:: Paranjoy Guha Thakurta

Battling the zoozoos

Paranjoy Guha Thakurta

Sept.06 : The income tax department and Vodafone International are locked in a unique legal tussle that could set new precedents on how capital gains tax is levied on corporate entities based outside India which acquire control over assets located within the country. This case is one that would be closely scrutinised as the Union ministry of finance contemplates major changes in the income tax laws based on the recently released Direct Taxes Code.

The legal dispute relates to the largest-ever merger and acquisitions deal that has taken place in the Indian telecommunications industry, a deal involving $11 billion or over Rs 50,000 crores at prevailing exchange rates. On February 11, 2007, Vodafone International Holdings BV (VIH), a company registered in Netherlands, announced that it had agreed to acquire a controlling interest in Hutchison Essar Limited (HEL) by acquiring a company that controls 67 per cent of HEL from a company registered in the tax haven of Cayman Islands, namely, Hutchison Telecommunications International Limited (HTIL).

In August and September that year, the assistant director of income tax (international taxation), Mumbai, N.K. Govila, issued two show cause notices, the first to Vodafone Essar Limited (VEL), the new name for HEL, and the second to VIH, under specific sections of the Income Tax Act, 1961, claiming that the gains made by VIH from the deal are taxable in this country.

If the income tax department obtains 22 per cent of the transaction value, the government would be richer by $2 billion or Rs 5,000 crores. Vodafone has argued that the Indian government does not have the jurisdiction to levy a tax on an overseas transaction. Further, it contends that even if capital gains tax is to be levied, it should be on the beneficiary (in this case, HTIL) and not the buyer of the controlling stake in HEL (that became VEL).

The deal is rather complicated. VIH acquired control over a "sale group" comprising CGP Investment (Holdings) Limited, a company incorporated in Cayman Islands and which is indirectly a wholly-owned subsidiary of HTIL, and its subsidiaries including companies in the Hutchison Essar group. CGP, incidentally, holds 100 per cent of the issued share capital of Array Holdings, a company incorporated and resident in Mauritius, which holds shares in various foreign companies which, in turn, holds shares directly or indirectly in 14 Indian and foreign companies. CGP, directly and indirectly through subsidiary companies, owns approximately 52 per cent of the issued share capital of HEL.

In May that year, the Foreign Investment Promotion Board (FIPB) approved the complicated transaction involving transfer of shares in the CGP group from HTIL to VIH subject to certain conditions imposed on (a) VIH, (b) Asim Ghosh (managing director of Vodafone Essar that was earlier Orange and subsequently Hutchison Essar) and companies controlled by him which collectively, indirectly held 4.68 per cent of HEL’s shares, (c) Analjit Singh and companies controlled by him which collectively, indirectly held 7.58 per cent shares in HEL, and (d) IDFC Private Equity Co. Ltd., IDFC Ltd., SSKI Corporate Finance Pvt. Ltd. and SMMS Investments Pvt. Ltd., which collectively, indirectly held 2.77 per cent of HEL.

These conditions were that each of the above companies or individuals or groups would ensure that the 74 per cent sectoral cap on foreign direct investment in telecom companies specified in Press Note 3 of 2007, dated April 19, 2007, issued by the government’s department of industrial policy and promotion, is not breached and that there would not be any transfer of direct or indirect financial interest in HEL without the prior consent of the government.

After the show cause notices were issued by the income tax authorities, both VIH and VEL moved the Bombay high court. On December 3, 2008, a bench of the court comprising Justices F.I. Rebello and J.P. Devadhar upheld the position of the income tax department. During the hearings, the Additional Solicitor General of India Mohan Parasaran remarked that this was a "test case". VIH then moved the Supreme Court which, on January 23, 2009, ruled that the income tax department should first decide on the issue of jurisdiction based on an examination of facts provided by VIH and facts obtained independently. The Supreme Court further ruled that if the concerned assessing officer decided he had jurisdiction to issue the show cause notices, VIH would have the right to go straight to the Bombay high court by bypassing the normal process of appeal — that is, via the Commissioner of Income Tax (Appeals) and thereafter, the Income Tax Appellate Tribunal.

The income tax department argues that all income received or deemed to have been received by a non-resident company includes income arising directly or indirectly through or from any business connection, property, assets or sources of income or from the transfer of a capital asset situated in India. The department claims that all income payable to a non-resident arising from sources in India should be subject to tax in India. The department contends that VIH failed to deduct tax at source and became an "assessee in default". The department has further argued that by inducting five individuals (Arun Sareen, Paul Donovan, Gavin Darby, Robbie Barr and Warren Finegold) in the reconstituted board of directors of VEL, the company met the requirements of being an "agent" of VIH through a business connection.

VIH, however, claims the income tax has no jurisdiction over it since it is a non-resident company and has no obligation to withhold tax for a transaction that took place with another non-resident company with respect to the transfer of shares in yet another non-resident company. Further, VIH claims that when the taxability of gains in the hands of the seller/payee has not been established prima facie in the first place, the tax department cannot seek to impose a withholding tax obligation on VIH as a mere payer. Moreover, since the taxability of the amount has not been determined, recovering tax from the recipient/payee is "premature, arbitrary and bad in law".

VIH further claims that without prejudice to the above issue, even if it presumed that there exists a transfer of a capital asset situated in India and such a transfer results in a taxable gain for the seller company, VIH cannot be deemed to be a tax assessee in India.

Time will tell who emerges victorious from this legal battle.

Paranjoy Guha Thakurta is an educator and commentator