The territorial jurisdiction of Indian tax authorities to tax cross-border transactions involving indirect transfer of shares of an Indian company has been a matter of controversy. It was generally understood that such transactions should not be taxed in India, since the situs of the shares sold are outside India and in the absence of any specific ?look-through? provisions. However, recently, Indian tax authorities have attempted to challenge this interpretation, which appears to steer against the accepted jurisprudence and seeks to lift the corporate veil, having far-reaching implications on international transactions.

In the era of evolving financial markets, structures put in place to channel legitimate investments across borders are perfectly acceptable, including multi-tier structures put in place for commercial reasons, such as leveraged buyouts. They provide exit flexibility to investors. These structures should not be subjected to the lifting of the corporate veil merely because it results in tax savings. Taxing such transactions on the basis of non-existing provisions would result in uncertainties amongst the existing investors.

In the past, similar transactions have been left untouched. Taxing similar transactions now would result in an unfair advantage to those past transactions.

Though such an approach might result in a temporary spurt in revenue for the Government, it could also have an adverse impact on investor sentiments and hamper future FDI flows into India. The ?preferred investment destination? image of India may take a beating in the case of such an approach being adopted by the tax authorities.

If other countries also start adopting the same approach, taking a cue from the arguments of Indian tax authorities, this would create a fair chance of affecting outbound structures of Indian corporates and hinder their global expansion plans. This, in turn, would hinder the overall growth of Indian corporates and, therefore, India itself.

Such a position would raise some practical issues as well. The parties involved would be foreign entities unaware of Indian tax laws. How would they withhold taxes and deposit in India? For instance, in the case of a listed foreign entity having an Indian subsidiary, there could be numerous transactions where withholding tax implications may arise to public shareholders, which seems to be an absurd position. How would the cost of the acquisition of such shares be computed and capital gains apportioned, if the foreign company whose shares are being sold also holds shares of companies other than Indian companies? Also, if a similar transaction results in a capital loss, would the tax authorities be willing to allow a set-off of such a capital loss? In the case of a multi-layered structure involving multiple countries, the tax impact would need to be examined in each country in the structure and the transaction could be subject to tax in multiple countries. This lack of clarity would result in enhancing litigation and consequential uncertainties. Resolution of the issues may result in a delay in the closure of deals. Also, the transaction documentation, especially the representations, warranties and indemnification clauses, are likely to get a lot more complex and elaborate.

If at all such transactions are to be taxed, a prospective amendment in the existing tax laws with a specific provision to tax such transactions would be a reasonable path forward, in order to provide prospective investors a better chance to plan their structures. Interestingly, the Direct Taxes Code?which is likely to come into effect on April 1, 2012?specifically spells out conditions under which such indirect transfer will be subject to tax in India. Since there are various instances of pending litigations in Indian courts (including the apex court), a better picture and a clear view forward would be available only after such litigations are settled.

The author is transaction tax leader, Ernst & Young. Views are personal

The right of a State to tax a non-resident arises from the existence of a nexus between him and that State. International law recognises a State?s right to tax income having its source in its jurisdiction. The Bombay High Court?s ruling in the Vodafone case has stirred a hornet?s nest mainly on account of the perception that there was no such nexus, as the transaction was entered between two foreign companies?outside India, and for shares of another foreign company. It is, therefore, argued that Revenue is stretching the concept of nexus by bringing in the issue of the foreign company?s underlying Indian assets.

Actually, the case revolves around a complex catena of facts, briefly stated here. The Hutchison Group of Hong Kong was controlling certain companies in India in joint ventures with others. It held a majority stake in an Indian company, Hutchison Essar Limited (HEL), through Hutchison Telecommunication International Ltd (HTIL) of Cayman Islands. HEL had interests in several telecom circles in India through a web of subsidiaries. In February 2007, HTIL agreed to procure and transfer to Vodafone International Holdings BV the entire share capital of an investment company in Cayman Islands called CGP Investments Holdings Ltd, which was controlling the Indian interests of the Hutch group. Pursuant to this, Vodafone took approval of FIPB. It also entered into a covenant with HTIL indemnifying it for certain tax liabilities and allowing it to retain $352 million out of the sale consideration. Thereafter, Vodafone paid the balance consideration and the share certificate of CGP was delivered to it in Cayman Islands. The transaction was accompanied with several other enabling agreements.

The Revenue contended that this was, in reality, a composite transaction for the transfer of all rights in HEL by HTIL, resulting in Vodafone stepping into the shoes of HTIL. It argued that the transaction gave rise to capital gains taxable in India, as, in effect, the controlling interest in the Indian assets of HEL got transferred, and Vodafone ought to have deducted tax. The central argument on behalf of Vodafone remained that as the transaction was of a share of CGP Cayman Islands?situated outside India?no income can be deemed to have accrued or arisen in India. It took the matter to the Bombay High Court in a writ against a Show Cause Notice issued by Revenue even before the tax liability was determined.

The Court held that it will be simplistic to assume that the transaction was only for the transfer of one share of CGP Cayman Islands. The price of $11 billion factored in a panoply of rights and entitlements including control premium, right to the Hutch brand in India, a non-compete agreement, the value of non-voting preference shares and entitlement to acquire further 15% interest in HEL. The transaction prima facie amounts to a transfer of a capital assets and not merely a transfer simplicitor of controlling interest?especially as it confers a right to enter the telecom business in India with a control premium.

Relying on the doctrine of substance versus form, the Court held that the label which parties ascribe to a transaction cannot be conclusive in determining its character. This has to be ascertained from the covenants and surrounding circumstances. A colourable device in which parties, while seeking to clothe the transaction with a legal form, actually engage in a different transaction which serve no business purpose except avoidance of tax, can be disregarded. It held that once the nexus between a non-resident and the country seeking to tax him is shown to exist based on a business connection or situs of assets within the State, taxability can arise.

The ruling has been given on the basis of facts indicating that the transaction was a colourable tax avoidance device. Therefore, Revenue will be ill-advised in invoking it in genuine business cases. Incidentally, the Direct Taxes Code codifies the anti-avoidance Rules under which a transaction can be declared as lacking commercial substance.

The author is former member, Central Board of Direct Taxes