Introduction
Facts
Decision
Other relevant cases
Comment
Introduction
On January 20 2012 the Supreme Court of India issued a landmark judgment in the much-awaited Vodafone case.
In February 2007 Hong Kong-based Hutchison Telecommunication International (HTIL) sold 100% of its holding in CGP Investments (based in the Cayman Islands) to Vodafone International Holdings BV (based in the Netherlands) for consideration of $11.2 billion, as follows:
Vodafone, Netherlands is a company controlled by Vodafone PLC, a UK-based company. CGP was incorporated in January 1998 in the Cayman Islands by the Hutchison group.
Facts
In February 2007 Vodafone acquired a single share of CGP from HTIL. CGP, which was then a subsidiary of HTIL, effectively held a 67% share of the economic value of Vodafone Essar Ltd through various Mauritian and Indian companies. The Indian Income Tax Authority contended that the transfer of a single share in CGP to Vodafone resulted in the transfer of HTIL's interests in Vodafone Essar Ltd to Vodafone. The authority alleged that, in addition to transfer of the share, other rights and entitlements were transferred as an intrinsic part of the transaction. The authority therefore initiated proceedings against Vodafone for a failure to deduct tax under Section 195 of the Income Tax Act 1961, seeking to recover $2.1 billion from Vodafone as alleged withholding tax liability.
In September 2007 the Income Tax Department issued a show cause notice to Vodafone under Section 201 of the act, seeking to treat Vodafone as an 'assessee in default' for not deducting tax at source in terms of Section 195 of the act. In October 2007 Vodafone filed a writ petition before the Bombay High Court challenging the jurisdiction of the department to issue the notice.
In December 2008 the high court held that the transaction was prima facie liable to tax in India. Vodafone then filed a special leave petition before the Supreme Court challenging the high court's ruling. In January 2009 the Supreme Court directed that the jurisdictional issues in relation to the power to tax the transaction first be determined by department. The court also mentioned that Vodafone was entitled, if necessary, to challenge the department's order before the high court.
In May 2010 the department passed an order under Section 201 of the act claiming jurisdiction to tax the transaction and treating the transaction as chargeable to tax in India. Vodafone was therefore treated as an assessee in default. In June 2010 Vodafone filed a writ petition before the high court challenging the department's order. In September 2010 the high court ruled that:
- Section 9 of the act was wide enough to cover the transaction;
- income is chargeable to tax in India; and
- the department had jurisdiction under the act to pass an order in relation to the transaction.
Vodafone again challenged the order of the high court before the Supreme Court, through a special leave petition. The hearings began on August 3 2011 and concluded on October 19 2011, after 28 days of arguments.
Decision
The Supreme Court's judgment clarifies the law, based on the provisions contained in the act. While delivering its judgment, the court recognised that it is important to provide certainty with regard to the interpretation of law and the maintenance of a robust judicial system, so that investors can determine the tax position for investment in India. If the government wishes to propose a limitation of benefits or 'look-through' provisions, this should be a policy decision introduced either under the extant law or the tax treaties.
'Look at' v 'Look through'
The court ruled that it is important for both the tax administration and the courts to look at the legal nature of the transaction in its entirety and holistically; a dissecting approach should not be adopted. The 'look-through' approach is permissible only in instances where it can be established on the basis of facts and circumstances that the transaction is a sham or is for the purposes of tax avoidance.
Indirect transfers
The court observed that Section 9 of the act cannot be extended to cover indirect transfers of capital assets or property situated in India, as the legislature has not used the words 'indirect transfers' in Section 9(1)(i) of the act. If these words are read into this section, the express statutory requirement of Section 9(1)(i)(4) of the act would be rendered worthless. The Direct Tax Code Bill 2010 specifically proposes that such indirect transfers be liable to tax in India. In the absence of such a provision in the existing statute, indirect transfers should not fall within the ambit of Section 9(1)(i) of the act and are thereby not liable to tax in India.
Purposive interpretation
The court noted that no purposive interpretation can be rendered to a legal statute. The effect of the language of the section should be given, especially when the language is unambiguous. A legal fiction has a limited scope and cannot be expanded by giving a purporsive interpretation, particularly if the result of such interpretation is to transform the concept of chargeability.
Situs of sale of shares
The situs cannot be determined on the basis of the location of the underlying assets. In the case at hand, the situs of the shares would be where the company was incorporated and where its shares could be transferred.
Basis of valuation
The court also noted that the basis of valuation cannot be the basis of taxation. Taxation is based on profits, income or receipt. In contrast, valuation may be a science, not law - to arrive at the value it is necessary to take into consideration the business realities, including the business model, the duration of its operations and concepts such as cash flow, discounting factors, assets and liabilities, and intangibles.
Applicability of the act
Section 195 of the act is applicable only when the transaction is liable to tax in India. In the event that the transaction is not liable to tax in India, Section 195 of the act has no applicability. The court's judgment in this case reiterates its previous judgment in GE India Technology Centre Private Limited v CIT.(1)
Representative assessee
The court finally noted that Section 161 of the act makes a representative assessee liable only if the eventualities stipulated in Section 161 of the act are satisfied.
Other relevant cases
In its decision the court also discussed a number of related cases. The court upheld the Westminster(2) principle - that is, that form prevails over substance in genuine transactions. In contrast, Ramsay(3) lays down the principle of statutory interpretation rather than an overarching anti-avoidance doctrine imposed on tax laws and enunciates the 'look-at' principle. Ramsay does not discard Westminster; in fact, Ramsay reads Westminster in the proper context by which a 'device', which was colourable in nature, had to be ignored as fiscal nullity.
The court also discussed Azadi Bachao Andolan,(4) McDowell(5) and Mathuram Agrawal.(6) The observations of Justice Chinappa Reddy in McDowell departed from the Westminster decision and were clearly made only in the context of artificial and colourable devices. In relation to cases involving treaty shopping and/or tax avoidance, the court noted that there was no conflict between McDowell and Azadi Bachao or between McDowell and Mathuram Agrawal. The court further noted that all tax planning cannot be said to be illegal, illegitimate and impermissible. Instead, every taxpayer is entitled to arrange its affairs so that the taxes shall be as low as possible and the taxpayer is not bound to choose the pattern which will benefit the treasury.
Comment
The court's judgment affects both corporate laws and tax laws, as follows.
The judgment provides a detailed analysis of and distinction between 'participative rights' and 'protective rights' - participative rights are a subset of protective rights. The participative rights in certain instances restrict the powers of a shareholder with a majority voting interest to control the operations or assets of the investee. Right of first refusal and call and put options that provide for exit offer protective and participative rights to a minority shareholder in an entity.
Holdings and subsidiaries are separate legal entities and have distinct relevance. Holding structures are recognised in both corporate and tax laws and, along with special purpose vehicles, have a specific place in legal structures in India. The subsidiary and its parent are distinct tax payers. The fact that the parent company exercises shareholder's influence on its subsidiaries does not generally imply that the subsidiaries are to be deemed residents of the state in which the parent company resides.
The interposition of foreign holding or operating subsidiaries is common practice in international law. This is in turn the basis of international taxation for foreign investors wishing to invest in Indian companies through an interposed foreign holding or operating company, such as a company based in the Cayman Islands or Mauritius for both tax and business purposes. In doing so, foreign investors can avoid the lengthy approval and registration processes required for a direct transfer (ie, without a foreign holding or operating company) of an equity interest in a foreign-invested Indian company. In a holding structure, an entity that has no commercial or business substance has been interposed only to avoid tax, following which the test of fiscal nullity is applied. It would be open to the Revenue to discard the interpositioning of that entity.
Controlling interest is not a separate capital asset; instead, 'control' is a mixed question of law and fact. Ownership of shares may, in certain situations, result in the assumption of an interest that has the character of a controlling interest in the management of the company (ie, an incidence of ownership of shares in a company, which flows out of the holding of shares). A controlling interest is therefore not an identifiable or distinct capital asset independent of the holding of shares. The control of a company resides in the voting power of its shareholders. Shares represent an interest of a shareholder, which is made up of various rights contained in the contract embedded in the articles of association. The right of a shareholder may assume the character of a controlling interest where the extent of the shareholding enables the shareholder to control the management. Shares and the rights that emanate from them cannot be dissected.
The court also noted that an effective shareholding will include direct as well as indirect interest in a company, and that pending exercise, options are not management rights. Furthermore, control is vested in the board of directors, not the shareholders. A holding company that owns enough voting stock in a subsidiary can control management and operation by influencing or electing its board of directors. The right to vote, right to appoint the board of directors and other management rights are incidental to the ownership of shares.
Unanswered issues
The judgment leaves a number of issues unanswered.
The right to determine whether the transaction is a preordained transaction created for the avoidance of tax or a transaction that evidences investment to participate has been vested with the authority. Various guiding principles in this determination include:
- the duration of the holding structure's existence;
- the period of business operations in India;
- the generation of taxable revenue in India during the period of business operations in India;
- the timing of exits; and
- the continuity of business on such exits.
Leaving the onus on the authority to determine whether the transaction relates to effectuating an investment in India is likely to prove controversial and may lead to further litigation.
The government may also choose to file a review or curative petition before the Supreme Court, under Article 137 of the Constitution. However, the quality of the judgment and the fact that it has been written by a three-member bench headed by the chief justice of India will leave very little scope for a review or curative petition.
It is also possible that the government may introduce an amendment (either retrospective or prospective) to bring the indirect transfer of shares outside India within the ambit of taxation. As this would result in the nullification of the present judgment, it would be unfortunate, as it would be directly contrary to the basic concepts of taxation and corporate laws.
Impact on ongoing litigation
In light of the guidance provided by the Supreme Court, detailed analysis must be made to determine the impact on any ongoing litigation, by evaluating the cases for similarities in facts, if any. Furthermore, for transfers of shares of a company in a country with which India has a tax treaty, the tax position must be evaluated. Companies must also justify their intention of an 'investment to participate' to the Indian Tax Authority.
Depending on how far the litigation has progressed, one of the following courses of action could be considered:
- filing a revision or review petition against an order passed by a court;
- filing a rectification petition under Section 154 of the act against an order passed by the authority (submitting that a Supreme Court order becomes the law of the land and therefore an order passed by the authority treating a transaction as liable to tax is a mistake apparent from records);
- filing a petition under Article 265 of the Indian Constitution against an order demanding tax, under Section 195 read with Section 201 (submitting that the tax is being demanded without the authority of law);
- claiming a refund of tax under the provisions of the act or under a writ petition; or
- filing a special leave petition before the Supreme Court under Article 136 of the Constitution.
Highlights
The judgment highlights that:
- the Hutchinson transaction was a valid structural transaction and the Indian authorities had no jurisdiction to tax such an offshore transaction;
- the government should include its policy in the law and tax treaties;
- the decision in Azadi Bachao Andolan does not need reconsideration;
- Section 9 of the act ought to be given a literal interpretation (this does not permit a 'look through');
- genuine strategic tax planning is permitted; and
- the transfer of shares in an offshore entity between two non-residents cannot be taxed in India.
The Supreme Court has delivered a landmark judgment and has strongly reinforced the primacy of the rule of law in India. It is hoped that the government will respect and accept the court's judgment.
For further information on this topic please contact Pranay Bhatia at Economic Laws Practice by telephone (+91 22 6636 7000), fax (+91 22 6636 7172) or email ([email protected]).
Endnotes
(1) 2010-TII-07-SC-INTL.
(2) 1935 All ER 259.
(3) (1981) 1 All ER 865.
(4) (2004) 10 SCC 1.
(5) (1985) 3 SCC 230.
(6) (1999) 8 SCC 667.