Vodafone revisited

Glimpses of an international arbitration

It is worth revisiting the Vodafone matter in as much as the Government of India (GoI) is currently in international arbitration with it. Interesting insights are to be derived from the process regarding the efficacy — the do’s and don’t’s — of international taxation. Revisiting its genesis, in 2007, a Hong Kong-based MNE, Hutchison, sold the operating licence of its wholly owned subsidiary in Cayman Islands, to Vodafone’s wholly owned Dutch subsidiary for $11 billion. Thus the transaction was an “indirect transfer” of assets located in India, transacted entirely outside India between two non-resident companies.

The Organisation for Economic Co-operation and Development’s (OECD’s) view on the taxation of indirect transfers has been, “The central conceptual issue is that of how taxing rights should be allocated between the country where the underlying asset is located and others involved in the transaction — should the country in which the asset is located have primary taxing rights on an indirect transfer of its ownership that takes place outside the location country? ….at least in the case of an asset that embodies location-specific economic rents….and other immovable property assets, the answer is ‘yes’.”  (See “Taxation of Offshore Indirect Transfers — A Toolkit,” OECD, October 2017). Though the OECD view is recent, it is nevertheless relevant.

Illustration by Binay Sinha

In the Vodafone case, it did not withhold tax from Hutchison. Reflecting that Hutchison had no remaining assets in India, the Indian Revenue Service (IRS), based on their legal position that Vodafone should have withheld tax from Hutchison, claimed a tax of $2.6 billion from Vodafone on the capital gains of Hutchison. The judicial procedures that followed culminated in the Supreme Court ruling in favour of Vodafone over GoI in 2012.

The genesis of the problem that ensued thereafter was in GoI’s changing the law retrospectively to enable taxation of indirect transfers. Vodafone submitted the retroactive effect of the law to international arbitration under the India-Netherlands Bilateral Investment Treaty, claiming that the change in law had upset a “settled position” represented by the Supreme Court decision. 

Earlier, I have written on the detrimental ramifications of retrospective taxation on economic growth and prosperity because of its deleterious impact on maintaining viability of a business model. The argument is simple: When a business considers an investment, it takes a decision reflecting its attitude towards risk — averse, neutral, or preferer — and its assessment of the prevailing laws on labour, investment, tax or trade. If these are amended in the future and, as long as the changes are applied prospectively, the risk model can be redesigned for future investment. If, however, any law is changed retrospectively, its impact on business decisions already made and implemented is adverse; resultantly the business outcomes get vitiated. For example, if unanticipated taxes have to be paid at a time in the future, then earlier cost, income and profit calculations are rendered erroneous.This is what I have called “impossibility to perform” in an environment of “uncertainty” rather than “risk taking”.

The Vodafone story is interesting since GoI revealed that it had provided Vodafone sufficient prospective caution for tax withholding from Hutchison. Vodafone too had considered the tax withholding aspect but essentially rejected it and decided to take the risk. For it possessed the knowledge that an Indian tax liability imposed on disposal could be sought from Vodafone or the HEL group, and the Indian courts could rule in favour of the Indian tax authorities.

When the Supreme Court, with its interpretation of the Income Tax Act,  ruled in Vodafone’s favour, Vodafone’s decision to take the risk appeared successful. It had not anticipated the retrospective legislation subsequently enacted by GoI that would annul the basis of the Supreme Court’s ruling, and would enable GoI to validate the tax demand. 

The earlier sequence of events may be recalled. Prior to the Supreme Court, the high court had ruled in GoI’s favour and it was only later that the Supreme Court reversed the prior judgment. Vodafone interpreted this sequence as a “settled” matter. However, GoI, taking into account the entire sequence including informing Vodafone beforehand of probable taxation, viewed the matter as not settled. Hence, it changed the law. 

In the ordinary instance, that could have been expected to apply (correctly) in cases that could arise prospectively. Prospective application would have been fine but changing the law for possible retrospective application from 1962 — first year of application of the 1961 Income Tax Act — caused rancour. And the question emerged whether the law was amended with retrospective applicability with the specific objective to remove the limits imposed in the Supreme Court ruling on Vodafone, or whether it was a genuine correction of a mistake in the wording of the law that had earlier failed to meet the original intention of the law so that the amended law’s retrospective application could be justified.

To extrapolate the law backwards, raises the issue of uncertainty in business decisions and investment, a matter that a GoI expert committee on indirect transfers that I chaired addressed in 2012.Countries such as the US and the  UK have allowed some retrospective application and for finite periods of time. European countries such as Sweden, on the other hand, have eschewed retrospectivity. There is no particular reason why India should select one or the other, except that India’s stage of economic development and commensurate need for foreign investment are strongly linked to eradicating uncertainty faced by businesses in their tax compliance related business decisions.

As of now, Vodafone continues with its position that the retroactive application of law was unfair while the GoI’s position appears to be that Vodafone took a calculated risk after being advised to withhold tax from Hutchison ahead of the transaction.

To conclude, India’s claim to tax revenue from indirect transfers of assets located in India is clear,and it should be routinely applied in the future. The OECD’s Base Erosion and Profit Shifting (BEPS) Actions support source based taxation.It is only the retrospectivity that remains a bone of contention since some countries have used it while others of equal importance have not.The outcome of the international arbitration remains of great interest to tax policymakers and experts globally.