ISSUE XIX : Vodafone rumblings …. Taxing controversies in tough times

Vodafone Rumblings …. Taxing Controversies in Tough Times

From businessmen to bloggers, from company CEOs to government officials, from external transactional advisers to internal strategy and M&A teams, no one is immune to the enormous impact upon the implementation of the highly controversial budget announcements made by the Finance Minister in India in March this year. On May 28, 2012, the budget proposals contained in the Finance Bill of 2012 were passed with effect from the start of the current financial year, i.e. April 1, 2012 which is when the new Act came into force.

This bulletin discusses some critical changes which could have far reaching impact on inbound M&A transactions in India with a thrust on issues ostensibly emanating from the Vodafone judgment issued by the Supreme Court in January 2012.

The Vodafone Effect

Putting an end to about a five-year old court battle spread across multiple forums, on January 20, 2012 the Supreme Court conclusively held that Vodafone had no liability to withhold tax as its controversial transaction, which led to ownership of an Indian company, was between two non-residents with no taxable presence in India. In the concluding section of our February 2012 Tax Bulletin – The Path-Breaking Vodafone Judgment – Ringing in New Tunes1we had questioned “how the battered government in an election year would use this judgment to frame both its short and medium term fiscal policy. Will it take cue from the annals of its pages and thousands of documents on record to bring about change in the law so that such transactions come within the tax ambit in the future?” While it was difficult to predict with any degree of certainty, yet, the fears were not unfounded and proved to be true within the next two months when the Indian government announced its budget proposals in March 2012 and proposed certain amendments to the tax law, the effect of which was wide-sweeping. It stirred a global debate.

So, what has really happened?

Effectively, the budget proposal was passed in the Finance Act of 2012. A new provision has been introduced which has the result of expanding the definition of capital asset in Section 9 of the Income Tax Act. The new definition states that a capital asset is an “asset being any share or interest in a company or entity registered or incorporated outside India shall be deemed to be and shall always be deemed to have been situated in India, if the share or interest derives, directly or indirectly, its value substantially from the assets located in India.” So, a transaction which takes places between two non-residents, whereby there is a transfer of shares or interest in an offshore entity which derive their value (directly or indirectly) substantially from Indian assets, will now be liable to be taxed in India. Interestingly, there is no guidance or clarity as to what would constitute substantial interest in the assets making it fertile for multitude interpretations.

The concern amongst most investors is the ability of the Indian government to tax the past transactions thereby leading to an atmosphere of economic uncertainty. While the change may not necessarily mean an automatic imposition of tax on Vodafone, but, with this change, the Indian tax authorities have sent a strong message, albeit a wrong one. First, the retrospective change demonstrates a sheer disregard for the independence of the judiciary. Second, by asserting their own powers to make changes, the finality of the highest court’s judgments, the entire premise on which the judicial process and rule of law is based become questionable. Third, the unfathomable part is that this change has a retrospective effect going back to 1962 – 50 years ago! It has thrown the business world into a speculative tizzy and, at the cost of repetition, sent an erroneous message to investors.

Invocation of treaty protection

The “battle” is far from over. When the endeavors of Vodafone, ranging from the company’s meetings with the high-level government officials to involvement of UK government officers, did not yield the results it wanted, it was left with one choice. In April, it has served the Indian government with a notice under the Bilateral Investment Promotion and Protection Treaty between India and the Netherlands for violation of the international legal protections granted to Vodafone and other international investors in India. The notice is the first step towards initiating an international arbitration where Vodafone had asked the government to either abandon or amend the retrospective aspects to the Finance Act, 2012 or face arbitration proceedings.

The official stand of the government is that it has complied with the Supreme Court order and refunded $2 billion to Vodafone, invocation of the bilateral treaty protection is early and untimely, and, as and when the amendments take place, it would give an appropriate response.

The ongoing debate and recent clarifications

In a country witnessing slow economic growth of 5.3% in the first quarter of 2012 after several boom years, concerns are abundant.

Is the Indian government targeting foreign companies in a highly volatile business climate where it needs the money from the tax revenue? Another question debated is will the revenue authorities could or would reopen cases starting from 1962? As noted before, the change does not give an automatic carte blanche to levy tax on Vodafone and more than a dozen other transactions reported in the media, but, the revenue authorities do have some options before them. They could rely on the new provision and send notices to the companies thereby triggering the start of another agonizing dispute. Additionally, the changes to section 9 entitle the revenue authorities to reopen the case so that they can pursue their claims. Moreover, even if they do not do that, the possibility of imposition of penalty by initiating proceedings in that respect could be launched as well.

In an effort to assuage the apprehensions of the industry and domestic and foreign companies alike, the Finance Minister has clarified and confirmed as follows. (The italicized comment is the view of the author on the clarification).

  • The retrospective amendments would not be used to reopen any cases where assessment orders have already been finalized. Time will tell if this will be implemented or will some other ruse be used to get more revenue.
  • Section 9 amendments seeking to tax indirect transfers between non-residents would not override the provisions of the signed Double Taxation Avoidance Agreements which India has signed with 82 countries. While this appears to be a positive step, but, there is no clarity about the real effect. How many transactions have taken place involving indirect transfers between non-residents of countries which have a DTAA with India? Absent specific numbers this seems like a proverbial carrot. The government should provide more transparency and factual details which will help corroborate its statements so far and will bring precision and visibility as to the perceived benefit.
  • The proposals would impact those cases where the transaction has been routed through low tax or no tax countries with which India does not have a DTAA. The minister’s stated position is that the government would not allow a corporation to avoid paying tax in India by operating from a tax haven. The percentage of countries/situations where this would apply is, in all probability, insignificant. Hence, the effect of this clarification would probably get diluted.

Will all be well?

In the ultimate analysis, the expectation is that the clarifications should not remain mere rhetoric. The government needs to act proactively and should not be in mere damage control mode. In view of the Finance Minister’s statement that it has given the necessary directions, it is critical that the Central Board of Direct Taxes issues the appropriate policy circular which will unambiguously state and document the foregoing clarifications formally.

In other words, the end is not near. The story has simply taken another twist and needs to be tracked. In the interim, ambiguity remains and foreign investors have to understand this element clearly. It is not the ideal situation but that is what it is at this stage. While structuring transactions, the focus on planning for and managing tax exposures/risks cannot be over-emphasized.

Authored by: Priti Suri

1  http://www.psalegal.com/upload/publication/assocFile/Taxation-2012hasdefinitelystartedwithabigbang.pdf

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