A Dutch company earning capital gains by selling shares in its Indian subsidiary does not need to pay tax in India if it offloads the shares to a non-resident entity, according to authority for advance ruling (AAR), the quasi-judicial body that decides on tax matters involving overseas firms.

The AAR came out with the order last week after a Dutch company KSPG sought ruling on its proposed divestment of shares in its Indian arm.

In its application, the foreign company asked AAR for two clarifications: One, whether it is subject to pay capital gains tax if it sells shares of its Indian subsidiary and two, whether it would need to pay tax in the event of buy back of shares of its local subsidiary.

KSPG has also sought exemption from AAR on payment of capital gains tax, citing the India-Netherlands Double Taxation Avoidance Agreement (DTAA), which provides for exemption if the gains earned from India arise from a transfer of shares of an Indian company to a non-resident firm.

The AAR held that tax is not payable in India on the sale of shares of an Indian company by a non-resident entity to another non-resident firm. AAR said the issue of payment of tax in India in the event of the buy back of these shares can be dealt in a separate application.

Shefali Garodia, partner, BMR Advisors, told ET: The ruling discusses principle of beneficial ownership in the context of tax treaties. But AARs reasoning for not ruling on the taxability in the event of buy back is not convincing.

A few years ago, KSPG had bought 100% stake of German firm Pierburg in Pierburg India. KSPG had made further investment in Pierburg India, post the transaction.

In the course of its argument at AAR, the Income-Tax department said that the transaction was carried out for the purpose of avoiding tax in India and therefore it does not merit tax exemption. It said the Indo-German tax treaty should be applicable in this case, as it the German firm Pierburg that gained from the transaction.

Under the Indo-German tax treaty, tax is payable in India for such transactions, the I-T department said. The AAR did not agree with the departments view. It pointed out that the Dutch company was a distinct legal entity with separate board of directors.