For many years, the Double Taxation Avoidance Agreement (DTAA) between India and Mauritius has been a major vehicle for foreign investment into the Indian market. Its favorable capital gains tax regime makes it the jurisdiction of choice for dozens of Foreign Portfolio Investors (FPIs). However, an important change came in 2016 with a view to limit treaty abuse.

The relevant amendment made gains on Indian shares, acquired post 1st April 2017 taxable in India. However, accompanied by a "grandfathering" clause, which ensures that investments made before this date would be exempt and not taxable to the extent of gains realized post-sale. This dual regime raised a complicated issue whether an investor, for the same year, would have a tax-exempt "grandfathered" gain and a taxable "non-grandfathered" loss?

In its recent ruling in the case of Atyant Capital India Fund - I v. Assistant Director of Income-tax the Mumbai Income Tax Appellate Tribunal (ITAT) has provided a clear, logical, and pro-taxpayer position to this issue.

The Factual Matrix: A Tale of Two Transactions

The situation involved a Foreign Portfolio Investor (FPI) located in Mauritius, specifically Atyant Capital India Fund - I. In the pertinent assessment year, the fund executed two main independent transactions regarding the sale of long-term shares.

1. The Grandfathered Gain: The fund harvested a significant Long-Term Capital Gain (LTCG) from the sale of shares which had been purchased prior to April 1, 2017. Due to the amended DTAA, these gains were “grandfathered,” and therefore, had full exemption from tax in India.
2. The Non-Grandfathered Loss: The fund also recognized a Long-Term Capital Loss (LTCL) as a result of selling a different set of shares purchased after April 1, 2017. This transaction fell outside of any grandfathering provisions and was subject to the provisions of the Indian Income-tax Act, 1961.

The Point of Contention: To Carry Forward or Not?

The Assessing Officer took the stance that the transactions ought to be aggregated. The officer determined that because the gain which was exempt, was greater than the loss which was taxable, there was therefore no loss overall, within the category of "Capital Gains". The result of this was the impossible conclusion that nothing could be carried forward in subsequent years. The effect of the reasoning was to use a real taxable loss to absorb a gain that was itself not even taxable in India.

The taxpayer contends that this is not the proper interpretation of the law. They assert that the exempt gain ought to be excluded altogether, per the treaty, and that the loss, taxable loss, was what remained and that such loss could be carried forward as per the Income-tax Act.

The Tribunal's Verdict: A Principled and Clear Demarcation

The ITAT effectively examined the outlines of the interaction between the DTAA and the domestic tax legislation, and determined the case in favor of the taxpayer. The Tribunal's reasoning was founded on the premise of treating the two transactions as completely separate transactions.

The crux of the decision was that the grandfathered transaction and the non-grandfathered transaction occurred in separate legal systems:

• Gain: The LTCG from pre-2017 shares is solely controlled by the India-Mauritius-DTAA. The treaty produces a specific exemption from taxation, such that in effect, it removes the income entirely from the taxable income of the India jurisdiction.
• Loss: The LTCL from post-2017 shares is controlled by the Income-tax Act. Since there is no exemption allowed for this transaction under the Income-tax Act, all provisions of the Income-tax Act, including those for expenditures and losses, apply fully.

Therefore, the Tribunal concluded that a non-taxable income line item, i.e., (the exempt gain), did not have relevance to the cap on tax relief potential associated with the taxable transaction (the right to carry forward a loss). It was decided that the assessee was entitled to the full carriage forward of the LTCL in order to offset against future capital gains, in accordance with the provisions of the Income-tax Act.

The Second Question: Setting Off Capital Loss Against Dividend Income

The case had another significant aspect. The assessee also attempted to set off this carried-forward LTCL against dividend income received in the year. On this issue, the Tribunal held against the taxpayer, reinforcing a basic principle in respect of India's tax regime.

Under the Income-tax Act, income is categorised under five different heads. The process of setting off a loss is clearly specified and hierarchical. Section 74 of the Act, dealing with losses under the head "Capital Gains" is absolutely clear: a capital loss can only be set off against income under the head "Capital Gains". It cannot be set off against income from different sources, like dividends. This part of the ruling confirmed the legally established position.

Implications for the Investment Community

The Atyant Capital decision has far-reaching implications and provides significant relief and certainty for FPIs:

1. Certainty on Loss Treatment: It creates certainty that reasonable losses incurred on investments that are not grandfathered may be carried forward so as to retain their value against future taxable gains.
2. Upholding Treaty Integrity: It upholds the purpose of the grandfathering provisions, ensuring that the protection afforded legacy investments is not undermined by offsetting it against taxable losses. 
3. Reinforcing Tax Principles: It demonstrates that while the DTAA may provide exemptions, the mechanics of carrying forward losses for taxable transactions remains reserved under domestic law.

To sum up, the Mumbai ITAT's considered order embodies a reasonable compromise. It is a substantial win for foreign investors as it enables the carry forward of losses, whilst maintaining the core principles of India's tax law, during a uniquely complex transition period for the India-Mauritius DTAA. This is a positive step towards achieving a more predictable and stable tax environment for international investors.