This past January, the Supreme Court in India ruled in Vodafone International Holdings B.V v. Union of India,Civil Appeal No. 733 of 2012 (arising from S.L.P. (C) No. 26529 of 2010) that the sale of stock of a company that was non-resident in India to another non-resident company was not subject to income tax in India. The result eliminated Vodafone Group's liability for approximately $2.5 billion in income tax in India (plus interest and other costs that would have resulted in a total liability of approximately $5 billion. The transaction involved was Vodafone’s 2007 purchase of the Indian (sitused) assets of Hong Kong’s Hutchison Telecommunications International. The case had gathered much controversy before the Supreme Court’s decision was announced as the lower court's decision upheld India's Revenue Department efforts to stretch its jurisdictional reach beyond what other international companies had thought was permitted.
Ultimately, the Indian Supreme Court reached the right result and provided a holding which would be expected in tax tribunals in many G-20 countries, including the United States. It also saved Vodafone up to $5 billion. Nevertheless, it has been noted that after the case was decided, the Indian Finance Minister introduced an amendment to the Indian Income Tax Act that would retroactively change the Supreme Court's decision in Vodafone, with effect from April 1, 1962 India Finance Bill 2012, ch. 6, proposed amendment to Income Tax Act section 9(1)(i).
The Operative Facts in Vodafone
In 2007, under a stock purchase agreement (SPA) , Hutchison Telecommunications International Limited (“HTIL”), a Cayman Islands company, sold all of its shares in CGP Investments (Holdings) Ltd. (“CGP”), another Cayman company, to Vodafone International Holdings BV (“VIH”), a Netherlands company. CGP held an interest in Hutchison Essar Limited (“HEL”), an Indian company. CGP's shareholding in the Indian company HEL was held indirectly through several Mauritius companies. CGP's ultimate parent company was Hutchison Telecommunications, i.e.,HTIL and CGP indirectly held 52% of HEL's stock (approximately 42% through wholly owned entities and 10% through entities with interests from unrelated parties, which, along with additional options, would result in a sale of a 67% interest to VIH).
In an effort to tax the stock sale, the Indian Revenue argued: (i) capital gains from the sale were subject to tax in India despite the fact that CGP was a nonresident of India because it indirect held, through its ownership of 52% of HEL’s stock, the underlying Indian assets of HEL; (ii) the gain or income was derived in India indirectly from the transfer of shares because of the change in control of HEL; and (iii) CGP was an exempted company in the Cayman Islands, by definition it could not do business in India and could only be in existence to hold shares of stock. Therefore, the situs of the CGP shares was where the underlying assets were, i.e., India. What a novel approach indeed.
Decision of the Bombay High Court
The High Court had previously found that the transfer of the CGP shares was not in itself sufficient to consummate the transaction between HTIL and VIH, and that the transfer of other “rights and entitlements” to VIH constituted the sale of a capital asset in India. The High Court further held that VIH had a withholding obligation on the sale and that VIH, as the purchaser of shares, was responsible for any unpaid income taxes of CGP in India. The Bombay High Court decision sparked much concern in the international business community. This was obvious inasmuch as many multi-tiered corporate structures are designed to avoid income tax in countries in which lower-tier subsidiaries conduct business operations. Two non-resident companies selling stock of holding companies or higher tier subsidiaries were viewed by most as not being subject to tax in such countries in which lower-tiered subsidiaries were operating. In addition, the Bombay High Court imposed the tax, in effect, on the buyer, i.e., Vodafone, in the form of a withholding tax. Shocking result no doubt.
The Wisdom of the Supreme Court of India to Reverse the Bombay High Court’s Decision
The Supreme Court rejected the High Court's approach, finding that there was a fundamental difference between a stock sale and an asset sale. The sale was effectuated outside of India, i.e., the Cayman Islands, and therefore the record contained no evidence that the situs of the stock was where the underlying assets were located. The Supreme Court quickly concluded there was no tax liability incurred by CGP on the sale of its stock and therefore no withholding obligation on the part of Vodafone.
Critical to the Indian Supreme Court’s analysis of the multi-tiered holding company structure employed by Vodafone is that a subsidiary is a legal entity and is subject to income taxes as a separate entity from its parent company. Still, the Court recognized that at times a subsidiary may be a sham or agent without business purpose other than tax avoidance purposes and will be ignored. In such instance a nonresident company could be subject to income tax in India on the sale of the “stock” of the sham entity. This “sham status” can be present in certain instances such as payment of bribes, circular trading or to avoid tax without any business purposes. The taxpayer Vodafone contended and the Court agreed that a business purpose for foreign investors to invest in India through a Cayman company was to avoid the lengthy approval and registration processes required for transferability of a foreign-owned equity interest in an Indian company, and the burden is on the Indian tax authorities under Indian law to show abuse. In examining whether CGP's legal structure had economic substance representing an investment in India, the Supreme Court looked at several factors, including duration of the holding structure and business operations in India; the generation of taxable revenue in India during these operations in India; timing of the exit; and continuity of business on the exit. CGP had been in existence since 1994 and had been subject to sizeable amounts of tax in India on its business operations. Looking at VIH’s ownership of CGP, the Supreme Court concluded that the structure of the telecom business conducted by HEL through VIH was not a sham. The Indian Supreme Court left open for consideration a distinction it had drawn distinguishing between a parent company having a persuasive position over its subsidiary rather than “power” over its subsidiary. The Court looked to the underlying stock ownership in the Indian operating company which included the presence of unrelated minority shareholders.
Comparison with U.S. Tax Law
In Vodafone, the Indian tax authorities attempted to tax a stock sale between two nonresident companies simply on the basis that the underlying (operating) assets were held and business conducted in India by an Indian company, i.e., HEL. Under the same facts but this time involving U.S. tax law, consider the outcome if HEL were a U.S. corporation doing business in the states and was owned by a foreign corporation, CGP. CGP sells its entire stock position to a non-resident corporation, i.e., VIH. VIH pays CGP for the stock and the transaction is closed outside of the United States. Under U.S. tax law, capital gains of foreign corporations are not subject to U.S. income tax as FDAP and are not otherwise subject to U.S. income tax under VIH unless it is a USRPHC (U.S. real property holding corporation under §897). See §§ 897(c), 954(c), 1445. From a sourcing standpoint, generally capital gains of nonresidents are sourced at the residence of the seller and therefore would constitute foreign source income. There is no “look through” the lower tiered subsidiary to construct an asset sale. But see §338. There would also be no withholding obligation on the part of the buyer. Compare §1441 (FDAP).
Such outcomes are relatively free from doubt under U.S. tax law (unless FIRPTA applies). Perhaps a better analogy to draw upon to give more credence to the Indian Revenue’s challenge in Vodafone are sales of stock by U.S. shareholders in a controlled foreign corporation or CFC.
Even if a foreign corporation (i.e., non-U.S. resident corporation) is not liable for income tax, the U.S. shareholders of controlled foreign corporations (CFCs) are subject to tax on certain income of those CFCs under certain circumstances. Subpart F income of the CFC, including capital gains, are passed through on a current basis to the U.S. shareholders (10% or more shareholders owning more than 50% of the CFC). Apparantly India did not have a similar set of rules from which to analyze VIH’s sale of its CGP stock.
It should also be recognized that the U.S. tax laws do have a “sham” transaction or “dummy corporation” approach to pierce the veil of a controlled subsidiary and ignore the corporate cover so to speak. In certain instances the foreign parent may even be deemed to be carrying on a U.S. trade or business or maintaining a permanent establishment in the U.S. See Inverworld v. Comm’r, 71 TCM (CCH) 3231 (1996) , reconsideration denied, 73 TCM (CCH) 2777 (1997).
Thus, the U.S. tax law would not have had much trouble with this case. If the CFC rules applied for a look through of the capital gain then the gain would move upstream to the U.S. shareholders. The same results would generally follow under the domestic tax laws of various G-20 members. It is noted however that some jurisdictions may tax the capital gains of non-residents.
As mentioned above, the analysis the Indian Supreme Court provided in analyzing the power over the subsidiary would not find a clear analogue under U.S. tax law. Perhaps restrictions on foreign ownership over Indian companies was relevant in the Court’s thinking in looking at this distinction so that as long as there is minority ownership there is not a sufficient basis to tax the capital gain of a non-resident, foreign parent company sellling the stock of its Indian subsidiary.
What Should Be the Take Away from Vodafone?
Minimally, international tax advisors and their clients should keep a watchful idea that the imputation of an asset sale in selling stock of a controlled subsidiary does not gather more judicial support both within India and elsewhere. In addition, some jurisdictions may indeed tax capital gains of non-resident companies in certain instances.