The Supreme Court in case of Ishikawa (298 ITR 408) had held that an income must have sufficient territorial nexus with India so as to furnish a basis of imposition of tax. A territorial nexus has to be decided having regard to internationally accepted principle. It must have a direct live link with services rendered in India.
In the recent famous case of Vodafone the controversy of territorial jurisdiction has again surfaced. It will be recalled that in Vodafone’s case, a 67 per cent shareholding stake in an Indian company was acquired by Vodafone group outside India from another company located in Cayman Islands. Since the transaction was between two foreign companies wholly outside India, it was contended that there was no jurisdiction to tax any capital gain in India.
The Mumbai High Court on December 3, 2008, decided this issue in favour of the Income-tax Department. The Hon’ble Court in principle held that in the facts and circumstances of the case, Indian tax authorities have jurisdiction to tax such income.
Vodafone filed SLP in the Supreme Court. The Supreme Court heard this matter on 23rd January, 2008 but refused to intervene. The Court directed Vodafone to first present its case before the tax authorities. Vodafone had approached the Mumbai High Court on the show cause notice without waiting for final assessment.
The question of jurisdiction of the authorities to assess the tax arising out of contract between foreign entities could be raised before the tax authorities. The court observed that I.T. authorities should deal with the fundamental question of whether the transaction between two foreign companies falls within the income-tax jurisdiction or not.
It is also reported that the Central Board of Direct Taxes has asked its officers to gather information on similar transactions that have taken place in the recent past. The tax authorities have now begun scrutinising mergers and acquisitions relating to Indian companies. The Chairman of CBDT has reportedly stated that “It will continue its attempt to bring to tax in India transactions involving transfer of Assets situated in India between entities located outside the country.”
The controversy of territorial jurisdiction is not new in India. But the recent development of Vodafone’s case vis-à-vis the decision of Mumbai High Court has sent virtual shock-waves to foreign companies holding equity stake in Indian companies.
The present legal scenario will discourage direct investment in India. Foreign companies will now be advised to route investment through those countries where tax treaties with India provide protection against capital gains tax. The examples of such countries are Mauritius, Singapore and Malta.
Where investments in India are routed through third countries with a view to avoid capital gains tax, it becomes a perfect case of “treaty shopping”. The government will be forced to accept treaty shopping as a legitimate tax planning device as observed by Supreme Court in case of Azadi Bachao Andolan (263 ITR 706) “Many developed countries tolerate or encourage treaty shopping, even if it is unintended, improper or unjustified, for other non-tax reasons, unless it leads to a significant loss of tax revenues. In developing countries, treaty shopping is often regarded as a tax incentive to attract scarce foreign capital or technology.”
It will be difficult for the government to control the above treaty shopping unless the tax treaties are revised. Amendment of treaties is also very difficult because treaties are negotiated and entered into at a political level. As observed by the apex court in case of Azadi Bachao (supra) “Treaty should be seen in the context of aiding commercial relations between treaty partners and as being essentially a bargain between two treaty countries as to the division of tax revenues between them in respect of income falling to be taxed in both jurisdictions”.
It is therefore felt that the government should clarify in clear terms the tax obligations of foreign entities in respect of income arising to them from assets or service located in India.
The author is a Partner in SS Kothari Mehta & Co
