Spectre of future tax code hangs over Vodafone win

By Justin Bharucha and Meghana Karande, Bharucha & Partners

On 20 January the Supreme Court held that the Indian Revenue Service (IRS) cannot bring into tax calculations the price of a sale of offshore assets from one person resident outside India to another such person merely because the offshore asset relates to shares of an Indian company.

Justin Bharucha Partner Bharucha & Partners
Justin Bharucha
Bharucha & Partners

The issues arose in 2007 when Vodafone International Holdings (Vodafone), an entity based in the Netherlands, acquired Vodafone India by acquiring CGP Investments (Holdings) from Hutchison Telecommunications International, both entities based in the Cayman Islands.

As CGP held approximately 67% of the Indian operating company, the IRS claimed that Vodafone should have withheld tax in accordance with the (Indian) Income Tax Act, 1961, in respect of the price paid to Hutchison. The IRS proceeded on the basis that withholding applied as the transaction effectively concerned assets in India.

Bombay High Court upheld the IRS contention and Vodafone preferred an appeal before the Supreme Court. The appeal was admitted on the condition that Vodafone deposit with the court ₹2.5 billion (US$50 million) plus a bank guarantee for ₹8.5 billion, which would be returned or handed over to the IRS depending on the outcome.

Court’s findings

Ruling in favour of Vodafone, the Supreme Court held that the IRS had no jurisdiction to levy capital gains tax on the sale and purchase of shares of CGP and, therefore, Vodafone was not required to deduct tax at source.

A significant aspect of the judgment is that it endorses an assessee’s right to arrange business affairs so as to reduce tax. The Supreme Court said that while a transaction must have some economic or commercial substance, “all tax planning is not illegal, illegitimate or impermissible”.

The court reiterated the principles it set out in Azadi Bachao Andolan, which upheld the provisions and constitutionality of the Indo-Mauritius double taxation avoidance agreement (DTAA). The court observed that the IRS stand that only investments originating in Mauritius (as opposed to investments routed through Mauritius) can benefit under the DTAA was “pitching it too high”.

Also important is that the court recognized the importance and prevalence of holding company structures and held that a holding company and subsidiary company are separate legal entities liable to be taxed separately. Subsidiaries are not to be deemed part of the parent company, and therefore residents of the country in which the parent is incorporated, merely because the parent holds shares in the subsidiaries .

Most significantly, the court reiterated that the burden is on the IRS to establish tax avoidance in the creation or use of such structures before it can invoke the “substance over form” principle or “pierce the corporate veil”. The court endorsed the Vodafone structuring as a bona fide foreign direct investment (FDI) into India and was of the view that FDI in India must be seen in a holistic manner, factoring in the period of business operations and generation of taxable revenues in India.

‘Look through’ rejected

Dismissing the IRS contention that transaction was liable to tax on a “look-through basis” under section 9(1)(i) of the Income Tax Act, as it amounted to an indirect transfer of capital assets situated in India, the court held that section 9(1)(i) covers only income arising from a transfer of a capital asset situated in India, and not income arising from the indirect transfer of a capital asset in India.

Meghana Karande Associate, Bharucha & Partners
Meghana Karande
Bharucha & Partners

The court held that look through “has to be expressly provided for in the statute or in the treaty”. Look through cannot be read into a section by interpretation and, in any event, “will not shift the situs of an asset from one country to another”.

The court also rejected the argument that CGP had no business or commercial purpose. The IRS had contended that since CGP was only a holding company and could not conduct business in Cayman Islands, CGP shares were situated where the underlying assets were situated (being India). The court held that the situs of CGP shares is where the register of CGP members is maintained.

Next step

This decision should increase investor confidence by ensuring the sanctity of DTAAs to which India is a party and also the security and validity of bona fide structures for FDI in India. However, the potential general anti-avoidance rules under the proposed Direct Tax Code may affect the Supreme Court decision in Vodafone by expressly legislating against such bona fide structures.

The ball is now firmly with the Indian government and, specifically, the IRS. Their next move will be crucial in determining how foreign investors view India – especially in the extant global economy and given India’s relative underperformance as a BRIC economy.

Justin Bharucha is a partner and Meghana Karande is an associate at Bharucha & Partners.


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