The
Supreme Court verdict quashing the tax department's
claim on Vodafone in the Hutchison-Essar acquisition
case is significant not just because of the Rs 11,200
crore loss of revenue implied in the case. It also
paves the way for other foreign companies to exploit
the interpretation of the law implied by the judgement
to avoid tax payment on capital gains that accrue
from the transfer of assets located in India. Given
the sum involved in this case and likely to be involved
in future instances, the loss is nothing but a national
shame in a country whose government claims that there
are inadequate resources to ensure food security,
address deprivation and provide employment. Not surprisingly
the government is making it appear that it is the
court, and not its own inclinations and policies,
that is tying its hands.
In this it has been helped by the controversy surrounding
the judgement, centred on the perception that the
bench has stretched itself in multiple directions
when interpreting the law on what constitutes tax
evasion. There is only one reason why investors would
choose to ''locate'' the ultimate ownership of a company
in a shell based in a country that is a tax haven
or is a low tax host that has a suitable tax treaty
with the country in which operations are based. That
is tax avoidance. This is what Hutchison had done
when it located the ultimate ownership of its majority
stake in Hutchison Essar Ltd (HEL) in a shell called
CGP located in the Cayman Islands. CGP in turn was
owned by Hutchison Telecommunications International
(Cayman) Holdings, another Cayman Islands company.
The issue was not whether this structure was adopted
with the express intention of selling CGP in order
to garner capital gains that would not be subject
to taxation. It is enough if the intent was that in
case Hutchison chose to sell at any point it should
evade tax on capital gains.
Not surprisingly, when Hutchison did sell CGP to Vodafone
Netherlands in 2007 for a sum of $11 billion, both
companies acted as if the transaction was not subject
to Indian tax law, even though Vodafone was in essence
acquiring an entity that earned its revenues from
operations in India. If Vodafone believed that Indian
tax law would apply, it would have withheld capital
gains tax to hand over to the Indian authorities.
Vodafone did not, because it was convinced and argued
(subsequently) that the company's ownership was structured
in a manner that the transaction did not fall under
the jurisdiction of Indian tax law. The Indian tax
authorities challenged that order on the grounds that
the operations and revenues that underlie CGP's valuation
occur in India. In that sense this was not an unrelated
transfer of CGP shares. It involved the transfer of
the future revenue stream from the operations of HEL
(renamed Vodafone-Essar). This was also supported
by the fact that, Vodafone had also acquired CGP's
'rights and entitlements' in HEL, involving elements
such as the use of the Hutch brand, loan obligations,
and the option to acquire an additional 15 per cent
stakeholding in HEL. This too would have affected
the valuation. The High Court upheld that view. The
Supreme Court struck it down.
There are two ways in which this Supreme Court judgement
has implicitly favoured entities that indulge in tax
avoidance practices. First, it has held that if loopholes
in the law, even if unintended, permit these entities
to use such practices to ''avoid'' tax payments, and
they indulge in ''legitimate'' tax planning, then they
are not in violation of any code. Second, it has suggested
that when assessing whether an entity is evading (not
avoiding) the tax law, the authorities have to examine
whether the means of evasion (which is here the creation
of CGP) was originally intended for this purpose.
Since Hutchison made its investments and engaged in
activities in India (in collaboration with Essar)
for sometime, and during that period CGP existed,
the latter is not seen as primarily created to avoid
capital gains.
For a court, the first of these positions seems warranted,
inasmuch as it is for the executive to ensure that
its laws do not have loopholes that result in tax
avoidance. In the case of income this requires ensuring
that nothing in the law or in treaties signed between
governments permits a company to avoid paying tax
on income to the government of the country in which
those receipts originate. In the case of capital gains
the issue is more complicated. The government cannot
prevent foreign investors from routing their investments
through shell companies located in tax havens or in
countries like Mauritius, with which India has signed
a double taxation treaty. Any transfer of that shell
company to another foreign owner outside the country
would transfer the shares it owns in the entity holding
and operating assets and deriving revenues in India.
The point then is to ensure that the transfer of share
ownership of any entity operating in India, earning
incomes from assets located in India, would be subject
to the tax laws applicable in this country. This would
prevent any distinction between share sale and assets
sale to be made. That would be fair because the value
of the shares depend on the value of the assets that
underlie them, and the value of those assets located
in India depend, in turn, on the future profile of
net revenues expected from the operation of those
assets.
What the Supreme Court has done is declare that as
the law stands, unless it can be shown that the investment
and subsequent transfer was made with the express
purpose of avoiding tax, this would also be a legitimate
transaction. There may be some justification in declaring
this to be an error on the part of the Supreme Court.
But that ''error'' is in keeping with the tendency on
the part of the government to propagate the view that
the development effort (led by the Executive) needs
a special dispensation favouring foreign investors
in this country.
The most obvious case of this tendency was the way
in which the issue of the right of companies that
had obtained a tax residence certificate in Mauritius
to be exempt (ostensibly under the double taxation
treaty with that country) from income tax in India
was established. Many of these companies are not even
originally registered in Mauritius and headquartered
in that country. It was on that basis that the income
tax department had slapped taxes on those companies.
But claiming that this would discourage foreign investment
in the country the then Finance Minister Yashwant
Sinha reportedly ensured that the Central Direct Taxes
Board issued a circular saying that this was indeed
acceptable. Clearly, the reading of both what the
law should be and the law is, was different by those
in the tax department and those responsible for fiscal
policy in the Finance Ministry.
At that time, civil society activists challenged in
the courts this interpretation of the law by the government.
And that time too the High Court delivered a judgment
that quashed the government's interpretation, which
was subsequently reversed by the Supreme Court (Azadi
Bachao Andolan case). To recall, the argument of the
government was that it was adopting the position notified
in the circular because that was necessary to attract
foreign investment into the country. That is, attracting
foreign investment using the tax concession route
was an acceptable principle from the point of view
of the Executive. In essence the court was taking
the position that it was up to the Executive to ensure
that the law on the matter was clear.
There have been other instances where the Executive
has very obviously favoured foreign investors on the
capital gains front. For example, the Budget for 2003-04
stated that: ''In order to give a further fillip to
the capital markets, it is now proposed to exempt
all listed equities that are acquired on or after
March 1, 2003, and sold after the lapse of a year,
or more, from the incidence of capital gains tax.
Long-term capital gains tax will, therefore, not hereafter
apply to such transactions. This proposal should facilitate
investment in equities.'' Long term capital gains tax
was being levied at the rate of 10 per cent up to
that point of time. The very next year, the Finance
Minister of the UPA government endorsed this move.
In his 2004 budget speech he announced his decision
to ''abolish the tax on long-term capital gains from
securities transactions altogether.'' These changes
were geared to coaxing foreign institutional investors
to invest more in India's stock markets. And they
did, now that the Indian stock market was a tax haven.
Given this background the ambiguity with regard to
the right to tax capital gains accruing abroad, on
equity linked to assets located in India and earning
revenues from the Indian market, is understandable.
The Finance Ministry, which does not mind giving tax
concessions favouring foreign finance to attract investment
into the country would prefer that this ambiguity
goes unnoticed. It is clearly engaged in an effort
to offer competitive tax concessions to attract foreign
investors away from other locations. But the pressure
on the tax department to implement increasingly weak
laws to garner additional revenues and improve tax
collection, forces it to read the law as it sees it
is. The net result is a divergence in viewpoints that
leads to instances like that observed in the Vodafone
case.
Seen in that light the Supreme Court judgment is a
godsend for the government. It can pretend that it
is the court that is responsible for an increasingly
lax tax policy in a country that the government claims
has little public money for crucial capital and social
expenditures. It is no doubt true that the judiciary
includes members who are part of the epistemic community
that believes that favouring foreign investors with
tax concessions is in the ''national'' interest. But
the fact is that the judiciary has invoked the ambiguity
inherent in the law when arriving at judgements such
as those reflected in both the Mauritius and the Vodafone
instances. It is for the Executive to clear that ambiguity.
But it would not, because it is the Executive that,
over the last two decades and more, has worked to
slant policy in favour of foreign investment as part
of the policy of economic reform and liberalisation.
Claiming to be helpless because of a court order is
a feeble excuse.
*This article was originally
published in the Frontline, Volume 29: Issue 5, March
10-23, 2012
