The Vodafone Tax Dispute — A Landmark Judgment of the Bombay High Court

The ongoing tax dispute between
the Indian Tax Authorities and Vodafone in connection with taxability of the $
11.2 billion Hutch-Vodafone deal is one of the biggest controversies in Indian
multijurisdictional M&A history. The quantum of tax demand by the Indian Revenue
Authorities in this particular case could be around Rs.12,000 crore plus
interest. Further, the outcome of this dispute could also have implications on
other similar cross-border deals being scrutinised by the Indian Tax Authorities
for possible loss of tax revenue. As a result, the developments of this case are
being closely followed by many multinationals, M&A consultants and even by the
International business and tax fraternity.

We have summarised below the key
aspects of the recent landmark judgment of the Bombay High Court on the Vodafone
tax dispute and have also given our personal comments on some of the questions
generally being raised by fellow professionals post this judgment.

In December, 2006, Hutchison
Telecommunications International Ltd. (HTIL), a company incorporated in Cayman
Islands and having its principal executive office at Hong Kong, held 66.9848%
interest in an Indian company, Hutchison Essar Ltd. (HEL) through a maze of
subsidiaries in British Virgin Islands, Cayman Islands and Mauritius (around 15
offshore companies) and through complicated ‘option’ agreements with a number of
Indian companies. HEL along with its Indian subsidiaries held licences for
providing cellular services in 23 telecom circles in India. The balance 33.0152%
interest in HEL was held by the Essar Group of Companies.

Vodafone (through its
Netherlands entity) entered into a share purchase agreement with HTIL in
February 2007 to acquire the said 66.9848% interest in Hutchison Essar Ltd. and
it claims to have acquired the same through purchase of the solitary share of a
Cayman Island company of the Hutch Group [viz., CGP Investments

(Holdings) Ltd. (CGP)].

The Indian Revenue Authorities
alleged that Vodafone International Holdings B.V., Netherlands (Vodafone BV) had
failed to withhold income-tax on the payment of consideration made to HTIL and,
hence, sought to assess tax in its hands as a taxpayer in default and it issued
a notice to Vodafone.

Vodafone BV had challenged the
issue of this notice before the Bombay High Court and the case was decided
against it. Vodafone filed a petition before the Supreme Court (SC); however,
the same was dismissed by the SC and it directed the Revenue Authorities to
decide whether it had jurisdiction to tax the transaction and it also said that
if the issue was decided against Vodafone BV, Vodafone BV was entitled to
challenge it as a question of law before the High Court.

The Revenue Authorities by an
order in May 2010 held that it had jurisdiction to treat Vodafone BV as an
assessee in default u/s.201 of the Income-tax Act, 1961 for failure to deduct
tax at source.

This order was challenged by
Vodafone BV before the Bombay High Court, by a writ petition. The key issue
before the HC was whether the Indian Revenue Authorities have the jurisdiction
to proceed against Vodafone BV and tax the transaction.

The basic contention of Vodafone
was that the transaction represents a transfer of a share (which is a capital
asset) of a Cayman Island company, i.e., CGP. CGP through its downstream
subsidiaries, directly or indirectly controlled equity interest in HEL. Any gain
arising to the transferor or to any other person out of this transfer of a share
of CGP is not taxable in India because the asset (i.e., share) is not situated
in India.

The contention of the Revenue is
that the share purchase agreement between HTIL and Vodafone and other
transaction documents establishes that the subject-matter of the transaction is
not merely the transfer of one share of CGP situated in Cayman Islands as
contended by Vodafone. The transaction constitutes a transfer of the composite
rights of HTIL in HEL as a result of the divestment of HTIL’s rights, which
paved the way for Vodafone to step into the shoes of HTIL. Such transaction has
a sufficient territorial nexus to India and is chargeable to tax under the
Income-tax Act, 1961.

The High Court dismissed the
petition of Vodafone BV and has accepted the argument of the Income-tax
Authorities that the transaction in question had a significant nexus with India
and the proceedings initiated by it cannot be held to lack jurisdiction.

Before analysing the facts of the instant case, the High Court made observations on certain general principles, some of which are given below :

    – Tax planning is legitimate so long as the assessee does not resort to a colourable device or a sham transaction with a view to evade taxes;

    – A controlling interest which a shareholder acquires is an incident of the holding of shares and has no separate or identifiable existence distinct from the shareholding;

       – S. 195(1) of the Income-tax Act, 1961 provides for a tentative deduction of income-tax, subject to a regular assessment;

The Parliament, while imposing a liability to deduct tax has designedly imposed it on a person and has not restricted it to a resident and the Court will not imply a restriction not imposed by legislation.

        ii) Analysis of facts:
The High Court analysed the various agreements entered into by the parties (like share purchase agreement between HTIL and Vodafone BV, term sheet agreement between HTIL and Essar group for regulating the affairs of HEL which was later replaced by a similar term sheet agreement between Vodafone and Essar group, brand licence agreement granting a non-transferable royalty-free right to Vodafone BV to use IPRs for a certain period, agreement for assignment of loans to Vodafone BV, framework agreements for option rights, etc.) and the various disclosures made by the parties (like disclosures made by HTIL in its annual reports, disclosures made by Vodafone in its offer letter, disclosures made by Vodafone before the FIPB, etc.) for ascertaining the subject-matter of the transaction and the business understanding of the parties to the transaction.

        iii) Conclusions:

Based on the analysis of the above documents and disclosures, the High Court held that:

The transaction between HTIL and Vodafone BV was structured so as to achieve the object of discontinuing the operations of HTIL in relation to the Indian mobile telecommunication operations by transferring the rights and entitlements of HTIL to Vodafone BV. HEL was at all times intended to be the target company and a transfer of the controlling interest in HEL was the purpose which was achieved by the transaction. The due diligence report of Ernst & Young also emphasises this and it also suggests that the transfer of the solitary share of CGP, a Cayman Islands company was put into place at the behest of HTIL, subsequently as a mode of effectuating the goal.

The rights under the option agreements were created in consideration of HTIL financing such Indian companies for making their investments in HEL. The benefit of those option agreements with Indian companies had to be transferred to Vodafone BV as an integral part of the transfer of control over HEL.

The transfer of the CGP share was not adequate in itself to consummate the transaction. The transactional documents are not merely incidental or consequential to the transfer of the CGP share, but recognised independently the rights and entitlements of HTIL in the Indian business, which were being transferred to Vodafone BV. These rights and entitlements constitute in themselves capital assets.

For Income-tax Law what is relevant is the place from which or the source from which the profits or gains have generated or have accrued or arisen to the seller. If there was no divestment or relinquishment of HTIL’s interest in India, there was no occasion for the income to arise. The real taxable event is the divestment of HTIL’s interests which comprises in itself various facets or components which include a transfer of interests in different group entities.

Apportionment of the consideration lies within the jurisdiction of the Assessing Officer during the course of the assessment proceedings. Such an enquiry would lie outside the realm of the present proceedings.

The transaction between HTIL and Vodafone BV had a sufficient nexus with Indian fiscal jurisdiction. The essence of the transaction was a change in the controlling interest in HEL which constituted a source of income in India. Accordingly, Indian Tax Authorities have acted within their jurisdiction in initiating the proceedings against the Petitioner for not deducting tax at source. As regards the withholding obligation on a non-resident, the High Court held that once the nexus with Indian fiscal jurisdiction is shown to exist, the provisions of S. 195 would operate.

    Issues involved and our view :
1. Whether all offshore share transactions which indirectly involve transfer of underlying Indian assets are taxable in India?

Ever since the Indian Revenue Authorities initiated proceedings against Vodafone, we have been hearing this concern from everyone including many international tax experts that how can the Indian Revenue Authorities tax a transaction of sale of shares of a foreign company by one non-resident to another non-resident by taking an argument that pursuant to such sale of shares, underlying assets in India get transferred?

We believe that in the instant case, the Revenue is not seeking to tax the transaction in India on the ground that there is an indirect transfer of underlying assets situated in India on account of a transaction of transfer of shares of a foreign company. It seems that the Revenue’s contention is that on evaluation of the various transaction documents executed by HTIL and Vodafone, it can be established that the transaction itself is for transfer of composite rights including, in particular, rights under a joint venture agreement (which constitute a capital asset situated in India) and the transfer of share of an overseas company is only a mode for facilitating the transaction.

It has to be accepted that for evaluating the taxability of a transaction, one needs to first understand the true nature and character of a transaction.

The High Court before analysing the facts in the instant case, laid down the general principle that legal effect of a transaction cannot be ignored in search of ‘substance’ over ‘form’. However, the High Court has also rightly held that in assessing the true nature and character of a transaction, the label which parties may ascribe to the transaction is not determinative of its character. The nature of the transaction (i.e., ‘form’ of the transaction) has to be ascertained from the covenants of the contract and from the surrounding circumstances. The subject matter of the transaction must be viewed from a commercial and realistic perspective. The terms of the transaction are to be interpreted by applying rules of ordinary and natural construction.

After going through the facts available on record, including various public disclosures made by the Hutch and Vodafone Group and share purchase agreement and other transaction documents entered into between the parties, which have been very well analysed by the High Court in its judgment, there is no doubt in the mind of the High Court that the subject-matter of the transaction in the instant case, even in ‘form’, is not one share of the Cayman Islands Company, but it is a transfer of controlling interest (including various rights and entitlements) in HEL, India. As noted by the High Court, the acquisition of one share of the Cayman Islands company was only a mode chosen by the parties to facilitate the process.

The High Court thus rejected the submission of Vodafone that the transaction involves merely a sale of a share of a foreign company, which is a capital asset situated outside India and all that was transferred was that which was attached to and emanated from such solitary share. The High Court also noted that it was based on such false hypothesis that it was being urged by Vodafone that the rights and entitlements which flow out of the holding of a share cannot be dissected from the ownership of the share.

2. Whether withholding is required on the entire consideration or there needs to be an apportionment?

The High Court has held that an enquiry on the aspect of apportionment of the total consideration would lie outside the purview of the proceedings before it and the aspect of apportionment lies within the jurisdiction of the Assessing Officer during the course of the assessment proceedings. Thus, it would be for the Assessing Officer to determine during the course of assessment proceedings whether there is any income out of the total consideration which cannot be said to have accrued or arisen in India or cannot be deemed to have accrued or arisen in India and hence cannot be taxed in India. The observations clearly relate to ‘assessment’ and not to deduction of tax.

It would also be relevant to note that the High Court while laying down the principles governing the interpretation of the provisions of S. 195 held that S. 195(1) provides for a tentative deduction of income-tax, subject to a regular assessment.

The High Court has only held that the composite payment by Vodafone had nexus with and included payment giving rise to income accruing or arising in India. Consequently, the High Court has decided the question before it, viz., whether the Indian Tax Authorities have the jurisdiction to take action against Vodafone for having made the payment without deducting tax as it was required to do u/s.195.

The High Court has not gone into, nor made any observations or given any decision about whether the whole or part of the payment would be liable to deduction of tax, the rate at which tax is to be deducted, etc. The High Court was not required to and has expressed absolutely no views on any of these matters which the Officer has to adjudicate.

3. Is there an inconsistency in the observation made by the High Court on the aspect of controlling interest not being a capital asset and its final conclusion?

The High Court before analysing the facts in the instant case, laid down the general principle that the controlling interest which a shareholder acquires is an incident of the holding of shares and has no separate or identifiable existence distinct from the shareholding. After a detailed evaluation of the specific facts and documents of this transaction, the High Court finally concluded that the essence of the transaction was a change in the controlling interest in HEL which constituted a source of income in India. With due respect to the High Court, is there an inconsistency in the observation made by the High Court and its final conclusion?
        
In our view, there is no inconsistency, as the entire order needs to be read harmoniously. The term ‘controlling interest’ in the general principle laid down by the High Court that ‘the controlling interest which a shareholder acquires is an incident of the holding of shares and has no separate or identifiable existence distinct from the shareholding’ seems to refer to controlling interest acquired as an incidence of acquisition of a particular number of shares. The High Court has not made any general observations about a case where the subject matter of the transfer is the ‘controlling interest’ and the requisite number of shares are transferred or delivered, directly or indirectly, for achieving the transfer of the ‘controlling interest’. In any case, the term ‘controlling interest’ used by the High Court in its final conclusion represents the entire business interest of HTIL in the Indian mobile telecommunication operations, i.e., HTIL’s interest in HEL, which includes (a) Equity interest of 42.34% held by HTIL through its subsidiaries (b) Equity interest of 9.58% held by HTIL through minority equity holdings of its subsidiaries in certain Indian companies which in turn held equity interest in HEL (c) Rights (and call and put options) representing HTIL’s economic interest in 15.03% equity of HEL (d) Assignment of loans (e) Other rights and entitlements.

Further to the above, it may also be worthwhile to evaluate if the above general principle will hold good in a situation where the transaction between the parties incidentally results in the acquisition of controlling interest in a subsidiary company (say, an Indian company) as a consequence of transferring shares of an overseas parent company. The same does not seem to have been evaluated by the High Court in the instant case, may be because such evaluation was not necessary here as the transaction was for transfer of entire business interest in HEL which included various rights and entitlements which anyway could not have been transferred in the manner in which they were transferred by the transfer of one share of CGP and the consideration was for the transfer of such entire business interest as a package.

4. Will the Vodafone case create a negative perception of India in the eyes of foreign investors?

As could be seen from the High Court order, the action of the Indian Tax Authorities in this particular case is based on a proper and detailed analysis of the facts and circumstances of this case and the relevant provisions under the domestic Income-tax law which are very widely worded. It is important to note that no tax treaty is applicable in this particular case and hence it is not a case that the Indian Government is not honouring its commitment to foreign investors by proposing to tax the impugned transaction in the case of Vodafone. Also, here it is not the claim of Vodafone that there is double taxation on the income from the transfer of controlling interest in HEL. Further, it has to be appreciated that tax cost is only one of the various costs of a business and business decisions are not taken entirely on the basis of tax cost.