If an asset is physically located within India, Indian Revenue has a legitimate tax claim on its disposition. But a recent case, involving the sale of a telecom company, challenged the taxability of such dispositions.
Factual Background:
In 2005, Vodafone acquired a stake in India’s largest telecom operator, Airtel. India was a huge market, so when another Indian operator, Hutch, came up for sale, Vodafone bid almost $11 billion. To complete this transaction, Vodafone acquired interests in a Cayman Islands corporation, CGP, which owned a majority stake in HEL, which in turn owned Hutch.
Vodafone’s $11 billion represented 51.96% of effective shareholding and 67% of Hutch’s economic value. A prominent audit firm reviewed the deal’s tax implications and concluded there would be no Indian tax consequences, since the transaction involved sale of shares in a Cayman Islands corporation.
Noting that a major telecom operator had changed hands without any taxes on the transaction, the Indian Income Tax Department charged Vodafone, under S. 201 of the Income Tax Act 1961, with flouting S. 195. Under S. 195, anyone paying a foreign company which does not have a tax presence in India must withhold from the purchase price an amount equivalent to the tax chargeable on the transaction.
Vodafone petitioned the Bombay High Court against the charge. The court concluded that since the transaction had a ”direct effect” on India, it was taxable. The Supreme Court, however, ruled in favor of Vodafone, and chided the Union Government to establish clear tax policy in order to attract foreign investment.
Holdings of the Supreme Court:
1) S. 9 is not a look through provision.
The Court agreed with the purpose of S. 9: income accruing from activities in India must be taxable by India whether the income arises directly or indirectly. Nonetheless, the Tax Department cannot “look through” a transaction, but merely “look at” it to evaluate taxability. If the legislature intended to tax gains arising from transferring the shares of a corporation that owns Indian assets, an indirect accrual of income, then it must explicitly so provide.
2) The control premium exercised in HEL was not a property right extinguished by this transaction.
A parent corporation’s de-facto control over its subsidiaries cannot be equated with a legally enforceable right. This is especially true in a situation like Vodafone, where the subsidiary enjoys considerable autonomy. The rights transferred to Vodafone were protective or participative rights, transferred normally given to minority shareholders to address concerns of usurpation of control by majority. Such rights cannot be equated to a property transfer.
3) Legitimate use of multi-jurisdictional entity structures by multinationals is not unjustified.
After evaluating the maze of contractual agreements, the Indian Supreme Court found it vital to the transaction that Vodafone acquired an upstream corporation instead of directly acquiring a stake in HEL. Had Vodafone acquired a 67% direct equity stake, it would have breached India’s cap on foreign investment for the telecom sector.
4) Vodafone was not an assessee in default.
The Indian Supreme Court concluded that Vodafone’s transaction was between two non-residents, and transferred an asset situated outside India. There was no ground for India to tax the transaction, and hence no default by Vodafone.
Retrospective Amendment:
The Indian Government was unhappy with the verdict, and introduced Finance Bill 2012. This bill amends S. 9, overruling the Court’s decision. The bill adds elements that were argued by Revenue before the Court:
- The rights and entitlements approach: An explanation was attached to S. 2(14), clarifying that “‘property’ includes and shall be deemed to have always included any rights in or in relation to an Indian company, including rights of management or control or any other rights whatsoever.” An explanation was also added to S. 2(47), broadening the definition of transfer to include transfers of rights associated with shares of an Indian corporation.
- Understanding “through” in S. 9: Explanation 4 has been attached to S. 9, and states that “through” shall be understood as “in consequence of,” “by reasons of,” or “by means of.”
- Explicit Clarification: If a foreign corporation derives, directly or indirectly, its value substantially from assets located in India, shares of that corporation are deemed situated in India. This amendment has been applied retrospectively from 1st April 1962.
Fallout
Since the S. 9 amendment dates back to 1962, a series of high-profile acquisitions concerning non-resident parties are suddenly taxable. This is viewed as yet another decision by India to push away foreign investment instead of facilitating it. Though this is not the first time the 1961 Act or S. 9 has been retrospectively amended, this amendment has drawn immense criticism from tax practitioners.
Was the litigation necessary?
For Vodafone the litigation was unnecessary. As the buyer in the transaction, Vodafone was not liable for tax on capital gains. Vodafone was charged as an “assessee in default,” having failed to deduct tax payable by the seller. However, the safe harbor certificate under S. 195 allows the payee to proceed with payment with the assessing officer’s authorization. Thus, the S. 195 exemption could have prevented this litigation.