Taxation of Cross Borders Mergers & Acquisitions: VodafoneHutch Deal

Dr. Monica SinghaniaAssociate Professor

Faculty of Management Studies (FMS)University of Delhi

Email: monica@fms.eduVenugopal Dastaru

MBA Class of 2012Faculty of Management Studies (FMS)

University of Delhi

AbstractAny mergers and acquisitions activity is intricate in its dimensions and would be affected by aplethora of laws and regulations depending on the stakeholders involved. Deal structuring froma tax perspective is one of the critical factors for any business restructuring proposition, suchthat the transaction is tax neutral or results in minimizing the tax implications. Such acquisitionsmay be routed through direct investments or through an International Holding Company (IHC).An IHC would be advantageous in case the promoter/company wishes to keep the cash flowsgenerated from overseas operations outside India for future growth needs. In case of directinvestments, the entire surplus amount would have to be repatriated to India and the same wouldbe subject to tax in India, thereby reducing the disposable income in the hands of thepromoter/company.

Income generated overseas could be repatriated to the Indian Company in the form of interest,royalties, service or management fees, dividends, capital gains. Such income when repatriated tothe Indian Company by the IHC or to the IHC by the target company would attract doubletaxation. Double taxation is a situation in which two or more taxes are paid for the sameincome/transaction which arises because of the overlap between different countries tax laws andjurisdictions. The liability is then mitigated or off settled by tax treaties between the twocountries. An ideal location for an IHC would be one with low/nil withholding tax on receipts,on income streams and on subsequent re-distribution as passive income. Some of thejurisdictions preferred for repatriating back to India include Mauritius, Cyprus, Singapore andNetherlands, which have relatively better tax treaties with India.

Essentially the Vodafone Hutch deal involved transfer of shares of a non-resident CaymanIslands based entity between two non-residents (Hutch and Vodafone). Apparently the

2transaction had no link with India and therefore the related parties to the transaction indeedassumed and claimed that no tax on this deal is payable in India. But the Indian taxauthorities thought otherwise. The Indian tax authorities issued notice to Vodafone undersection 201 of the Indian Income Tax Act 1961 so as to show cause as to why it should not betreated as an assessee in default since it (Vodafone) had failed to discharge its withholdingtax obligation with respect to tax on gains made by Hutch on the sale of shares to Vodafone.In addition, the Indian tax authorities decided to treat Vodafone as an agent of Hutch undersection 163 of the Income Tax Act 1961 to recover the tax dues. On Vodafones challenge tothe notice, the Bombay High Court on December 3, 2008, approved the Indian tax authoritiesjurisdiction to initiate investigation so as to determine whether the over $11 billionHutchison-Vodafone transaction was liable for capital gains tax in India. Finally on January20, 2012, the Supreme Court ruled in favour of Vodafone. The Supreme Court disagreed withthe conclusions arrived at by the Bombay High Court that the sale of CGP share by HTIL toVodafone would amount to transfer of a capital asset within the meaning of Section 2(14) ofthe Indian Income Tax Act and the rights and entitlements flow from FWAs, SHAs, TermSheet, loan assignments, brand license etc. form integral part of CGP share attracting capitalgains tax. Consequently, the demand of nearly Rs.12,000 crores by way of capital gains tax,would amount to imposing capital punishment for capital investment since it lacks authorityof law and, therefore, stands quashed.

Keywords: Business restructuring, cross border transactions, tax haven, capital gains

I. Introduction

Mergers and acquisitions play a major role in the globalization process. Tax laws should betteraccommodate cross border merger and acquisitions. In an endeavour to geographically expandthe utilization of their competitive advantages, merger and acquisitions allow the firms to do soin a fast, effective and perhaps in an inexpensive manner.

Many countries have some tax rules that grant certain benefits to merger and acquisitionstransactions, usually allowing some deferral of the tax otherwise imposed on the owners of someof the participating parties upon the transaction. On the other hand, once mergers andacquisitions transactions cross borders, countries are much less enthusiastic to provide taxbenefits to the involved parties, understanding that, in some cases, relief of current taxationpractically means exemption since such countries may completely lose jurisdiction to tax thetransaction.

Cross-border merger and acquisitions, although presenting many of the same issues as domesticdeals, are usually more complex and rife with surprises and other pitfalls, more so when thenumber of geographies involved in the transaction increases. The sheer range of concerns hasexpanded as the speed and volume of international deals have increased. Domestic merger and

3acquisitions are, generally and on average, socially desirable transactions. In many countries,they enjoy tax (deferral) preferences, but only to the extent to which they use stock tocompensate target corporations or their shareholders.

The legal framework for business consolidations in India consists of numerous statutoryprovisions for tax concessions and tax neutrality for certain kinds of reorganizations andconsolidations. With India rapidly globalising, and the economy growing and showing positiveresults, a sound tax policy is essential in this regard. Tax is an important business cost to beconsidered while taking any business decision, particularly when competing with other globalplayers. The new direct tax code that the Government is planning to introduce, to replace thecurrent Income-tax Act, 1961, is expected to emphasise on transparency and taxpayer-friendliness.

Any mergers and acquisitions activity is intricate in its dimensions and would be affected by aplethora of laws and regulations depending on the stakeholders involved. Progressivederegulation in sectors such as banking, insurance, power, aviation, housing and policyrationalization in others like broadcasting, telecommunications and media, coupled with thegovernments decision to exit non strategic areas through divestment/ disinvestment has furthertriggered M&A activities in India. Further considering competition in the world market andpressure on the top line and bottom line, Indian Companies are increasingly looking at mergersand acquisitions as instruments for momentous growth and a critical tool of business strategy.

Deal structuring from a tax perspective is one of the critical factors for any businessrestructuring proposition, such that the transaction is tax neutral or minimizing tax implications.Such acquisitions may be routed through direct investments or through an International HoldingCompany (IHC). An IHC would be advantageous in case the promoter/company wishes to keepthe cash flows generated from overseas operations outside India for future growth needs. In caseof direct investments, the entire surplus amount would have to be repatriated to India and thesame would be subject to tax in India, thereby reducing the disposable income in the hands ofthe promoter/company.

Income generated overseas, could be repatriated to the Indian Company in the form of interest,royalties, service or management fees, dividends, capital gains. Such income when repatriated tothe Indian Company by the IHC or to the IHC by the target company would attract doubletaxation. Double taxation is a situation in which two or more taxes are paid for the same

4income/transaction which arises because of the overlap between different countries tax laws andjurisdictions. The liability is then mitigated or off settled by tax treaties between the twocountries.

An ideal location for an IHC would be one with low/nil withholding tax on receipts, on incomestreams and on subsequent re-distribution as passive income. Some of the jurisdictions preferredfor repatriating back to India include Mauritius, Cyprus, Singapore and Netherlands, which haverelatively better tax treaties with India.

The paper discusses about the taxation issues in cross border mergers & acquisitions in India. Itdiscusses about structuring the transactions. It also discusses about the taxation issues in sales ofshares and sale of assets. It also studies about the various laws governing the cross bordermergers & acquisitions. The paper takes VodafoneHutch deal as a special case to study thetaxation issues in cross border mergers and acquisitions. The paper proposes to showcase whatlies at the heart of this VodafoneHutch deal, the effect of taxation on such transactions, the wayforward of the deal, options for the parties involved, impact on future cross border M&A,concept of tax haven, possible tax planning in such cases, tax treaty shopping how far legaland ethical and the present tax law in India is in this regard.

II. Historical Background

Given the role that mergers and acquisitions play in globalization process, the Indian businessenvironment has indeed altered radically with the changes in the economic policy and with theintroduction of new institutional mechanisms. The industrial policy changes in 1991 ushered inan era of liberal trade and transactions in industrial and financial sectors of the economy. In thelast two decades, India witnessed substantial rise in mergers and acquisitions activity in almostall sectors of the economy. Indian industries underwent structural changes in the post-liberalisation period wherein mergers and acquisitions were accepted as vital means of corporaterestructuring and redirecting capital towards efficient management. In a way, restructuring ofbusiness became an integral part of the new economic paradigm. Restructuring andreorganization became important as the controls and restrictions gave way to competition andfree trade. Restructuring usually involves major organisational changes such as shift in corporatestrategies to meet increased competition and rapidly changing market conditions.

5Regulatory Framework: The relevant laws that are to be implicated in a cross border mergersand acquisitions in India are as under:

Companies Act, 1956: Cross border M&A, both the amalgamating company or companies andthe amalgamated (i.e. survivor) company are required to comply with the requirements specifiedin Section 391-394 of the Companies Act, which, inter alia, require the approval of a High courtand of the Central government. Section 394 and 394A of the Act set forth the powers of theHigh Court and provide for the court to give notice to the Central Government in connectionwith amalgamation of companies.

Foreign Exchange Laws: The Foreign Direct Investment Policy of India needs to be followedwhen any foreign company acquires an Indian company. FDI is completely prohibited in certainsectors such as gambling and betting, lottery business, atomic energy, retail trading andagricultural or plantation activities. The Foreign Investment policy of Government of Indiaalong with the press notes and clarificatory circulars issued by the department of investmentpolicy and promotion, Foreign Exchange Management Act, 1999 (FEMA) and regulations madethere under, including circulars and notifications issued by the RBI from time to time, theSecurities and Exchange Board of India Act, 1992 and regulations made there under (SEBIlaws).

Income Tax Act, 1961: A number of important issues arise in structuring a cross-border mergerand acquisitions deal to ensure that tax liabilities and cost will be minimized for the acquiringcompany. The first step is to explore leveraging local country operations for cash managementand repatriation advantages. Moreover, the companies should be looking at the availability ofasset-basis set up structures for tax purposes and keeping a keen eye on valuable tax attributes inmerger and acquisitions targets, including net operating losses, foreign tax credits and taxholidays. As per the provisions of the Income Tax Act, capital gains tax would be levied on suchtransactions when capital assets are transferred. From the definition of transfer, it is clear that ifmerger, amalgamation, demerger or any sort of restructuring results in transfer of capital asset, itwould lead to a taxable event. As far as merger and acquisitions are concerned, the provisions ofIndian Income Tax Act, 1961 with respect to amalgamation (section 2(1B)), demerger (section2(19AA)), securities transaction tax (STT), capital gains, slump sale, set off and carry forwardof losses, etc. need to be examined intricately to establish legitimate safeguards.

6Tax structure is important factor in mergers and acquisitions. Tax laws determine the desired taxtreatment of the transaction whether it is taxable or tax free. An ideal tax structure should besuch that it minimizes the tax leakage, such as tax withholding relating to cross border mergersand acquisitions.

Proposed tax treatment under Direct Tax Code: It is to be noted that recently, the FinanceMinister has released the new Direct Tax Code which seeks to bring about a structural change inthe tax system currently governed by the Income- tax Act, 1961. Summarized below are the keyproposed provisions that are likely to have an impact on the mergers and acquisitions in India:

Currently, the definition of amalgamation covers only amalgamation between companies. Itis now proposed to include, subject to fulfilment of certain conditions, even amalgamationamongst co-operative societies and amalgamation of sole proprietary concern andunincorporated bodies (firm, association of persons and body of individuals) into a companyin this definition.

For amalgamation of companies to be tax neutral, in addition to existing conditions the Codeproposes that amalgamation should be in accordance with the provisions of the CompaniesAct, 1956.

In case of demerger, resulting company can issue only equity shares (as against both equityand preference shares as per existing provisions) as consideration to the shareholders ofdemerged company, for the demerger to qualify as tax neutral demerger.

Irrespective of sectors (for instance manufacturing or service), the benefit of carry forwardand set off of losses of predecessor in the hands of successor Company is proposed to beavailable to all the companies. As per existing provisions in view of definition of industrialundertaking certain companies were not able to utilize the benefit of losses as a result ofamalgamation. Further, the Code provides for indefinite carry forward of business losses asagainst restrictive limit of 8 years under existing provisions.

Profit from the slump sale of any undertaking is proposed to be taxed as a business income asagainst capital gains income.

Code seeks to eliminate the distinction between long term and short term capital asset.

7Introduction of General Anti Avoidance Rule (GAAR) which empowers the Commissionerof Income-tax (CIT) to declare an arrangement as impermissible if the same has beenentered into with the objective of obtaining tax benefit and which lacks commercialsubstance.

Taxation of Mergers & Acquisitions: A Comparative Study

There have been many recent developments in the competition and taxation laws of variouscountries. The tax is a deciding factor for any cross border reorganization and so all thecountries should try to have a favourable tax environment.

United States: The two primary relevant federal securities laws in US that has to be complied,are the Securities Act of 1933 (the Securities Act) and the Securities Exchange Act of 1934(the Exchange Act), including the rules and regulations promulgated by the Securities andExchange Commission (the SEC).

Internal Revenue Code of 1986, as amended (Code), is provided by the federal government, thiscode provides for tax laws in US. Section 267 of their internal revenue code (IRC) exempt UScorporate entity in some cases relating to taxation aspect as far as mergers and acquisitions areconcerned.

Singapore: Income is taxed in Singapore in accordance with the provisions of the Income TaxAct (Chapter 134) and the Economic Expansion Incentives (Relief from Income Tax) Act(Chapter 86). Singapore has also signed a Comprehensive Economic Cooperation Agreement(CECA) with India.

United Kingdom: Finance Act 2009 and Corporation Tax Act 2009 which are likely to have aconsiderable impact on U.K. acquisition structuring. The existing Treasury consent regime(whereby certain transactions involving a foreign body corporate may be unlawful without priorconsent) is replaced with a reporting requirement for large transactions from 1 July 2009. Minorchanges have been made to the U.K. controlled foreign company (CFC) rules from 1 July 2009over a two-year transitional period.

European Union: European competition law is governed primarily by Articles 85 and 86 of theTreaty Establishing the European Community. Article 85 is designed primarily to achieve thesame goal as the Sherman Act in U.S. legislation insofar as it prohibits all agreements and

8concerted practices that affect trade among E.U. members and which have as their mainobjective the prevention, restriction or distortion of competition. Article 86 is designed to meetthe policy objectives of the Clayton Act in that it prohibits the abuse of a dominant marketposition through unfair trading conditions, pricing, limiting production, tying and dumping.

So, India has followed the footsteps of the developed economy by tax reforms and otherregulatory developments. US, UK and Singapore seems to have a friendly environment formergers and acquisitions by Indian companies.

III. Literature Review

As per the Cross-border Transactions - an India Tax and Regulatory Update, issued onJanuary 1, 2009 by Deloitte, India has always been perceived as a difficult jurisdiction to dobusiness with. In spite of India having substantially opened the doors for foreign investment andthere being no lack of local entrepreneurial talent, the country still ranks low in terms of being apreferred business destination.

The Taxation of Cross-Border Mergers and Acquisitions, issued by KPMG, discusses LimitedLiability Partnership Act and tax attributes of various assets and share purchases. It highlightswithholding taxes in various countries, deal structures and various tax liability structures underacquisition or merger by various modes. It compared tax liability under asset purchases,demerger, amalgamation, various corporate laws covering transfer taxes, IT laws and otheraccounting principles.

In Vodafone International Holdings BV v. Union of India [(2008) 175 Taxmann 399 (Bom.HC)], December 3, 2008, Hutchison Essar Ltd. (Hutch India), a company incorporated inIndia, was a joint venture of the Hong Kong-based Hutchison Telecommunications InternationalLtd (Hutch Hong Kong) and the India-based Essar Group. Hutch India was in the business ofproviding telecommunication service in India. Hutch Hong Kong held 67% of the shares ofHutch India through CGP Investments Holdings Ltd (the Cayman Islands SPV), an SPVregistered in Cayman Islands, and some other shareholders. As a result of this sale, capitalgains, estimated at $ 2 billion, accrued to the Cayman Islands SPV. Considered from the point ofview of jurisdictions, it is clear that the sale transaction took place between the Dutch SPV(owned by a UK group) and the Cayman Islands SPV (owned by a Hong Kong company). Theultimate effect however was the transfer of controlling shares of an Indian company.

9FDI in Telecom Sector in India

In Basic, Cellular Mobile, Paging and Value Added Service, and Global Mobile PersonalCommunications by Satellite, Composite FDI permitted is 74% (49% under automatic route)subject to grant of license from Department of Telecommunications subject to security and licenseconditions.

FDI up to 74% (49% under automatic route) is also permitted for Radio Paging Service andInternet Service Providers (ISP's)

FDI up to 100% permitted in respect Infrastructure Providers providing dark fibre (IP CategoryI); Electronic Mail; and Voice Mail

This is subject to the conditions that such companies would divest 26% of their equity in favour ofIndian public in 5 years, if these companies were listed in other parts of the world. In telecommanufacturing sector 100% FDI is permitted under automatic route. The Government has modifiedmethod of calculation of Direct and Indirect Foreign Investment in sector with caps and have alsoissued guidelines on downstream investment by Indian Companies. Inflow of FDI into Indiastelecom sector during April 2000 to February 2010 was about Rs. 405,460 million. Also, more than8 per cent of the approved FDI in the country is related to the telecom sector.

3G & Broadband Wireless Services (BWA): The government has in a pioneering decision,decided to auction 3G & BWA spectrum. The broad policy guidelines for 3G & BWA have alreadybeen issued on 1stAugust 2008 and allotment of spectrum has been planned through simultaneouslyascending e-auction process by a specialized agency. New players would also be able to bid thusleading to technology innovation, more competition, faster roll out and ultimately greater choice forcustomers at competitive tariffs. The 3G will allow telecom companies to offer additional valueadded services such as high resolution video and multimedia services in addition to voice, fax andconventional data services with high data rate transmission capabilities. BWA will become apredominant platform for broadband roll out services. It is also an effective tool for undertakingsocial initiatives of the Government such as e-education, telemedicine, e-health and e-Governance.Providing affordable broadband, especially to the suburban and rural communities is the next focusarea of the Department.

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BSNL & MTNL have already been allotted 3G & BWA spectrum with a view to ensuring early rollout of 3G & WiMax services in the country. They will pay the same price for the spectrum asdiscovered through the auction. While, Honourable Prime Minister launched the MTNLs 3Gmobile services on the inaugural function of India Telecom 2008 held on 11th December2008, BSNL launched its countrywide 3G services from Chennai, in the southern Tamil Nadu stateon 22nd February 2009.

Mobile Number Portability (MNP): Mobile Number Portability (MNP) allows subscribers toretain their existing telephone number when they switch from one access service provider toanother irrespective of mobile technology or from one technology to another of the same or anyother access service provider. The Government has announced the guidelines for MobileNumber Portability (MNP) Service Licence in the country on 1st August 2008 and has issued aseparate Licence for MNP. The Department of Telecommunication (DoT) has already issuedlicences to two global companies for implementing the service.

IV. Vodafone Hutch case

The acquisition of Hutchison Essar by Vodafone at an enterprise value of $19.3 billionwhich comes to around $794 per share was one of the biggest cross border deals in thebooming Indian telecom market at that time. Vodafone won the 67% block on sale byHutch-Essar leaving behind Reliance Communication and a consortium led by Hindujasas well. It paid around 10.9 billion dollars for the acquisition.

Profile of Co-parties

Owners: Vodafone: 67% Essar: 33%

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Vodafone Profile: Vodafone Group plc is a global telecommunications company headquarteredin Newbury, United Kingdom. It is the world's largest mobile telecommunications companymeasured by revenues and the world's second-largest measured by subscribers, with around 332million proportionate subscribers as at 30 September 2010. It operates networks in over 30countries and has partner networks in over 40 additional countries. It owns 45% of VerizonWireless, the largest mobile telecommunications company in the United States measured bysubscribers.

Its primary listing is on the London Stock Exchange and it is a constituent of the FTSE 100Index. It had a market capitalisation of approximately 92 billion as of November 2010, makingit the third largest company on the London Stock Exchange. It has a secondary listing onNASDAQ.

Essar Profile: The Essar Group is a multinational conglomerate corporation in the sectors ofSteel, Energy, Power, Communications, Shipping Ports & Logistics as well as Constructionheadquartered at Mumbai, India. The Group's annual revenues were over USD 15 billion infinancial year 2008-2009.

Essar began as a construction company in 1969 and diversified into manufacturing, services andretail. Essar is managed by Shashi Ruia, Chairman Essar Group and Ravi Ruia, Vice ChairmanEssar Group.

Hutch Profile: Hutchison Whampoa Limited of Hong Kong is a Fortune 500 company and oneof the largest companies listed on the Hong Kong Stock Exchange. HWL is an internationalcorporation with a diverse array of holdings which includes the world's biggest port andtelecommunication operations in 14 countries and run under the 3 brand. Its business alsoincludes retail, property development and infrastructure. It belongs to the Cheung Kong Group

Vodafone-Essar: The case - Hutchison International, a non-resident seller and parent companybased in Hong Kong sold its stake in the foreign investment company CGP InvestmentsHoldings Ltd., registered in the Cayman Islands (which, in turn, held shares of Hutchison-Essar- Indian operating company, through another Mauritius entity) to Vodafone, a Dutch non-resident buyer. Vodafone Essar is owned by Vodafone 52%, Essar Group 33%, and other Indiannationals, 15%. On February 11, 2007, Vodafone agreed to acquire the controlling interest of67% held by Li Ka Shing Holdings in Hutch-Essar for US$11.1 billion, pipping Reliance

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Communications, Hinduja Group, and Essar Group, which is the owner of the remaining 33%.The whole company was valued at USD 18.8 billion. The transaction closed on May 8, 2007.

The total is Vodafone Essar subscription is 106,347,368 subscribers i.e., 23.94% of thetotal 444,295,711 subscribers.

Individual Investors: Individual large stake holders Analjit Singh and Asim Ghosh sold theirstakes to Vodafone in December 2009. Asim Ghosh, the former managing director of VodafoneEssar, had 4.68 per cent stake in the company held through investment firm AG Mercantile, andsold a part of it for about Rs 3.3 billion. Analjit Singh, who had a share of 7.58 per cent throughthree companies, sold a part of his stake for over Rs 5 billion. After the sale, the stakes held byGhosh and Singh in Vodafone Essar will come down to 2.39 per cent and 3.87 per centrespectively.

Vodafone Hutch deal Time Line

The time line for the Vodafone and Hutch deal is as follow:

2007/05/29 - Court sends notice to Vodafone and Hutch

2007/05/05 - Vodafone-Hutch deal gets Finance Minister's nod

2007/04/04 - Vodafone-Hutch deal: Decision likely at next FIPB meeting

2007/03/19 - FIPB to take up Vodafone proposal on Tuesday

2007/03/16 - Hutchison offers $415 m to Essar as `sign-on bonus'

2007/03/16 - Vodafone's Hutch deal in order: Kamal Nath

2007/03/15 - Essar, Vodafone reach agreement on jointly managing Hutch

2007/02/18 - What Vodafone will collect from the Hutch call

2007/02/15 - `Roses for Essar, telephony for masses'

2007/02/15 - Vodafone pledges $2-b investments

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2007/02/12 - Hutch: Vodafone top bidder with $19-b offer

2007/02/11 - Hindujas to partner Qatar Telecom, Altimo for Hutch

2007/02/10 - Hutch bidding goes to the wire

2007/01/11 - Vodafone offer in a few weeks

2007/01/09 - Vodafone starts due diligence of Hutch

2007/01/06 - Hutchison, Essar differ over right of refusal

2007/01/03 - Essar gets fund pledge worth $24 b for Hutch-Essar buy

2006/12/29 - Reliance Comm in race for Hutch-Essar

2006/12/23 - Vodafone joins race for Hutchison Essar stake

2006/12/21 - Vodafone may join race for Hutch

Taxation issue in Vodafone Hutch deal: The Indian Revenue authorities issued show causenotice to Vodafone arguing that they had failed to discharge withholding tax obligation withrespect to tax on gains made by Hutch on sale of shares to Vodafone. Vodafone filed a writpetition in the Mumbai High Court challenging the jurisdiction of the Revenue department.

The revenue department issued show-cause to Vodafone asking for an explanation as towhy Vodafone Essar (which was formerly Hutchison Essar) should not be treated as anagent (representative assessee) of Hutchison International and asked Vodafone Essar topay $ 1.7 billion as capital gains tax.

Indian Income Tax department view: The whole controversy in the case of Vodafone isabout the taxability of transfer of share capital of the Indian entity. Generally, the transferof shares of a non-resident company to another non-resident is not subject to tax in India.But the revenue department is of the view that this transfer represents transfer ofbeneficial interest of the shares of the Indian company and, hence, it will be subject totax.

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The revenue authorities are of the view that as the valuation for the transfer includesthe valuation of the Indian entity also and as Vodafone has also approached theForeign Investment Promotion Board (FIPB) for its approval for the deal, Vodafonehas a business connection in India and, therefore, the transaction is subject tocapital gains tax in India.

Vodafone view: On the contrary, Vodafones argument is that there is no sale ofshares of the Indian company and what it had acquired is a company incorporated inCayman Islands which, in turn, holds the Indian entity. Hence, the transaction is notsubject to tax in India.

Vodafone argued that the deal was not taxable in India as the funds were paid outside India forthe purchase of shares in an offshore company that the tax liability should be borne by Hutch;that Vodafone was not liable to withhold tax as the withholding rule in India applied only toIndian residence that the recent amendment to the IT act of imposing a retrospective interestpenalty for withholding lapses was unconstitutional.

Now the taxmans argument was focused on proving that even though the Vodafone-Hutch dealwas offshore, it was taxable as the underlying asset was in India and so it pointed out that thecapital asset; that is the Hutch-Essar or now Vodafone-Essar joint venture is situated here andwas central to the valuation of the offshore shares; that through the sale of offshore shares,Hutch had sold Vodafone valuable rights - in that the Indian asset including tag along rights,management rights and the right to do business in India and that the offshore transaction hadresulted in Vodafone having operational control over that Indian asset. The Department alsoargued that the withholding tax liability always existed and the amendment was just aclarification.

Key questions before the High Court:

Whether the show cause notice issued by the Revenue authorities was withoutJurisdiction as Vodafone could not be said to be liable under section 201 of theIncome tax Act 1961 for not withholding tax?

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Whether the provisions relating withholding tax obligation under section 195 ofthe Acts have extra territorial application and a non resident without presence inIndia has an obligation to comply with it?

Whether the transaction per se resulted in income chargeable to tax in India?

Vodafones Petition and Arguments: Vodafones argument is that there is no sale of shares ofthe Indian company and what it had acquired is a company incorporated in Cayman Islandswhich in turn holds the Indian entity. Hence, the transaction is not subject to tax in India.

The petitions and arguments of Vodafone are as under:

It was not in default (under section 201) for not withholding tax as the law applied tosituations where tax had been withheld and not deposited. Hence, to impose an obligationwhere no withholding had been made was unconstitutional. Giving a contextualinterpretation, person liable to withhold tax could not include a non resident having nopresence (in India), since such an interpretation would amount to treating unequals asequal by imposing onerous compliance obligations as applicable to residents or non-residents having a presence in India. The transfer was with respect to ownership of sharesin a foreign company and no capital asset in India. Further, change in controlling interestin Indian companies was only incidental to change in foreign shareholding.

Vodafone also challenged the constitutional validity of retrospective amendments tosections 191 and 201 of the Act, motivated to impose an obligation on payer to withholdtax.

The transfer of the shares of CGP which was a capital asset situated outside India could notresult in any income chargeable to tax in India. A share in a company represents a bundle ofrights and its transfer results in a transfer of all the underlying rights. However, what weretransferred were only a share and not the individual rights.

When there is no look-through provisions under the Income Tax Act, 1961 ("the Act"), such aprovision cannot be read into the statute and the corporate veil cannot be lifted unless a tax fraudis perpetrated. The Supreme Court ("SC") in the case of Azadi Bachao Andolan (2003) 263 ITR706 has held that there was no tax consequence in India when the shares of one of the

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intermediate holding company in Mauritius were transferred. Similarly, there should not be atax consequence, even when an upstream holding company transfers its shares.

Analysis of the issue: HC ruling in Vodafone Case: The HC held that the series of transactionsin question has a significant nexus' with India. Since the essence of it was change in controllinginterest in HEL, it constituted a source of income in India. It held that the price paid byVodafone factored in, as part of the consideration, diverse rights and entitlements beingtransferred as part of the composite transaction. Many of these entitlements were not relatableto the transfer of the CGP share. It held that intrinsic to the transaction were transfer of otherrights and entitlements. Such rights and entitlements constitute capital assets' as per theprovisions of the Act.

The apportionment of consideration paid by Vodafone for a bundle of entitlements stated abovelies within the jurisdiction of the Indian Revenue. The Indian Revenue Authorities sought toapportion income resulting to HTIL between what has accrued or arisen or what is deemed tohave accrue or arise as a result of a nexus with India and that which lies outside.

Subsequent to the HC ruling, the Revenue has raised a tax demand of Rs. 112,180 million onVodafone for failure to withhold taxes. Meanwhile, the appeal filed by Vodafone before theSupreme Court was heard in November 2010.

Analysis of decision: This is a landmark ruling which throws light on principles of taxation ofcross-border transfers. The High Court's observation on the principle of proportionality' that aportion of the income would be chargeable to tax is a significant one. The Court has alsoobserved that the other rights and entitlements, passed on as a part of the deal are separate assetsand can be regarded as capital assets', within the meaning of the Act. These observations seemto indicate that transactions involving a simpler transfer of shares of a company outside India,which has companies in its fold in India, would not be chargeable to tax in India. However, ifcertain other rights and entitlements in India are transferred along with the transfer of shares,there would be an incidence of tax in India.

This decision could certainly embolden the Revenue authorities to investigate offshoretransactions, which have a connection with India or cases where limited interest exists in Indiaand the demand raised by the Revenue authorities is a clear indication of things to come.

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The Dutch government, on behalf of Vodafone, has approached the Indian government forsettling a three-year-old dispute involving a tax claim of over Rs 11,000 crore. Netherlands haswritten to India asking it to consider an alternate dispute resolution that will run parallel to theongoing court process through what is termed as a Mutual Agreement Procedure (MAP).

India would examine the request and take a decision in accordance with the provisions of theIndia-Netherlands double tax avoidance agreement (DTAA). MAP is an alternate process ofdispute resolution, and is an option available to a taxpayer in addition to and concurrent with theappellate process. However, under MAP, once the proceedings are initiated, it is possible toobtain a stay on the tax demand provided one gives a bank guarantee.

This opens up the possibility of a settlement on the lines of what Vodafone clinched in the UKearlier this year, when it agreed to pay 1.25 billion in taxes to settle a decade-long disputedating back to 2000 regarding its Luxembourg subsidiary.

Supreme Court of India Decision

The Supreme Court today ruled in favour of Vodafone in the $2 billion tax case saying capitalgains tax is not applicable to the telecom major. The apex court also said the Rs 2,500 crorewhich Vodafone has already paid should be returned to Vodafone with interest. The decisionwill be a big boost for cross-border mergers and acquisitions here. The Income tax departmentscontention, if upheld, would have rendered standard transaction structures too risky forcingforeign companies to weigh potentially new litigation and insurance costs. Nearly five yearsafter the Indian taxman issued the first notice to Vodafone international on September 2007 forfailure to withhold tax on payments made to Hutchison Telecom, Chief Justice of India SHKapadia and Justice KS Radhakrishnan pronounced their judgement.

The SC has ruled that the transaction is not taxable in India, and it has made the followingobservations/ comments while pronouncing its ruling:

Presently, there are no look-through provisions in the Indian domestic tax law to taxthe transaction.

There is no extinguishment of property rights in India through the transfer of sharesbetween two foreign entities of shares in another foreign entity.

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Similarly, provisions which treat a person as an agent/representative of a foreignentity for the purpose of levy and recovery of tax due from such a foreign entity is notapplicable in the absence of a nexus.

There is no conflict between the earlier decisions of the SC in Azadi Bachao Andolan,and Mc Dowell. The SC in the case of Azadi (263 ITR 706), had held that an actwhich is otherwise valid in law cannot be held as sham, merely on the basis of someunderlying motive supposedly resulting in some tax advantage. The SC in the case ofMc Dowells (154 ITR 148), held that sanction cannot be accorded to a colourabledevice.

The duration of the holding structure, timing of exit and continuity of business, areimportant factors while evaluating as to whether the transaction as a whole is a sham.Considering the factual matrix in the present scenario, the SC held that the transactionis not a sham.

Withholding tax provisions in the Indian domestic tax law cannot apply to offshoretransactions

The Tax Authority has also been directed to refund the entire amount (US$ 0.5billion) deposited by Vodafone as part payment towards the demand in early 2011along with interest

Tax policy certainty crucial for national economic interest.

The decision of the SC is expected to be a milestone development in the taxation ofinternational transactions and on the judicial approach to tax avoidance. This case is, perhaps,the first in the world where the issue of taxation on indirect transfer of shares is beinglitigated before a countrys highest judicial forum. The principles emanating from this rulingcould therefore, have ramifications beyond India. It could also be of relevance in shapingIndias tax policy on international taxation and tax avoidance in the future.

V. Summary & Concluding remarks

Indian tax laws are complex and possibly are in the process of getting more complicated by theday in terms of regular annual amendments and judicial decisions which continuously revise thejudicial interpretations in the light of changing business environment. The growing importance

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of the Indian economy and the increasing demands for resources has given the government theconfidence to tax offshore deals wherever possible. In the case of transactions involving largecapital sums, it would be advisable for the concerned parties to approach the Authority forAdvance Rulings (AAR) which would freeze the tax treatment for a particular transaction in thecase of a non resident. This would avoid the kind of pitfalls that Vodafone finds itself in.

This would also have a major impact on deals with a country with which India does not have aDouble Taxation Avoidance Agreement (DTAA). The major legal battles such as the Vodafonedispute which essentially determine the fate of a large chunk of Foreign Direct Investments intoIndia and is in this context much awaited. The challenge lies in balancing the interest of theinvestors and the revenue authorities. The new direct tax code that the Government is planningto introduce so as to replace the current Income-tax Act, 1961 (the IT Act), is expected toemphasize on transparency and taxpayer-friendliness.

At present, the dispute resolution mechanism in India moves slowly. Assessment proceedingscontinue for more than two years from the date of filing of the tax return. Thereafter, the twoappellate levels take approximately two to seven years to dispose of an appeal. If the dispute stillcontinues, on a question of law, the matter gets referred to the High Court and the SupremeCourt which generally takes very long. This is worrying the Indian corporate sector as it takes alot of management time and effort. There is a need to expedite the litigation procedure. Thereshould be a limitation period on disposal of appeals as well.

Amendments brought about by the Finance Act, 2008 would have a major impact on transfer ofshares overseas, especially in a case where the seller of the shares is a resident (as per tax laws)of a country with which India does not have a Double Taxation Avoidance Agreement (DTAA).The amendment also brings the investors from countries like the US and UK within the tax netin India, since Indias DTAA with such countries provide for taxation of capital gains inaccordance with the domestic tax laws of India. In this way, there is an urgent need to speed upthe system and bring more clarity in rules and amendments.

References

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K.R. Girish and Himanshu Patel, KPMG, Deals: India wants more taxes from cross-borderM&A, February 19, 2008, International Tax Review.Government widens scope of anti-abuse provisions in I-T Act by Abhineet Kumar & Sidhartha,March 4, 2010, Mumbai.India issues advance ruling on capital gains tax implications of an intra group share transferby Ernst &Young.Taxation of Cross Border Mergers and Acquisitions, 2010 Edition, KPMG United Statesavailable on http://kpmg.com/Global/en/IssuesAndInsights/ArticlesPublications/Documents/Tax-MA-2010/MA_Cross-Border_2010_India.pdfCross-border mergers and acquisitions - Addressing the taxation issues from an Indianperspective, Gaurav Goel.Economic Times, Times of India, Mint web pages for various news and updatesCross Border Business Reorganization: Indian Law Implications, Aniket Singhania & VaibhavShukla.Corporate Mergers & Acquisitions, Gurminder Kaur, 2005.Direct Taxes Law & Practice, 2011, Dr. Vinod K. Singhania and Dr. Kapil Singhania, TaxmannPublications, India.Vodafone Hutch Supreme Court ruling