Column : Dialling into tax trouble

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: The recent decision of the Bombay High Court in the Vodafone case would have a significant impact on the cross border transactions relating to assets located in India. Vodafone, a mobile service provider had acquired 100% shares in a Cayman Islands company for $11.2 billion from Hutchison International, a Hong Kong based company. This Cayman Islands company previously owned by Hutchison, had a 67% shareholding in Hutchison Essar Limited, an Indian entity, through an intermediate Mauritius entity.

In effect, this acquisition had indirectly given Vodafone a controlling interest of 67% in the Indian entity and, in the process, gave access to it in the Indian market. The tax department issued show cause notice to Vodafone to explain why tax was not deducted at source by it before making payment to Hutchison. The tax department contested that in effect the purchase was of the business operations of the Indian company whose shares were held ultimately by the Cayman Island company. Vodafone contended that no tax was due in India because the deal was between two offshore companies and if any tax arose Hutchison was liable for it. It asserted that the tax withholding provisions of the Indian tax code do not have extra-territorial application.

The Bombay High Court rejected the Vodafone’s contention. The decision of the High Court can be summarised in the following three propositions.

First, even though the transaction was a transfer of a controlling interest in the Cayman Islands company, it was in essence a transfer of a capital asset located in India. As the Court observed, “the subject matter of transfer... is not actually the shares of a Cayman Island company, but the assets situated in India”. The transaction enabled Vodafone to be a joint venture partner in the Indian entity and acquire a beneficial interest in the license granted by the Indian telecom regulator. The Court emphasised that the object of the transaction was “to successfully pierce the Indian mobile market to enlarge its global presence”.

Second, even though the transaction was between two non-residents, took place in a foreign country and it related to the assets of a foreign entity, it is taxable under Indian tax law if it leads to a transfer of assets located in India. In coming to the conclusion, the Court placed reliance on the “Effects Doctrine”. This doctrine which originated in the context of American competition laws mandates that foreign entities would be subject to domestic laws if their behaviour or transactions produce an “effect” within the domestic territory. The “nationality” of firms is irrelevant. The Indian Supreme Court applied this principle in the context of competition law and now the Bombay High Court has extended it to tax law.

Third, the Court rejected the Vodafone’s contention that the showcause notice must be set aside because it did not have any liability to withhold tax under Indian law based on the nature of the transaction. The Court ruled that a show cause notice does not give rise to any liability and Vodafone should substantiate its position before the tax authorities. The Court reiterated the settled principle that a show cause notice can be challenged only under two circumstances—the government does not have any power to investigate the facts and issue the notice or if the facts as alleged in the notice, even if they are true, do not give rise to any tax liability. The Court held that the Vodafone did not satisfy either of these conditions.

The Court said that it could not make a judgement on the true nature of the transaction or whether provisions of the income tax law were valid because Vodafone failed to produce documents relating to the transaction. This failure seems to have played a big role in the Court’s decision because the Court termed it as a “willful failure” and drew an adverse inference against the petitioner.

Tax analysts will certainly try to confine this ruling to the unique facts of the case. It will certainly affect all cross-border transactions and tax clauses would be extensively negotiated to allocate the burden of tax liability.

This ruling will create new issues: What is the status of all transactions entered in tax-efficient jurisdictions? Would the ruling have been different if Vodafone brought the assets from the intermediary Mauritius entity rather than through the Cayman Islands entity because Cayman Islands does not have a Double Taxation Avoidance Treaty with India? How will this ruling be applied for the transfer of shares in a foreign entity which owns assets located in India and in other jurisdictions? Can the government invoke this ruling reopen the cross border transactions which have already closed? While the full impact of this ruling is not clear, this case certainly shows that Indian courts are willing to expand the scope of Indian tax laws.