Vodafone Ruling: Many-Layered Impact

The arbitration award by an international tribunal on the Vodafone tax dispute has brought to the fore many a lacuna and loophole in tax laws that crafty tax evaders use to stay out of the tax net. While it comes as a lesson for us to make timely and foolproof laws, it also raises issues of the sovereignty of laws and bilateral pacts that don’t all add up

Vodafone has hit the headlines with the news that is causing discomfort to the government of India. The British telecom giant has won the arbitration case against our government over a tax demand of Rs.22,100 crores. The tax demand was the outcome of a retrospective legislation of 2012, which was brought about by the then Finance Minister, Late Sri Pranab Mukherjee. The award was given by an international arbitration tribunal in Hague. The panel unanimously overruled the Indian Government’s $3 billion tax demand against the Vodafone Group, finding it to be a breach of fair treatment under the country’s bilateral investment protection pact with the Netherlands, while also awarding costs.

The genesis

The issue goes back to 2007. Vodafone Netherlands had purchased Li Ka-shing’s Indian mobile business, which was owned through a maze of offshore entities. The Hong Kong tycoon owned a Cayman Islands-based investment firm which controlled, via other offshore investments, Hutchinson Essar Ltd., the Indian unit operating the business in India. The deal involved the transfer of shares of Li Ka-shing for which Vodafone paid $12 billion. The result was that the Indian mobile business run by Hutchinson Essar Ltd was acquired by Vodafone getting the ownership of 67% stake in the Indian unit. The taxable capital gains on the sale of shares to acquire the Indian business was the reason for the dispute.

As per tax authorities in India, the buyer Vodafone should have withheld the tax portion on the capital-gains while making payment to the non-resident seller, which it failed. A demand was raised on Vodafone, which was now operating in India, in the capacity of a representative assessee. The matter was disputed by Vodafone before the Bombay High Court and the case was won by the Income Tax Department. The case was then taken to the Supreme Court by Vodafone where the telecom company won. The Court held that shares sold were located outside India and also held by a non-resident and hence capital gains do not arise in India.

‘The Hong Kong tycoon owned a Cayman Islands based investment firm which controlled, via other offshore investments, Hutchinson Essar Ltd., the Indian unit operating the business in India. The deal involved transfer of shares of Li Ka-shing for which Vodafone paid $12 billion. The result was that the Indian mobile business run by Hutchinson Essar Ltd was acquired by Vodafone getting the ownership of 67% stake in the Indian unit’

Retrospective law

The decision of the Supreme Court got annulled by the Finance Act 2012 when a retrospective clarificatory legislation was brought on the statute. The new law said that capital gains will arise if the transfer of shares outside India involves factually a transfer of business in India. The new law clarifies that transfer cannot hide under technicalities and what has to be seen is the factual transfer of an asset in India. Based upon the amended law, a new demand was created which also included interest and penalty along with the basic tax amount, and this tax demand became the subject matter of arbitration. The shocking thing about the arbitration award is that even the Indian nominee on the arbitration panel voted against the Indian Government.

During the period of disputes and arbitration, Vodafone widened its ownership of the business in India by purchasing the balance shareholding in the business unit. It also went into a partnership deal with Idea of the Birla Group.

Impact on other disputes

This arbitration award will have an adverse impact on similar other deals, which are also on the arbitration table, like the case of British Cairn Energy, which sold its Indian operations to an entity owned by the Vedanta Group. Here also the tax department had raised a demand based on capital gains arising on the sale of Indian business and had even collected it through Vedanta.

The government of India has so far not given its official response on the arbitration award.

Differing opinions

Analysts have opined differently. The majority of them have remarked that the government should accept the award and forego the loss. It is argued that India will lose face in foreign investment circles if the award is not accepted and the matter is further delayed by avoidable litigation. Legally, it is argued that the Indian Arbitration Act makes a foreign arbitration award binding on us. On the other hand, there is a forceful argument that our Parliament is supreme and that a law on taxation which is applicable to all cannot be subjected to scrutiny and decision by a foreign tribunal. We are a sovereign country and any award by a foreign entity is like transgressing our sovereign boundary. The Supreme Court of India alone enjoys the power of judicial review on the laws passed by the Parliament and that too in a limited domain that the law panel does not violate the basic features of our Constitution.

‘As against its 40,000-odd population, Cayman Islands has more than 80,000 registered companies. Most of these companies operate through post-box numbers, as they do not have any brick and mortar office. The legal and technical owner of the Indian operation which Vodafone of Netherlands later acquired, was just a one share company. This one share was transferred to get the physical acquisition of a big business in India’

Web of tax evasion

The Vodafone case throws light on how offshore entities, through web formation, control business in other countries in such a way that the tax impact on them remains either minimal or even nil. The Hong Kong-based tycoon, in this case, chose the distant Cayman Islands, a tax haven, to operate a business in India through a structured matrix of entities. The Cayman Islands has a unique distinction as against its 40,000-odd population, it has more than 80,000 registered companies. Most of these companies operate through post-box numbers, as they do not have any brick and mortar office. The legal and technical owner of the Indian operation which Vodafone of Netherlands later acquired, was just a one share company. This one share was transferred to get the physical acquisition of big business in India.

A peep into the web of ownership which was acquired by Vodafone reveals a nefarious tax avoidance architecture by the Hong Kong tycoon. There is no reason to shut our eyes on the facts of the case when our precious tax is involved. Based on these facts, the Bombay High Court had upheld the case of chargeability of capital gains tax on the nebulous transfer. Vodafone won the case before the Supreme Court based on the literal interpretation of the provision that when both buyer and seller are non-residents and when the asset sold is located outside India, there is no tax liability in India.

Why retro laws

Retrospective legislation is not illegal, though it is seldom done, and our parliament deemed it fit to erase the lacuna in the provision, so as to save tax lost, through an aggressive tax avoidance mechanism of the earlier owner of the mobile business in India.

In the aftermath of this Vodafone case and the arbitration award, it is being argued by experts that we should henceforth not go for retrospective amendments in our tax laws. Taxpayers plan their affairs as per the existing laws and it is unethical to hit them by laws which were not on the statute. Retrospective legislation is seen as something akin to backstabbing taxpayers.

It is true that retrospective amendments are not good and that they should be desisted. However, such amendments become necessary for various reasons. Tax laws are framed based on the intention of the Parliament but sometimes they are seen that the drafted provisions do not echo such intention, as interpreted by the courts. In such a situation amendment and even retrospective amendments are brought. Also, tax laws which are the tools for tax collection are sometimes seen as being misused by tax evaders and the same loopholes then require plugging so that unethical taxpayers are brought back into the tax kitty by the retrospective amended law, as it happened in the case of Vodafone. We must get back our basic lost tax but we should do it early.

It is important to attract foreign capital and for that, it is equally important to ensure ease of doing business in India. In this context, bilateral investment protection pacts with other countries become relevant. We must incorporate clauses in the pact to present India as a trustworthy country for capital investment. The clauses should not be vague but articulate enough.

Questionable jurisdiction

It is difficult to understand as to how the investment pact with the Netherlands was considered applicable to our tax laws. Investment-related clauses may deal with our market, our workforce, our banking system and our judiciary in the case of disputes. Tax is an essential component of business and the tax laws of a sovereign country cannot be a clause in the investment pact with another country. Laws framed whether prospectively or retrospectively are equal for all taxpayers and the same cannot be considered against investment relationship with one country or one company. I feel that there is something wrong with the arbitration award and that we must dispute it.