Vodafone Tax Case

Arindam Daschowdhury (PGDM 100109)Deepak B.S. (PGDM 100110)16-08-2011*V/s

Executive SummaryVodafone International Holding (Vodafone NL) was issued an order by the Indian Tax Authority assessing a capital gains tax alleged to have arisen on acquisition of controlling interest in an Indian entity, Vodafone-Essar Ltd from Hutchison EssarThe 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 entityThe Tax Authority has alleged that Vodafone NL failed to withhold Indian tax on the payment of consideration made to Hutch for acquiring the controlling interestVodafone NL filed a writ petition in the Bombay High Court (HC) against the Tax Authoritys orderThe HC commenced proceedings on the writ petition on 4 August 2010The 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

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Facts and BackgroundVodafone International Holdings BV, based in Netherlands and controlled by Vodafone UK, obtained the controlling interest and share of CGP Investments Holdings Ltd (CGP) located in Cayman Island for a value of $11.01 billion from Hutchinson Telecommunications International Ltd (HTIL), which had stake in Hutchinson Essar Ltd (HEL) that handled the company's mobile operations in IndiaHEL had its stake in CGP Holdings, from which Vodafone bought 52 per cent of HEL's stake in 2007, thereby vesting controlling interest over themThe Bombay High Court, on September 8, ruled that when the underlying assets of the transaction between two or more offshore entities lies in India, it is subject to capital gains tax under relevant Income Tax laws (ITL) in IndiaThe Court invoked the nexus rule wherein a state can tax by connecting a person sought to be taxed with the jurisdiction, which seeks to tax (The treatment of the company as an Assesse in Default (AID) under Section 201(1)of the Income Tax Act) The court came to the conclusion that Vodafone is liable to pay taxes at source (TDS)Vodafone has now appealed before the Supreme Court to revisit the judgement, which makes them liable for a record amount of Rs 12,000 crores going to the tax authorities' kitty 16-08-2011*

Overview16-08-2011*

Tax Authoritys ContentionThe subject of the transaction is a composite transaction involving a transfer of rights in an Indian companyThis resulted in an accrual or deemed accrual of income from a source of income in India or from an asset in India or through the transfer of capital asset in IndiaThe transfer of shares of the Cayman Islands entity was a means to transfer the controlling interest in IndiaThere was a presence of territorial nexus in India for the transaction carried out and accordingly there was liability on Vodafone NL to withhold taxes

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Vodafones PleaThe provisions were not applicable to the current case and the primary obligation to discharge the tax was with the payee (Hutchison Telecommunications International Limited) Unless the payee had defaulted in making payment of taxes, on demand by the Revenue authorities, tax could not be recovered from the payerThe withholding tax provisions cannot have extra-territorial application i.e. cannot apply in an offshore transaction involving two non residents in respect of a capital asset (i.e. shares) and payment outside IndiaThe transaction is not chargeable to tax in India since it involves transfer of shares of a non-resident company by one non-resident to another and is not a transfer of a capital asset situated in India16-08-2011*

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 so tax saving is not the sole objective in adopting a particular structureAuthenticity of the structure was explained by chronological events of liberalization of the Indian economy, Foreign Direct Investment (FDI) policy, Hutchs entry in different telecom circles etc. leading to the acquisition of shares by Vodafone NLMerely because an entity is an investment company (with reference to Cayman Islands entity) it could not be said that the particular company is designed to avoid tax and such Indian exchange control regulations recognize such investment companiesThe structures were legally formulated, considering the commercial expediency and economic realities, and the decision to purchase shares was also governed by commercial expediency Indian operations are being carried out by the Indian entity and other operating companies which are separate legal entitiesThe corporate veil cannot be imposed unless there is proof that the transaction is sham and designed to evade tax so a genuine transaction undertaken within permissible legal framework cannot be called a sham transaction.

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Transfer of shares is different from transfer ofunderlying assets

The ITL specifically recognizes shares as a capital assetSale of shares results in transfer of bundle of rights viz., right to dividend, right to vote, right to control etc and each right cannot be vivisected and taxed separatelyThrough 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

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Situs of shares transferred not in India, nolook through provisions in India

As per the ITL, transfer of a capital asset is taxable in India if it is situated in IndiaSitus 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 IndiaRules 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 triggeredUnder 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 but the ITL do not have such provisions to tax the transactionVodafone 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

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No business connection in India

As per the ITL, business connection means existence of business relations between a non-resident and any other person, arising out of its business activities, which contributes directly or indirectly to the earning of income in IndiaThe business connection test is applied while calculating the business income and, hence, has no application in computing capital gains and in such cases the taxability of income is restricted to business operations carried out in IndiaSince, 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

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No liability to withhold Indian tax on paymentsbetween 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 IndiaConnectivity 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 and none of these conditions are satisfied in the fact of Vodafone NLThe 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 IndiaFurther, 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 IndiaThe 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 laterThe intent in these provisions was 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

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The High Court DecisionIt holded that the notice is legally tenable and thus dismisses the writ petitionThe following are the observations made by the High Court:Income was earned towards consideration for transfer of its business/economic interests as a groupThe subject matter of the present transaction is nothing but transfer of interests, tangible and intangible in Indian companies and not an innocuous acquisition of shares of a Cayman Islands CompanyThe interest in Telecom License is jointly held with the Essar Group along with the use of Brand & Goodwill and non-compete rights given by HTIL and so there is a right to enter into Telecom Business in India, with a premium for the controlling interest As there was admittedly a transfer of controlling interest in the Indian company, there was an extinguishment of rights and relinquishment by the transfer or in the shares of the Indian company which constituted a transfer The shares in the Cayman company were merely the mode or the vehicle to transfer the assets situated in India The choice of the assesse in selecting a particular mode of transfer of such assets will not alter or determine the nature or character of the asset16-08-2011*

As the assesse (Vodafone) had wilfully failed to produce the primary/original agreement and other prior and subsequent agreements/documents , so it was impossible to appreciate the true nature of the transaction and the constitutional validity of Income-tax provisions could not be gone intoIt is settled law that a writ cannot be entertained against a mere show-cause notice unless the Court is satisfied that the show cause notice was totally unjustified in the eye of law for absolute want of jurisdiction of the authority to even investigate into factsThe High Court Decision (Contd)16-08-2011*

A look BeyondChargeability to tax of an offshore transaction between non-residents: The Court has not made any observation on the chargeability of the said transaction to tax and so it appears to acknowledge a distinction between the shares perse (held outside India) and the underlying rights/interests/assets (based in India)It observes that the share transfer could be treated as mere mode for transfer of underlying assets and so this appears to navigate against the accepted jurisprudence and seeks to impose the corporate veil having far-reaching implications on transactions domestically and internationallyIf the value is created significantly in India, there are merits in the Revenues perspective, however prior to seeking a levy of tax on such transactions, the legislature should first make appropriate provisions in the tax laws While, the position of the Courts on the chargeability of tax is yet to be decided, this judgment indicates the direction in which the legislature could move: Media reports suggest that notices to several companies are in the pipelineThe revenue department is embroiled in a legal battle with US-based General Electric for its 60% stake sale in Genpact which were sold for $500 million in 2007.In yet another transaction, telecom major AT & T stake sale in Idea Cellular to the Tata Industries in 2005 has also been sent a tax notice.Internationally, US private equity fund Lone Star has faced tax hurdles in Seoul, Korea over its planned sale of Korea Exchange Bank to HSBC.16-08-2011*

As part of the corporate tax strategy, appropriate attention should be provided to:Use of jurisdictions with good treaty networks for implementing global investment structuresClarity and consistency in disclosures and filings under other regulations and with regulatory authoritiesReview of shareholder agreements to understand the references to key business rights, its situs and its transferabilityUse of an indemnification clause for recourse to seller in case of tax liabilityHygiene in corporate communications (particularly external media)A look Beyond (Contd)16-08-2011*

Thank You..16-08-2011*