Vodafone case: What is the message?
Ameet Patel 30 January 2012

The judgement has addressed the issues of certainty and stability in a fiscal system and has rightly identified the areas for improvement for the Indian legislature to boost the confidence of foreign investors. We would now have to wait and watch to find out how the revenue authorities react to this bitter defeat in such a high profile case

For the past few days most tax professionals in the country who practice in international taxation have had only one thing on their minds—the Supreme Court’s verdict in the famous Vodafone case. Financial newspapers, TV channels and various law and accounting firms in India and abroad have been talking about this decision and analyzing it at depth.

What is the big noise about? Why is it so important? How does it impact foreign direct investment (FDI) in India? What does this defeat mean for the Income Tax (I-T) department? This article seeks to answer some of these questions.

The basic issue that gave rise to this whole controversy is that a foreign company incorporated in Netherlands—Vodafone International Holdings BV (VIH) entered into a share purchase agreement with another foreign company incorporated in Cayman Islands—Hutchison Telecommunications International (HTIL) to buy one share of a third company incorporated in Cayman Islands—CGP Investments (Holdings) (CGP) for about $ 11 billion. CGP ultimately held shares in an Indian company called Vodafone Essar (VEL) which was an operating company engaged in the business of mobile telephony. The entire shareholding structure was highly complex and included about 30 companies spread across various jurisdictions.

It may be noted that there was no sale of shares of the Indian company. The Indian tax department however took a stand that in effect, what was really being sold were the underlying assets and business of the Indian company VEL and therefore, this gave rise to income that was taxable in India. Consequently, there were various repercussions on VIH and HTIL. This stand of the Indian tax department resulted in a huge demand on VIH on the ground that it had failed to deduct tax at source (known in popular Indian parlance as TDS) from the payment that it made to the seller company HTIL as required by section 195 of the Income Tax Act (ITA).

Thus this controversy had several angles to it and there were a large number of issues that the Bombay High Court and now the Supreme Court had to decide upon. The fundamental issues that were to be decided upon were:

a)    Whether the sale of one share of the Cayman Islands-based company CGP was, in effect, sale of underlying assets and business interests in an Indian operating company VEL?
b)    Does India have the jurisdiction to tax income/surplus arising from sale of assets not situated in India?
c)    Can the provisions of Section 195 apply to a non-resident payer of income or do they apply only to resident payers?
d)    Was the complex holding structure used by the Vodafone group merely a tool to avoid taxes in India?
e)    Can the corporate veil be lifted to look through a particular transaction?
f)    Is substance over form important in such cases or form over substance?
g)    Would this be a case of tax avoidance through tax planning and therefore, it qualified to be struck down as illegal based on the Supreme Court’s famous decision in the case of McDowell (rendered sometime in 1985)?

In order to understand the controversy better, it would be important to understand some of the facts and some of the tax provisions closely.

Why did the I-T department claim that the transaction gave rise to income taxable in India?
The genesis of the stand lies in section 9(1)(i) of the ITA which states that “all income accruing or arising, whether directly or indirectly, through or from any business connection in India, or through or from any property in India, or through or from any asset or source of income in India or through the transfer of a capital asset situate in India” would be deemed to accrue or arise in India. And such income would be chargeable to tax in India.

The I-T department took a stand that the Cayman Islands-based company CGP (whose single share was being sold) was the ultimate holding company of VEL in India. The huge amount that was being paid ostensibly for that one single share was actually being paid for the value of the assets and business of VEL. Therefore, there was an indirect transfer of assets situated in India. Accordingly, as per the Indian tax authorities, this sale gave rise to income that could be said to have accrued or arisen in India and which was therefore chargeable to tax in India.

Here the main issue in dispute is whether section 9(1)(i) covered in its purview income accruing or arising indirectly in India or whether the term ‘indirectly’ was also qua the term “through the transfer of a capital asset situate in India”. The I-T department was of the view that because there was an indirect transfer of assets and business interests that were located in India, section 9(1)(i) applied to this transaction.

How come the purchase of the share was made liable for the tax?
Under the ITA, the onus of withholding TDS is on the payer. When it comes to payments to non-residents, there is a common section—Section 195 under which deduction has to be made. As per this section, whenever a payment is to be made to a non-resident and that payment gives rise to income chargeable to tax in India, the payer is required to deduct tax at source.

In this case, the I-T department took a stand that it was necessary for VIH to deduct tax at source under Section 195 (as the purchase of one share of CGP by VIH from HTIL gave rise to capital gains chargeable to tax in India) at the time of making payment to HTIL and because this was not done, the tax was required to be recovered from VIH.

Here, the main issue in dispute was whether Section 195 applied to payments by non-residents also or whether it applied only to payments by a resident.

Dividing line between tax evasion and tax avoidance
The I-T department was of the view that the complex shareholding structure put in place to ultimately hold the shares in the Indian company VEL was employed by a clever foreign corporate house with the primary objective of avoiding tax payment in India. It was the Income Tax department’s contention that the use of various tax havens/tax friendly jurisdictions (Mauritius, Cayman Islands, and Netherlands) was a part of a well thought out strategy to avoid paying tax in India.

Throughout the entire legal battle leading to the Supreme Court, there has been constant reference to three important decisions of the Supreme Court in the cases of:

  •   McDowell and Co
  •   Azadi Bachao Andolan
  •   Mathuram Agrawal

It was the contention of the I-T department that in the case of McDowell, the Supreme Court had dealt with the issue of when could a case of tax avoidance be brought under the tax net. It was argued by the revenue department’s lawyers that the subsequent decision of the Supreme Court in the case of Azadi Bachao Andolan (ABA) needed to be overruled as it departed from the McDowell judgement. It was also stated that in the ABA case, the court did not take into consideration the observations of the Supreme Court in the case of Mathuram Agrawal.

Here, a brief reference to the case of ABA would be necessary. This was a rare case where the I-T department and the tax payer community were on the same side. They were both fighting a public interest litigation (PIL) which challenged the tax benefits being availed by Mauritius-based investors. In this case, the court ruled that the treaty was a valid document entered into by the Government of India and that if an investor had in its possession a Tax Residency Certificate duly issued by the Mauritian tax authorities, then the benefits of the treaty were available to the investor and the Indian tax authorities could not challenge the validity of the Mauritian tax residency of such an investor. It may be added that this case had put to rest a huge controversy that had arisen at that time about Mauritius-based entities and the tax exemption that they claimed in respect of capital gains earned from sale of shares of Indian companies. Ever since that decision was rendered, virtually, all Mauritian foreign institutional investors (FIIs) and investors were having a peaceful time with the Indian tax authorities and there have not been any major tax disputes since then on the issue of access to the tax treaty.

However, in the Vodafone case, the I-T department has tried to open the can of worms again and has tried to challenge the Supreme Court’s decision by referring to the other two decisions.

The main argument of the tax authorities before the Supreme Court in this case was that the maze of holding and subsidiary companies present only proved that the whole structure was put in place with an intention to avoid payment of tax in India. Consequently, based on the McDowell’s case, the same should be “looked through” instead of being merely “looked at”. If this was done, then it would be obvious that finally, what was being sold were the assets and business interest in VEL which was an Indian company. By “looking through” the structure, the tax department wanted the court to pierce the corporate veil and go deeper right up to the ultimate subsidiary company i.e. VEL.

Thus, there were a large number of very important issues before the Supreme Court. The stakes too were substantially high and this case had become the talk of the international community with most international tax conferences having speakers referring to it. For the I-T department, victory in this case would have boosted its sagging revenue collections and would have also given it the moral support and strength to pursue a whole host of other high-profile and high stakes M&A transactions and try to extract its pound of flesh from the big money that is being exchanged for taking over lucrative Indian business arms of multinational companies.

Supreme Court’s verdict
The Supreme Court bench which heard this case comprised of three judges—justice SH Kapadia the Chief Justice of India, justice KS Radhakrishnan and justice Swatanter Kumar. The hearing of the case lasted for several weeks and the judges took their own time to finally decide the case. On 20 January 2012, justice Kapadia read out the judgement that was finalized by him and justice Swatanter Kumar. In a surprising development, justice Radhakrishnan passed a separate order in which he finally concurred with the two-judge order.

In effect, the Supreme Court judges have held in favour of VIH and have ruled that the sale of one share of CGP by HTIL to VIH did not give rise to capital gains that was chargeable to tax in India and accordingly, VIH was not liable to deduct tax at source from the payment made by it to HTIL.

The gist of the Supreme Court’s orders on the important principles and issues raised in appeal is as under.

Azadi Bachao Andolan vs McDowell and McDowell vs Mathuram Agrawal
The Supreme Court has rightly interpreted and reconciled the decisions in the case of Azadi Bachao Andolan, McDowell and Mathuram Agrawal on the concept of tax avoidance/tax evasion.

The English courts in the case of Commissioner of Inland Revenue vs His Grace the Duke of Westminster  and WT Ramsay vs Inland Revenue Commissioner  have laid principles on the concept of tax avoidance / tax evasion. The Westminster principle states that “given that a document or transaction is genuine, the court cannot go behind it to some supposed underlying substance”. The said principle has been reiterated in subsequent English courts judgements as “the cardinal principle”.
 11935 All E.R. 259
  21981 1 All E.R. 865

In the case of Ramsay, the House of Lords had held that the transaction should be fiscally nullified if the same are entered through a colourable device. It was also held that the court has to look at a document or a transaction in the context to which it properly belongs. It is the task of the court to ascertain the legal nature of the transaction and while doing so it has to look at the entire transaction as a whole and not to adopt a dissecting approach.

Based on the above principles, the apex court in the case of McDowell, relying on the English case of Ramsay, held that where there are artificial and colourable devices adopted by the taxpayer to avoid tax then the same should be ignored and the corporate veil should be lifted.

Whereas the Supreme Court in the case of Azadi Bachao Andolan had held that legitimate tax planning is permissible and the same cannot be ignored merely because the taxpayer has so arranged its affairs to minimize its tax cost.

The Supreme Court has rightly reconciled both the apex court decisions and has held that where the taxpayer has done legitimate tax planning then it is unjust to hold the same to be illegitimate or illegal or impermissible merely because tax is minimized. Further, it has been held that where the taxpayer has arranged its affairs through the use of colourable device or by resorting to dubious methods and subterfuges to minimize tax then the revenue authorities have every right to lift the corporate veil.

Applicability of Section 9(1)(i)—Does it includes indirect transfer of capital assets /property situated in India?
On the issue of applying section 9(1)(i) of the ITA, the revenue authorities contended that under section 9(1)(i) they can “look through” the transfer of shares of a foreign company holding shares in an Indian company and treat the transfer of shares of the foreign company as equivalent to the transfer of shares of the Indian company on the premise that section 9(1)(i) covers direct and indirect transfers of capital assets.

The Supreme Court has analyzed the said section 9(1)(i) and has held that charge on capital gains arises on transfer of a capital asset situate in India. The said sub-clause consists of three elements, namely, transfer, existence of a capital asset and situation of capital asset in India. All three elements must exist together for an income to accrue or arise in India.

The court has given a categorical finding that section 9(1)(i) of the ITA does not cover indirect transfers and that the words “directly or indirectly” used in section 163  read with section 9(1)(i) go with the income and not with the transfer of a capital asset. Further, the legislation has not used the words indirect transfer in section 9(1)(i) and therefore, adopting the ‘look through’ principle would amount to legislation by the courts.

Interestingly, the court has gone on to state that the legislature in its wisdom has proposed to cover indirect transfer of capital asset under the proposed Direct Tax Code. This proposal indicates that indirect transfers are not covered by the existing section 9(1)(i) of the ITA.
 3Section 163 of the ITA deals with persons treated as agents of non-resident in India.

The Supreme Court has given a food for thought to the Indian legislature to provide “look through” provisions either in the statute or in the treaty to cover such situations. According to the court, applying the “look through” provisions is a matter of policy and the same should be expressly provided and cannot be read into the provision on the basis of purpose construction.

Recognition of Holding Structure
The Supreme Court has aptly recognized the holding company structure which has been accepted not only internationally but also under the Indian Companies Act as well as the ITA. The approach of both the corporate and tax laws, particularly in the matter of corporate taxation, generally is founded on the separate entity principle i.e. to treat a company as a separate person for tax purposes. Further, under the tax treaty, a subsidiary and its parent are also totally separate and distinct tax payers.

The apex court has accepted the need for corporate structures which are created for genuine business purpose at the time when investment is being made or further investments are being made or when a group is undergoing overall or financial restructuring or when operations such as consolidation are being carried out to clean defused or over-diversified interests. Sound commercial reasons like hedging business risk, hedging political risk, mobility of investment, ability to raise loans from diverse investment often underlie creation of such structures.

The court has further stated that in transnational investments, the use of a tax neutral and investor friendly countries to establish SPV is motivated by the need to create a tax efficient structure to eliminate double taxation wherever possible and also plan their activities attracting no or lesser tax so as to give maximum benefit to the investors and that it is a common practice in international law, which is the basis of international taxation, for foreign investors to invest in Indian companies through an interposed foreign holding or operating company such as Cayman Islands or Mauritius based company for both tax and business purposes. In doing so, foreign investors are able to avoid the lengthy approval and registration processes required for a direct transfer (i.e. without a foreign holding or operating company) of an equity interest in a foreign invested Indian company.

The Supreme Court had applied the “look at” concept enunciated in Ramsay in which it was held that the revenue authorities or the court must look at a document or a transaction in the context to which it properly belongs to. It is the task of the revenue department/court to ascertain the legal nature of the transaction and while doing so it has to look at the entire transaction as a whole and not to adopt a dissecting approach. The Revenue cannot start with a question as to whether the impugned transaction is a tax deferment /saving device but that it should apply the “look at” test to ascertain its true legal nature.

Applying the above test, the Supreme Court is of the view that every strategic foreign direct investment coming to India, as an investment destination, should be seen in a holistic manner. While doing so, the revenue department/courts should keep in mind the following factors:

  •   The concept of participation in investment
  •   The duration of time during which the holding structure exists
  •   The period of business operations in India
  •   The generation of taxable revenues in India
  •   The timing of the exit
  •   The continuity of business on such exit

The onus is on the revenue department to identify the scheme and its dominant purpose to prove that the impugned transaction is undertaken as a colourable or artificial device to avoid tax.

Taxability of the transaction in India
Based on the above facts, the court finally held that the transaction of sale of one share of CGP by HTIL to VIL was not subject to tax in India by the Indian tax authorities.

Application of section 195 to a non-resident payer
The Supreme Court has held that Section 195 applies to a resident payer in respect of payments made to a non-resident and that it cannot be applied to a non-resident payer. Accordingly, the court has held that VIH cannot be held liable for deduction of tax at source from payment made to HTIL. Also, in any case, since the court held that the transaction did not give rise to any income accruing or arising in India, the question of applying section 195 to such a transaction did not arise.
The Supreme Court has laid down some far reaching principles relating to international taxation. An important point that the court appears to have highlighted to the Government of India is to bring about a semblance of certainty in tax laws. This decision of the Supreme Court should be read and appreciated in the context of the recent aggression that the I-T department has displayed while completing assessments of various tax payers. Whether it is a multinational as is the case in the Vodafone situation or whether it is a local company or an individual, the common thread that runs across most completed assessments is of aggression and belligerence. It would not be an exaggeration to state that most assessments completed in the country result in disallowances and additions to the income returned by the tax payer. This, in turn, has the effect of large demands being raised against the tax payers—of tax, interest and penalty. The Vodafone case is symptomatic of this aggression. It is only in recent times that our I-T department has got ambitions of taxing extra-terrestrial transactions. This would rarely have happened 10 years back. But today, it’s a different story. Those tax payers who take their tax returns lightly and pay scant attention to what is stated in the cumbersome tax return forms that the government has prescribed are only putting their peace of mind in jeopardy. Today, the Income Tax Act is relatively a simple Act and there is hardly any scope for ingenious tax planning. In this scenario, if a tax payer attempts to cut corners or to put in place complex structures to avoid taxes, he would only be inviting a long drawn litigation. Only the brave-hearts and the ones with deep pockets can afford to litigate in our country.

In conclusion, it can be definitely said that this is one of the landmark and exceptional judgements passed by the Indian judiciary and for the time being, seems to have salvaged the faith of foreign investors in the Indian judicial system. The judgement has addressed the issues of certainty and stability in a fiscal system and has rightly identified the areas for improvement for the Indian legislature to boost the confidence of foreign investors. We would now have to wait and watch to find out how the revenue authorities react to this bitter defeat in such a high profile case. It may not be out of place to mention here that history is replete with examples of retrospective amendments carried out in the law with a view to nullify the judgements passed by the courts. It would be a matter of great shame for the country if, in this case too, the finance ministry gets tempted to strike down a sensible and reasoned order by amending the law retrospectively.

(The author is a partner of Sudit K Parekh & Co)

7 years ago
I cannot understand one thing. Though VIH is a non resident payer.How IT dept apply sec 195 and rise that issue.
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