THE TAX CONUNDRUM

Is Vodafone’s victory a setback for the Indian government?

Ø What happened?

In February 2007, Vodafone acquired 67% stake in Hutchison Essar Ltd (HEL) for around INR 575 billion (1$ = INR 50). The Income Tax (IT) department issued a show cause notice in September 2007 for trying to avoid tax payment to which Vodafone filled a petition in Bombay High Court in October the same year. In the course of next two years the battle just got more intense and on September 8, 2010 the Bombay High Court ruled in favor of the IT department and subsequently Vodafone was asked to pay to IT department INR 11,297 Crores. Not willing to throw in the towel, on September 14, 2010 the British Telecom giant went to the Supreme Court, the apex body of India’s judicial system. In the mean time the High Court’s order was implemented where in INR 2500 crores had to be deposited to the IT department and INR 8500 crores in bank guarantee by the telecom operator.

Finally on January 20, 2012, the curtains came down on the four year old case where in the apex court ruled in favor of Vodafone and asked the IT department to return the INR 2500 crores deposited with two months along with an interest payment of 4%. The Chief Justice also asked the Supreme Court to return the INR 8500 crores in bank guarantee with four weeks.

Ø  The Acquisition aspect.

Brief

Hutchison Telecom International Limited (HTIL) is leading provider of telecommunications services worldwide. It is based out of HongKong. HTIL offers services in other countries also (Indonesia, Vietnam, SriLanka, Thailand, Israel).

Now any large enterprise would typically consists of subsidiary corporations. The purpose is to have a better view of the enterprise both for the management as well as for the lenders.

Actual Deal

Vodafone International Holding BV acquired 100% share in CGP holdings limited based in Cayman from Hutchison Telecommunications International Holdings Limited, a BVI company. The Cayman Islands based company owned more than 50% in HEL.

Ø  Tax laws in India.

Brief

The Indian Income Tax Department in governed by the Central Board of Direct Taxes (CBDT). CBDT is one of the arms of Department of Revenue under the Ministry of Finance, Government of India.

Sections

Whenever there is a transfer of capital assets, it results in capital gains. A capital asset is defined under Section 2(14) of IT act 1961. Capital asset is a property of any kind, including assets that are movable or immovable, tangible or intangible, fixed or circulating, but excluding trading stock held for the purpose of realizing a financial or economic return.

Section 195 of IT act’s objective is to avoid a loss of revenue to exchequer as a result of tax liability in the hands of a foreign resident. So deduct tax from the source itself instead of chasing the foreign nationals.

Section 163 (1) (c) states that the income whether received in India or outside India, that income is liable to be taxable in India provided that it is attributable to operations carried out in India.

Section 9 (1) states that all income accruing to a non-resident from a business connection in India shall be deemed to have arisen in India and therefore subject to tax in India.

Ø  Supreme Court reasoning

The Supreme Court has noted that the transaction between HTIL and Vodafone International holdings was an offshore transaction between two non-resident entities and therefore does not come under the jurisdiction of the tax authorities in India.

The Revenue Department initially filed the case against Vodafone with respect section 195 of the IT act. But section 195 of IT act clearly says that tax is payable only when a payment is made from a resident to another non-resident entities. As stated above the transaction is between two non-resident entities and thus section 195 does not apply for this transaction.

Section 9 (1) of IT act does not state about that indirect transfer of capital assets. This is exactly what has happened in this offshore transaction and thus this section could not be applicable for tax deduction. Section 163 (1) also could not be invoke as the court categorically stated that there is no transfer of capital assets situated in India. The apex court has reiterated the fact that it is just transfer of shares and not capital assets and such transactions can’t be taxed under existing tax laws. The court also held that the offshore transaction was a structured foreign direct investment (FDI).

The court also took cognizance of the fact that the Direct Taxes Code (DTC) bill proposes the taxation of offshore share transactions, even from indirect transfer of a capital asset situated in India. The above proposal is stated in Section 5 (1) (d) which says “the income shall be deemed to accrue in India, if it accrues, whether directly or indirectly, through or from the transfer of a capital asset situated in India.” There are further provisions about the gains arising out of transfer of capital assets in the DTC.

The Supreme Court also came out with pretty strong worded statements like “Capital punishment meted out for capital investments”. So clearly the court was clear in its reading of the laws as it is.

Ø  Implications.

The Supreme Court has again showcased that the judicial systems in India are still alive and kicking. The verdict came in as a shock/surprise to a majority of the people. This proves that there is fairness in the judicial system of our country.

Well the government has some serious thinking to do in terms of the revenue outflow. The government, already reeling under tremendous pressure from the fiscal side, will certainly feel the heat. This verdict has also driven home the point about bringing in transparency in the tax laws of our country.

But not all has gone bad. This verdict will boost the foreign investor’s confidence level sky high and encourage investment (I mean FDI and not FII). The loss of revenue for the government now may be insignificant when compared to the long term gains arising due to increased investment inflow into the country. As the 2008 subprime crisis has show, FII and portfolio investments can be trusted at our own peril. FDI inflows will have a more stabilizing effect on our economy. With the dark and gloomy clouds of recession still hovering over the developed economies, the time is just ripe for India to take the big leap.

Well GOI is keen on bringing those offshore deals similar to the Vodafone one into the tax net. GOI has also made it clear that the amendment to the tax laws was just a question of time. why would the government like to forego indirect transfers worth around Rs. 35000 crores. Only time will tell the foreign investors sentiment on this issue.

L.KISHAN CHAND
Class of 2013