Why Vodafone ruling is historic
Hindu Business Line
Tax Partner, Ernst & Young
In the history of international tax litigation it would go un-contested that the Vodafone case was probably the most followed tax controversy of all times. While Vodafone won and that indirect transfer of Hutchison's India business cannot be brought to tax, the Supreme Court has done great service to the tax legal fraternity by elucidating some very pertinent rules of interpretation. Settled principles that have been tossed around, despite binding judicial precedents and absence of any contrary legislative amendments, are dealt with and explained.
Some of these are the cardinal principles of interpretation, look-at principle, tax planning vs. tax avoidance (McDowell and Azadi Bachao Andolan), motive test, principle of fiscal nullity, separate entity principle, interpretation of deeming fiction, source rule, etc. The judgment also pragmatically elucidates the difference between “pre-ordained” transactions for tax avoidance vis-à-vis a transaction for “investment to participate” while laying down certain guiding factors. Once the threshold of “tax avoidance” has been crossed by the bona-fides, taxation should follow the “rule of law”.
Direct Tax Code
It is important to consider the relevance of some key observations of the SC, as below, in the light of the proposed Direct Tax Code (DTC):
The transaction cannot be “looked through” as the law provides for taxability of the gains arising from the transfer of a capital asset “situated” in India. A legal fiction has limited scope and purposive interpretation cannot expand its scope;
The structure, namely the CGP Vehicle to hold shares in the Indian Company was set up in 1994 and had been continued for many years. This was not a “fly by night” operator. There is an acceptance and acknowledgement of the fact that foreign companies invest in India through foreign holding or investment companies for both tax and business purposes;
It would not be possible to dissect the transaction of sale of shares into different components viz controlling interest etc., in the absence of any such understanding or agreement to that effect.
Interestingly, the SC has travelled beyond the question of taxability and dealt with other factors such as foreign direct investment (FDI), investor confidence and consistency in tax policy that are corner stones for a developing economy like India. The SC has acknowledged the use of holding companies and investment structures by investors for commercial purpose and expressed that the use of these elements in international structures may not necessarily result in tax avoidance. The order also concedes that unless the anti-abuse provisions are incorporated in the law or limitation of benefits provisions are incorporated in the treaties, absent a specific provision, revenue authorities cannot look through a transaction.
At the same time, the SC also took cognisance of the conscious effort being made by the DTC, which by its very design, seeks to empower the Indian income-tax administration to reach out to what appears to be income earned and received abroad, but which has a clear Indian nexus.
In arriving at its conclusion, whether a “look through” aspect is envisaged under the current law for taxing offshore transactions, the SC did conclude that the current I-T Act does not cover the same. This conclusion was supported by comparing the provisions of the current I-T Act with the provisions proposed under the DTC. The second important factor that has relevance from a DTC perspective are the observations on tax avoidance vs. tax planning, use of holding companies and investment structures, and that a transaction cannot be dissected into separate components when what is being transferred are shares – lock, stock and barrel.
The DTC provides for introduction of the General Anti-avoidance rule (GAAR) that gives revenue the powers to declare any arrangement an impermissible avoidance arrangement. There is a fine distinction between tax planning and tax avoidance. In framing a GAAR that is sufficiently wide in its application, there is a serious risk to penalising bona-fide transactions. International experience suggests that GAARs have promoted uncertainty and litigation challenges. While the SC has advised that legal doctrines like “look through” and “limitation of benefits” being policy matters should be brought about by legislative changes rather than interpretive efforts, the most paramount is certainty.
From past experience, the predictable reaction is a slew of amendments in the forthcoming Finance Bill to negate impact of the SC verdict. Of course, it's not going to be an easy decision for the Government as it will have to strike a balance between tax collections and investor confidence that is driven by certainty. This is an opportunity to the Government for an image makeover on tax legislative front by moderating its response and truly promote certainty!