In India’s most vigorously contested tax dispute, on Friday, a three-member bench of the Apex Court pronounced its verdict vindicating Vodafone’s stand questioning the jurisdiction of the tax administration. The controversy which assumed unprecedented media visibility in the past few years surrounded Vodafone’s obligation to withhold tax on alleged capital gains that Hong Kong based Hutch group made in relation to USD 11 billion investment (Vodafone) made for acquiring controlling interest in a telecom license.
What’s wrong with legitimate tax planning ? if there are loopholes in law, its legislatures job to fix them !
Instead of Direct acquisition in an Indian company, Vodafone’s Dutch subsidiary acquired shares in a Cayman Island company, popularly called CGP, which was controlled by the seller Hutch group. CGP held interest in Indian telecom operating companies via a web of complex holding and intermediately companies. Simply stated, Vodafone’s basic argument was that the Indian law extends to capital gains on assets located in India and since the acquisition of interest was in a Cayman Island company, it was not an asset located in India and hence, not liable to tax. The deeming provisions under the Indian law did not extend to such offshore acquisition of shares even though, it had underlying assets in India. The tax administration argued to the contrary extending the term ‘direct & indirect’ transfer of assets codified in a 60 year old legislation.
HC’s interpretation of law or an artificial theory of proportionality ?
After a three year Court battle, the Mumbai High Court in 2010 held that though the sale of isolated share of the Cayman Island company CGP is not liable to tax, such sale cannot be viewed in isolation and that there were a bundle of ‘rights & entitlements ’ that were an integral part of the deal. The HC after analysing the agreements, concluded that such rights had economic nexus with India and hence, they would be considered as assets located in India and hence taxable. The HC in the process propounded an incoherent & artificial theory concluding that there was a transfer of capital asset in India ignoring jurisprudence & established principles on what constitutes assets located in India. The HC order did not in any manner suggest that the scheme of acquisition was sham or tax avoidance of a nature that deserved lifting of the corporate veil . Instead, it choose to apply a fuzzy ‘see through’ concept nonexistent in the present tax code. What followed was the HC’s directive to the tax administration to complete the complex job of determining Indian nexus for computing the tax liability. As anticipated, the Revenue attributed a substantial part of the consideration to India and raised tax demand to the tune of USD 2 Billion. To me, this was the weakest part of the judgment. I wonder how the HC after concluding that there were legitimate reasons for Vodafone to enter into such agreements could have invoked theory of ‘see through’ when India does not have anti-avoidance rule enshrined in its code ? It was also unclear from the order if what was brought to tax was capital gains on sale of an asset or business income on acquisition of rights & entitlements ?
It’s a clear victory for Vodafone !
The Apex Court struck at the very root of the issue and highlighted the ‘ look to’ principle instead of ‘look through’. The SC pleadings that lasted over months invited a barrage of questions ( from the Chief Justice ) on the ownership structure, timing of evolution of such structures, business necessity to enter into web of agreements for acquiring controlling interest, averments made before India, UK & Hong Kong regulators in relation to Indian investment etc. The bench at one stage seemed inclined to revisit its earlier judgment’s in the cases of Azadi Bachao Andolan & Mc Dowell rendered in the context of legitimacy of Tax planning. It intensively debated the age old West Minister (house of lords) principles which held that a tax payer is well within its right to make use of legitimate tax planning tools. The SC in its wisdom didn’t feel the need to interrupt established principles & refused to entertain a plea for referring the Azadi case rendered in the context of Mauritius treaty to a larger bench. Besides holding that the tax administration had no jurisdiction over Vodafone, all the other principles went in favour of Vodafone with respect to they being wronged in treated as an agent for recovery of tax, non-applicability of anti-avoidance rule & withholding provisions.
Complex holding structures have become business necessity :
In coming to the conclusion, the Court has observed that investment structures have to be respected unless Vodafone had resorted to participation in Indian entities by way of pre-ordained structure aimed at avoiding taxes. It was clear that the structures that were put in place (in ‘98) prior to the acquisition were not invented by Vodafone and that the complexity in structure evolved as a result of business necessities & regulatory constraints. On the proportionality theory propounded by the HC to tax a part of the transaction, the SC was least convinced and held the USD 11 billion was a consolidated deal and allocating assets based on economic nexus would mean an artificial bifurcation of assets. SC seems to have followed the legal instruments that interlinked all the agreements to the share purchase agreement by which CGP shares were acquired. It logically follows that if the sale of CGP shares are not taxable and can’t be bifurcated, the question of taxability does not arise. On holding & subsidiary company structures, the SC observed that it is a common practice even recognised by Indian corporate & tax laws and use by foreign investors is common.
Thumps up to FDI – investors & administration need certainty :
In the course of verbal arguments, on several occasions, a questions were raised regarding the impact of such dispute on FDI. It didn’t come as surprise to me that the Apex Court commented on Indian administration’s role with respect to tax policy, stability factor, certainty in interpretation. Supporting its conclusion, the Court felt that taxability of such transaction hinges on legislative provisions with respect to ‘limitation of benefits’ & ‘look through’ provisions and that they are a matter of overall tax policy. It implied that in absence of a legislative framework, such provisions cannot be invoked with conflicting interpretations. Whether we like it or not, Vodafone has become a case study in virtually every grouping of Tax , Finance & General Counsels of Multinationals. The developments have been followed closely by all investors who have interest in India and a consistent theme that emerged in all debates was the reach of law, in absence of anti-avoidance provision.
What’s in store next?
As the debate continue, it is certain that tax administrations in other jurisdictions, particularly China, Indonesia and other emerging markets in Latin America who have been closely watching the developments now have the benefit of principles articulated by India’s highest court, which is most respected for its independence.
For the tax administration, several observations made by the SC ( more as an orbiter dictate ) need pondering. The usual argument advanced by officials that as tax administrators our job is to collect tax, is perhaps being challenged. Foreign investors don’t invest for tax reasons - they measure investment destinations on certainty and stability of its tax policies amongst various factors. Vodafone verdict is an important inflection point for tax administration to work towards design of tax policies which don’t create the sentiment it has.
In conclusion and in defense of the tax administration, I must confess that given the quantum of tax involved in the dispute, no administration would have let it go without a tough battle.
On the day of the judgment, a grouping of Silicon Valley tax directors asked my views and comment on Vodafone victory and I responded by saying that this is victory of India’s fair, independent & impartial judiciary where other jurisdictions could have been influenced by factors such as quantum of tax involved, national interest etc. However, the Indian judiciary stood firm and I would like to know those jurisdictions where the rule of law prevails and it’s a better place ( than India) to invest!
The author is Chairman of BMR Advisors & views are entirely personal.
