The Indian Supreme Court Answers Vodafone's Call

By James J. Tobin, Esq.  

Ernst & Young LLP, New York, NY

I've admitted in prior commentaries that all my favorite famous quotes come from either Learned Hand or Yogi Berra.  But now I've just finished reading the 275-page decision by the Indian Supreme Court in the well-publicized Vodafone case and I'm excited to have some new favorite quotes to add to my list. The court's decision in the case represents a huge win for the taxpayer and, in my view, a potential confidence builder for foreign investors wrestling with the Indian legal system. Further, as the majority of the precedents extensively analyzed by the Supreme Court were cases decided under English law, I am hopeful that the principles underlying the ruling will have influence on courts and tax authorities outside of India, as well.

The issue at hand in the Vodafone case was potential Indian capital gains tax imposed on a foreign corporation's transfer of shares of a foreign holding company which owned a chain of subsidiaries through which was ultimately owned the effective majority interest in an Indian operating company. The facts are quite well known at this point, so the following is a quick refresher on the essential elements of the structure and the transaction.

One of the Vodafone group's Netherlands subsidiaries ("Vodafone") acquired from Hutchison, a Hong Kong company, 100% of the shares of a Cayman Islands company, CGP. CGP, through a complex ownership structure, owned several Mauritius companies which in turn owned varying percentage interests in HEL, an Indian company that operated one of the largest mobile telephone businesses in India.  Calculated in the aggregate and taking into account certain call option arrangements, the Mauritius companies owned the majority interest in HEL. The purchase price paid by Vodafone for the acquisition was over $11 billion.

The Indian tax authorities asserted that Hutchison was liable for Indian capital gains tax on the sale based on multiple different theories, including that CGP, the Cayman holding company, and its intermediate subsidiaries should be looked through and that the sale was in substance the sale of an Indian asset. Alternatively, the tax authorities asserted that the sale of shares involved a bundle of intangible rights in India, such as a control premium, non-compete agreements, and put/call arrangements, which had an Indian nexus.  Based on these theories, the tax authorities assessed Vodafone for failure properly to withhold tax. Given the amount at stake, there was little doubt the ultimate resolution would require action by the Indian Supreme Court.

While it feels like we all have been watching this case for a long time, Vodafone actually achieved very speedy access to the Indian Supreme Court through the means they used in challenging the assessment by the tax authorities. Suspense mounted, however, when a holding for the tax authorities at the Bombay High Court level last year left significant doubt as to whether a favorable ruling would be achieved at the Indian Supreme Court level.

Given the complexity of the case and the space constraints of this commentary, I will try to limit myself to the highlights. The Indian Supreme Court focused extensively on the position of the tax authorities that the intervening holding companies had no commercial substance and were inserted for tax avoidance reasons.  The court's analysis also addressed the twin concepts of beneficial ownership and treaty shopping, which were implicated in this case because the Indian operating company was owned by a string of Mauritius companies that would potentially have been eligible for protection from capital gains tax under the India-Mauritius income tax treaty had those companies sold their interests in the Indian company directly.  Thus, the decision has wide relevance beyond Vodafone itself because so many multinationals find themselves embroiled in tax disputes in India that involve these two issues.

Moreover, the decision should have a ripple effect far beyond India because tax authorities in many other countries, including Australia, China, Indonesia, and Korea to name a few, have advanced theories similar to those that had been relied upon by the Indian tax authorities in making tax assessments on inbound investors.

The court's ruling included an opinion by Chief Judge Kapadia and a concurring opinion by Judge Radhakrishnan. Both opinions include great detail on the facts and provide exhaustive analysis of Indian and international precedents. Highlights include the following:

  •   The tax status of a corporation as a separate entity/separate taxpayer should generally be respected.  To support this conclusion, the court reached all the way back to the 13th century and Pope Innocent IV who apparently concluded that corporate bodies could not be excommunicated because they only exist in abstract. I did not cite-check this reference but clearly saw it as a propitious start for the taxpayer (and a vindication of my long-held feeling that we international tax planners usually are on the side of the angels).
  •   The court concluded that the burden was on the tax authorities to establish abuse with respect to a holding structure. In this regard, the court noted various business purposes for the use of holding companies and separate subsidiaries, including easing regulatory approvals, limiting exposure to creditors, etc.
  •   The court strongly endorsed the view that tax planning is a legitimate right of a taxpayer. I was reminded of my favorite quote on the topic from Learned Hand: "Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one's taxes."1 On this point, my U.K. colleagues quote from Lord Tomlin's opinion in the Duke of Westminster's case; happily, Judges Kapadia and Radhakrishnan seem to like him as well, as they quoted his famous line from that case: "Every man is entitled if he can to order his affairs so that the tax attaching under the appropriate Acts is less than it otherwise would be…".
  •   While supporting the overall principle that tax planning is permitted, the court also extensively analyzed the substance-versus-form issue, including the well-known U.K. cases Ramsay, Furniss v. Dawson, and Craven v. White. Generally, the court concluded that abuse challenges should be limited to so-called round-trip schemes, fraud situations, and cases where preordained steps purely for tax purposes are inserted in a transaction to achieve a desired tax result. Judge Kapadia set forth six factors that should be considered in assessing whether a holding structure is abusive:
    •   The concept of participation in an investment;
    •   The duration of time during which the holding structure exists;
    •   The period of business operations in India;
    •   The question of taxable revenues in India;
    •   The timing of the exit; and
    •   The continuity of business operations in India upon such exit.

 In this case, the Hutchison structure had been in place for many years and was set up as the valuable Indian assets were acquired. The structure thus clearly satisfied the court's criteria.

  •   The court was quite dismissive of the tax authorities' theories with respect to the separate existence of certain Indian-nexus intangible assets, such as control premium, non-compete covenants, brand license rights, etc. It viewed all of these rights as encompassed in the value of the corporate group, which was transferred by way of the sale of shares of CGP. The sale agreement allocated value only to the CGP shares and the court basically saw that as the end of the issue. I would generally agree with the court - with the possible exception of a non-compete agreement agreed to by the seller as such an agreement could represent additional value outside the intrinsic business value of a target corporation.  In this case, no separate value was ascribed to a non-compete agreement, which, given the nature of the business and the unlikelihood of Hutchison re-entering the market, seems to reflect the economic reality. Nevertheless, the opinion by the concurring judge specifically concluded that a non-compete agreement entered into outside of India would not give rise to a taxable event in India. This is an interesting topic area in the international tax world and I imagine this conclusion will be a point of discussion in future M&A transactions in India.
  •   While not clearly required for the court's holding, the judges also analyzed the issue of beneficial ownership for tax treaty purposes. This was done to underscore the lack of a tax avoidance motive for the sale by Hutchison of the shares of CGP because the Mauritius subsidiaries could have sold their Indian investments directly without Indian capital gains tax, due to the provisions of the India-Mauritius treaty.

The court noted that the tax authorities had challenged the potential availability of the Mauritius treaty on the grounds that the Mauritius subsidiaries were not the beneficial owners of the Indian assets or income. The court was emphatic in its view that the treaty should apply despite the fact that the Mauritius subsidiaries were owned and funded from outside of Mauritius. It noted that 42% of foreign direct investment (FDI) into India comes through Mauritius and that the government in negotiating the treaty would have been well aware that local Mauritius investors would not be able to fund such investments. The court opined that, in the absence of a Limitation on Benefits clause in the treaty, the "tax department cannot at the time of sale/disinvestment/exit from such FDI, deny benefits to such Mauritius companies of the treaty by stating that FDI was only routed through a Mauritius company." Bottom line: Justice Radhakrishnan states that setting up a wholly-owned Mauritius subsidiary or special purpose vehicle for genuine substantial long-term FDI into India "can never be considered set up for tax evasion." Music to my ears! Consistent with the OECD Commentary on beneficial ownership, a topic on which I commented in this column several months back (40 TMIJ 613, 11/14/11). And the right answer.

So, all in all, a great taxpayer victory, secured at what no doubt was very substantial out-of-pocket cost to Vodafone in fighting all the way to the Indian Supreme Court. Given that it is the Indian Supreme Court, this is the final word on the subject, right? Well, unfortunately, maybe not. As the court also noted, there is proposed legislation pending in India - the so-called Direct Tax Code (DTC) - which includes both an indirect stock transfer rule and a general anti-abuse rule (GAAR). The indirect stock transfer rule provides that the shares of a foreign holding company that has over 50% of its value attributable to Indian assets will be considered Indian-situs assets, gain on which may be subjected to tax in India.  Such a statutory provision would not be unprecedented as several countries have provisions that are similar, albeit narrower than the proposal being considered in the DTC. One example is the taxable Canadian property rules in Canada, but those rules only apply to Canadian real property value. The GAAR rule in the DTC has specific reference to tax treaties and includes both ownership and local commercial substance standards as criteria for applying the GAAR test, which could provide a new basis to challenge Mauritius structures.

The DTC is in draft form only and is still just a proposal at this stage. One would hope that the strong tax policy statements contained in the court's decision together with the diminished FDI activity currently would cause Indian legislators to hit the pause button and rethink the underlying investment ramifications of those proposals. Despite my enthusiasm upon reading the decision, I'm not sure I would bank on the Vodafone outcome for the long term at this point. Therefore, prudent investors into India would be well served to review carefully the implications of the Vodafone decision on their existing structures and their pending controversy matters and to consider whether restructuring is warranted in the near term because of the potential negative legislation.

The wisdom of being prudent should not detract from our appreciation of what is an extremely positive outcome in the Indian Supreme Court. As Yogi would say, "I'd like to thank everyone who made this day necessary." The aggressive assessment by the tax authorities combined with a determined defendant has made for good law and a great precedent in a notoriously difficult tax environment. Still, even an optimistic guy like me can't help hearing the wise Yogi reminding us that "it ain't over `til it's over."

Hold the Phone! As this edition goes to press we find that Yogi's sage advice was proven correct even more quickly than could have been expected. The Indian government released major tax reform proposals in its budget on March 16. Taking an unabashed "The Empire Strikes Back" approach, the budget includes a proposal that, if passed into law, would retroactively repudiate the Supreme Court's holding in Vodafone and specifically override virtually all aspects of the Court's well-reasoned decision. Under the budget, any indirect stock transfer would be taxable in India if a foreign entity being transferred derives its value substantially from assets situated in India that are held directly or indirectly. This provision is introduced as a "clarification" of existing law with retrospective effect back to April 1, 1962. There's more than a little irony in that date: not just the year - in which the U.S. introduced our Subpart F rules - but also April Fool's Day. The proposed provision also would impose an Indian withholding tax obligation even where the transaction occurs between a foreign purchaser and foreign seller.

In addition to this supreme overreach on the taxation of capital gains, the budget includes a proposed GAAR provision that is even broader than the one that was included in the proposed Direct Tax Code and that I noted above with some concern. The GAAR proposal in the budget would give the tax authorities free rein to deny or recharacterize any deemed "impermissible avoidance arrangement" where one of the main purposes was to obtain a tax benefit. In another direct assault on the Supreme Court's ruling, the GAAR proposal is made specifically applicable to tax treaty arrangements and specifically overrides the guidelines laid down by the court in sustaining the validity of the Mauritius holding structures in the Vodafone case based on factors such as the length of ownership, long-term foreign direct investment objectives, etc. Therefore, existing Mauritius structures could potentially be at risk from April 1, 2012 - another apt link to April Fool's Day - other than those structures with significant commercial substance or ultimately held by local Mauritius investors. The GAAR proposal includes provision for appointment of a GAAR panel to review assertions of GAAR by the tax authorities. However, likely not a lot of solace in a country where unfavorable decisions by even the Supreme Court are overridden retroactively…

There are a number of other goodies in the budget proposal - some with similar retroactive effect - that are beyond the scope of this postscript. In my view, the proposals here are shocking and if passed most certainly should raise legal/constitutional issues that would again have to wind their way through the court process in India. I indicated at the start of this article that the Supreme Court's holding in Vodafone would be a potential confidence-builder for foreign investors dealing with the complex and even hostile Indian legal and tax systems. If passed, these proposals would shatter any such confidence. And indeed their mere proposal surely will have a chilling effect. One can only hope that the Indian Parliament will recognize this and will right the course.

This commentary also will appear in the April 2012 issue of the  Tax Management International Journal.  For more information, in the Tax Management Portfolios, see Isenbergh, 900 T.M., Foundations of U.S. International Taxation, Levine and Miller, 936 T.M., U.S. Income Tax Treaties - The Limitation on Benefits Article, and Kotwal and Hansraj, 966 T.M., Business Operations in India,  and in Tax Practice Series, see ¶7110, U.S. International Taxation - General Principles, and ¶7160, U.S. Income Tax Treaties.

  1 Gregory v. Helvering, 69 F.2d 809, 810 (2d Cir. 1934), aff'd, 293 U.S. 465 (1935).