India Tax Alert - 24 January 2012
Vodafone – Supreme Court holds sale of shares outside India between nonresidents is not taxable
By Rajesh H. Gandhi, Promod Batra and Swati Goyal
A three-judge panel of the Supreme Court of India unanimously held on 20 January 2012 in Vodafone International Holdings BV that the sale of shares outside India between two nonresidents (Hutchison and Vodafone) is not liable to tax in India and, accordingly, Vodafone did not have an obligation to withhold tax on consideration it paid for the acquisition of a Cayman Islands entity. (Civil Appeal No. 733 of 2012 (arising out of S.L.P. (C) No. 26529 of 2010).)
In February 2007, Hutchison Telecommunications International Limited, Cayman Islands (HTIL), sold 100% of its indirect holding in CGP Investments, Cayman Islands (CGP), to Vodafone International Holdings BV, Netherlands (Vodafone), for USD 11.2 billion. The Indian tax authorities subsequently contended, inter alia,that the underlying asset transferred was a "controlling stake" in the Indian operating company Hutch Essar Limited (HEL), which was indirectly held by CGP. Accordingly, the tax authorities proceeded to levy tax on the transaction based on the contention that Vodafone was under an obligation to withhold Indian taxes when making payments to the Hutch Group.
The matter was litigated before the Bombay High Court, by a writ petition, and then before the Supreme Court. The Supreme Court remanded the matter back to the tax authorities to decide the preliminary issue of "jurisdiction." The Supreme Court also noted that Vodafone could challenge the decision of the tax authorities on "jurisdiction" directly before the High Court.
In May 2010, the tax authorities issued an order that they had the necessary jurisdiction to proceed against Vodafone and also alleging failure on the part of Vodafone to withhold taxes. Vodafone then filed a writ petition before the Bombay High Court challenging the tax authorities' jurisdiction to pursue an offshore transaction of this nature because the transaction had absolutely no nexus with the territory of India.
The Bombay High Court, in its order dated 8 September 2010, dismissed the petition by stating that the diverse rights and entitlements acquired by Vodafone had sufficient nexus with the territory of India for the tax authorities to initiate proceedings against Vodafone. Vodafone thereafter filed a Special Leave Petition before the Supreme Court appealing the Bombay High Court order.
Observations and ruling of the Supreme Court
The Supreme Court held that the Indian tax authority had no jurisdiction to tax the offshore transaction involving the sale of CGP shares because it was a capital asset situated outside India. In arriving at the conclusion, the Supreme Court examined various legal and factual aspects surrounding the transaction as discussed below.
Tax avoidance under Azadi Bachao Andolan and McDowell
The Court examined whether there was any conflict between the Court's earlier decisions in Azadi Bachao Andolan (examining the use of conduits in tax planning) and McDowell (contrasting legitimate tax planning to tax avoidance/evasion), and found no conflict between the two in cases of treaty shopping and tax avoidance. The Court further observed:
- The McDowell ruling acknowledges that tax planning may be legitimate provided it is within the framework of law and that a "colorable device" cannot be part of tax planning and it is wrong to encourage the belief that it is "honorable" to avoid payment of tax by resorting to dubious methods.
- Not all tax planning is illegal, illegitimate and impermissible.
- In ascertaining the nature of a transaction, the transaction must be looked at in its entirety (the "look at" approach) as opposed to adopting a "dissecting" approach.
International tax aspects of holding structures
The Court noted that it is common practice in international law for foreign investors to invest in India through interposed foreign holding or operating companies for tax and business purposes. There are sound commercial reasons behind creation of corporate structures and developing built-in exit mechanisms when making investments or undertaking overall restructuring. Moreover, India's laws (e.g. on companies, taxes, acquisitions, etc.) view special purpose vehicles and holding companies as legitimate entities.
As noted above, the Court observed that, in ascertaining the legal nature of a transaction, the whole of the structure and transactions must be looked at rather than adopting a "dissecting" approach. Every strategic foreign investment into India should be evaluated in a holistic manner, keeping in perspective such factors, among others, as the duration for which the holding structure exists, the period of business operations in India, "participation in investment" (a concept referenced by the Court without elaboration), the timing of exit and continuity of the business upon exit.
The existence of a strong corporate business purpose for a transaction indicates that the transaction is not a colorable or artificial device. Similarly, the stronger the evidence of a device, the stronger the corporate business purpose must be.
Look-through aspect of income deemed to accrue or arise in India
Section 9 of the Income Tax Act, 1961 (ITA), provides that income accruing or arising to a nonresident outside India from the transfer of a capital asset situated in India is fictionally deemed to accrue or arise in India. The Court had to consider whether section 9 anticipates any "look through" component when the assets underlying the non-Indian capital asset are situated in India (i.e. an indirect transfer). In response to this inquiry, the Court concluded that a legal fiction cannot be expanded by giving a purposive interpretation (i.e. applying the rule based on its intent and purpose when enacted), particularly if it is to transform the concept of "chargeability." More specifically, the Court noted:
- Taxability under ITA section 9(1)(i) arises when all the three elements (transfer, existence of a capital asset and situation of such asset in India) exist simultaneously.
- Section 9(1)(i) cannot, by a process of interpretation, be extended to cover "indirect" transfers of capital assets or property situated in India.
- The words "directly or indirectly" appearing in section 9(1)(i) qualify the word "income" and not "transfer of a capital asset" – if an indirect transfer of a capital asset is read into the section, then "capital asset situated in India" is rendered nugatory. Similarly, the section makes no mention of "underlying asset."
- The fact that the draft Direct Taxes Code proposes the (prospective) taxation of offshore share transactions indicates that "indirect" transfers are not currently covered under section 9(1)(i).
Consequently, section 9(1)(i) is not a "look through" provision and only covers income arising from a direct transfer of a capital asset situated in India.
Extinguishment of HTIL property rights over HEL
The Court also examined whether the transaction entailed the transfer of parent HTIL's property rights over HEL by extinguishment (which could qualify as a "transfer" of a capital asset for purposes of levying capital gains tax).
The Court observed that the transaction being examined is a sale of shares and not an itemized sale of assets because the sale was of the entire investment made by HTIL through CGP. Moreover, there is a conceptual difference between a preordained transaction created for tax avoidance purposes and a transaction that evidences investment to participate in India. To determine which category the transaction falls into, certain factors must be taken into account, namely: duration of time during which the holding structure existed, the period of business operations in India, generation of taxable revenue in India, the timing of the exit and continuity of the business on exit, among others. In examining these factors in Vodafone, it can be observed that:
- The Hutchinson structure has been in place since 1994 and cannot be said to have been created as sham or for tax avoidance. Further, HTIL and Vodafone are not "fly by night" operators or short-term investors.
- HTIL, as a group holding company, had no legal right to direct its downstream companies in the matter of voting, the nomination of directors or management rights. Applying the test of enforceability, influence and persuasion cannot be construed as a right in the legal sense. Thus the rights of HTIL to direct a downstream subsidiary (in its capacity as a shareholder) would be a persuasive position or influence at best and this cannot be construed as a "right" in the legal sense (given that it is not enforceable).
- If the transaction satisfies all the parameters of "participation in investment" (which the Court did not elaborate on), then it is not necessary to address questions relating to de facto versus de jure control, legal versus practical rights, etc.
- In respect of the continuation of exit rights, right of first refusal and tag along rights under a settlement agreement, such rights could be said to have already existed under the Hutchison structure and therefore could not be said to have flowed from the Share Purchase Agreement (SPA). The SPA's objective was to cover situations that may have arisen during the transition and those that were capable of being anticipated and dealt with; the preservation of such rights with a view to continuing the business in India could not be considered an extinguishment.
- In applying the "entirety" (or "look at") test without invoking the dissecting approach, the Court found that the extinguishment of rights took place because of the transfer of CGP shares and not by virtue of the various clauses of the SPA.
Consequently, the Court held that the transfer by way of extinguishment of HTIL's rights over HEL, if any, was the "effect" of the transaction and not the transaction itself. Any such extinguishment, therefore, did not qualify as a transfer of a capital asset.
Splitting consideration for CGP shares
The Court also addressed whether the consideration for acquisition of CGP shares could be split, in light of the ruling by the High Court that the transfer of CGP shares to Vodafone resulted in the acquisition of diverse rights and entitlements by Vodafone that had sufficient territorial nexus with India to be taxed.
The Supreme Court found that the High Court did not examine the transaction holistically and mistook a 51.96% equity transfer (in lieu of a consideration constituting 67% of the economic value of HEL) as a 67% equity transfer. Moreover, the fact that Vodafone attributed the additional payout (i.e. beyond 51.96% of the economic value of HEL) to a control premium, use of the Hutch brand, commitment to a non-compete arrangement, etc., was fully acceptable and justified. Further, it was not open to the tax authorities to split the consolidated payment and apply a portion thereof towards each of these individual aspects (apart from the share sale transaction) when the transaction did not contemplate such a split.
Other charging provisions
Finally, the Court also negated any potential application of ITA section 195 or section 163 to the facts of the case. Section 195 provides for the withholding of tax on payments made to nonresidents if such payments are chargeable to tax in India. Given the absence of taxability of Hutch in India (on the sale of CGP shares to Vodafone), section 195 does not apply.
Section 163 specifies who may be considered an "agent" of a nonresident in India, and thus a "representative assessee" under section 160. The Court rejected the tax authorities' argument that Vodafone is a "representative assessee" of HTIL in India and held that section 163 does not apply where there is no transfer of a capital asset situated in India.
In holding that the indirect transfer of capital assets located in India is not subject to tax in India, the Supreme Court provided guidance on adopting an approach that looks at the entirety of the transaction ("look at" approach), rather than a "look-through" or "dissecting" approach for determining whether a transaction is a sham transaction. This "look at" approach examines aspects relating to holding structures and the relationship between a holding company and its subsidiaries and any SPAs, respecting the legal form/substance of the transaction. The ruling augurs well for determining the taxability of cross-border transactions wherein underlying assets are held in India.
Further, the Supreme Court also observed that certainty is integral to the rule of law. Certainty and stability form the basic foundation of any fiscal system and tax policy and are crucial for taxpayers (including foreign investors) in making rational economic choices in the most efficient manner.
Of additional note, while the taxpayer did not claim benefits under the India-Mauritius income tax treaty, one of the judges made certain crucial observations on investing into India through Mauritius that provide strong support to the treaty in its present form.