The Vodafone’s tax saga made the legislature of our country realize that our tax laws are obsolete and insufficient to cater to the modern corporate environment. If you are wondering, what the issue all about, here’s a simple explanation:
Capital Gain Tax
Capital Gain Tax is the tax that one has to pay if he makes gains on selling capital assets like land, building or even shares.
Tax Deduction at Source (TDS)
When two parties – buyer and the seller enter into a transaction, the seller would have to pay Capital Gain Tax to the Government, on profit he makes by selling his asset. But the practice is that the buyer while paying for the purchase, deducts the said tax amount from the total purchase amount, sets that portion aside to be paid to the Government, and pays the remaining to the seller. This is called Tax Deduction at Source.
- Vodafone International Holdings BV: Netherlands based telecom company
- Hutchison Telecommunication International Ltd. (HTIL): Hong- Kong based company
- Hutchison Essar Ltd. (HEL): India based company
- CGP Investments Holdings Ltd.: Cayman Island based company (Cayman Island is a tax haven, implying, it imposes negligible tax on business transactions)
What the parties did
HTIL, the Hong-Kong company, the big boss in this case, owned CGP – the Cayman Islands Company. CGP instead, held 67% stakes in Hutchison Essar Ltd or HEL – the Indian company.
HTIL ———-> CGP ————->HEL
HTIL sought to sell its India based HEL by selling away CGP. Vodafone agreed to buy the same for about 11 billion dollars.
Now comes the question – what is wrong or apparently wrong with the transaction?
Section 9 of Income Tax Act
Section9(1) of the Income Tax Act said that income is deemed to accrue or arise in India (directly or indirectly) through or from any business connection, property, asset, source of income, or transfer of a capital asset situated in India.
Based on this law, the Income Tax Department decided to issued notice to both HEL (now VEL – Vodafone Essar Ltd) and Vodafone stating that they are in default of payment of Capital Gain Tax of 2.1 billion dollars, for a purchase of an Indian company – HEL from HTIL by Vodafone (Here, Vodafone being the buyer should have deducted the tax at source to pay to the Government, but it did not do so)
At the Bombay High Court
After much drama, when the matter reached the Bombay High Court, the arguments from both sides were as follows:
Among several arguments, Vodafone’s main contentions were that:
- It had entered into a genuine transaction within permissible legal framework, which therefore cannot be called sham transaction. It said that Indian exchange control regulations recognized investment companies like CGP, based in tax havens like Cayman Islands.
- Vodafone contended that there is no income that accrues or arises in India since the transaction took place with respect to shares of a company located outside India, i.e. shares of CGP in Cayman Islands, under a contract entered into outside India, and payment was made outside India.
- Capital Gain Tax is levied on profits made from transfer of “assets”. Vodafone argued that through purchase of shares, it has acquired a right to control the Indian business operations and not the ownership of the assets in India, which continues to remain with the Indian entity – HEL. It tried to draw distinction between transfer of shares and transfer of underlying assets or undertaking.
IT Department’s argument:
- According to the Revenue, the deeming as given in Section 9, is a legal fiction and all income derived by a nonresident from whatever source is brought within the ambit of the provisions if there is a nexus.
- Section 2(14) of the Income Tax Act, defines a capital asset as ‘‘property of any kind held by an assessee, whether or not connected with his business or profession.’’ Shares are capital assets the transfer of which results in capital gains that are taxable under the ITA.
Bombay High Court’s decision
The Bombay HC ruled that where the underlying assets of the transaction between two or more offshore entities lies in India, it is subject to Capital Gains Tax under relevant income tax laws in India. The Court invoked the territorial nexus rule wherein a state can tax if it finds connection between the state and the person sought to be taxed. The court concluded that Vodafone was liable to deduct tax at source (TDS).
At the Supreme Court
When the case reached the Supreme Court, the Apex Court set aside the Bombay High Court’s decision and held that such Capital Gain Tax cannot be imposed on Vodafone because the transaction was an overseas one, thereby India lacked tax jurisdiction.
Amendment with retrospective effect
Upon this, the legislature proposed amendment to the ITA, with retrospective effect from 1962 so that all persons, whether residents or non-residents, having business connection in India, will have to deduct tax at source and pay it to the government even if the deal is executed on foreign ground.
Though legislature may make laws with retrospective effect, as a matter of principle, it must refrain from trying to achieve indirectly, what it couldn’t by direct ways. Supreme Court had opined that Vodafone attempted and succeeded in tax avoidance which is legal as opposed to tax evasion. In fact Vodafone was not the first company to be able to escape tax in this manner. It has been a trend with multinational companies to make flimsy companies in tax havens and transact through them. It is yet to be seen how the case turns out with both parties trying to reach amicable settlement.
Picture courtesy: Zeenewsindia