February 23, 2012
Updated: June 14, 2012 13:15 IST
Prashant Bhushan
In the Vodafone case, the Supreme Court has again made a wrong call on tax avoidance, setting a precedent that jeopardises thousands of crores of potential revenue for the exchequer.
Tax avoidance through artificial devices — holding companies, subsidiaries, treaty shopping and selling valuable properties indirectly by entering into a maze of framework agreements — has become a very lucrative industry today.
A large part of the income of the ‘Big 5' accountancy and consultancy firms derives from tax avoidance schemes which flourish in the name of tax planning. Their legality has agitated courts in India and abroad for a long time. In 1985, a 5-judge bench of the Supreme Court in the McDowell case settled the question decisively, observing:
“In that very country where the phrase ‘tax avoidance' originated, the judicial attitude towards [it] has changed and the smile, cynical or even affectionate though it might have been at one time, has now frozen into a deep frown. The courts are now concerning themselves not merely with the genuineness of a transaction, but with [its] intended effect for fiscal purposes. No one can now get away with a tax avoidance project with the mere statement that there is nothing illegal about it. In our view, the proper way to construe a taxing statute, while considering a device to avoid tax is … to ask … whether the transaction is a device to avoid tax, and whether the transaction is such that the judicial process may accord its approval to it.”
“It is neither fair not desirable to expect the legislature to … take care of every device and scheme to avoid taxation,” the ruling added. “It is up to the Court … to determine the nature of the new and sophisticated legal devices to avoid tax ... expose [them] for what they really are and refuse to give judicial benediction.”
‘Legitimate tax planning'
Despite such a clear pronouncement, two recent judgments of smaller Supreme Court benches have gone back to calling artificial tax avoidance devices “legitimate tax planning”.
Though the Income Tax Act obliges even non-residents to pay tax on incomes earned in India, many foreign institutional investors avoided paying taxes citing the Double Taxation Treaty with Mauritius. This treaty says a company will be taxed only in the country where it is domiciled. All these FIIs, though based in other countries and operating exclusively in India, claimed Mauritian domicile by virtue of being registered there under the Mauritius Offshore Business Activities Act (MOBA). Companies registered under MOBA are not allowed to acquire property, invest or conduct business in Mauritius.
Yet these ‘Post Box Companies' claimed to be domiciled there and the I-T department allowed them to get away with claiming the benefits of the treaty for many years. Given the benign attitude of the Indian tax authorities and the fact that there was no capital gains tax and virtually no tax at all on these companies in Mauritius, most FIIs and most of the foreign investment in India, by 2000, came to be routed through Mauritius.
The party finally ended when a proactive tax officer tried to stop this blatant evasion. Relying on McDowell, he lifted the corporate veil of MOBA companies to determine their place of management and actual place of residence. Since this happened to be in different countries in Europe or North America, the relevant Double Tax Avoidance treaty became the one between India and that country. All these treaties provided for capital gains to be taxed where the gains had accrued. Since the gains accrued in India, he levied capital gains tax on these FIIs.
The CBDT circular
Responding to the FIIs' distress calls, the then Finance Minister, Yashwant Sinha, got the Central Board of Direct Taxes to issue a circular stating that once a company had obtained a tax residence certificate from Mauritius, it would not be taxed in India.
The CBDT's circular was challenged in the Delhi High Court by Azadi Bachao Andolan and a retired Income Tax Commissioner. The petitioners also pleaded that the government be directed to amend the treaty with Mauritius since it had become a tax haven. The High Court allowed the writ petitions and quashed the CBDT circular, holding it violative of the I-T Act.
The government appealed, telling the Supreme Court that its circular — which effectively offered a tax holiday to FIIs — was needed to attract foreign investment. The petitioners responded that tax exemptions could only be granted by Parliament, either by amending the Income Tax Act or by the Budget passed each year, and not by the government in the guise of such a circular. However, a two judge bench in 2003 called this device an act of legitimate tax planning which could be promoted by the government to attract foreign investment, defied the Constitution bench judgment in McDowell and set aside the Delhi High Court judgment.
In the Vodafone tax case, which was heard by a 3-judge bench of the Supreme Court, the court had the opportunity to correct the transgression of the McDowell principle in the Mauritius case. In 2007, Hutchinson Telecom International (HTIL), which owned 67 per cent of Hutch Essar Limited (HEL), an Indian telecom company, sold its holding to Vodafone International (VIH BV). Both companies announced that Hutchinson had sold, and Vodafone had bought, 67 per cent of the shares and interest in the Indian company for over $11 billion.
Section 9(1) of the Income Tax Act says incomes which shall be deemed to accrue or arise in India include “all income accruing or arising, whether directly or indirectly, through … the transfer of a capital asset situated in India.”
Vodafone's claim
Since the transfer of the Indian telecom firm's shares and assets to Vodafone had led to capital gains for Hutch, the IT department demanded capital gains tax from Vodafone, which was liable to withhold this tax from the amount they paid Hutch. Vodafone claimed the transaction was not liable to tax since it was achieved by transferring the shares of a Cayman Island-based holding company and did not involve the transfer of a capital asset situated in India. The High Court rejected this contention by holding:
“The facts clearly establish that it would be simplistic to assume the entire transaction between HTIL and VIH BV was fulfilled merely upon the transfer of a single share of CGP in the Cayman Islands. The commercial and business understanding between the parties postulated that what was being transferred … was the controlling interest in HEL. HTIL had, through its investments in HEL, carried on operations in India which HTIL in its annual report of 2007 represented to be the Indian mobile telecommunication operations. The transaction between HTIL and VIH BV was structured so as to achieve the object of discontinuing the operations of HTIL in relation to the Indian mobile telecommunication operations by transferring the rights and entitlements of HTIL to VIH BV. HEL was at all times intended to be the target company and a transfer of the controlling interest in HEL was the purpose which was achieved by the transaction.
“Ernst and Young who carried out due diligence of the telecommunications business carried on by HEL and its subsidiaries made the following disclosure in its report:
“The target structure now also includes a Cayman company, CGP Investments (Holdings) Ltd. CGP Investments (Holdings) Ltd was not originally within the target group. After our due diligence had commenced the seller proposed that CGP Investments (Holdings) Ltd should be added to the target group …”
The due diligence report emphasizes that the object and intent of the parties was to achieve the transfer of control over HEL and the transfer of the solitary share of CGP, a Cayman Islands company, was put into place at the behest of HTIL, subsequently as a mode of effectuating the goal.”
Following McDowell, where the Supreme Court had decisively frowned upon tax avoidance schemes, the High Court rejected Vodafone's contention that this transaction was not liable to tax. But in appeal, a Supreme Court bench of 3 judges headed by Chief Justice Kapadia accepted Vodafone's claim that the capital gain had arisen only from the transfer of the single share in the Cayman Island company and had nothing to do with the transfer of any asset situated in India.
Despite the fact that the entire object and purpose of the transaction between Hutch and Vodafone was to transfer the shares, assets and control of the Indian telecom company to Vodafone, the Supreme Court declared in January 2012 that the transaction has nothing to do with the transfer of any asset in India!
With such welcoming winks towards tax avoidance devices, it is unlikely that any foreign company would be called upon to pay tax or at least capital gains tax in future in India. Thousands of crores of tax revenue, and the future attitude of the courts towards innovative tax avoidance devices, will be shaped by these two judgments.
The Vodafone case is in the lineage of the Mauritius case inasmuch as both encourage tax avoidance devices ostensibly to attract foreign investment. The 2G judgment of the Supreme Court cancelling 122 telecom licences granted four years earlier, in sharp contrast, enforces the constitutional principle of equality and non-arbitrariness. The proponents of FDI are groaning that this will stem the flow of investment. Honest foreign companies should not be deterred by this judgment, which strikes a blow against crony capitalism. But even if FDI becomes a casualty in the enforcement of the rule of law, so be it.
Our courts must send a clear signal that India is not a banana republic where foreign companies can be invited to loot our resources and even avoid paying taxes on their windfall gains from the sale of those resources.
(The author is a Supreme Court advocate)
Arvind P. Datar's responds to this article
March 2, 2012
Updated: March 2, 2012 15:52 IST
Vodafone is a misunderstood case
Arvind P. Datar
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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.
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The article “Capital gains, everyone else loses” by Prashant Bhushan (February 23, 20120) gives a wrong impression that the Vodafone case has resulted in a loss of several thousands to the exchequer and the Supreme Court has blessed a massive tax evasion scam. The truth is that the demand made by the Income Tax Department was wholly unsustainable. If the Vodafone case had a tax implication of just Rs.10 crore, the case would have been over before the Income Tax Appellate Tribunal itself and there would not even be a single comment in the press or electronic media. But the law does not change if the tax demand is of a large amount.
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 any one 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.
The McDowell case
Prashant Bhushan makes detailed reference to the decision of a five-judge bench in this case. The tragedy is that the observations in the McDowell case were wholly unnecessary. The only issue there was whether the excise duty directly paid by the purchasers of liquor could be included for the levy of sales tax. There was absolutely no need to get into the distinction between tax avoidance and tax evasion. The McDowell judgment had blurred the distinction between these two concepts by not correctly following the development on this subject in the United Kingdom. The true principle is that tax avoidance is perfectly legitimate, but tax evasion is not. For example, central excise duty is exempted for units located in Himachal Pradesh. If an assessee sets up his manufacturing unit in the exempted area, he is “avoiding the excise duty” by taking advantage of a lawful scheme. This is tax avoidance and not tax evasion. Similarly, there is no bar in one non-resident company selling its shares to another non-resident company outside the territory of India. The Indian Income Tax Act does not apply to such transactions and such a transaction cannot be treated as tax evasion.
India-Mauritius treaty
There has been severe criticism of the India-Mauritius Treaty and it has been accused of depriving the Indian government of crores of rupees of tax revenue. If there is a policy decision to permit tax exemption for investments through Mauritus, one cannot blame the courts for any potential loss of revenue. The government is fully conscious of the so-called loss of direct tax revenue but these incentives are essential to foreign direct investments. The huge growth in the telecom and other sectors has been substantially done through the Mauritius route. One cannot forget the enormous employment generated by FOI and the substantial increase in excise duty, sales tax and other duties and cesses. To merely harp on loss of income tax is not correct.
In the end, the Supreme Court's decision is absolutely correct and adheres to the fundamental principles of company and tax laws. In the Vodafone case the demand was for capital gains tax which never arose in India. Once the hollowness of the department's claim was exposed, the absence of any liability became clear. One should not look at any judgment with a jaundiced eye and condemn it on the ground that it results in a loss of tax revenue.
The courts merely interpret the law and if a transaction is not liable to Indian income tax, one must graciously accept the result.
(The author is a senior lawyer of the Madras High Court.)
Read Prashant Bhushan’s response
March 2, 2012
Updated: March 9, 2012 19:53 IST
Prashant Bhushan responds
Mr. Datar's response to my criticism of the Supreme Court's Vodafone judgment is precisely Vodafone's lawyers' arguments before the courts, which is natural since he was one of them. Though the stated object and purpose of the sale purchase agreement between Hutch and Vodafone was to transfer the shares, assets and control of the Indian Telecom Company HEL, which was also evident from their sale purchase agreement, press releases, filings before the SEC, and their FIPB application, they claim to have achieved this by transferring a single share of a Cayman Island-based holding company and then entering into a series of framework agreements. This “device” of using the transfer of the Cayman Island company in the bid to avoid Capital Gains tax is precisely the tax avoidance devices that the Constitution bench in McDowell mandated, must be frustrated by the courts. The Court said: “It is up to the Court to take stock to determine the nature of the new and sophisticated legal devices to avoid tax and … to expose the devices for what they really are and to refuse to give judicial benediction.”
Moreover, in this case, as the Bombay High Court pointed out, the purpose of Vodafone to transfer the assets, shareholding and control of HEL from Hutch could not be achieved by just the transfer of the Cayman Island company. Therefore the set of framework agreements. In their words, “The transaction between HTIL and VIH BV was structured so as to achieve the object of discontinuing the operations of HTIL in relation to the Indian mobile telecommunication operations by transferring the rights and entitlements of HTIL to VIH BV. HEL was at all times intended to be the target company and a transfer of the controlling interest in HEL was the purpose which was achieved by the transaction.”
Tax avoidance devices have been honed to a fine art by clever lawyers and consultants advising such corporations. Unfortunately, in the Vodafone and the Mauritius cases, the court has winked at them instead of frowning upon and frustrating them as mandated by the binding judgment in McDowell.
(Prashant Bhushan is a Senior Advocate and member of the civil society team that drafted the Jan Lokpal Bill.)
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