Around two years ago, Asian economies were being hailed as the next generation of global drivers, while the old, tested, economies like the United States and Europe were labelled as “tail economies”. Recent economic developments have changed the picture faster that the world imagined possible, and today Asian economies are struggling with burgeoning current account deficits, high inflation, nose diving currencies and weak GDP growth. With global economies better wired, thanks to sophisticated technological development in last two decades, no single economy can behave in an arrogant and isolated manner, as the pace of capital flight is as quick as a mouse’s click.
Today, a stable and certain regulatory and legal environment is non-negotiable for investors and any country that rocks the boat, irrespective of its economic position, cannot hold its own for long. The name “Vodafone” will remain synonymous with the vagaries of India’s fiscal system and will act as a reference point for very long time for investors around the world. The Indian tax and regulatory environment has lately been notorious for shifting goalposts, allegedly to achieve short-term goals.
Briefly recapping the facts: Vodafone UK through one of its group companies acquired shares of another company, which was owned and controlled (We Indian lawyers are in love with these two words “owned” and “controlled”, as these are defined by different regulators differently.) by HTIL, Hong Kong. Vodafone International Holdings BV acquired one share of a Cayman Island based company CGP from HTIL. As a result Vodafone indirectly acquired a controlling stake in Hutchison Essar Limited (HEL), an Indian company holding a licence to provide telecommunications services in India.
The Indian tax authorities initiated proceedings against this transaction and demanded capital gains tax on the value of the transaction under the Indian Income Tax Act, 1961 (the ITA). The proceedings culminated in an appeal before the Supreme Court of India, which, in January 2012, gave a historic verdict and clarified certain positions of law under the ITA. The Court, while interpreting Section 9 of the ITA, held that under Indian law, a ‘look at’ approach and rather than a ‘look through’ approach can be adopted. As a result the sale of shares is relevant for determining the tax liability in India and not the indirect transfer of certain underlying assets including rights located or based in India. Further, the Court refused to examine the economic and commercial legitimacy of the structure used by Vodafone to acquire an interest, indirectly, in an Indian telecom company. As a result, the Supreme Court quashed the proceedings initiated by the tax authorities by holding that the transaction of sale of a single share of CGP by HTIL outside India is not taxable in India under the ITA.
On the day of verdict, Vodafone must have felt relieved since it struggled with the tax demand for a quite some time, which created uncertainty as to its Indian operations. However, the celebrations were short-lived and the Indian finance minister introduced the Finance Bill, 2012 on 16 March 2012, and introduced following two proposals:
- to retrospectively amend the relevant income tax provisions so as to make the indirect transfer of assets resulting from the sale of shares of non-resident companies taxable in India; and
- to validate the proceedings, tax levied and collected from Vodafone.
In the wake of the amendment, Vodafone was staring at another epic battle before the Indian courts. Then came the change of the guard at the Finance Ministry, with the then finance minister becoming president of India and a new, forward-looking finance minister taking controls of the Income Tax Department. As per the information available in the public domain, Vodafone and the Indian government are currently negotiating to find the right forum to resolve their dispute. Rumours abound that Vodafone would be willing to pay the tax amount, if other liabilities in the form of penalty and interest are waived by the Indian government. However, there is no credibility to this theory as no official statement or instruction has been made by either party.
That may be the position so far as the Vodafone is concerned, but what does it entail for similar transactions happening offshore, which also involves indirect transfer of assets situated in India? The analysis is also relevant ast the Finance Act, 2012 did not take away the superiority of Double Taxation Avoidance Agreements (DTAA)benefits. Therefore, the question that remained unanswered was whether Indian tax authorities would charge tax on such offshore transactions even when the DTAA between India and another country provides for exemption of capital gains tax in India. Section 90 of the ITA grants superiority to DTA’s over Indian tax law to the extent that they are more beneficial to the claimant assessed. In the absence of the said provision being amended, the DTAA benefit is to be extended to the assessed party so far as such benefit is more beneficial in comparison with provisions of the ITA.
How can such a proposition remain untested in a country such as India for long?
Recently, one such transaction, popularly known as the Sanofi case, came before the High Court of Hyderabad. In this case, Sanofi, a French entity, acquired shares of ShanH, another French entity, which held 80 per cent of the shares of an Indian entity called Shanta Biotech Laboratories (SBL). The Income Tax Authorities, again with full vigour, proceeded against Sanofi to claim capital gains tax in India in the wake of the amended provisions of the ITA, as per which SBL, an entity located in India, is providing substantial value to the French entity. The matter went to Andhra Pradesh High Court, which, while examining the case, interpreted Article 14 of the India–France DTAA and held that Article 14(5) provides for taxability in the country where a company is residing and does permit a ‘see through’ approach. The Court held that it cannot be said that an actual alienation of ShanH shares amounts to a deemed alienation of SBL’s shares. The fact that the then current valuation of the shares of ShanH was as a result of SBL’s assets is irrelevant. The Andhra Pradesh High Court further held that retrospective amendment made in Section 9 of the ITA does not impact the provisions of the India–France DTAA because Section 90 provides superiority to DTAAs over Indian tax law.
Although the judgment by Andhra Pradesh High Court has been challenged before the Supreme Court, the current position is that if a particular tax treaty provides for no capital gains tax in India, the offshore transaction involving indirect transfer of Indian asset or property cannot be charged to capital gains tax in India.
However, following the amendment of Section 9 of the ITA, a transaction involving the indirect transfer of Indian assets or property is subject to tax in India only if the foreign company whose shares are being transferred derives substantial value directly or indirectly from the assets located in India. Even in cases where a treaty benefit is not available, the open-ended question is how to determine if the shares to be transferred derive substantial value from the assets located in India. Although to date there is no clarity on the manner or methodology to be adopted while determining substantial value, based on certain suggestions given by advisory committees set up by the Finance Ministry, we sincerely hope that the government will come up with some kind of methodology or threshold to determine substantial value in terms of the amended provisions of the ITA.
Many of us treat Vodafone as the trigger for the slowing down of economy and drying up foreign investment in India. Since 2012, when the ITA was retrospectively amended to nullify the judgment of Supreme Court, foreign investment has drastically reduced resulting in GDP growth of just 4.8 per cent in the last quarter. However, with the recent actions taken by the finance minister in the form of opening up of FDI in multi-brand retail and an increase in the FDI caps in the insurance and defence sector, the political will to attract foreign capital is in place. However, the rocked boat will take some time to stabilise.