Thursday, September 9, 2010

Some Thoughts on the Vodafone Judgment: A Case for Reconsideration?

The blog has discussed the Vodafone controversy in some detail, and commented on important extracts from the Bombay High Court’s judgment yesterday. This post discusses parts of the judgment in more detail, and suggests, with respect, that the judgment is incorrect. For the convenience of our readers, the paragraph number in question is indicated in brackets where appropriate.

Chandrachud J. begins by noting the exact nature of the transaction and the corporate entities involved in it (¶¶ 2 – 52). It is important to appreciate that, as a matter of law, there were two avenues open to the Revenue to charge the Vodafone transaction [“the Transaction”] to tax – under s. 5(2) r/w s. 45 of the Income Tax Act, 1961, or under s. 9(1)(i) r/w with s. 45. S. 5(2) provides that income that “accrues or arises in India” is chargeable, while s. 9(1)(i) covers all income arising through or from any business connection in India” or through the transfer of a capital asset situate in India”. The difference between the two provisions is that s. 5 pertains to actual receipt (or accrual) of income, while s. 9 is a deeming provision that, by legal fiction, determines that income is deemed to accrue or arise in India. In addition, the Revenue relied on s. 195 to engage withholding tax provisions, and on s. 201 to prove that Vodafone is an “assessee-in-default”.

To succeed under the first limb of chargeability, the Revenue needed to show that Vodafone acquired a “right to receive” income in India, for this is what the term “accrues or arises in India” means. Presumably, Chandrachud J. rejected this submission, for ¶ 78 moves swiftly to consider the law on the scope of the deeming provision – s. 9(1)(i). This is not surprising, for the Transaction involved the sale by a non-resident to a non-resident the share of a non-resident company, through an agreement executed outside India, subject to the laws of England, and for which payment was made outside India.

To succeed under the second limb, the Revenue was required to demonstrate that a “capital asset” was transferred, and that it was “situate” in India. Its case began with the interesting proposition that, in addition to shares, a “controlling interest” constitutes an independent capital asset. This, if true, would have concluded the case, for it is undeniable that Vodafone acquired an indirect “controlling interest” in Hutchison Essar Ltd. [“HEL”]. However, it is not, and a long line of cases has established that “controlling interest” is merely incidental to the ownership of shares. In ¶70, Chandrachud J. accepts this position and holds that “a controlling interest does not for the purpose of the Income Tax Act 1961 constitute a distinct capital asset”.

Thus, one avenue remained – that although the “share” sold was not situate in India, it in “reality” represented the transfer of capital assets situate in India. Chandrachud J. begins this part of the judgment with a comprehensive analysis of the scope of the deeming provision in s. 9 of the ITA, and refers with approval to one of the more important decisions on the point – CIT v. Qantas Airways. In Qantas, the assessee, an Australian airline, sold aircrafts outside India. Notably, the Revenue had not even suggested in that case that this was an indirect transfer of a capital asset “situate in India” but rather argued that the proceeds of the sale constituted income “from a business connection in India”. S.B. Sinha J. rejected this submission, noting that the intention of Parliament was to exclude “any any income derived out of sale or purchase of a capital asset effected outside India [emphasis mine].

In ¶63, Chandrachud J. summarises the position of law in India, noting that a “sham” is a transaction in which the parties “while ostensibly seeking to clothe the transaction with a legal form, actually engage in a different transaction altogether”. As we shall see, this point is of vital importance to the conclusion the Court draws later.

With this background, and after an analysis of extra-territoriality in taxation, Chandrachud J. applies these principles to the facts (¶ 120), and begins by noting that “the case of the Petitioner is that the transaction was only in respect of one share of CGP in Cayman Islands … this being a capital asset situate outside India…” To test this submission, Chandrachud J. looks to two types of facts– (a) the conduct of the parties and (b) the documents. The conduct of the parties revealed that both Vodafone and Hutchison had construed the transaction as a sale of telecom interests in India. For example, Vodafone and Hutchison had stated to the FIPB that the object of the transaction was the acquisition of a controlling interest in HEL, and the companies’ officers had made statements to this effect to the Stock Exchange and to the Press. Similarly, the documents in the Transaction were clearly designed to facilitate the transfer of control over HEL to Vodafone – for example, Framework Agreements entered into with companies holding a stake in HEL, a non-compete agreement with Hutchison vis a vis HEL and the sale deed itself (which referred to “Company interests” as a 66.9848 % stake in the issued share capital of HEL). Based on these factors, Chandrachud J. concluded that:

… it would be simplistic to assume that the entire transaction between HTIL and VIH BV was fulfilled merely upon the transfer of a single share of CGP in the Cayman Islands. The commercial and business understanding between the parties postulated that what was being transferred from HTIL to VIH BV was the controlling interest in HEL.

It is submitted that this is an unfortunate conclusion. As Chandrachud J. had himself observed in ¶63, a transaction is something other than what its legal form suggests it is only if that is the true intention of the parties themselves. In this case, Vodafone and Hutchison entered into a transaction that involved the sale of a share of a non-resident company, for a consideration of about $ 11 billion. Was the objective of the transaction the transfer of control over the Indian entity? Of course it was. But does it follow that the legal nature of the transaction was the transfer of shares in HEL? It is submitted, with great respect, that it does not.

The “legal nature” of a transaction is a manifestation of the intention of the parties. For example, if a transaction is termed a “sale” but in fact confers extremely limited rights on the buyer, it may be considered a “licence” notwithstanding the nomenclature, because that is the legal substance of the transaction. But if it is in “legal” reality a sale, it cannot be considered a “licence” because, for example, the “economic consequences” of the transaction are akin to a licence. For this reason, it is also submitted that the conduct of the parties, the submission to the FIPB, the statements to the Stock Exchange are of very limited relevance in determining the legal nature of the Agreement of 11 February 2007. Thus, the petitioner’s case was that the Transaction, in law, is the transfer of a single share of a non-resident company.

The point was put very well by Lord Diplock in Snook v. London and West Riding Investments:

I apprehend that, if it has any meaning in law, it means acts done or documents executed by the parties to the "sham" which are intended by them to give to third parties or to the court the appearance of creating between the parties legal rights and obligations different from the actual legal rights and obligations (if any) which the parties intend to create … for acts or documents to be a "sham," with whatever legal consequences follow from this, all the parties thereto must have a common intention that the acts or documents are not to create the legal rights and obligations which they give the appearance of creating. No unexpressed intentions of a "sham" affect the rights of a party whom he deceived [emphasis mine].”

Many find this somewhat inequitable – after all, why should India permit companies to take advantage of the corporate form and low-tax jurisdictions to avoid what would otherwise be payable on a simple transfer of HEL shares? The answer is that while nothing prevents the Indian legislature from enacting a General Anti Avoidance Rule, such as the one proposed in the Direct Taxes Code, courts cannot do so. As Lord Cairns observed, “if the Crown cannot bring the subject within the letter of the law, the subject is free, however apparently within the spirit of the law the case might otherwise appear to be” [emphasis mine]. Despite ambiguous observations in McDowell, the Supreme Court has clarified in Azadi Bachao Andolan that Indian law adheres to this rule. What makes yesterday’s judgment even more ironic is that Chandrachud J. himself notes that an assessee who engages in such tax avoidance “does not tread upon a moral dilemma or risk a legal invalidation” (¶ 56).

Finally, the Court rejected the Samsung approach to s. 195, which has been independently confirmed by the Supreme Court today, and also held that it is open to the assessee to raise the plea of apportionment before the Assessing Officer. However, it is submitted with respect that this judgment is an unfortunate one, for it conflates “legal substance” with “objective of the transaction”. One hopes that the Supreme Court will take a different view.


13 comments:

Alok said...

The approach to understanding the Vodafone judgment in this post is completely wrong on law and facts.

On law

1. Vodafone was proceeded against under s.201(1) as assessee in default for failing to deduct taxes under s.195.

2. Liability to deduct taxes under s. 195 is awakened when the sum being paid to the non-resident is chargeable to tax in India.

3. Chargeability to tax here is to be determined not in the manner of assessment under Chapter XIV, but whether or not
a. The payment has the character of income
b. The source of the Income is in India.

4. Section 5(2)(b) read with section 9(1)(i) makes it clear that where an Indian asset has been transferred, the amount paid is deemed to have accrued or arise in India and therefore taxable in India.

5. Further, the legal effect of a transaction does not extend only the extent that parties intend it to. Parties cannot call a sale a license and demand that the sale have the same effect as a license in law or vice versa.

6. Tax authorities are entitled to examine an agreement and see what the parties are in fact entering into instead of just taking the parties' word for it, and not limiting themselves merely to the legal effect that the parties' lawyers say it has.

On the facts:

1. The transfer of the 1 share in CGPC did not result in the transfer of the Indian assets. Rather it was the transfer of the share along with the transfer of various rights held by HTIL in HEL that led to the transfer of the Indian asset. Control did not change hands merely because the 1 share of CGPC stod transferred. The transaction was a composite one, and the said composite transaction is being taxed and not just its individual parts. In any case, the ultimate liability of HTIL to tax in India was to be determined in later proceedings as the present case is only for the purposes of tax deduction.

2. Territorial nexus of this transaction was evident from the fact that the Framework Agreement and the SPA itself mandates that the transaction will not go through if appropriate Indian regulatory approvals do not come through. In addition, the name of the acquired company was changed, as was the brand-name and other IPR. If the transaction had no nexus with India, what should be made of these facts?

3. HTIL has received dividend from HEL and on its account books filed with the authorities in HK, its own disclosures to its shareholders and to regulators across the world, it treats HEL as an Indian asset. When parties themselves understand the transaction to be one where an Indian asset is being transferred, why should they be permitted to avoid paying tax on it by adopting a different position before the tax authorities?

Lastly, Azaadi Bachao Andolan itself needs reconsideration on its interpretation of the McDowell case. Anyone who reads the majority judgment in McDowell v CTO (5 judges) cannot fail to note this passage in the majority judgment.

"26. Tax planning may be legitimate provided it is within the framework of law. Colourable devices cannot be part of tax planning and it is wrong to encourage or entertain the belief that it is honourable to avoid the payment of tax by resorting to dubious methods. It is the obligation of every citizen to pay the taxes honestly without resorting to subterfuges.

27. On this aspect one of us, Chinnappa Reddy, J., has proposed a separate and detailed opinion with which we agree."


On this aspect, I fail to understand how Azaadi Bachao Andolan, being a two judge Bench, and taking a contrary view to that of Chinappa Reddy J (and by that extension the majority in McDowell), can be held to be good law.

Mihir Naniwadekar said...

Alok-

Re points 1 to 4, I doubt there is any disagreement. Re point 5 and 6, you are correct that the true legal nature of the transaction has to be seen. But the true 'legal nature' of a transaction is distinct from the 'motive behind' the transaction

Re your point regarding Azadi-McDowell- undoubtedly you are right. But, the Bombay High Court is bound by what Azadi says about McDowell. When a 2 judge bench of the SC interprets a 5 Judge Bench, it is the understanding of the 2 judge bench which binds all lower courts. There is abundant authority for this proposition. Porrits and Spencer (P&H HC) and Akshay Textiles (309 ITR, Bom HC) are two. The SC has also affirmed this is a case related to dividend stripping, I believe.

Mihir Naniwadekar said...
This comment has been removed by the author.
Mihir Naniwadekar said...

Re point 3 - I assume that you agree that chargeability has to be determined in this case on an interpretation of S. 5 and S. 9;
Re point 4, I am assuming that by "Indian asset" you mean "asset situate in India"

V. Niranjan said...

@ Alok, the view you express is held by many. I disagree, and address your points below in the order in which you made them. This comment makes the legal points, the next one factual.

On law

1. While you are correct that s. 201 is invoked, Vodafone was not proceeded against under s. 201 for the purpose of these proceedings. See paragraph 970 of the impugned order, quoted in para 146 of the Bombay HC's judgment.

2. Correct. But see below.

3. Correct. My contention is that this Transaction fails the second test, for the reasons outlined in the post and further below.

4. S. 5(2)(b) does not make it clear that there is income when an "asset is transferred" - the income must arise through the transfer of a capital asset "SITUATE IN INDIA", according to s. 9(1)(i), or from or through the other tests enumerated therein. It must therefore be established that the capital asset in this case was "situate in India", which, for the reasons in the post, it was not.

5 and 6: Correct. The legal nature of a transaction is not controlled by the nomenclature parties assign to it, and tax authorities are entitled to scrutinise the agreement. But the crucial point here is that the tax authorities must determine the true LEGAL nature of the agreement, not its CONSEQUENCE, or EFFECT. To understand this better, we may look at three types of things one can do with an agreement: understand its legal form, understand its legal substance, and understand its economic substance. Lord Diplock's observations in Snook, and Supreme Court judgments cited in the post make it clear that the Court is concerned with LEGAL substance.

V. Niranjan said...

On the facts

1. Correct. It was the transfer of 1 share of CGP combined with the other agreements that gave Vodafone ultimate control. But consider this: even the transfer of 100 p.c. of the equity shares of a company does not amount to a transfer of that "undertaking" (Brooke Bond India v. UB Ltd.). Similarly, the licence that HEL held is not a "transferable commodity" under s. 4 of the Telegraph Act, 1882

2. You make an important point here. The FIPB issue has proved influential in both cases. Undoubtedly it shows that the transaction has a "connection" with India. But we must ask whether that connection is "nexus for the purposes of taxation law". It is settled law that a transfer of a capital asset situate outside India by a non-resident to a non-resident does not give India nexus to tax. Qantas Airways, for example, makes this point on facts more favourable to the Revenue than in the Vodafone case.

3. Correct. Parties do understand that Vodafone has acquired the Indian telecom interests of Hutchison. But that is a commercial CONSEQUENCE of an agreement to transfer a share of a holding company, and not the transaction itself. For example, suppose company "A" owns five cars in India as its only assets. If I transfer 100 p.c. of the equity shares of the company that owns Company A, would you say that I am in fact transferring ownership of the five cars?

Lastly, whether Azadi Bachao needs reconsideration is a matter of dispute. It is clear though that the decision was binding on Chandrachud J. It is also settled law that the "interpretation" of a decision is itself ratio decidendi for future courts - which means that any lower court or a Bench of the Supreme Court that is bound by Azadi is bound by Azadi's interpretation of McDowell.

Even substantively speaking, as to McDowell, paragraph 26 which you extract only shows that the majority only rejects "colorable devices". The discussion just before paragraph 26 shows that the majority approved decisions like BM Kharwar and Jiyajeerao Cotton Mills, which essentially state what Azadi states. Para 27 must be read in light of these considerations.

To conclude, I think the difficulty with the Vodafone transaction is that it appears to be a case of a party "taking advantage" of the law. Yet, both English and Indian law recognise that a citizen is entitled to arrange his affairs in accordance with the law so as to minimise tax liability - and Vodafone did no more than adopt a common method of acquiring companies.

Alok said...

"To conclude, I think the difficulty with the Vodafone transaction is that it appears to be a case of a party "taking advantage" of the law. Yet, both English and Indian law recognise that a citizen is entitled to arrange his affairs in accordance with the law so as to minimise tax liability - and Vodafone did no more than adopt a common method of acquiring companies."

I have no doubt that citizens are free to arrange their affairs (in regard to taxation) in a manner in accordance with the law.

I just dispute multinational companies' right to do so. Especially when they deny the right of every country to tax them on their income.

Vodafone wasn't engaging in any dodgy transaction. It is a valid transaction. But it doesn't mean that for the purposes of tax, the Govt. and courts should approach this matter with a set of blinders designed to favour the assessee.

Alok said...

"Was the objective of the transaction the transfer of control over the Indian entity? Of course it was. But does it follow that the legal nature of the transaction was the transfer of shares in HEL? It is submitted, with great respect, that it does not."

The legal nature of the transaction was not the transfer of shares in HEL, true, but the legal nature of the transaction was a transfer of the controlling interest in HEL.

Controlling interest itself has been held to be an asset. This asset is situate in India as all the other facts indicate. It would be absurd to suggest that the situs of the asset keeps changing depending on the residence of the controlling entity.

All the legal and factual quibbling apart, I think at some level we should also debate the public policy considerations in this case. Not that they find discussion in the judgment (or are likely to find discussion in the appeal either), but it is nonetheless worthwhile, in my opinion, to question whether when faced between two fairly plausible interpretive possibilities, courts should choose the one which favour one which benefits a multinational non-resident company or the Government.

I think the Vodafone judgment should also be debated at this level, along with the merits of its legal and factual reasoning.

Anonymous said...

Re alok's last comment:

In fact controlling interest is not a capital asset on its own. Justice Chandrachud's judgment doesn't dispute this.

Alok said...

Re: Anonymous

My mistake. Debating international tax in the middle of the night leads to such things :)

I meant the sum total of rights and entitlements as Chandrachud himself as said, as opposed to merely treating the share as a capital asset.

"These rights and entitlements constitute in themselves capital assets within the meaning of of Section 2(14) which expression is defined to mean property of any kind held by the assessee."

Anonymous said...

Alok, thanks for clarifying. Now let's look at the sum total- share plus 'x' let's say. Now I am sure you will agree that a person cannot transfer something in which he has no interest. And that as a matter of law, a company has no interest in the property of its subsidiaries. Unless the corporate veil is lifted. So, hutch had an interest in the share, only its subsidiaries had an interest in the 'plus x' part. So, hutch could not have transferred anything but the share to vodafone, unless the veil is lifted. Now, was the veil lifted? Justice chandrachud does not say so- he doesn't even discuss the cases on lifting of the veil! What is the basis of the decision in law? The effect of the transfer of the share was that a whole bundle of rights could be exercised by vodafone- that doesn't mean that the bundle of rights itself was 'transferred'

On the policy concern, that is- I agree- important. The govt. has revenue to gain, and possibly foreign investment to lose. Should a judge be taking the call? I don't think so...

Shantanu Naravane said...

Alok, another thing I am not very clear on is why you seek to make a distinction between multinational companies and citizens, in arranging affairs to reduce the burden of taxation. The distinction would have been sound had the justifications for tax avoidance been traceable to rights of citizens, which they are not. Hence, legally speaking, the distinction between multinational companies and citizens seems on unsound foundations.

It is of course possible that policy concerns (also read as increased taxed revenues) require that Governments do all they can to ensure that multinational companies do not escape the tax net. However, as 'Anonymous' points out, that is an argument for the legislature changing the law or fine-tuning its DTAAs (which has been happening recently).

Anonymous said...

1. The transaction under consideration is the transfer by investors in a company registered in Cayman Islands of the shares in it to a purchaser in USA.
2. Let us recall the basic principles of taxation. When income arises from a transaction of sale, it can be assessed in three ways –
a. according to the place in which the sale was effected,
b. according to the place where the property sold is situate.
c. according to the residence of the seller or
If any one of these taxable events is in India, the transaction may be brought to tax. Even then, if the same transaction is subject to tax in another country, because another taxable event occurs there, we have to go by the Double Taxation Avoidance Agreement between those two countries.
3. If none of the three taxable events occurs in India, the income arising from the transaction cannot be subject to tax in India. Of course, if any shareholder is in India he will have to pay capital gains tax on the sale of his shares.
4. In a case of immoveable property the situs of the sale is naturally the place where the property exists. In the case of moveable property it is the place where the possession of that property is handed over. In the case of shares in a company, it is universally accepted that the place of transfer is the place where the company is registered. Therefore the place where the sale is effected will be Cayman Islands where the company is registered and that will not be a taxable event in India.
5. When shares in a company are sold, the subject of the sale is only the shares and not the property that the company may hold. For instance even in India, if a company dealing in real estate holds lands, the transfer of the shares of that company cannot be considered to be sale of lands. The only way in which it can be done is to establish that the company is a sham and a device to conceal the real owner. Sham means that it was not intended to be real at all.
6. Therefore if the seller is not resident in India and the asset sold is also not in India, there is no question of taxing that non-resident on income arising from that sale. The attempt in Vodofone case was to say that though the sale was of shares in Cayman Islands, it actually represented property in India and therefore it attracted tax in India.
7. The consequential question is how to collect the tax from a non-resident and recourse is taken to provisions relating to deduction of tax at source. Section 195 provides that any person responsible for paying to a non-resident, any sum chargeable to tax, shall deduct tax thereon and remit it to the government. Section 204 defines a person responsible for paying. Reading these together it is apparent that when no money flows from the Indian company to the investor in the holding company in Cayman Islands, the question of deduction of tax at source cannot arise at all.