India's tax department has jurisdiction over tax bills in cross-border mergers, a court ruled, dismissing a petition by Vodafone and setting a precedent for foreign firms looking to buy into Indian companies.
The Bombay High Court ruling came as foreign firms show renewed interest in acquiring Indian companies, lured by growth prospects in the world's second-fastest growing major economy.
But the decision may prompt overseas firms to be more cautious about plans to enter India through acquisitions.
"This will make the deals costlier for strategic buyers and private equity firms," said Jagannadham Thunuguntla, equity head of SMC Capital. "Investors who are planning to enter into India hoping there will be no tax liability will think twice."
Vodafone, fighting a tax bill in India from its 2007 purchase of Hutchison Whampoa Ltd's mobile business in the country, had filed an appeal with the court in June challenging the tax department's jurisdiction over the bill.
After the court ruling, Vodafone said it remained confident that there was no tax to pay on the transaction. The company said it had time to review the judgement and consider its next step that includes an appeal to the Supreme Court.
"Vodafone is seeking legal advice to challenge this part of the judgment," it said in a statement.
The world's largest telecommunications operator by revenue, which paid $11.1 billion for the deal with Hutchison, has not said how much the authorities were seeking. A person with knowledge of the matter earlier told Reuters it was about 120 billion rupees ($2.6 billion).
Indian tax authorities have said Vodafone's deal was liable for tax because most of the assets were based in India and under Indian law, buyers have to withhold capital gains tax liabilities and pay them to the government.
"I don't think this will be a major roadblock for M&A deals in India, but the tax issue will be much more on the people's radar than it was before," said an investment banker with a leading foreign bank in India. "The companies are now going to assess their tax liabilities before entering into a deal."
London-listed Vedanta Resources, which agreed to buy a majority stake in Cairn India from Cairn Energy for up to $9.6 billion, could face similar taxes, though the situation was unclear as the deal has not closed yet.
A Cairn Energy spokesman said: "We will pay any relevant taxes that is due in India and U.K... What is eventually paid will be determined by the final proceeds".
Emirates Telecommunication Corp has been mulling investment in Indian telecom firms Reliance Communications and Idea Cellular.
Wednesday's ruling marks another setback for Vodafone in India, where the company has not met with the success it hoped for when it bought into the market in 2007. In May it took a charge of 2.3 billion pounds due to fierce competition and rapidly escalating spectrum costs.
Chief Executive Vittorio Colao, frustrated with Indian regulations covering the auction of 3G spectrum licences, said then that telecoms rules in the world's second-fastest growing telecoms market did not make sense.
The Bombay High Court had concluded its hearing in Vodafone's appeal last month. "The petition is dismissed," the two judges who heard the case said in a ruling on Wednesday. "The IT authority's order can't be held to lack jurisdiction."
The court said India's tax authorities would not issue a final order to Vodafone for the next eight weeks, even though tax proceedings would continue. Vodafone was free to separately raise with them the issue of its liability to deduct tax on the transaction, the judges said.
Vodafone earlier said Indian law did not require it to deduct tax and that capital gains tax is usually paid by the seller.
Vodafone is elsewhere pursuing a strategy to exit non-strategic minority investments and said on Tuesday it sold its 3.2 percent stake in China Mobile for $6.6 billion.