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Supreme Court’s verdict in Rs.11,000 crore Vodafone case

A big shot in the arm for global investment in India!

              One of the most sensational cases ever, in the history of Indian Income-tax, came to be decided by the Supreme Court on January, 20, 2012. The Vodafone ruling, involving a mammoth tax stake of around Rs.11,000 crores, which has been delivered in favour of the taxpayer and against the  revenue assumes great significance, since it has also reinforced the faith of the global investor community in the Indian judicial system.


               The core controversy before the Apex Court was whether India could tax capital gains arising from sale of shares of overseas companies, merely because such companies had downstream subsidiaries in India. The tax authorities had contended that the sale of the share capital of a Cayman Islands company that ultimately held approximately 67 per cent in Hutchison Essar (now Vodafone Essar) gave rise to capital gains tax liability in India, and therefore, Vodafone was required to deduct tax on payments made to Hutchison for acquiring the shares. In response, Vodafone argued that the transaction was not taxable in India and that the Indian income-tax authorities did not have jurisdiction to proceed against them for any alleged failure to withhold tax.

              The contention of the tax authorities in this case, as well as their increased scrutiny over other similar transactions, attracted much attention in the global investing community, particularly considering that the tax authorities’ approach represented a fundamental change in India’s long-standing position on the taxability of such transactions. Given that transactions like these are fairly common all over the world, the uncertainties surrounding the need to evaluate and perhaps provide for Indian tax costs on such deals added a whole new dimension to the economics of investing in India.

              The Bombay High Court in September 2010 had ruled that the transaction involved the transfer of rights and entitlements situated in India and, therefore, the tax authorities had jurisdiction to proceed against Vodafone for failure to deduct tax. Vodafone filed an appeal before the Supreme Court.


               The Supreme Court, in its recent judicial pronouncement, has overruled the Bombay High Court and conclusively held that the transaction did not give rise to tax liability in India. In addition to analyzing the specific facts of this case, the Supreme Court has also laid down several key principles that will be of significance in the context of cross-border merger and acquisitions (M&A).
               The Court did not find favour with the Revenue’s argument that even if the shares of the foreign company are situated in the Cayman Islands, its transfer attracts Indian tax, because the foreign company owns Indian assets and that there is an ‘indirect transfer’ of the Indian assets liable to tax u/s. 9(1)(i) of the I.T. Act. The Court analyzed that three elements must exist for the section to apply, namely, ‘transfer’, ‘existence of a capital asset’ and ‘situation in India’. It went on to hold that, “this is a legal fiction and cannot be expanded by giving ‘purposive interpretation’. The Revenue’s argument, that u/s. 9(1)(i) it can ‘look through’ the transfer of shares of a foreign company holding shares in an Indian company and treat the transfer of shares of the foreign company as equivalent to the transfer of the Indian assets on the premise that Sec. 9(1)(i) covers direct and indirect transfers of capital assets, is not acceptable. Sec. 9(1)(i) does not cover indirect transfers of capital assets/property situate in India. The argument that as the transaction had a deep connection with India, i.e. ultimately to transfer control over the Indian company, the ‘source’ of the gain is India is not acceptable. ‘Source’ in relation to an income means where the transaction of sale takes place and not where the item of value, which was the subject of the transaction, was acquired or derived from. As the purchaser and vendor are offshore companies and since the sale took place outside India, applying the source test, the source is also outside India.”

                With reference to the Revenue’s charge in respect of liability to withholding tax on such transactions, the Supreme Court has held that, “the expression ‘any person’ in Sec. 195 means any person who is a ‘resident’ in India. Sec. 195 applies only if payments are made by a resident to another non-resident and not between two non-residents situated outside India. Sec. 195 did not apply to the present transaction, because it was between two non-resident entities, through a contract executed outside India and consideration passed outside India. The transaction had no nexus with the underlying assets in India. In order to establish a nexus, the legal nature of the transaction has to be examined and not the indirect transfer of rights and entitlements in India.”

              The Court has judiciously observed that the revenue authorities must look at the transaction as a whole and not look-through or dissect it into its constituent elements. It has also noted that the legal form of a transaction could be disregarded only if the transaction was established to be a sham or a tax avoidance transaction. Most importantly, the court has observed that a transaction could not be considered as sham merely because capital gains tax was not payable at the time of exit.

             While disposing of the case, the court highlighted the need for certainty in tax policy and observed that it was for the government to incorporate doctrines like ‘limitation of benefits’ and ‘look through’ in the law to avoid disputes. This is in line with the approach of many other countries, who when faced with similar challenges, have taken a legislative rather than a litigative approach in this regard.

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