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Rediff.com  » Business » Why the Vodafone tax case assumes significance

Why the Vodafone tax case assumes significance

Last updated on: January 27, 2012 12:25 IST

Why the Vodafone tax case assumes significance

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Uday Ved

The government would do well to weigh a legislative approach against revenue considerations.

India has been experiencing a perceptible decline in foreign investment flows that, in turn, has impacted its overall GDP growth rate.

The decline may be attributed to diverse factors, but many consider the economic uncertainties that confront investors in India, especially those emanating from tax challenges, a key factor influencing foreign investment flows.

It is against this backdrop that the landmark decision delivered by the Supreme Court in the Vodafone case assumes significance.

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Why the Vodafone tax case assumes significance

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The controversy and the decision

The controversy before the court lay within a fairly narrow compass. The issue was whether India could tax capital gains arising from sale of shares of overseas companies merely because such companies had downstream subsidiaries in India.

The tax authorities had contended that the sale of the share capital of a Cayman Islands company that ultimately held approximately 67 per cent in Hutchison Essar Limited (now Vodafone Essar Limited) gave rise to capital gains tax liability in India, and that, therefore, Vodafone was required to deduct tax on payments made to Hutchison for acquiring the shares.

In response, Vodafone, inter alia, argued that the transaction was not taxable in India and that the Indian income-tax authorities did not have jurisdiction to proceed against them for any alleged failure to withhold tax.

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Why the Vodafone tax case assumes significance

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The contention of the tax authorities in this case, as well as their increased scrutiny over other similar transactions, attracted much attention in the global investing community, particularly considering that the tax authorities' approach represented a fundamental change in India's long-standing position on the taxability of such transactions.

Given that transactions like these are fairly common all over the world, the uncertainties surrounding the need to evaluate and perhaps provide for Indian tax costs on such deals added a whole new dimension to the economics of investing in India.

The Bombay High Court in September 2010 had ruled that the transaction involved the transfer of "rights and entitlements" situated in India and, therefore, the tax authorities had jurisdiction to proceed against Vodafone for failure to deduct tax.

The Supreme Court, however, overruled the Bombay High Court and held that the transaction did not give rise to tax liability in India.

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Image: The Supreme Court overruled the Bombay High Court and held that the transaction did not give rise to tax liability in India.


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Why the Vodafone tax case assumes significance

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In addition to analysing the specific facts of this case, the Supreme Court also laid down several key principles that will be of significance in the context of cross-border merger and acquisitions (M&A).

Specifically, the Court observed that the revenue authorities must look at the transaction as a whole and not look-through or dissect it into its constituent elements. It also noted that the legal form of a transaction could be disregarded only if the transaction was established to be a sham or a tax avoidance transaction.

Most importantly, the court observed that a transaction could not be considered a sham merely because capital gains tax was not payable at the time of exit.

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Why the Vodafone tax case assumes significance

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Global experience

While disposing of the case, the court highlighted the need for certainty in tax policy and observed that it was for the government to incorporate doctrines like "limitation of benefits" and "look through" in the law to avoid disputes.

This is in line with the approach of other countries that, when faced with similar challenges, have taken a legislative rather than a litigative approach in this regard.

For instance, China has introduced Circular 698 that imposes a reporting obligation in cases of indirect transfers of Chinese companies. It also authorises the tax authorities to disregard certain intermediate entities under anti-avoidance principles, if they are established for tax avoidance purposes and lack business purpose.

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Why the Vodafone tax case assumes significance

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Australian law, too, provides for the taxability of indirect transfers, though only in the context of disposal of interests in companies (Australian or foreign) that directly or indirectly own substantial Australian real property. A similar change was made by legislation to cover treaty situations after the landmark Lamesa case.

The UK has somewhat similar provisions in the law, though they are restricted in scope to cover only disposal of interests in companies (UK or foreign) that derive their value directly or indirectly from oil and gas assets situated in the UK.

In an Indian context too, the Direct Taxes Code Bill, 2010 (DTC) provides for taxation of such transactions in India, by providing that gains from sale of interest in a foreign company will be taxed in India if the assets owned (directly or indirectly) in India is more than 50 per cent of the value of total assets of the foreign company.

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Tags: UK , India , Lamesa , DTC

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Why the Vodafone tax case assumes significance

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Interestingly, the approach under the DTC is far more wide-ranging than the limited provisions adopted by other countries (real property interests in Australia, oil and gas interests in the UK and tax avoidance/lack of business purpose situations in China).

As the government debates its response to the decision, it would do well to weigh the economic implications of a legislative response against revenue considerations. Should it decide to pursue legislative options, it may be useful to consider whether it is necessary to go in for an all-encompassing provision like the one proposed under the DTC or whether a more narrowly-tailored provision to tax indirect transfers of select national assets is a better route.

However, till such time as Parliament reacts, the Supreme Court's decision will be the law of the land. It will undoubtedly provide much-needed certainty to global investors on the taxability of similar transactions and will have a far-reaching positive impact on several other similar cases currently under scrutiny by the income-tax authorities.

The writer is head of tax, KPMG in India.




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