The Vodafone verdict - Supreme Court judgement & DTC Provisions

The Supreme Court Judgement in the Vodafone case will have a short life as Direct Tax Code has specific provisions to tax such income.  Delay in implementing Direct Tax code may prompt the Government to amend the Income Tax Act, 1961 as early as during this year budget itself.  This article discusses the Vodafone judgement "as it is" and also tries to understand the provision under DTC.

The much talked about Vodafone verdict has been delivered and the trade heaved a sigh of relief on receipt of a favourable decision.  The sections under question where Section 9(1)(i), Section 195 & Section 163 of the Indian Income Tax Act, 1961.  The following are the main areas of dispute

1. Whether a share transfer involving two off shore entities one of which is registered in a tax haven called "Cayman Islands' is subject to Capital Gains tax in India since the underlying company whose shares are being transferred has assets / business / generates income in India
2. Whether the non-resident being the purchaser of shares liable under section 195 to deduct Capital Gains tax on such transfer as a representative assessee of the seller

Vodafone International Holdings BV (VIH) incorporated in the Netherlands bought shares from Hutchison Telecommunications International Limited (HTIL) registered in Cayman Islands.  The Shares transacted where of Hutchisson Essar Limited which is registered in India and carrying on business in India.

The contention of the tax department in simple words are :

Though the transaction between VIH & HTIL has been transacted overseas but the underlying assets / business of the subject matter company is in India therefore the provisions of section 9(1)(i) are being invoked and the transaction is liable to Capital Gain tax in India.  Further as per section 195 tax is deductable on payment of consideration by VIH as a Representative Assessee as defined under section 163.

Arguments of VIH in simple words are :

The transfer of shares are between two off shore entities beyond the jurisdiction of Indian tax laws, and hence the share transfer cannot be taxed under deeming provisions of section 9(1)(i) and section 195 cannot be invoked against VIH.

The Key observations of Supreme Court are :

1. Principle of "Look At" and not "Look Through" upheld.  Section 9 has a deeming provision for taxation of income.  Section 9 is not a "Look Through" provision but a "Look At" provision
2. There is no transfer of Capital assets transfer which is situated in India
3. Only if the transaction is a sham could tax authorities invoke the "Substance over form" principle or "Piercing the Corporate Veil" test
4. Section 9(1)(i) being a deeming provision can be invoked only in case of - Transfer; existence of a capital asset & situation of such asset in India.  The subject matter in this instance case is "Indirect Transfer" which cannot be deemed as income under section 9(1)(i) as there is no "Direct Transfer"

The Supreme Court further states that Tax Planning is not illegal provided the transaction in not a sham or coloured transaction.  In this instance case the companies incorported in Cayman Islands are there in existence since the last 14 years and cannot be said to be incorporated for the purposes of avoidance of capital gains tax in India. 

The Supreme Court was of the view that since this is not a Sham transaction and the transactions are between two off shore entities there is no jurisdiction for Indian Tax Laws

The was forward - DTC or No DTC

The way forward will be definitely not as per the Supreme Court ruling.  First the Government will come out with an amendment to the Income Tax Act, 1961 (may be even retrospective) to plug this gap as early as this budget. 

The Direct Tax Code 2010 (DTC) - Section 5(4)(g) on Income deemed to accrue in India, has the following provision :

"income from transfer , outside India, of any share  or interest in a foreign company unless at any time in twelve months preceeding the transfer , the fair market value of the assets in India, owned, directly or indirectly, by the company, represent at least fifty per cent of the fair market value of all assets owned by the company"

Clearly the way forward is to tax the Vodafone kind of transactions, and the language of the law is quite clear. 

Summary

In this case Supreme court interpreted the law "as it stands" which is welcome as it brings in consistency in interpreting the law and the trade is quite clear on do's and don'ts under the laws of the land.  Taxation of all business income should be possible and this should not be taken away by poor drafting of tax laws and tax havens.  Government should act swiftly to plug these holes and ensure that revenue is protected.  Caution should be taken in drafting tax laws which should contain clear provisions and not subject to interpretation and consequent litigations.  Clear provisions will enable corporates to be clear on their tax liabilities and plan their strategies around it.