensation. The claim was based on liability in tort. The amount agreed to be paid under the Approved Settlement is in the nature of damages or compensation, agreed to be paid by way of settlement without going to trial and without admitting guilt or liability. The AAR’s order particularly seems to have capitalized the point that under the FRCP, the amount received by way of settlement in US litigation cannot be treated in a different fashion than a compensation received post trial. It is worth pointing out that over 95% of civil disputes in the US courts are settled prior to trial. If the AAR was to accept the contention above the majority of the settlements in the US courts would not be taxable. Also, the US courts tend to significant analysis prior to certifying a class for a class action lawsuit; hence the formation of the class in this case demonstrated some merit in the matter.
Cause of action: right of action vs. cause of action
The cause of action arose in India. The right to sue arose out of the misrepresentation of IC, by the alleged manipulation of the financial statements of IC with the alleged connivance of Indian Auditors and Foreign Auditors. The Authorized Claimants acquired a right to sue in the US because of a statute (read Securities Exchange Act and Securities Act of US) providing a remedy. They exercised a right of action. A right of action is different from a cause of action. Even though they had a right of action in the USA, their cause of action arose or accrued in India by the alleged misrepresentation, deceit or fraud practiced in India by IC, Indian Auditors and Foreign Auditors. The right to compensation arose in India as the source of the compensation is the alleged tort perpetrated in India.
Passing of Title to the QSF
Once the fund goes from the segregated account in India, IC loses its control over it and its right to it is solely dependent on the court not approving the settlement. On the approval of the court, the title to the fund vests in QSF. The transfer from the segregated account in India to the initial escrow account in the US itself was based on an interim or preliminary approval by court of the settlement. That approval was subsequently confirmed by the final approval. The title to the fund passed to QSF in any event, when it was transferred from the segregated account in India to the initial escrow account.
Receipt of Income by QSF
When the title to the funds passes to the QSF, the title passes to the Authorised Claimants. By the settlement arrived at by the parties and the deposit of the fund in the segregated account, title to the fund is lost to IC. Even if that was not the case, the title would be lost when the funds are transferred to the initial escrow account. Once it went to that account, only a disapproval of the settlement by court can revive the right of IC over the fund. In the present case, the preliminary approval to the settlement by the court was followed by the transfer into the initial escrow account after getting the permission of the Reserve Bank of India for such transfer. Since the settlement was finally approved by the US court, the title to the funds vested with QSF with effect from the date of it being credited to the initial escrow account, if not from the date of deposit in the segregated account itself.