Circular 789 is taking on a life of its own

If there is one thing the recent decision of the Delhi bench of the Indian income tax tribunal in SC Lowey v Asst. Comm’r[1] makes clear, it is that Circular 789, intentionally or unintentionally, has taken on a life of its own. Let me explain.

Distinguishing Tax Residence from Beneficial Ownership

The concepts of tax residence and beneficial ownership in the context of tax treaties are distinct and serve different purposes. While it is true that, in some sense, they both affect a person’s entitlement to treaty benefits, tax residence functions as a foundational or gating criterion—a prerequisite for accessing benefits under a treaty. Beneficial ownership, on the other hand, operates as an additional, more specific criterion that applies only to certain categories of income, such as dividends, interest, and royalties, ensuring that these benefits are not granted to conduit or intermediary entities lacking a legal or economic entitlement to the income.

Tax residency certificates, or TRCs, by definition, are intended solely to assure the recipient of a person’s tax residence. They are not intended to assure the recipient that a person is the beneficial owner of the income he receives. This makes sense because the tax laws of most countries link tax residence to some readily ascertainable criteria like citizenship or physical presence (in the case of individuals) and place of incorporation or management (in the case of legal entities). An assessment of whether a person is legally or economically entitled to his income is usually neither required, nor undertaken, to determine a person’s tax residence.

Circular 789: A unique proposition

Yet, on April 13, 2000, the Indian government issued a “Clarification Regarding Taxation of Income from Dividends and Capital Gains under the Indo-Mauritius Double Tax Avoidance Convention”[2] which “clarified” that:

“wherever a Certificate of Residence is issued by the Mauritian Authorities, such Certificate will constitute sufficient evidence for accepting the status of residence as well as beneficial ownership for applying the DTAC accordingly.”

Circular 789 effectively ensures that a person holding a Mauritian TRC automatically qualifies not just as a resident, but also as a beneficial owner for purposes of the India-Mauritius treaty. Why?

Presumably, to simplify administration, ensure certainty and boost foreign investment. When Circular 789 was issued, India craved foreign capital and wanted to assure foreign investors that the benefits of the Mauritius treaty would not be challenged and undermined by its tax authorities. These benefits were widely considered crucial to sustaining foreign interest in India at the time. In this context, Circular 789 made sense.

However, India has come a long way in the two decades since Circular 789 was issued. Its tax department is now far more sophisticated, and the lucrative exemptions once available under the Mauritius treaty no longer exist. So why has Circular 789 not been withdrawn?

At cross purposes: Ss.90(4) and (5) of the Income Tax Act

In 2012, Section 90(4) of the Income-tax Act was enacted, requiring a non-resident taxpayer claiming benefits under a tax treaty to furnish a TRC to evidence their tax residence – the prerequisite for claiming the benefits. The explanatory memorandum to the Finance Bill 2012 clarified that this requirement aimed to curb unintended treaty benefits being claimed by third-party residents of non-contracting states. It emphasized that while the TRC was a necessary condition, it was not sufficient on its own to secure treaty benefits.

In 2013, the government proposed enacting Section 90(5) in the Finance Bill to codify the principle that a TRC was necessary but not sufficient to claim treaty benefits. However, this proposal faced pushback from foreign investors and international stakeholders, concerned it could lead to tax authorities questioning TRCs and creating uncertainty for treaty claimants. The government responded by issuing a press note clarifying that a TRC would be accepted as conclusive evidence of residence, and tax authorities would not challenge the resident status of the holder.

Ultimately, when the Finance Act 2013 was enacted, Section 90(5) was diluted to require the furnishing of “other documents and information” as prescribed, rather than reiterating that a TRC was insufficient. Additionally, Section 90(4) was amended to simplify the TRC requirement, removing the mandate for the certificate to contain prescribed particulars, thereby accepting TRCs issued in various formats by different countries.

This change in approach was accompanied by a shift in messaging, evident from the explanatory memorandum to the Finance Bill 2013 and Circular No.3 of 2014, which issued after the enactment of the Finance Act 2013. While the memorandum reiterated that the TRC was a necessary but not sufficient condition for treaty benefits, the circular emphasized concerns raised by foreign stakeholders and tax authorities regarding varying TRC formats. It clarified that sub-section (4) was amended to remove the requirement for TRCs to include prescribed particulars, thereby ensuring TRCs issued by different countries in their respective formats would suffice. It further noted that sub-section (5) was introduced to require taxpayers to furnish additional documents and information as prescribed, effectively shifting the focus from the TRC to supplementary evidence for treaty claims. This 2012 and 2013 amendments - from emphasizing the insufficiency of TRCs to reaffirming their acceptance as evidence of residence and casting the amendments as responsive to investor concerns - reflect an abortive attempt to move away from the benevolence of Circular 789.

The events of 2012 and 2013 would suggest that a TRC is necessary, and establishes a prima facie entitlement, to ‘claim’ treaty benefits. It does not guarantee the ‘grant’ of treaty benefits. Additional conditions, such as limitations on benefits (LOB) or beneficial ownership requirements, should, where applicable, still apply. The original intent behind Section 90(4), as articulated in 2012, indicates that the TRC was never intended to be the sole requirement to ‘avail’ of treaty benefits. Instead, a TRC serves as a starting point for establishing residence, with the burden on the taxpayer to satisfy other treaty-specific requirements. Thus, as amended, the Income-tax Act acknowledges the need for additional treaty-specific conditions to be fulfilled and, at least as far as treaties other than the Mauritius treaty are concerned, moves away from the broader assurances provided by Circular 789 which effectively treated a TRC as sufficient evidence of both residence and beneficial ownership under the Mauritius treaty.

In a sense, the 2012 and 2013 amendments to S.90 of the Income Tax Act represent the simultaneous codification and curtailment of the principles reflected in Circular 789. While Circular 789 treads a TRC as conclusive evidence of both residence and beneficial ownership, the Income-tax Act recognizes a TRC as evidence only of residence. Second, the Act explicitly leaves open the question of beneficial ownership, requiring taxpayers to provide additional proof to satisfy treaty-specific requirements.

Despite all of this, Circular 789 remains in force. How are we then to square Circular 789 with the amended S.90? One way, perhaps, is to limit its application exclusively to the Mauritius treaty.

The problem with SC Lowy

Viewed as an exception to the norm, there it would hardly seem appropriate to extend Circular 789’s applicability beyond the Mauritius treaty. Yet, this is exactly what the tribunal does, in finding that the taxpayer is the beneficial owner of interest payments received through an alternative investment fund in India:

Based on Circular No.789 of 2000 issued by the CBDT clearly held out that a TRC issued by authorities would constitute sufficient evidence for determining fiscal residence and beneficial ownership. (In our view, even though above circular was issued in relation to the transactions with Mauritius, still the substance of above direction of CBDT hold good for other treaties as well.)

The rationale (or lack thereof) for doing so is far from convincing. It is one thing to hold that the TRC establishes a residence, quite another to hold that it establishes beneficial ownership, outside of the Mauritius Treaty. The tribunal relies on the judgment of the Delhi High Court in Tiger Global v AAR[3], but that case involved the Mauritius treaty, and it not particular helpful to the tribunal's holding.

While circulars are generally binding on the tax department if they are beneficial to the taxpayer[4], Circular 789 applicability should, for the reasons discussed above, be limited only to the Mauritius treaty. There is no legal basis to extend its application to any other treaty. And if one exists, the tribunal is not telling.

[1] ITA No.3568/Del/2023

[2] Circular no. 789 dated April 13, 2000

[3] [2024] 165 taxmann.com 850 (Delhi)

[4] Navnit Javeri v K.K. Sen, [1965] 56 ITR 198 (SC); UCO Bank v Comm’r, [1999] 104 Taxman 547 (SC)