Summary of Proceedings before Bombay HC in case of Vodafone International Holding B.V

Vodafone International Holding B.V. (Vodafone NL) was issued an order by the Indian Tax Authority assessing a capital gains tax alleged to have arisen to the Hong Kong based Hutchison Group (Hutch) on acquisition of controlling interest in an Indian entity, Vodafone-Essar Ltd. The controlling interest was acquired by acquiring the shares of a foreign holding company that indirectly held more than 50% of the shares of the Indian entity.

The Tax Authority has alleged that Vodafone NL failed to withhold Indian tax on the payment of consideration made to Hutch for acquiring the controlling interest. Vodafone NL filed a writ petition in the Bombay High Court (HC) against the Tax Authority’s order. The HC commenced proceedings on the writ petition on 4 August 2010.

We here summarized the arguments made by Vodafone NL before the HC during the proceedings in the past two weeks. While submissions have been made on a number of technical issues arising from the case, the main thrust of the arguments has been that the transaction was not designed to evade Indian tax, transfer of shares of a company is different from transfer of underlying assets of that company, situs of the shares that was transferred is not in India and the Indian Tax Law (ITL) does not contain ‘look through’ provisions.

Facts and background

It may be recalled that Vodafone NL was issued a notice by the Tax Authority seeking to tax capital gains arising to Hutch, which had sold its stake in a Cayman Islands entity to Vodafone NL. The Cayman Islands entity indirectly owned more than 50% controlling interest in the Indian entity. Vodafone NL was sought to be assessed as an assessee-in-default (AID) for not withholding taxes on the sale consideration paid to Hutch. Vodafone challenged the issue of this notice before the HC. The HC in its order [220 CTR 649], pronounced in December 2008, had held that the notice issued by the Tax authority cannot be termed extraneous or irrelevant or erroneous on its face so as to require it to be quashed under the writ jurisdiction of the HC. Kindly refer EY tax alert dated 5 December 2008 for detailed contents and our comments on the HC order.

Against this HC order, a special leave petition filed by Vodafone NL before the Supreme Court (SC) was dismissed with an observation providing for the jurisdictional issue to be examined by the Tax Authority as a preliminary issue. If the preliminary issue were to be decided against Vodafone NL, it would be entitled to question the decision before the HC as a question of law. Kindly refer EY tax alert dated 29 January 2009 for more details on the SC order.

Pursuant to the SC observation, the Tax Authority asserted that it had jurisdiction to tax the transaction in the hands of Vodafone NL and issued an order treating Vodafone NL as an AID. Vodafone NL filed a writ petition in the HC against the order. The arguments presented by Vodafone NL before the HC are summarized below:

Transaction not designed to evade tax, structure evolved over a period of years

• Incorporation of a company in any jurisdiction is driven by several economic, political and commercial factors. Tax saving is not the sole objective in adopting a particular structure.
• Hutch is originally based in Hong Kong, which is one of the favorable tax jurisdictions in the world. Thus, creation of subsidiaries in Mauritius, Cayman Island etc. would not necessarily be based on tax benefits. Authenticity of the corporate structure was explained by explaining chronological events of liberalization of the Indian economy, Foreign Direct Investment (FDI) policy, Hutch’s entry in different telecom circles etc. leading to the acquisition of shares by Vodafone NL.
• Merely because an entity is an investment company (with reference to Cayman Islands entity) it could not be said that the particular company is a conduit, designed to avoid tax. Moreover, the Indian exchange control regulations recognize such investment companies.

• The structures were legally formulated, considering the commercial expediency and economic realities, and the decision to purchase shares was also governed by commercial expediency as it has resulted in a consolidated share acquisition as against frag mental share purchase, if the shares would have been acquired from several downstream Mauritius entities.
• Indian operations are being carried out by the Indian entity and other operating companies which are separate legal entities. Reliance was placed on the SC decision in the case of Azadi Bachao Andolan [263 ITR 706] wherein it was held that the legal form would prevail over the substance unless it is shown that fraud has been perpetrated.
• The corporate veil cannot be lifted unless there is proof that the transaction is sham and designed to evade tax. A genuine transaction undertaken within permissible legal framework cannot be called a sham transaction.

Transfer of shares is different from transfer of underlying assets or undertaking

• The ITL specifically recognizes ‘shares’ as a capital asset.
• Sale of shares results in transfer of bundle of rights viz., right to dividend, right to vote, right to control etc. Each right cannot be vivisected and taxed separately.
• Through purchase of shares, Vodafone NL has acquired a right to control the Indian business operations and not the ownership of the assets in India, which continues to remain with the Indian entity.

Situs of shares transferred not in India, no ‘look through’ provisions in India

• As per the ITL, transfer of a capital asset is taxable in India if it is situated in India. Situs of shares lies in the place where the share register is maintained and in the absence of such share register being maintained, the situs lies at the place of incorporation of the company. Therefore, since the shares of the Cayman Islands entity are being transferred, it cannot be taxed in India.
• Rules of apportionment of sale consideration applies only if different jurisdictions claim right of taxation under the source rule. As there are no activities in India, the source rule and, consequently, rules of apportionment would not be triggered.
• Under certain ‘look through’ provisions, if the value of shares is derived from the value of shares of an underlying asset (say, land) then the transaction is liable to tax even in the country where the asset (land) is situated, even though the transferred asset (share) is not situated in that country. The ITL do not have such provisions to tax the transaction.
• Income accruing or arising in India is different from income arising overseas, the valuation of which depends upon underlying Indian assets. Methodology of valuations i.e., based on the valuation of an enterprise cannot trigger capital gains tax in India.
• Vodafone NL had never objected that it had not acquired controlling interest over the Indian operations. However, there being no transfer of Indian assets or change in ownership of Indian business, the share sale transaction is not subject to tax in India.

Specific arguments on certain issues

No business connection in India

• As per the ITL, business connection means existence of business relations between a nonresident and any other person, arising out of its business activities, which contributes directly or indirectly to the earning of income in India.
• The business connection test is applied while calculating the business income and, hence, has no application in computing capital gains. Furthermore, in such cases, the tax ability of income is restricted to business operations carried out in India. Since, Hutch has neither any business presence nor carries out any business activities in India the same cannot come within the ambit of taxation under the ITL.

Chinese Circular not relevant

• The Chinese circular on indirect transfer of Chinese-resident enterprises by foreign enterprises cannot be relied on as the ITL does not incorporate anti-abuse provisions or ‘look through’ laws for taxation of indirect transfers. Further, the foreign enterprise making the indirect transfer is required to submit the prescribed information/ documents to the Chinese tax authority to ascertain the substance behind the form. If it is found that the said transaction has been devised to abuse tax provisions, only then would it be subjected to tax under the Chinese tax laws. Thus, in the present case as the transaction is not devised to evade tax, the Chinese Circular is of no help.

Approvals, media statements, not correctly interpreted

• The transfer of shares did not require any approvals from any of the regulatory authorities as it was within the existing sectoral limits. The application to the Foreign Investment Promotion Board (FIPB) was made only as a cautionary measure. The only regulatory requirement was to inform the FIPB that Vodafone NL has obtained no objection certificate from an existing Indian partner in accordance with the FDI rules.
• Media interviews and public statements were misinterpreted. Right from the beginning the intention of acquiring controlling interest in the Indian business operations through acquisition of shares in the Cayman Islands entity was made clear.

No liability to withhold Indian tax on payments between two non-residents

• The withholding tax provisions are applicable to any person who has certain territorial nexus and, hence, is adequately connected to the Indian Territory; the person should be subjected to Indian laws or should have a presence in India. Vodafone NL does not have any presence in India. A wide interpretation to include even non-residents who do not have any presence in India would be absurd.
• Connectivity with the Indian laws should be evaluated by considering the factors such as, party to the contract is a resident of India, transactions is consummated in India or is governed by Indian laws and the payment is made from/in India; all factors being interlinked with each other. None of these conditions are satisfied in the fact of Vodafone NL.
• The provisions of the ITL extend to whole of India and, therefore, it was never intended to cover persons who did not have any presence in India. Further, wherever it was felt necessary, the parliament has incorporated extra territorial coverage in certain laws such as the foreign exchange law that applies to a branch, office or agency outside India that is owned or controlled by person resident in India.
• The logical intention in insertion of withholding tax provisions in respect of non-resident was to ensure that taxes are gathered well before funds leave Indian shores as the Indian Government would not be able to chase the non-resident for tax collection and enforcement later.
• The intent in these provisions was, therefore, never to obligate a non-resident, who does not have any presence in India, but to comply with withholding tax provisions such as withholding of taxes, depositing the same, filing returns, issuing certificates etc.
• The wiser or meaningful interpretation would be that these provisions can apply to a nonresident only if it has a presence in India in the form of a branch or permanent establishment in India. It is a settled principle that law can never be given an interpretation which can never be implemented or enforced.
• Obligation to withhold taxes can only be invoked if (a) The sum paid or credited is chargeable to tax. (b) The payer is a person on whom legitimate obligation to withhold taxes can be cast, which in turn should be in consistence with the principles of conflict of laws.

Additional arguments on AID:- Vodafone NL also argued that when the transaction of purchase took place failure to withhold taxes would not make the payer an AID under the ITL, but only failure to remit the taxes withheld. The scope of a person who can be  treated as an AID was expanded to also include failure to withhold taxes by the Finance Act 2008 with retrospective effect. The constitutional validity of the retrospective application of the amendment was also challenged. Also, since the Tax Authority has not made efforts to collect tax from the income recipient, Vodafone NL cannot be regarded as an AID.

Comments:– Cross-border acquisition of Indian companies has been a focus of the Indian tax authorities over the last couple of years. It is fairly well established that if the acquisition involved a direct transfer of shares of an Indian company, the same would trigger a taxable capital gains under the domestic tax laws. However, there have not been precedents in the past where tax authorities have attempted to tax capital gains arising on transfer of shares of a foreign holding company of an Indian subsidiary on the basis that such transfer involves an indirect change in controlling interest of the Indian subsidiary. Hence, the outcome of the litigation of the Hutch-Vodafone case is keenly awaited. The Tax Authority is likely to submit its arguments to the HC in support of its order next week. We will keep you updated on further developments.

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