The Bombay High Court on Wednesday dismissed a petition by the Britain-based global mobile giant Vodafone challenging a $1.7-billion tax notice served on the company related with the acquisition of majority stake in an Indian company last year for $11.1 billion. The HC order – if not challenged in a higher court – will result in about $2 billion (Rs 10,000 crore) flowing into the Income Tax Department.
Vodafone is likely to challenge the order in the Supreme Court. The high court has granted an eight-week stay, providing Vodafone time to appeal. The transaction was one of the largest mergers and acquisitions in India last year and the court’s directive could have a potential implication on several other such acquisitions, both executed and potential.
VC Circle brings to you viewpoints from two leading corporate lawyers (Shantanu Surpure & Vijay Sambamurthi) discussing the ramifications of the High Court order.
On Attracting Capital Gains Tax
Shantanu : According to reports, the justices held that there was no “patent illegality” in the IT Department’s notice to Vodafone. This supports the view that the IT Department may take a wider tax footprint including in cross-border transactions outside the jurisdiction of India.
Vijay : Since Vodafone’s potential liability arises on account of its alleged failure to withhold tax from the payments it made to Hutchison Whampoa, the primary issue is that of whether the transaction in question attracted Indian capital gains tax in the first place, and if the answer to that question is in the negative, then of course, there can be no question of a liability on Vodafone for failure to withhold tax. Broadly speaking, a transaction could attract Indian capital gains tax liability either if (i) the seller is an Indian resident party, or (ii) if the capital asset being transferred is an Indian capital asset. Since the buyer and seller in this case were both non-resident entities, the key legal issue is that of whether or not there was a transfer of a “capital asset” as defined in the Income Tax Act, 1961.
The news reports suggest that the Hon’ble Court has taken the view that notwithstanding the fact that the company whose shares were sold is not an Indian resident, the said transfer still amounted to a transfer of an Indian capital asset, as there was a change in the indirect controlling interest of an Indian company. On this basis, the news reports suggest, the Hon’ble Court has held that as the person making payment to a seller for a transaction that was taxable in India, Vodafone was liable to have withheld taxes from Hutchison Whampoa.
If the above is indeed the basis and rationale behind the dismissal of Vodafone’s writ petition, it seeks to establish a legal principle that an “indirect controlling interest” is also a capital asset distinct from the shares of an Indian company. I understand from press reports that Vodafone might prefer an appeal to the Supreme Court on the matter and has been given time to prepare its appeal.
Shantanu : At a time when India is already suffering from the negative impact of a global recession and terrorism, the recent judgment may further dampen foreign direct investment (“FDI”) into India.
Vijay : If the Supreme Court upholds the High Court’s decision, then it would establish a binding legal position that indirect controlling interest in an Indian company amounts to a “capital asset”, which position would have the force of the law of the land as per the Constitution of India. Needless to say, while such a position might result in a short-term surge in revenue for the Indian Government, however huge, it could have a pronounced adverse effect in terms of investor sentiment and impede FDI inflows into India.
Such a principle would most certainly increase apprehensions amongst the global business community about the unpredictability of the Indian tax regime, which in turn might adversely influence their decision to invest in India. This is a particularly badly timed double whammy for the Indian economy, which has already seen a slowdown in FDI on account of the global financial turmoil.
On Mergers & Acquisitions
Shantanu : In particular, this has an immediate bearing on similar cross-border transactions where the transactions occur between non-Indian entities which have Indian assets (the sale of the offshore holding company entity comes with the underlying Indian subsidiary companies).
Vijay : Firstly, this case is not merely about Vodafone’s potential tax bill for the Hutch-Essar transaction, but also about the principle being applied by the tax authorities to numerous other deals that have already taken place in the past! This could mean several done M&A deals possibly getting scrutinized by the tax authorities and several legal proceedings being commenced for recovery.
If that were to occur, it would also mean that the buyers in those deals would likely be studying their share purchase agreements with a fine tooth comb to consider options for recovering from the sellers any liability imposed on the buyers by Indian tax authorities. Indemnification clauses in share purchase agreements are likely going to be studied and debated (and fought over!) like they never have before in India.
On Deal Structuring
Vijay : Any global M&A transaction, even if it is a buy-out of one US company by another, for example, would now have to specifically address the tax implications arising on account of the transfer of “indirect controlling interest” of any Indian subsidiaries that the target company might have. This would make the transaction more expensive as a whole. This would also raise questions about how the ‘indirect controlling interests” of the Indian subsidiaries of the target company are to be valued.
It would also mean, of course, that the Indian tax authorities could earn revenue on a global transaction that has nothing to do with India, but for the target having a subsidiary in India. One can expect the legal documentation (especially the representations & warranties and indemnification clauses) in global M&A deals to get a lot more complex (if they weren’t complex enough already!).
On Investments Through Tax -haven routes
Shantanu : Many VC and PE funds invest in similar offshore structures with Delaware, Cayman and Mauritius being the most typical jurisdictions for holding companies. These holding companies typically then hold Indian subsidiaries.
Mauritius transactions have been under scrutiny for several years because of potential “round-tripping” issues where money may be routed out of India and then back into India. The Vodafone case adds a new dimension where the issue is not necessarily round tripping but one of capital gains where the IT Department is extending its jurisdiction outside of India. In any case, whether they are VC/PE or M&A transactions, the result may be greater scrutiny of offshore transactions including a demand to see the otherwise confidential transaction documents.
There are several interesting unanswered questions from the Vodafone case. The Vodafone case involved the Cayman Islands which does not have a double taxation treaty with India. In contrast, both the US and Mauritius have double taxation treaties with India.
Would a Mauritius blocker entity in between the Cayman parent entity and the Indian subsidiary have been an effective tax shield? Would a Mauritius holding company (rather than Cayman) have been more effective as a tax shield? Similarly, had this been a Delaware holding company and capital gains tax already been paid in the US, then the IT Department may not have able to claim the tax as it would have resulted in double taxation.
One upshot of the case may be that holding company structures may move to jurisdictions which have a double taxation treaty with India, although the scenarios described above have not been tested in the courts yet.
Vodafone will certainly appeal the verdict to the Supreme Court. The likely argument will be that the transaction occurred between two offshore entities and therefore India does not have tax jurisdiction. The Bombay High Court at least was unsympathetic to this view.
The Vodafone case is not without precedent as tax authorities globally have also become more aggressive on the taxation of offshore entities.
As an example, in the period after the Asian financial crisis in the late 1990s – three leading US private equity funds, ie. Newbridge Capital, Carlyle and Lone Star Funds routed investments in Korea either through the Malaysian tax haven of Labuan or through Belgian or Cayman entities. Upon the sale of assets in Korea in the mid 2000s, the Korean tax authorities made similar capital gains tax claims as the IT Department. In addition, Korean prosecutors brought criminal charges of tax evasion against Lone Star executives.
Vijay : If a Cayman Islands company which indirectly owns a subsidiary in India does an IPO in the US markets (very common start-up structuring model in the US) in which the founders sell their shares through an offer for sale, that could also potentially be held to be a transfer of an “indirect controlling interest” of an Indian company by the founders, resulting in Indian capital gains tax liability! A rather strange position, if one considers that even income earned by transfer of ADRs and GDRs and FCCBs issued by Indian companies (and which are convertible into direct equity positions of the Indian company) has specifically been exempted under the Income Tax Act from capital gains tax!
Shantanu : Given the emerging scenario, the prudent approach for funds or companies entering into offshore India related transactions would be to factor in capital gains or other tax liabilities both at the time of the initial structuring and at the time of the potential exit, both of which may impact valuation. In addition, indemnity provisions in the transaction documents, particularly with respect to future tax claims and liability, will become critical.
Vijay : Ironically, if this principle is upheld that an indirect controlling interest in an Indian company is an Indian capital asset, it would effectively mean that had Vodafone directly bought the shares of Hutch Essar India from Hutchison Whampoa’s Mauritian subsidiary (instead of buying the shares of the Cayman subsidiary which owned the Mauritian subsidiary), Vodafone would have had no liability whatsoever, as the selling entity, being a resident of Mauritius, would have been exempt from capital gains tax anyway.
Ironically again, this would mean that the importance of jurisdictions like Mauritius and Singapore would now only INCREASE in the context of private equity and M&A transactions.”
Shantanu Surpure is the Managing Attorney, Sand Hill Counsel, a Mumbai and Silicon Valley-based law firm.
Vijay Sambamurthi is the founder partner of Lexygen, a Bangaore based law firm focused on private equity/venture capital, M&A and general corporate transactions.
Disclaimer: Since, the order of the Bombay High Court is still awaited, the authors views are based on the reports that appeared in the press.