The Supreme Court of India, on 20 January 2012, put an end to one the country’s most high profile litigations, and in the process delivered a judgment that will go a long way in changing perceptions of India as a global commercial destination.
Vodafone B.V. International (“Vodafone”), a company incorporated in the Netherlands, had a long-standing tiff with the Indian Tax Authorities regarding the acquisition of shares in CGP Investments, a wholly owned subsidiary of Hutchison Telecommunications International Limited (“HTIL”). In February 2007, Vodafone acquired a 100% stake in CGP Investment, a company incorporated in the Cayman Islands, from Hutchison. The Income Tax Authorities argued that apart from the transfer of shares, certain rights and entitlements, were also transferred and were an intrinsic part of the transaction.
CGP Investments held shares totalling 67% in Hutchison Essar Ltd. in India, through various companies incorporated in Mauritius and India. The Income Tax Authorities sought to tax the ‘capital transfer’ of shares of Hutchison Essar, supposedly situated in India, worth US$11 billion. The Income Tax Authorities contended that Vodafone ought to have withheld US$2 billion under Section 195 of the Income Tax Act in respect of the this transaction.
In September 2007, the Income Tax Department issued a show cause notice to Vodafone under Section 201 of the act, seeking to treat Vodafone as an ‘assessee in default’ for not deducting tax at source in terms of Section 195 of the act. In October 2007 Vodafone filed a writ petition before the Bombay High Court challenging the jurisdiction of the department to issue the notice.
In December 2008, the Bombay High Court held that the transaction was prima facie liable to tax in India. Vodafone then filed a special leave petition before the Supreme Court challenging the high court’s ruling. In January 2009, the Supreme Court directed that the jurisdictional issues in relation to the power to tax the transaction first be determined by department. The court also mentioned that Vodafone was entitled, if necessary, to challenge the department’s order before the High Court.
In May 2010, the department passed an order under Section 201 of the act claiming jurisdiction to tax the transaction and treating the transaction as chargeable to tax in India. Vodafone was therefore treated as an assessee in default. In June 2010 Vodafone filed a writ petition before the High Court challenging the department’s order. In September 2010 the high court ruled that:
- Section 9 of the act was wide enough to cover the transaction;
- Income is chargeable to tax in India; and
- The department had jurisdiction under the act to pass an order in relation to the transaction.
Vodafone again challenged the order of the high court before the Supreme Court, through a special leave petition. The hearings began on August 3 2011 and concluded on October 19 2011, after 28 days of arguments.
A careful legal analysis of the aforesaid judgment will show that the Supreme Court in deciding the case in favour of Vodafone considered the following important issues.
Analysis Of The Verdict
The Supreme Court, in reversing the Bombay High Court’s decision, displayed the robustness of the Indian judicial system. Settling a matter of such magnitude in a span of 5 years is commendable considering how ponderous and hesitant the Courts and Legislature have been in the past while addressing issues of national importance. The judgment in itself is very lucid and, most importantly, plugs many loopholes that have been confusing both industry and income tax authorities for many years. The Court did not succumb to the pressure of the numbers involved but rather upheld the Rule of Law. The judgment addresses a number of issues: lifting of the corporate veil, situs of assets, controlling interest and extinguishment, jurisdiction over indirect transfers, tax avoidance and tax planning, and finally, substance versus form. It is, therefore, imperative to deconstruct the judgment into its constituent parts and assess the issues dealing with corporate law in depth.
2.1 Separate Entity Principle
The Supreme Court observed that the corporate and tax laws treat a company as a separate person. A parent company and its subsidiary are totally distinct taxpayers and tax treaties also give the same treatment to parent and subsidiary. The fact that the parent company exercises shareholder’s influence on its subsidiaries does not generally imply that the subsidiaries are to be deemed residents of the State in which the parent company resides. However, the separate entity principle can be disregarded by the tax authorities when there is no reasonable business purpose in creating corporate structures and these structures are used for tax avoidance or avoidance of withholding tax
2.2 Acquisition Of Shares v. Acquisition Of Shares Along With Other Rights And Entitlements
The Bombay High Court concluded that Vodafone acquired share of CGP along with other rights and entitlements including options, right to non-compete, control premium, customer base, brand, licenses, etc., and these other rights and entitlements are capital assets within the purview of provisions of Income-tax Act.
The Supreme Court held that High Court should have applied look at test and examined the transaction holistically. The Supreme Court observed that payment by Vodafone to HTIL was for the entire package and both the parties never agreed upon a separate price for the CGP’s share and other rights and entitlements. Accordingly, it was not open to the income-tax authorities to split the payment and consider a part against individual items. The Supreme Court was of the view that the transaction between HTIL and Vodafone was a contract of outright sale of CGP’s share for a lump sum consideration.
2.3 Section 195 – Applicable Only When A Transaction Is Taxable In India
Section 195 requires the payer to deduct tax at source from payments made to non-residents which are chargeable to tax in India.
It was held by the Supreme Court that shareholding in CGP is a property situated outside India and the transfer of the share by HTIL to Vodafone (an offshore transaction) did not give rise to any taxable income (capital gains) in India. In the absence of any taxable income, the question of deduction of tax at source under section 195 would not arise.
2.4 Corporate Veil And The Vodafone Judgment
Vodafone challenged the tax levied in the Bombay High Court, which ruled against it and in favour of the income tax authorities (the “Revenue”), holding that “the essence of the transaction was a change in the controlling interest in HEL which constituted a source of income in India”. Vodafone appealed to the Supreme Court, which overturned the judgment of the Bombay High Court and ruled that Vodafone was not liable to pay income tax on the transaction. Other than in the context of tax planning and assessment, this decision of the Supreme Court has important implications in the context of the legal principle of the corporate veil and when it may be lifted, particularly in the context of tax avoidance.
Indian law recognizes that upon incorporation, a company acquires a distinct legal identity, different from that of its shareholders, members or directors. This separate corporate existence enables the company to contract with its shareholders and third parties, to acquire and hold property in its own name, to sue and be sued in its own name, and shareholders of a company are not personally liable for the acts or liabilities of the company. It has perpetual succession, its life is not dependent on that of its shareholders and remains in existence, however often its members change, until it is dissolved.
The earliest legal case that recognized that a company is a separate legal entity, distinct from its members, is often traced back to Salomon v. Salomon, and a number of other decisions following it, have firmly established this principle.
In certain circumstances, courts may ignore the independent personality of the company, and lift the corporate veil to go behind the corporate personality, to the individual members or to the economic entity constituted by a group of associated companies. This enables a court to lift the corporate veil of the company in order to determine the persons responsible for controlling / carrying on the functions of the company. The principle was summarised by the Supreme Court in Life Insurance Corporation of India v. Escorts Ltd. when it stated:
“… the corporate veil may be lifted where a statute itself contemplates lifting the veil, or fraud or improper conduct is intended to be prevented, or a taxing statute or a beneficent statute is sought to be evaded or where associated companies are inextricably connected as to be, in reality, part of one concern. It is neither necessary nor desirable to enumerate the classes of cases where lifting the veil is permissible, since that must necessarily depend on the relevant statutory or other provisions, the object sought to be achieved, the impugned conduct, the involvement of the element of the public interest, the effect on parties who may be affected, etc.”.
In this case, the corporate veil was proposed to be lifted to ascertain the real investing entities, when investments were made through a number of intermediary companies. Insofar as parent / subsidiary companies are concerned, the principle of the corporate veil demands that they also be treated as separate legal entities, unless they are in actuality and function as, a single economic entity. Hence, where the subsidiary, though having a distinct legal personality, does not in fact act autonomously and essentially carries out the instructions given to it by the parent, it is possible to say that the subsidiary and the parent are really one and the same.
The Court has to examine whether the two companies are truly separate and independent, and among the factors it will consider are whether the persons conducting the business were “guided by the same head and brain” and whether the parent decided what the subsidiary should do. Courts have also lifted the corporate veil if it is found that a subsidiary company has been constituted with the sole intention of concealing the true facts, to act as a façade and thereby perpetrate a fraud, or to “look at the realities of the situation and to know the real state of affairs”.
Courts have the power to lift the corporate veil and disregard the independence of the corporate entity if it is used for tax evasion or to circumvent tax obligations, or to ascertain the residential status of the company for the purpose of tax incidence, or where the principle of corporate personality is too flagrantly opposed to justice, convenience or in the interest of revenue. In the Vodafone case, the Supreme Court dealt with the principle of the corporate veil and when it can be lifted, primarily in the context of taxation in India, at Paragraphs 66 to 68 of the judgment of the Chief Justice, and Paragraphs 43 to 46, 56 to 61 and 75 to 76, of Justice Radhakrishnan’s judgment.
The Chief Justice first recognizes the principle of the corporate veil by noting that
“[t]he approach of both the corporate and tax laws, particularly in the matter of corporate taxation, generally is founded on the abovementioned separate entity principle, i.e., treat a company as a separate person. The Indian Income Tax Act, 1961, in the matter of corporate taxation, is founded on the principle of the independence of companies and other entities subject to income-tax”.
On this basis, he further notes in the context of parent / subsidiary relationships, that it is generally accepted that the group parent company would give guidance to group subsidiaries, but that by itself would not justify lifting the corporate veil or imply that the subsidiaries are to be deemed residents of the State in which the parent company resides, and that “a subsidiary and its parent are totally distinct tax payers”.
The Chief Justice then clarifies that it is only in a situation where the subsidiary is fully controlled or subordinate to the parent company, and / or the actual controlling parent company makes an indirect transfer through “abuse of organization form/legal form and without reasonable business purpose” which results in tax avoidance, that the separate legal entities may be ignored and the subsidiary’s place of residence may be linked with that of its parent company, and tax imposed on the actual controlling parent company.
“Thus, whether a transaction is used principally as a colorable device for the distribution of earnings, profits and gains, is determined by a review of all the facts and circumstances surrounding the transaction. It is in the above cases that the principle of lifting the corporate veil or the doctrine of substance over form or the concept of beneficial ownership or the concept of alter ego arises.”
While dealing with the aspect of tax liability in India and indirect transfers / holding company and subsidiary company relationships, the Chief Justice notes that it is common for foreign investors to invest in Indian companies indirectly, through an interposed foreign holding or operating company, such as Cayman Islands or Mauritius based company, for both tax and business purposes. The GAAR (General Anti Avoidance Rules), adopted by India and its judicial anti-avoidance rule, permit the Revenue to “invoke the substance over form principle or piercing the corporate veil”, if it is able to establish that the transaction in which the corporate entity is used is a “sham or tax avoidant”. As an example, if the Revenue finds that in an investment transaction / acquisition, “an entity which has no commercial/business substance has been interposed only to avoid tax”, then in such cases the Revenue would be entitled to ignore the separate legal identity or interposition of that entity, to look at the holding company as having directly made the investment / acquisition. The Chief Justice then lists out six factors that may be considered in order to determine whether the transaction is a sham and whether in a specific case, the corporate veil may be lifted, i.e. “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.”
Justice Radhakrishnan judgment also recognises the principle of the corporate veil and that a company / subsidiary company, is a separate entity which will be held to be so except in very limited circumstances. In the context of tax liability, he repeatedly observes that the veil can be lifted only if the Revenue establishes that the transaction / corporation has been “effected to achieve a fraudulent or dishonest purpose, so as to defeat the law”, or where it is “fraudulent, sham, circuitous or a device designed to defeat the interests of the shareholders, investors, parties to the contract and also tax evasion”. As such, merely because there is a holding / subsidiary relationship in which the holding company controls the subsidiary or that they are a single economic unit, would not justify a lifting of the corporate veil, unless it is for the purposes of “tax evasion”.
In the final analysis, the Supreme Court in Vodafone, decided against lifting the corporate veil as the tax authorities failed to establish, that the Vodafone transaction was a sham or tax evasion scheme. The Chief Justice noted, “There is a conceptual difference between preordained transaction which is created for tax avoidance purposes, on the one hand, and a transaction which evidences investment to participate in India” and that in order to ascertain into which bracket the transaction fell, one should take into account the six factors mentioned above. In this regard the Chief Justice observed that the Hutchison structure (i.e. the parent company in Hong Kong, the intermediate subsidiary in the Cayman Islands, and the final subsidiary in India etc.), had existed for a considerable length of time generating taxable revenues right from 1994, that the Share Purchase Agreement envisaged “continuity” of the telecom business, and that accordingly the Hutchison structure was not created or used as a sham or tax avoidance scheme. In the circumstances, where the court is satisfied that the transaction satisfies all the parameters of “participation in investment” the Court need not go into the questions such as de facto control vs. legal control, legal rights vs. practical rights, etc., and accordingly, there was no need to lift the corporate veil of the Hutchison or Vodafone entities.
2.5 Situs Of Assets
The fundamental issue addressed by the Supreme Court is that the Indian Tax Authority does not have any territorial jurisdiction to tax the overseas transaction between Vodafone and HTIL. The Tax Department put forward the point that Section 9 of the Income Tax Act, 1961 contained a ‘look through’ provision which allowed taxation of indirect transfers. It must be kept in mind that shares of a Cayman Islands company which were owned by another Cayman Islands company were transferred to a Netherlands company.
Kapadia, C.J. pointed shed some light on the applicability of the charging section, i.e. Section 9 of the Act in the wake of arguments of the Tax Department. For a transaction to be chargeable under Section 9, it must satisfy three conditions, namely, existence of a capital asset, transfer of such asset, and the situation of such asset in India. All three elements must exist together in order to attract Section 9. Radhakrishnan, J. further elaborated on this point. He points out that Section 9 has no ‘look through’ provision and such a provision cannot be brought through construction or interpretation of a word ‘through’ in the section. As a result, indirect transfers cannot be taxed in India. Arguendo, assuming, that Section 9 contained a ‘look through’ provision, even then such a provision will not affect the situs of an asset from one country to another. Shifting of situs may be done only by express legislation.
Although both Kapadia, C.J. and Radhakrishnan, J. held that the situs of the CGP Investments shares is the place of incorporation/register of shares, they appear to have adopted different approaches. The Chief Justice has applied the Companies Act, 1956 while Justice Radhakrishnan has adopted the conflict of laws rules on situs of shares. Under the Companies Act, the situs of shares is always where the company is corporated and where its shares can be transferred. In the present case, CGP Investments’ Register of Members was maintained in the Cayman Islands and the transfer of shares from HTIL to Vodafone was also recorded in the Cayman Islands. Moreover, these facts were not disputed by the Tax Department. The conflict of laws approach provides that the situs of a company’s shares shall be the place where the company was incorporated. Moreover, Cayman Islands law does not recognise multiplicity of registers and as a result the situs of shares of CGP Investments is held to be the Cayman Islands.
2.6Controlling Interest, Rights And Entitlements
One of the most important questions involved in this case is whether Vodafone acquired a ‘controlling interest’ in Hutchison Essar. If there was no ‘controlling interest’ transferred, then the question of a connection with India would not arise. In order to understand what the Supreme Court held with respect to ‘controlling interest’, it is important to revisit the facts of the case.
Vodafone paid HTIL a sum of US$11.5 billion for a 52% stake in Hutchison Essar, via 100% acquisition of CGP Investments, to HTIL. However, also included in the arrangement, was 15% worth of call options in Hutchison Essar held by HTIL but which would now vest in Vodafone.
So, potentially, Vodafone acquired 67% stake in Hutchison Essar. This, the Tax Department believes, is an acquisition of a ‘controlling interest’ in Hutchison Essar.
There is also the question of the Term Sheet agreement entered into by HTIL with Essar in 2003. This agreement granted the former a ‘Right of First Refusal’ over any sale of shares in Hutchison Essar by Essar and it also granted Essar ‘Tag Along Rights’ in respect of Essar’s shareholding in HEL. This Term Sheet agreement was given effect to in the Share Purchase Agreement entered into by HTIL with Vodafone as it gave Essar the right to Tag Along with HTIL and exit from Hutchison Essar and this suggests that Term Sheet agreement was a legally binding contract.
Another point to be noted is that before the Share Purchase Agreement, the board of directors of Hutchison Essar were appointed in the following ratios: 6 appointed by HTIL, 4 appointed by Essar and 2 appointed by TII, a company which indirectly held 19.5% in Hutchison Essar. TII was one of the intermediate subsidiaries of HTIL. The Term Sheet agreement contained a provision that the ‘practice’ of appointing the directors in the above ratio would continue. As a result, post-acquisition, Vodafone would now appoint 8 directors (6+2) and Essar would continue to appoint 4 directors.
On this point, the Supreme Court has held that mere nomination of directors is different from a right or power to control and manage the affairs of the company. ‘Controlling interest’ is not an independent capital asset and Vodafone did not acquire such ‘controlling interest’ in the form of 67%. The 15% options are, at best, analogous to potential share and until such rights are exercised, no voting rights or managerial control exists. Furthermore, ‘continuing the practice’ of appointing directors cannot be equated with controlling interest. As a general rule, sale of shares cannot be broken up into separate individual components and such components are not distinct capital assets.
As per the Kapadia, C.J., control and management is a facet of the holding of shares and applying the principles governing shares and the rights of the shareholders to the facts of the Vodafone case suggest that the transaction indeed was a straightforward share sale.
Controlling interest is not a separate capital asset; instead, ‘control’ is a mixed question of law and fact. Ownership of shares may, in certain situations, result in the assumption of an interest that has the character of a controlling interest in the management of the company. A controlling interest is therefore a not an identifiable or distinct capital asset independent of holding shares. The control of a company resides in the voting power of its shareholders. Shares represent an interest of a shareholder, which is made up of various rights contained in the contract embedded in the articles of association. The right of a shareholder may assume the character of a controlling interest where the extent of the shareholding enables the shareholder to control the management. Shares and the rights that emanate from them cannot be dissected. Further, the judges seem to have missed out on one important question. They judges have not discussed adequately, whether the rule that ownership of shares cannot be automatically equated with controlling interest, is applicable in all circumstances. There is doubt whether the said rule will hold good in a situation where the transaction between the parties is explicitly for acquisition of controlling interest in a subsidiary company and the same is given effect to by transferring shares of an overseas parent company. This, in our view, does not seem to have been addressed in the judgment.
Vodafone’s Conflicting Signals
3.1 Business Will Be Attracted To A Country Only When There Is Certainty
Just as the study of economics can have conflicting schools of belief for each given situation, in law, too, situations do arise where two schools of thought can apply to a particular judgment, as it has in the case of Vodafone. It is, however, rare in modern jurisprudence for any particular judgment to attract so much mileage for such a long period of time, covering diverse aspects of the law. This position is similar to a 20:20 match in which the situation is periodically in flux. It makes one believe that the Vodafone case is not a mere taxation issue.
It is a well-known fact that the Companies Act, 1956, does not equate ownership of shares with ownership of assets. If the logic that a sale of shares amounts to sale of assets is considered veracious or accurate, does that mean that, for example, shares in a real estate company that are transferred by shareholders will amount to the sale of a derivative (that is, the land bank of the company since land is the underlying asset)? This logic does not sound rational because assets are the property of the company and not of the shareholders.
The Bombay High Court in a milestone verdict, however, held that a change in controlling interest attracts tax. The verdict was given on the basis of an evaluation of agreements entered into by the parties and various disclosures made by the parties for ascertaining the subject-matter of the transaction and the business understanding of the parties to the transaction.
The Supreme Court commented that the principals laid down in the judgments of McDowell and Azadi Bachao Andolan could be invoked only when the taxpayer chooses to use an artificial and colourable device devoid of any commercial objective and one cannot read McDowell’s case in a manner to characterize all tax planning as illegitimate. The proper course in construing revenue acts is to give a fair and reasonable construction to their language without leaning to one side or the other, but keeping in mind that no tax can be imposed without words clearly showing an intention to lay the burden and that equitable construction of the words is not permissible.
A person cannot be guided by a law that did not exist at the time when the action occurred. It is fundamentally unfair to hold a person to be in contravention of the law when that law did not exist when the alleged contravention occurred. The Union Budget tabled in Parliament for the ensuing fiscal year has, by way of a clarificatory amendment, endeavoured to tax transactions covered with retrospective effect from 1 April, 1962, meaning several foreign investments will now be open to taxation, especially those completed in the last five to six years. It is undisputed that the legislature does have the power to legislate with retrospective effect, but in doing so it must ensure two conditions:
1) a legislature can by a retrospective amendment in law validate such law that has been declared by court to be invalid, provided the infirmities and vitiating factors noticed in the declaratory-judgment are removed or cured;
2) if by such a validating and curative exercise made by the legislature, the earlier judgment becomes irrelevant and unenforceable, that cannot be called an impermissible legislative overruling of the judicial decision.
Whatever the arguments for or against Vodafone, it is pertinent to note that business will be attracted to a country only when there is certainty and fair play. The lessons to be learnt from here are that business should be more careful when it comes to dealing with government because, as the saying goes, whether the knife falls on the watermelon or the watermelon falls on the knife, it is the watermelon that gets cut.
3.2 Shares And Assets
The demand for tax in the Vodafone case was a result of failing to understand the difference between the sale of shares in a company and the sale of assets of that company. It is an elementary principle of company law that ownership of shares in a company does not mean ownership of the assets of the company. Thus, an individual who owns 45 per cent or 85 per cent of the share capital does not own 45 per cent or 85 per cent of that company’s assets. The assets belong to that company which is a separate legal entity. In the Vodafone case, 51 per cent of Hutchison Essar Ltd. (HEL) was directly owned by the Hutchison group of Hong Kong through a multiple layer of companies and ultimately by a company incorporated in the Cayman Islands. This was not the result of any devious tax planning scheme but the consequences of the growth of Hutchison Essar Ltd. by acquiring several telecom companies over the years. Hutchison International decided to exit its Indian operations and a public announcement was made to this effect.
Vodafone was the successful buyer of the share of the Cayman Island company for $11-billion. Consequently, by purchasing one share of the Cayman Island company, Vodafone came to own 51 per cent of share capital of HEL. The transfer of shares of one non-resident company (Hutchison) to another non-resident company (Vodafone) did not result in the transfer of any asset of HEL in India. All the telecom licences and assets continued to belong to HEL or its subsidiaries.
The absurdity of the demand in the Vodafone case can be explained by two simple illustrations. Hyundai Motors India Ltd. is a wholly owned subsidiary of the parent Hyundai company in Korea. The Indian subsidiary has a large factory near Chennai and perhaps owns several other assets. If, for example, Samsung purchases 65 per cent of the share capital of the parent Korean company in Seoul can it be argued that Samsung has automatically purchased 67 per cent of the factory at Chennai? Consequently, can it be said that the sale of shares in Korea resulted in a capital gain in India which requires Samsung to deduct tax at source under the Indian Income Tax Act, 1961? Under Section 9(1)(i) of our Act, there is liability to tax only if there is a transfer of a capital asset in India. In this illustration, the capital asset that is transferred was the share in Korea and there is no transfer of assets in India. The Indian subsidiary continues to exist and continues to own the factory as well as other assets.
The absurdity can also be seen by a domestic illustration. Tata Motors Ltd. has its headquarters at Mumbai and factories at Jamshedpur and Pune. If another Indian group purchases 67 per cent of the shares of Tata Motors Ltd., the transfer of shares takes place in Mumbai which is the registered office of that company. Can anyone say that there is a corresponding transfer of 67 per cent of its factory, lands and buildings at Pune and Jamshedpur as well? Can the local stamp authorities in Jharkhand and Maharastra demand stamp duty on the ground that there is also a transfer of underlying assets? It is elementary that what has been sold is only 67 per cent of the paid-up share capital of Tata Motors Ltd.
The assets of that company remain with that company and do not get transferred. The sale of the shares of Tata Motors cannot and does not result in the transfer of its “underlying assets.”
This is exactly what happened in Vodafone. The shares owned by Hutchison were sold to Vodafone indirectly purchasing 51 per cent of the share capital of Hutchison Essar Ltd., a company registered in Mumbai. Not a single asset of this Mumbai based company was transferred either in India or abroad. Indeed, there would be no transfer of any asset in India.
This is also exactly how several international transactions are concluded. Vodafone was not the first case where transfer of shares between non-resident overseas company resulted in a change in control of an Indian company. But controlling interest is not a capital asset; it is the consequence of the transfer of shares. The demand made by the Income Tax Department in the Vodafone case was thus contrary to elementary principles of company and tax law.
Impact Of The Ruling
The Vodafone case is a landmark judgment which clarifies many tax concepts. The judgment has received applause from various parts of the industry and this ruling has seemingly raised India’s profile as a top investment destination. India will now no longer be an intimidating prospect for foreign investors. A great boost in Foreign Direct Investment is expected following this judgment. Indirect transfers will no longer be taxed and this should convince investors that there exists a safe route to invest in India.
4.1 Impact On Similar Business Deals
The judgment delivered the Supreme Court would immensely benefit the companies who have concluded business deals involving similar issues. These deals besides the one of Vodafone were on the list of income tax department. The judgment would save the companies involved in other deals from litigation.
4.2 Impact On Investments Routed Through Tax Heaven Jurisdictions
The judgment would also help the genuine transactions of investments routed through tax heaven jurisdictions. The scrutiny by income-tax authorities is expected to go down in case big ticket business deals representing a genuine Foreign Direct Investment (FDI) in India.
As of today, a considerable chunk of FDI in India is routed through tax heaven jurisdictions including Mauritius. It may also be a scenario that a company from a jurisdiction (other than tax heaven jurisdictions) invests in Mauritian company which in turn invests in an Indian company. In such a scenario, the income tax authorities many a times contend that the ultimate beneficial owner of the shares (subject-matter of transfer) is a company which is a resident of non-tax heaven jurisdiction. Accordingly, the exemption from capital gains tax (in India) extended by Double Taxation Avoidance Agreement (DTAA) between India and the country (tax heaven jurisdiction) is disputed.
In the concurring part of the judgment, it was noted by Justice K.S. Radhakrishnan that to say that the Indo-Mauritian Treaty will recognize FDI and FII only if it originates from Mauritius, not the investor from third countries who have incorporated company in Mauritius, is pitching it too high. In other words, benefits of DTAA cannot be denied to Mauritian company in case investment in its share capital flows from a third country provided the investment in India through Mauritian company is not a sham transaction or a colourable device to evade taxes.
4.3 Impact On Pending Litigation
India is considered as one of the few emerging countries that slap retrospective tax on deals done outside the country by foreign companies. The Vodafone verdict assumes importance as it could have major repercussions on other purchases of Indian assets by foreign companies. The judgment settled a prolonged litigation which had created a lot of uncertainty for multinationals having similar structures and/or who had entered into similar transactions. This should provide much needed respite to other litigants in other cases where the Vodafone controversy had been initiated by the revenue authorities and is currently pending at various stages of litigation across the country. The following are the beneficiaries which could benefit from the Supreme Court’s verdict:
- SABMiller is involved in a clash with the Indian tax authorities who demanded payment of US$39.5 million in tax on the brewery group’s 2006 acquisition of Indian assets from Foster’s Group, the Australian brewer The company received a demand for payment of tax on the US$120 million deal. The matter is pending before the Bombay High Court.
- Genpact India was recently served with a show cause notice by the Tax Department. The US company General Electric sold nearly 60% interest in Genpact India to two private equity players – General Atlantic and Oak Hill Partners – for about US$500 million in 2004. The deal was structured through Luxembourg entities. The Delhi High Court held that Genpact India is not a representative of General Electric USA and is not liable to pay capital gains tax.
- Japanese firm, Mitsui, in April 2007 sold 51% stake in Indian iron ore miner Sesa Goa to Vedanta Group for US$981 million. The deal was routed via Finsider International, a company incorporated in the UK, which held the Sesa Goa shares. Vedanta had purchased 100% in Finsider.
- In 2005, AT&T and Aditya Birla Nuvo signed a US$150 million under which the former sold 16% in Idea Cellular India to Aditya Birla Nuvo through its holding company AT&T Mauritius. New Cingular Wireless was the holding company of AT&T Mauritius. Later, Tata Industries acquired AT&T’s remaining 17% stake in Idea Cellular India from AT&T Mauritius. The Tata Group later exited Idea Cellular. The case is pending before the Supreme Court.
- French drug-maker Sanofi Aventis bought a majority stake in Indian vaccine company Shantha Biotech in 2009 for around US$770 million. The deal was through an SPV created by Merieux Alliance that held 90% in the Indian company. The Authority for Advance Rulings (AAR) ruled that the French company that sold its controlling interest in Shantha Biotech to another French company will have to pay capital gains tax to the Indian government, even though the deal was cut outside India.
THE ramifications of the Supreme Court verdict in the Vodafone case could be much wider than what is obvious at first sight, with implications not just for taxation but for the much broader issue of corporate regulation in general. In order to appreciate this, it is necessary to set the premises used by the court to arrive at the conclusion that the demand imposed by the tax authorities on Vodafone was illegitimate against some of the realities of the Indian corporate sector. These premises are not necessarily crystal clear in the judgment, but that only makes it more amenable to interpretations of the kind that are highlighted here.
The substantive facts of the Vodafone-Hutch transaction – that even though it was an offshore transaction, its ultimate purpose as well as result was the transfer of control over a company, now called Vodafone Essar Limited (VEL), which was registered in India, which owned capital assets located in India and whose business was in India – are well known and the parties concerned never made a secret of it. The Supreme Court judgment, too, does not dispute these substantive facts.
By denying the legal significance of some crucial facts, however, the court has concluded that the provisions of the Income Tax Act, according to which income arising from the transfer of capital assets located in India would be deemed to be income originating in India and be subject to capital gains tax, were not applicable to the Vodafone-Hutch transaction.
To arrive at this conclusion the judgment appears to have relied on not one but two different premises, though both have a common underlying basis. Either of these, if correct, would be sufficient for the court’s conclusion to be valid. It is their correctness, however, that needs to be scrutinised with reference to their larger implications and not only in relation to the particular case at hand.
The first premise was that the transaction between Vodafone and Hutch was a share transfer (sale) rather than a transfer of capital assets and that the ownership of the capital assets remained vested in the Indian company. The judgment took recourse to the legal distinction between a company and its shareholders and the fact that the de facto controlling right enjoyed by those holding a large block of shares in a company is not in the nature of a legally enforceable right. The judgment, however, carries these to the point where it ended up ignoring the real distinction between a shareholding that constituted a controlling interest and that which was a pure financial investment.
It is entirely immaterial here that the share(s) actually transferred were not of the company located in India but of offshore companies that ultimately controlled the shares that constituted the controlling interest in the Indian company. Even if the shares were of the company located in India, in the court’s view it would not constitute a transfer of capital assets.
Once it is accepted that the shareholders of a company have a distinct legal identity from the company, no matter what the proportion of shares that they hold is, it follows that two companies would have distinct identities even if one held a controlling share in the other. The Supreme Court judgment makes it a point to emphasise that even a subsidiary has an identity distinct from its parent holding company. Stretched so far, this argument must mean that the law be blind to the essential connection linking the offshore transaction between Vodafone and Hutch and the company located in India.
This connection existed because what was sold to Vodafone was the company at the apex of a structure of holding and subsidiary companies located abroad, through which more than half the shareholding of the company in India was ultimately controlled. The denial of any legal significance of this chain of holdings underlies the second premise of the Supreme Court’s verdict, namely that nothing located in India changed hands as a result of the Hutch-Vodafone transaction. In the court’s view, since the asset (share) actually transferred had a foreign location it was outside the jurisdiction of Indian tax authorities.
To arrive at the judgment, the Supreme Court had to find a way around the 1985 judgment of the same court in the McDowell case, which upheld the principle of going behind the corporate veil to thwart illegitimate tax avoidance. The way in which the Vodafone judgment achieves this appears in effect to be a case of applying a particular logic only in order to deny its applicability in the same breath.
What the judgment argues is that such going behind the corporate veil or looking through would be legitimate only in cases where it can be established that there is a deliberate intention of evading taxes. In the Supreme Court’s view no such conclusion was warranted in this case if the steps that led to the creation of the complex holding structure of VEL and the eventual Vodafone-Hutch transaction were seen in their proper context. The paradoxical result of this reasoning is the following – once the legality of the structure has been established, its existence cannot be recognized. The conclusion that counts, according to the Supreme Court, is that the structuring of the transfer of control from Hutch to Vodafone was not done in a particular way with the intention of avoiding taxes. Since, therefore, the corporate veil cannot be pierced, the fact that there was a transfer of control from Hutch to Vodafone must be ignored. An additional implication would be that as long as it can be established that a mechanism was not originally created with the intention of avoiding taxes, it does not matter if it eventually has such a result.
The Supreme Court judgment in the Vodafone case has thus upheld the principles of maintaining a very sharp separation between companies and their shareholders and laid down very stringent standards for determining when these fine legal distinctions can be overlooked in favour of a more realistic approach. It is this that makes the judgment, given the realities of the Indian corporate sector, amenable to be used for undermining the much-needed regulation of that sector. It is not surprising, therefore, that it has been welcomed so heartily in corporate circles.
Lack of enforcement has long been a feature of corporate regulation in India, and tax evasion is only one expression of this larger phenomenon. Apart from undertaking actions that are purely illegal, finding and using legal loopholes to circumvent or manipulate regulations and defeat their purpose has been an entrenched feature of corporate culture in India. Aiding in the subversion of regulation has been a second important feature of the Indian corporate sector, which also has a long history. This is the prevalence of multi-company structures whereby a common control is exercised over a number of legally separate companies, often taking advantage of the right of these companies to own each other’s shares. The deliberate creation of such structures and undertaking business activities through them rather than single companies, sometimes precisely to bypass regulations, has been the pattern in India.
Multi-company structures and corporate malpractices have gone together in many different ways other than in the case of tax evasion. For instance, in an earlier era, Indian business groups used multiple companies to try and corner licences in individual industries. Indian and foreign firms also used separate companies controlled by them to get around the reservation of some sectors for small-scale industries.
The diversion of funds raised from financial institutions or capital markets through one company with a particular activity to other group companies with different activities has been quite regularly practised in the Indian corporate sector. Insider trading or share-price rigging through companies legally independent of the companies whose shares were being transacted is also known to have happened. Such examples can be multiplied. The ones cited are, however, sufficient to establish that for proper regulatory enforcement the legal recognition of the common identity binding legally independent companies, derived from the fact that they are controlled by the same actors, is crucial. This has never been easy – the explicit provisions for such recognition that once existed in the Monopolies and Restrictive Trade Practices (MRTP) Act, 1969, were themselves circumvented in ingenious ways by business firms in India. The Supreme Court judgment in the Vodafone case makes it even more difficult.
Even before the Vodafone verdict, the liberalisation measures since the early 1990s have contributed to weakening corporate regulation. Liberalisation has not meant the end of all regulation. The emphasis on creating a corporate-friendly climate has, however, resulted in a more permissive environment, further eroding the state’s capacity to discipline private capital. At the same time, restrictions on the use of multi-company structures that flowed from the earlier anti-monopoly laws have been withdrawn. These have happened alongside the opening up of the economy and increasing cross-border transactions.
One consequence is that multi-company structures have increasingly come to include within themselves offshore corporate entities, many registered in tax havens. Indian affiliates of foreign multinational firms, of course, always had cross-border connections with corporate entities registered elsewhere, but these have now become common even in the case of Indian firms. In other words, the scope for using multi-company structures spread across many jurisdictions to get around regulations in India has increased. If the Vodafone verdict is seen in such a context, then the need to invalidate its serious implications becomes even more pressing.
Whether the undoing of the major repercussions of the Vodafone verdict will result through the Income Tax Department’s successfully appealing for a review of the judgment remains to be seen. If it does not, and perhaps even if it does, an appropriate legislative response may be necessary. It is not, however, sufficient for legislation to merely explicitly provide for taxing capital gains arising from transactions of the Hutch-Vodafone kind. What is required is the opening up of the web of connections between myriad corporate entities spread across a variety of jurisdictions to legal scrutiny and recognition of the purposes for which they exist.
The Supreme Court judgment in the Vodafone case will put to bed several controversies in taxation. Our judicial system normally takes several years to close a case beyond final appeal. The fact that Vodafone got their judgment in about five years and in a manner that upholds several international principles in law reposes faith in India’s judiciary.
Vodafone was, as described by the revenue department, a test case where Revenue wanted to stretch interpretation of the Income-Tax Act to hold overseas transfers with an underlying value in India liable to tax in India, if the ‘intent’ of the transacting parties was transfer of the underlying value. Revenue contended that the transaction sought to avoid tax and that Vodafone ought to have withheld tax on the consideration it paid Hutch.
On the other hand, it was Vodafone’s contention that the true legal effect of the transaction was to transfer the shares of an overseas company. The fact that there were statements made commercially to say that the sale/acquisition was of an Indian telecom business was not relevant. The Supreme Court has upheld that the legal implications of a transaction cannot be disregarded and in this case, the legal effect was to transfer the shares of an overseas company. One could not ‘look through’ and pierce the corporate veil of a legitimate holding company that was used as an investment vehicle and thereby try and tax the underlying value of the subsidiaries.
The observations of the Chief Justice of India that foreign direct investment flows towards locations with a strong governance infrastructure – good laws, efficacious enforcement of laws by the legal system – and that certainty is integral to the rule of law is remarkable and noteworthy. Hopefully, they will set the tone for the future.
The judgment has several long-term implications. First, and foremost, it provides a basis for interpretation, namely, that one has to ‘look at’ a transaction rather than ‘look through’ a transaction unless one is concerned about fraud or a similar situation. The tax authorities cannot dissect a transaction and treat a transaction as a sum of its constituents instead of the way the transaction has been entered into by the parties. This principle is indeed critical. The Supreme Court has built caveats to cover artificial devices and frauds, but barring that, the form of the transaction would prevail.
Second, the issue of tax avoidance versus tax evasion gets clarity. The Supreme Court has held that tax avoidance within the legal parameters continues to prevail and the principle laid down in this regard in the case of Azadi Bachao Andolan continues to hold fort. Importantly, the Supreme Court has held that one cannot impose form over substance in statute or impose limitation of benefits in a tax treaty.
Third, the international principles of jurisprudence of respecting holding company structures, particularly those that have been in place for a length of time and have not been created merely for the purposes of exit, have been blessed. This, again, is very welcome and will do away, with significant certainty, with the Revenue authorities’ desire to pierce the corporate veil and look at the substance of the transaction in several cases.
Rather than view the judgment as a defeat for Revenue, one should view it as a victory for the Indian judicial system. This will promote inflow of foreign funds to India and ultimately benefit revenue much more than the immediate loss to the exchequer. The stakes involved matter more than Vodafone.
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