In the Vodafone case, a plea was raised on behalf of Revenue that CGP shares were sold by HTIL to VIL by virtue of share purchase agreement, which extinguished all the rights of HTIL in HEL (Hutchinson Essar Ltd.) and in the process there was transfer of rights and entitlements falling within the expression (capital asset), defined in Section 2(14).  Accordingly, the Revenue contended that if transfer of a capital asset situated in India happens ‘in consequence of’ something which has taken place overseas (including transfer of a capital asset), than all income derived even indirectly from such transfer, even though abroad, becomes taxable in India.  That, even if control over HEL were to get transferred in consequence of CGP share sale outside India, it would yet be covered by Section 9(1)(i) of Income Tax Act.  Also Revenue placed reliance on ‘Source Test’ to contend that the transaction had a deep connection with India, namely, ultimately to transfer control over HEL and hence the source of gain to HTIL was in India.

Before traversing the above issue, I am reminded of the comments appearing in the Eighth Edition of Kanga & Palkhivala ‘Income Tax’ which while referring to the continued efforts of Revenue to enlarge the scope of Section 9(1)(i) and its various sub-clauses, hint that if the tax net is sought to be extended wide enough to collect taxes even in cases where foreigner’s income has no nexus with India, only because the income is derived from transaction with an Indian, it can equally levy tax on a hotel in a foreign country where an Indian goes to stay or dine or a foreign store where an Indian buys shirts etc.  So much to establish a nexus.

Under Section 9(1)(i), income is deemed to accrue or arise in India if it accrues directly or indirectly through or from any business connection in India or through or from any property in India, or through or from any asset or source of income in India or through the transfer of a capital asset situated in India.  Thus Section 9(1)(i) gathers in one place various types of income and directs that income falling under each of the sub-clauses shall be deemed to accrue or arise in India. Broadly there are 4 items of income.  Each item of income is distinct and independent of the other, with independent requirements to bring them under respective sub-clauses.

This section deals with categories of income accruing to the assesse outside India, and through a fiction, the section seeks to shift the situs of accrual of income to India.  A Legal fiction has a limited scope and it has to be construed strictly in keeping with the context in which that fiction was created.  In interpreting a provision creating a legal fiction, the court is to ascertain for what purpose the fiction is created, but in construing the fiction, it is not to be extended beyond the purpose for which it is created.  A legal fiction cannot be expanded by giving purposive interpretation, particularly if the result of such interpretation were to change the concept of chargeability occurring in Section 9(1)(i). According to the Supreme Court, Section 9(1)(i) is not a ‘Look Through’ provision in as much as it operates on a fiction and does not have the necessary statutory support which alone can provide ‘Look Through’.

The three elements which are necessary for charging of capital gains are (a) transfer, (b) existence of a capital asset and (c) situation of such asset in India.  The fiction created by Section 9(1)(i) applies to the Assessment of income of non-resident.  In the case of a non-resident,  if any income accrues or arises to  it directly or indirectly outside India, as a sequel to the transfer of a capital asset situated in India, then the same is fictionally deemed to accrue or arise in India, thereby creating liability to tax by reason of 5(2)(b) of the Act. Thus, the main purpose behind enactment of Section 9(1)(i) is to capture through a fiction such income arising to a non-resident outside India on transfer of capital asset situated in India, which may otherwise go untaxed.  By fictionally deeming such income as accruing or arising in India, it is caught within the mischief of 5(2)(b) of Income Tax Act for tax purposes.

The two basic principles for imposition of tax which are set out in Section 5 are (a) source and (b) residence.  Section 5(2) is a source based rule in relation to non-residents.  The source in relation to income has always been construed to be where the transaction takes place and not where the item of value, which was the subject of the transaction, was acquired or derived from.  In the case of Vodafone, the entire transaction of sale took place outside India and hence Source Test will not establish that the transaction had connection with India.

The question raised by Revenue is whether the transfer of shares of the foreign company holding shares in an Indian company can be treated as equivalent to the transfer of shares of the Indian company on the premise that Section 9(1)(i) covers direct and indirect transfers of capital assets. The single judge in his separate but concurring Judgment observed that on transfer of shares of a foreign company to a non-resident off-shore, there is no transfer of shares of the Indian company.  In such a case, it cannot be contended that the transfer of shares of the foreign company results in an extinguishment of the foreign company’s control of the Indian company.  Equally, it does not constitute an extinguishment and transfer of an asset situated in India.  Even assuming that there was a transfer of capital asset in India, such a transfer was not a direct transfer and would, at the most, amount to an indirect transfer of capital assets/properties situated in India.  A plain reading of Section 9(1)(i) would indicate that the words, directly or indirectly appearing in Section 9(1)(i) go with the income and not with the transfer of capital asset.  Therefore, the transfer of capital asset as envisaged in the said section would relate to direct transfer and not indirect transfers. To make the section applicable for indirect transfers also would amount to change the content and ambit of Section 9(1)(i).  Further, the legislature has expressly provided for indirect transfers, wherever indirect transfers are intended to be covered, like Section 64 of the Income Tax Act.  The absence of the same in Section 9(1)(i) would make the intention of the  legislature clear that indirect transfers were sought to be kept out.  If indirect transfer of capital asset is read into Section 9(1)(i), then the words ‘capital assets situated in India’ would be rendered nugatory, since Section 9(1)(i) applies to direct transfer of capital assets situated in India and not otherwise. 

Supreme Court also seeks to draw support for its view from DTC Bill 2010, which proposes to tax income from transfer of shares of a foreign company by a non-resident where at any time during 12 months preceding the transfer the fair market value of the assets in India, owned directly or indirectly by the company, represents at least 50% of the fair market value of all the assets owned by that company.   Thus the DTC bill for the first time proposes taxation of off-shore share transactions, especially when such transactions involve an economic interest of a particular threshold level in India for the non-resident company.  The proposed measure amply demonstrates that indirect transfers are not covered by the existing Section 9(1)(i) of the Act; otherwise there is no need for the DTC Bill to expressly provide that income accruing even from indirect transfer of a capital asset situated in India would be deemed to accrue or arise in India.  Further, in the absence of any enabling provisions in the present scheme of enactment, the question of providing ‘Look Through’ on the basis of purposive construction is precluded.  Thus on a variety of grounds, Supreme Court held that Section 9(1)(i) would not apply to indirect transfer of a capital asset situated in India.

The Supreme Court decision in the recent Vodafone case must be considered a body blow for Indian taxation, India as a whole and the necessary onslaught on tax haven abuse that I and many others are involved in.

First, it is important to note that this was always an unusual case: Vodafone was being sued for tax which it was said it should have withheld from a payment it made to Hutchison Essar Limited for a stake in that company’s Cayman subsidiary that in turn owned its Indian mobile phone operations. Vodafone did not, as a result, ever make a profit in this matter: it was being sued for tax that might have been due by a third party if that third party had made its gains in India. It did not make that gain in India for what might (to simplify matters) be considered a straightforward reason, and that was because it had ensured that ownership of the Hutchison Essar mobile phone network in India was not recorded in India at all, but in the Cayman Islands. The claim was Vodafone should have withheld the tax due on the capital gain as a result.

The ruling on this case is over 250 pages long and cannot all be considered in detail here. What is interesting to me is the discussion on whether the structure used by Hutchison was reasonable tax planning or an unreasonable arrangement subject to challenge by India. The principles on which this decision was made where all defined in English taxation law and effectively required comparison of three cases and the principles within them. Everything effectively turned on whether the legal form of the transaction in Cayman  should prevail or its substance in India should be taxed.

The first critical case considered was, as a result, the 1936 decision in what has become known as the Duke of Westminster case. In this now notorious decision the House of Lords defended the right of a person to arrange their affairs howsoever they wished so long as it was legal and there was, they said, nothing the tax authorities could do to challenge the outcome in that case. This is in turn built on an 1869 decision which confirmed that tax in the UK has to be charged in accordance with “law”[1] as a result of it being said in the House of Lards that:

If the person sought to be taxed comes within the letter of the law he must be taxed, however great the hardship may appear to the judicial mind to be. On the other hand, if the Crown, seeking to recover the tax, cannot bring the subject within the letter of the law, the subject is free, however apparently within the spirit of the law the case might otherwise appear to be. In other words, if there be admissible, in any statute what is called an equitable construction, certainly such a construction is not admissible in a taxing statute.

This was the issue at stake in the Westminster case, and this was the matter also at stake in the Ramsey and Dawson cases from the 1980s also discussed in the decision on Vodafone, both of which were considered to have to some degree over-turned the Westminster ruling (although with subsequent restrictions also being applied in the UK, it should be noted). The unfortunate fact is that the judge in this case has, I think, clearly favoured Westminster over Ramsey, calling the latter a simple ruling on interpretation and treating the former as being law. Given the facts of this case, and their relative similarity with Dawson, that is surprising, but it seems he refused to see beyond the law of contract and address the underlying issue as both Ramsey and Dawson allowed.

In that case his failure to interpret the law in what seems to me to be the correct way leads us straight into consideration of whether India now has need for a general anti-avoidance rule (GAAR).

If all tax were about one action and one consequence then tax law would be easy, and determining if tax law applied or not would generally be relatively straightforward. But some tax is not like that at all. Aggressive tax planning is about putting together a string of transactions, each legal in their own right (or they would not be tax avoidance but would become tax evasion) but with the series, in combination, achieving a result quite different from that which parliament might ever have intended. It is this unintended outcome in combination that a GAAR is designed to tackle, especially in those cases where, despite the best will of judges, there is nothing at all to make the resulting tax avoidance illegal.

Graham Aaranson QC has suggested the UK should have a limited form of GAAR. Personally, I would have liked him to go further: stopping the most egregious schemes a he suggests such a GAAR should be limited to is not, in my opinion, enough. I was consulted by Graham Aaronson during the course of his review.

What is more worrying is that I am not sure as yet that Aaranson’s tackled the biggest problem, internationally, with these GAARs, and that’s simply whether or not the judges will embrace them or not. In Australia they by and large have and so they’ve made some gains. In Canada the judges virtually refused to operate a GAAR. The result has been a GAAR that’s failed to deliver. All of which has always left me thinking that an essential component of a GAAR is a change to the basis on which tax law is interpreted from a legal (literal) basis to an equitable (common law) basis.

The Australians almost got there (but not for tax) a long time ago with their law of 1901[2] on legal interpretation which said:

In the interpretation of a provision of an Act, a construction that would promote the purpose or object underlying the Act (whether that purpose or object is expressly stated in the Act or not) shall be preferred to a construction that would not promote that purpose or object.

This seems to get to the very core of the problem in the Vodafone case. It seems to me that what we want our judges to do when looking at tax law is to assess the substance of the transaction and to ignore its form. The result has a massive advantage: it is about as comprehensible as most law can ever be. If the man on the Clapham Omnibus could see that the substance and form of the transaction were the same (an asset in India is sold and tax is payable in India) then they’d know they would have complied with the law. If the substance and form do not coincide i.e. an asset is sold in India and tax is payable, if at all, in Cayman, they’d know they were in trouble. What can be more certain that that?

Ancient law, designed in an age of steam ships, is crippling India as it is crippling other countries in the age of the internet. It’s time we changed these laws now. Only that way can we get tax justice – and that’s a situation where the right amount of tax (but no more) is paid in the right place at the right time where right means that the economic substance of the transactions undertaken coincides with the place and form in which they are reported for taxation purposes.

[1] Partington v. Attorney-General (1869), L.R. 4 E. & I. App. 100, per Lord Cairns at p. 122.

[2] Section 15 AA of the Acts Interpretation Act, 1901 downloaded 4 December 2006 from  http://www.austlii.edu.au/au/legis/cth/consol_act/aia1901230/s15aa.html

The issue came up before the Apex Court. It was argued by the Revenue that by the transfer of CGP shares, effectively, the rights in the underlying assets of HEL situate in India were transferred and, therefore,the capital gain on transfer of CGP shares is deemed to accrue or rise in India u/s.9(1)(i). Let us look at the arguments of the Revenue and of Vodafone.

The revenue put forward two arguments, viz,

1. HTIL has under the SPA, directly extinguished its property rights in HEL and its subsidiaries, and if this argument fails,
2. Income from sale of CGP would fall within S.9 of the Income-Tax Act as that section provides for a look through.

It was argued that the word “through” in S.9 means  ”in consequence of” and, therefore, if transfer of a capital asset situate in India happens “in consequence of” something which has taken place overseas, then income derived even indirectly from such transfer, even though abroad, becomes taxable in India.

The Court found no merit in both the arguments of the Revenue.

Section 9(1) lays down that the following incomes shall be deemed to accrue or arise in India-

i)“All income accruing or arising, whether directly or indirectly through or from any business connection in India, or through or from any property in India, or through or from any asset or source of income in India, or through the transfer of a capital asset situate in India.”

In this case, we are concerned with the last sub-clause of S.9(1)(i) which refers to income arising from “transfer of a capital asset situate in India” The court held that to fall within the said sub-clause, three conditions should be satisfied, namely, (i) there should be a transfer,

(ii) existence of a capital asset and

(iii) situation of such capital asset should be in India.

All three elements should exist to apply the last sub-clause. Any income which accrues or arises to a non-resident directly or indirectly, outside India is fictionally deemed to accrue or arise in India if such income accrue or arises as sequel to the transfer of a capital asset situate in India. This fiction is brought in to avoid any possible argument on the part of the non-resident vendor that profit accrued or arose outside India by reason of the contract to sell having been executed outside India. This is the main purpose behind enactment of S.9(1)(i) of the act.

The Court held that the language of the section has to be given effect when it is unambiguous and admits of no doubt regarding its interpretation, particularly when a legal fiction is embedded in that section. A legal fiction has a limited scope and it cannot be expanded by giving purposive interpretation particularly if the result of such interpretation is to transform the concept of chargeability.

The revenue contended that under section 9(1)(i) it can “look through” the transfer of shares of the foreign company as equivalent to the transfer of shares of the Indian company on the ground that section9(1)(i) covers direct and indirect transfer of capital assets. The court vary categorically held that section 9(1)(i) cannot be extended to cover indirect transfer of capital asset./property situate in India by a process of interpretations. If that is done, it would amount to changing the content and ambit of section 9(1)(i). The word indirect is used in the section in relation to income and not in relation to transfer.

The Direct Tax Code (DTC) Bill, 2010 proposes to tax income from transfer of shares of a foreign company by anon-resident, where at any time during 12 months preceding the transfer, the fair market value of the assets in India, owned directly or indirectly, by the company, represent at least 50% of the fair market value of all assets owned by the company. Thus, the DTC bill, 2010 proposes taxation of offshore share transactions. This proposal indicates in a way that indirect transfers are not covered by the existing Section9 (1)(i)of the Act. In fact, the DTC Bill 2009, expressly stated that income accruing even from indirect transfer of a capital asset situate in India would be deemed to accrue in India. Therefore, in the existing section 9(1)(i), the word indirect cannot be read on the basis of the purposive construction. The provision of “look through” should be expressively provided in the statute or in the treaty. In the same manner, limitation of benefits has also to be expressly provided in the treaty. 

Section9(1)(i) permits the tax authority to “look at” the arrangement. In this case CGP investment was not brought in at the last moment before the transfer of the shares. The Court observed that MNCs have such holding subsidiary structure for commercial reason rather than for tax saving/avoidance. Therefore, in the absence of circumstances indicating that colorable device was used to structure the transaction, Section 9(1)(i) has to be interpreted literally. 

In my view, the following principles are clearly laid down/upheld by the Supreme Court and will decide the course of the cases pending in appeal at various stages-

1. The source of income lies where the agreement for a transaction is executed and not where the underlying economic interest lies.
2. Two conditions must be satisfied to invoke S.9(1)(i), viz, (i) there must be a capital asset situated in India and (ii) there should be a transfer of such capital asset and such transfer should yield gain.
3. Offshore transfer of shares of a foreign company holding shares of an Indian company does not amount to extinguishment of assets of the Indian company situated in India.
4. S.9(1)(i) is a legal fiction. A legal fiction has a limited scope and the scope cannot be expanded by giving purposive interpretation. The words ‘direct or indirect’ used in the section apply to income and not to indirect transfer of a capital asset. The DTC specifically covers direct or indirect transfer of capital asset. Where there is no specific provision in the Act or the Treaty, the Court cannot apply ‘look through’ or ‘limitation of benefit’ tests.
5. Shares and various rights attached to shares pass together, they cannot be dissected. Where a transaction involves transfer of shares lock, stock and barrel, the transaction cannot be broken into components. The fact that the transfer of CGP shares enabled the buyer to acquire control over the step down subsidiaries does not shift the situs of the CGP shares. Transfer of control over the underlying assets as a result of transfer of CGP shares was incidental to the transfer of shares and one has to have a holistic approach to the entire transaction.

 The decision has brought certainty to the cases opened by the Department post the Mumbai High Court ruling in this case. The Government may introduce ‘look through’ provision with prospective effect. If such a provision is introduced with retrospective effect, it may have to be tested for its validity.

The Supreme Court ruling on Vodafone has come as a breath of fresh air - long awaited and much needed to all - tax practitioners and tax payers alike.  The majority judgement by Chief Justice S H Kapadia & Justice Swatanter Kumar - and minority concurring judgement by Justice K S Radhakrishnan.

The stand taken by the Tax Department in the words of Justice Radhakrishnan amounted to - "imposing capital punishment for capital investment".  We all hope the Tax Department will take a more investor friendly approach hereafter.

The decision has not only re-affirmed our faith in the judiciary, but has also reaffirmed the basic first principles of taxation that we have learnt, grown up with, and practiced all these years.

M&A transactions were the most impacted by the revenue position on Vodafone and I am sure there were many deals which actually did not fructify because of the Withholding Tax (WHT) deadlock.  Those that did fructify took many man months of painful negotiations merely on negotiating the WHT exposure with various options being exercised which included requirements of advance rulings, escrow mechanisms, indemnities and even going on to take insurance cover!  The problems were further compounded with exits being made by sellers who were not in a position to give either indemnities or manage escrows.  In all, transaction costs increased and Indian assets became more expensive to buyers, while eroding the asset value of sellers at the same time.     

Both buyers and sellers in cross border M&A transactions completed even before the Vodafone transaction were all on tenterhooks awaiting "the mid-night call"!  The revenue apparently had drawn up a list of all transactions and possibly was awaiting this judgement before launching the offensive.  There is obviously a question in the air now as to what the next steps of the revenue would be.

In my view, retrospective amendment would not be attempted by the Government as to my mind it would have a very negative impact in the present circumstances of downturn, lower FDI and depreciating Rupee.  The Government is making all efforts to boost the investment climate and a retrospective amendment would be counterproductive - but with the bludgeoning deficit you never know what North Block may consider prudent.

However, one aspect is clear that a retrospective amendment would not apply or would be very difficult to implement against the buyer as he would need to comply with the law prevailing at the time of deduction. Therefore retrospective amendment if at all would possibly hit the sellers who earned the profit.  However, sellers in Mauritius and other favourable treaty jurisdictions, would be able to possibly take benefit of the Judgement since Azadi Bachao Judgement has been upheld.

This judgement would go a long way in re-establishing the first principles of taxation - particularly form over substance and the time tested dictum that a tax payer is entitled to arrange his affairs in such a manner as to minimize his tax liability. Tax structures, holding companies, SPVs have been recognised as being for legitimate / commercial business reasons.   We now would need to await the Direct Tax Code and introduction of GAAR which may make the life of this judgment short-lived.

While the judgement has upheld all the first principles, following are some of the important observations /facts which have been considered by the Honourable Supreme Court in coming to this conclusion. These could be used by the Tax Department to distinguish this judgement which may continue as a risk for the past M&A transactions.

The judgement stresses on the following :

a) Hutch was not a fly by night operator

b) Structure was in position since 1994

c) Monies were invested in the telecom business which continued even after the acquisition

d) The government was aware of and therefore accepted the structure that was put in place for investment by Hutch   

We may now come to a very important question as to how this decision would apply to M&A transactions where capital gains exemptions may have been claimed.  There could be three key options :

(a) transfer of Indian company shares by a tax  resident of a beneficial tax treaty country

(b)transfer by a foreign company of another foreign company shares where :

    i) entire or substantial assets / value lies in India

    ii) there are global operations and a minority value lies in India

As regards the transaction at (a) above, both judgements have upheld the Supreme Court decision in Azadi Bachao Andolan and accordingly one could rely on that aspect of this decision for claiming exemption. I say this with a word of caution – please still look at maturity and reasonable substance before taking the decision to give treaty benefits – to avoid device argument. The transactions at (b)(i) above would be squarely covered by the judgment unless the revenue contends that the intermediary entity was created for the purpose of the transaction and has been in existence for a short time, thus, is a device.  However with regard to a transaction at (b)(ii) above where there are substantial Non-Indian assets, the fear of any tax attack would be practically zero.

The majority decision has clearly stated that the revenue may invoke a substance over form principle or pierce the corporate veil only after it is able to establish that the transaction is a sham or tax avoidant.  The judgment goes on to give an example that if a structure is used for circular trading or round tripping or to pay bribes, then the same should be discarded by applying the test of fiscal nullity.

The Court has said that every strategic foreign direct investment coming to India as an investment destination should be seen in a holistic manner.  While doing so the revenue/court should keep in mind the following factors :

a) participation in investment

b) duration of time for which the holding structure exists

c) period of business operations in India

d) generation of taxable revenues in India

e) timing of the exit

f) continuity of business on such exits

Corporate business purpose of a transaction is evidence against a colorable or artificial device.   

There is a conceptual difference between preordained transactions which is created for tax avoidance on the one hand and a transaction which evidences investment to participate in India.  The Judgement also said that you have to look at the transaction holistically and not adopt a dissecting approach.

The judgement however does not go into aspects of the level of onus cast on a deductor -- would not reasonable care be sufficient to discharge this onus? 

On jurisdiction the minority concurring judgment by Justice Radhakrishnan clearly states that where the buyer has no presence in India and the transaction has no direct nexus with India, then there can be no Withholding Tax liability in terms of section 195 on ground of lack of jurisdiction.

The majority decision has not covered this aspect, and hence, the minority decision would have persuasive value and may not be considered as obiter-dicta.

On an overall analysis, in my view the apparent deadlock on M&A transactions would by and large have been cleared and hence transactions would be facilitated as the risk of non deduction would stand substantially reduced on appropriate facts.

However, my advice to all buyers would be to carefully vet the facts and circumstances before taking a decision not to deduct tax at source as the onerous liability to deduct tax continues to the same extent as liability of seller to pay taxes.

Cross-border M&As involving Indian companies has been a focus of the Indian tax Authority (ITA) over last couple of years. While taxability for acquisitions involving direct transfer of shares of an Indian company is fairly established, the uncertainty created by the approach of ITA in the context of the Vodafone’s case has been lingering in the minds of several foreign investors. This has, inter alia, been impacting the inflow of foreign investment into India.   

After a prolonged wait of over 5 years, the Supreme Court of India (SC), on 20 January 2012, pronounced its ruling in the Vodafone’s case.  The ruling of SC would set a binding precedent for other similar transactions, as well for those transactions which are currently being investigated by the ITA and are in various stages of litigation.

To recap the controversy - Hutchison Telecommunications International Ltd (Hong Kong) held 67% of the shares of Hutchison Essar Ltd (India) indirectly through CGP Investments Holdings Ltd (a Cayman Islands SPV) and also held call options in Mauritius and India. The stake of Hutch Hong Kong in the Cayman Islands SPV was acquired by Vodafone (UK), through a Netherlands based SPV viz. Vodafone International Holdings BV (Vodafone). As a result of this sale, capital gains, estimated at $ 11 billion, accrued to the Cayman Islands SPV. The ITA, being of the view that the transaction would give rise to capital gains chargeable to tax in India, held that Vodafone was under an obligation to withhold tax at source while making the aforesaid payment of sale consideration. The matter was litigated upto the SC level. 

Setting aside the decision of the Bombay High Court (HC), the SC’s order echoed some significant principles as stated below –

• The situs of the capital asset, being shares, would be situated where the company is incorporated and where the register of members is maintained;
• Gain arising to a foreign company from transfer of shares of a foreign holding company, which indirectly held underlying Indian assets (Indirect Transfer) is not taxable in India;
• The ITA has no jurisdiction under Indian Tax Laws (ITL) to tax the gains arising to a foreign company from such Indirect Transfer by applying the ‘look through’ principles in a deeming fiction created under ITL;
• The withholding tax provisions under the ITL will not apply when there is an offshore transaction between two non-residents; accordingly, such provisions would not have an extra territorial operation;
• Provisions which treat a person as an agent/representative of a foreign entity for the purpose of levy and recovery of tax (due from such a foreign entity) are not applicable in the absence of a nexus;
• Tax planning within the framework of law is permissible, unless the planning is a sham or a colorable device; the onus is on the ITA to establish that a transaction is a ’sham’.

The SC acknowledged a critical aspect in context of holding structures stating that use of investment / holding structures can often be driven by business/commercial purpose and the use of these elements in international structures does not imply tax avoidance. The SC held that taxpayers are free to choose lawful arrangement which suits its business and commercial purpose and brought forth the conceptual difference between preordained transaction for tax avoidance and transactions which evidences investment participation into India. The SC laid down following guiding principles that would help in ascertaining if a transaction is preordained or not:

• Concept of participation in investment;
• Duration of time during which the holding structure existed;
• Period of business operations;
• Generation of taxable revenue during the period of operations;
• Timing of exit;
• Continuity of business on such exit, etc.

This should provide tremendous certainty to investors as they can now plan their affairs on lines similar to Vodafone’s case and be assured of the tax position. This should clearly boost cross-border M&As transactions. However, the judgment does provide a window for the ITA to look through in certain cases like round tripping, money laundering, parking black money, structures set in place to make payment of bribe, etc.

SC also observed that inclusion of an anti-abuse provision under the statute/tax treaty is a matter of national economic policy and, in the absence of the same, it cannot be implied.

Albeit, everyone is waiting to look out for any legislative amendment starting with the impending Budget, which in an extreme case could be with   retrospective effect! In anticipation, a multi-tier structure could still be preferred over a single tier structure from the perspective of minimizing capital gains tax on future divestment subject to introduction of the Generall Anti Avoidance Rules (GAAR). 

Among the most frequently used jurisdictions for inbound investment into India, Mauritius is a preferred jurisdiction,  inter alia, due to benefits available under the India-Mauritius Tax Treaty (Tax Treaty). A Circular issued by the Central Board of Direct Taxes (CBDT) which permits the Tax Treaty benefits based on the existence of a valid Tax Residency Certificate (TRC) of Mauritius and the Supreme Court (SC) ruling [in case of Azadi Bachao Andolan (263 ITR 706)] upholding the validity of the CBDT Circular have generally provided certainty to taxpayers regarding the use of the Tax Treaty. This contention has been re-affirmed by the single Judge’s order while pronouncing Vodafone decision. While the Tax Treaty was not the subject matter in the Vodafone’s case, the SC held that Tax Treaty benefit cannot be denied in the absence of Limitation Of Benefit (LOB) clause and presence of CBDT Circular. This will not only help to rest the controversy in transactions which are currently being investigated by the ITA, but also see more investments coming in through Mauritius.  However, in light of the above, the often talked about possibility of renegotiation of the India-Mauritius tax treaty and introduction of General Anti-Avoidance Rules (GAAR) in the ITL could be amplified. It is, therefore, important for taxpayers to review the existing and future structures that involve the use of beneficial tax treaties and assess possible steps for managing the risks that may arise.

The SC decision is a milestone development in the taxation of international transactions and on the judicial approach to tax avoidance within India. The principles emanating from this ruling would have wider ramifications beyond India. The verdict could play a significant role in shaping India’s future tax policy on international tax aspects. This landmark judgment is a great victory for taxpayers; though one will have to wait and watch the reaction of the ITA. The line of thinking of the legislators viz intention to tax indirect transfers with more that 50% Indian assets and introduction of GAAR was anyways put forth in the proposed Direct tax Code 2010.

(Views expressed are personal)

Some days back, the country (and rather the world!) was witness to a landmark judgement by the Hon’ble Supreme Court in the case of Vodafone. What followed was a jubilation by the taxpayers, with the apex court holding that indirect transfers are not taxable under the Indian Income-tax Act. Chief Justice Kapadia pronounced the majority judgement. While Justice Radhakrishnan did concur with the majority judgement, his observations touched upon certain very interesting aspects under the Indian tax law, specifically the extra-territorial application of Section 195. Justice Radhakrishnan categorically held that in the absence of any express provisions, Section 195 cannot impose any withholding obligation on a non-resident.

This brief article deals with the following questions:

1. Whether Section 195 can be said to have extra-territorial application, in the sense, whether the obligation under the said Section extends to a non-resident payer?
2. More importantly, whether the minority judgement of Justice Radhakrishnan can be said to create a binding precedent for the lower courts?

Let us take the first question first.

Section 195 states that “any person” responsible for paying to a non-resident any sum chargeable under the provisions of the Act shall at the time of payment or credit, whichever is earlier, deduct income-tax thereon at the rates in force. On a literal interpretation of the term “any person”, it includes even a non-resident and hence on first blush, it seems that the provisions of Section 195 extend even to a non-resident payer. However, the question to be introspected is that whether such a literal interpretation is appropriate. For instance, Section 139 states that “every person being a company” shall file a tax return. There is no qualification to the said stipulation and it is not necessary that “every person being a company” should have taxable income in India. Now, Section 2 defines a company to include a body corporate incorporated under the laws of foreign country. In other words, the term ‘company’ can include all companies incorporated outside India. On a literal interpretation of Section 139, all companies in the world (whether or not they have any taxable income in India) would need to file a tax return in India; but clearly this would lead to an absurd interpretation!!

Hence, a principle which emerges is that the legislature cannot be intending to do that which is "out of the ordinary", merely by reason of its having used general words which can be interpreted widely. In this context, one may refer to the wisdom of Lord Esher, who observed that "the Legislature cannot be supposed merely by reason of its having used general words to be intending to do that which is out of the ordinary and for which there is a sufficient basis in law for presuming that it did not intend to do, or could only inadvertently have expressed its intention to do, on account of the generality of the words used".

It can be argued that the rule against extra-territorial application of a statute is something “other than the ordinary” and unless an express provision is legislated to that effect (rather than, merely use of generic words), the presumption would be that a particular statute cannot have an extra-territorial application. For instance, the Bombay High Court in the case of Chhanubhai Vs. Sardul (AIR 1957 Bom 99) observed that “the ordinary principle of construction is that a Legislature is dealing with the subject

matter situate within its own territorial jurisdiction”. A similar view was taken by the Hon’ble Supreme Court in the case of CIT Vs. Malayalam Plantations Ltd (53 ITR 140) in the context of application of Estate duty law.

Hence, the question to be introspected is whether the provisions of the Income-tax Act, 1961 expressly provide for application of extra-territorial rule. In this context, one may refer to Section 1(2) of the Act which states that the Act extends to the whole of India. It is strongly arguable that the said sub-section conveys only a ‘territorial’ coverage. One may argue that these words imply that the Income-tax Act applies to:

1. persons in India; or
2. acts done in India;

For instance, the Indian Penal Code, 1860 expressly states that the act applies to any citizen of Indian for any offence committed in any place “beyond India”.

Considering the above, it is fairly arguable that a non-resident (who is not a person in India) cannot be imposed a burden to collect taxes under Section 195 on behalf of the Indian Government !! This argument is de hors of whether or not the amount under consideration is chargeable to tax in India.

There is a counter argument to the above proposition that the Supreme Court decisions in the case of Electronic Corporation of India Ltd (44 Taxman 342A) and Eli Lilly & Co. (India) Pvt Ltd (178 Taxman 505) seems to suggest that withholding tax provisions (which are machinery provisions) have an extra-territorial applicability. My personal view is that these decisions do not pronounce such a view.

In the case of Electronic Corporation of India, the Indian company had attempted to argue before the Hon’ble Supreme Court that the provisions of Section 9(1)(vii) which taxes fees for technical services in the hands of a foreign company (even when activities are carried out wholly outside India) are ultra vires the Constitution on the extra-territoriality argument. The Hon’ble Supreme Court commented that a foreign entity having a nexus with India can be brought under the ambit of the Income-tax Law, but on the larger question of whether the provisions are extra-territorial, it referred the matter to a Constitution Bench. We understand that the appeal was later withdrawn by the appellant and hence, the country could never know what the Constitution Bench may have held.

As regards the case of Eli Lilly & Co. (India) Pvt Ltd, what the apex court held was that Section 192 puts an obligation on the Eli Lilly (an Indian company) to estimate income under the head “salaries” (including income received by the employees from the foreign parent of Eli Lilly & Co. (India) Pvt Ltd).There was never a mention regarding Section 192 applicable to the foreign parent, who paid part of the salaries outside India.

Hence, it is strongly arguable that the aforesaid two judicial decisions do not truly dwell upon the issue of application of withholding tax provisions to non-resident payers.

To conclude, there is lot of merit in arguing that Section 1(2) read with Section 195 cannot put an obligation on the non-resident payer to withhold taxes on payments to residents or non-residents.  Interestingly, the Revenue’s own Circulars under the 1922 Act support this contention (Refer Circulars dated January 22, 1940 & March 5, 1940).

The second question is whether the minority judgement of Justice Radhakrishnan can be said to create a binding precedent for the lower courts?

This is the most interesting part. Justice Radhakrishnan clearly observed in para 185 that the term “any person” under Section 195 only covers resident payers. Was the argument of non-applicability of Section 195 due to the non-extra territorial rule taken up by the appellant in the Vodafone Case? The answer is absolutely yes. To this extent, the observation given by Justice Radhakrishnan can be said to be an adjudication on one of the core issues involved in the appeal. However, while this is the view of Justice Radhakrishnan, can it be said to be the view of the Supreme Court bench which delivered the judgement? Clearly, the majority decision given by Justice Kapadia did not touch upon this issue of extra-territorial application of Section 195. So, can the observation of Justice Radhakrishnan be said to be obitar dicta of the Supreme Court, which can still act as a binding precedent for lower courts. Unfortunately, the answer seems to be in the negative. Even for an observation to be regarded as an obitar dicta, it needs to be an observation of the Supreme “Court” and not just the Supreme Court “Judge”.

While the majority judgement did not expressly dispute the proposition of Justice Radhakrishnan on applicability of Section 195 to a non-resident, it did not imply its acceptance too.  It seems that a majority concurrence is a must in order for a proposition to become a binding precedent (Refer Supreme Court decision in the case of Ramesh Dabhai Naika).

Accordingly, it seems that strictly from a legal perspective, the proposition of Jusice Radhakrishnan on the non-applicability of Section 195 to non-residents cannot be regarded as the proposition of the Supreme Court and consequently, may not be legally binding on lower courts. But it does create a powerful argument (persuasive, nonetheless) for counsels arguing before lower courts as well as Supreme Court on the non-applicability of Section 195 (as well as other withholding tax provisions) to non-residents.

It seems that the last word on the extra-territorial application of Section 195 was missed by a whisker!

When the Supreme Court pronounced its final verdict in the surrounded-by-controversy Vodafone tax case, corporates across the globe heard carefully; because it’s not every day that a 3 member bench of the Apex Court of India lays down principles of jurisprudence in a tax matter which has INR 11,000 crores at stake.

As stalwarts Harish Salve, Former Solicitor General & counsel for Vodafone, and Solicitor General Shri Rohinton Nariman on behalf of the Revenue, fought the legal battle over the taxability of a transaction of transfer of shares of an overseas company between two non-residents; the nation looked on with keen interest, for the verdict in this case would decide for several others whether overseas transfers with an underlying value in India would be liable to tax in India.

Now that the Supreme Court has in its momentous verdict ruled that such overseas transfers between two non-residents are not taxable in India, one wonders what was it that made a tax battle between the Indian tax department and a large telecom service provider ‘Breaking News’ for the entire world.

Impact of Vodafone Verdict on India as an Investment destination

First and foremost, the answer lies in the far reaching impact that this judgment would have on the investment sentiment of foreign investors and the image of India as an investment friendly destination. This verdict has revealed the independence and correctness of the Indian Judiciary and sent out a need-of-the-hour message to the world – “Justice prevails in India”.

The developments in the past few months had done some serious damage to the portrayal of India as an investment destination, the uncertainty in tax issues and the huge quantum of Transfer Pricing adjustments being amongst the key factors. The ever-continuing debate on investment routed through Mauritius and the sword hanging on the verdict of the Vodafone case caused a lot of battering to the Indian M&A sector. This thumping decision has sent out a strong positive sentiment for doing business in India and has brought certainty and clarity to all foreign investors; who were looking at this judgment as a crystal ball which would tell the fate of their Indian ventures.

Supreme Court on scope of Section 9 of Indian Income-tax Act

This judgment has laid down firm principles for the scope, applicability and interpretation of the Indian tax laws as on date. In this case, the moot question was whether the transaction led to transfer of capital assets situated in India. The provisions of Section 9 of the Indian Income-tax Act deem certain incomes to accrue or arise in India. However, to trigger the deeming provision under Section 9, it is essential that the capital asset must be situated in India.

The Supreme Court has laid down that in this case the situs of the assets transferred was outside India, and in the absence of specific provisions to tax such a transaction, Section 9 cannot be interpreted so as to tax the underlying assets in India. Taxation of such transactions has to be driven by specific language and not by interpretation or purpose, because if the latter were permitted, the tax administration would become very uncertain.

Various other countries, like China, have legislated on such indirect transfers and arrived at a consensus, but in absence of any such specific legislation in India, the underlying assets in India cannot be brought under the tax net by stretching the interpretation of Section 9 of the Indian Income-tax Act.

Supreme Court on applicability of Section 195 of Indian Income-tax Act

This judgment has laid down that since there is no taxability of income, no obligation would devolve upon the payer to deduct tax under Section 195. Further, the Supreme Court stated that Section 195, in its view, would apply only if payments are made from a resident to another non-resident and not between two non-residents situated outside India. Further, Justice K.S. Radhakrishnan has even noted in his judgment that Section 195 has no extra territorial operation. This has come as a huge sigh of relief for various non-residents who make offshore payments, on which the Indian tax department intends to impose withholding obligations, and consequently a plethora of litigation is pending in this genre.

‘Look at’ instead of ‘Look through’

This Supreme Court verdict has provided a principle for interpretation that one has to 'look at' a transaction rather than 'look through' when it is a legitimate one. The Apex Court has upheld that the form of the transaction would prevail, barring only cases which involve sham transactions, artificial devices or frauds.

The Supreme has laid down that every strategic foreign direct investment coming into India should be seen in a holistic manner. The Indian tax department cannot start with the question as to whether the transaction is a tax deferment/colorable device. In doing so the following key ‘look at’ factors are pronounced in the judgment:

a. Concept of participation in investment;

b. The duration of time during which the holding structure exists;

c. The period of business operations in India;

d. The generation of taxable revenues in India;

e. The timing of the exit; and

f. The continuity of business on such exit.

The Supreme Court has further laid down that the onus will be on the Indian tax department to identify the whether the transaction undertaken is a tax deferment/saving/colorable device.

The Supreme Court stated that proposed DTC expressly covers indirect transfer of capital asset. In absence of specific provision in the current Indian Income-tax Act or treaty, the Courts can not apply ‘look through’ approach or invoke principle of Limitation of Benefits (‘LOB’), as LOB cannot be imposed or read into the law.

In this verdict, the Apex Court has conjugated the economic and legal realities and ruled that a corporate structure which has been accepted for years for all other purposes should not be dissected at the time of sale; solely for tax purposes. Due to this analogy, the verdict would prove to have significance even outside the realm of taxation laws.

Tax planning vs. Tax evasion

The Supreme Court has also shown respect for holding company structures which have been in place for a length of time and have not been created merely for the purposes of exit. The Indian tax department had contended that the decision in the case of Azadi Bachao Andolan[1] would need to be reconsidered in so far as tax evasion was concerned as it had departed from the principles laid down in the case of McDowell[2].

The Supreme Court has noted that the McDowell ruling also acknowledges that tax planning would be legitimate when it is within the four corners of law. The Apex Court has pronounced that there is no conflict between Azadi Bachao Andolan and McDowell as regards tax evasion and hence no consideration by a larger bench is required.

The Supreme Court upholding the principle laid down in the case of Azadi Bachao Andolan on the much debated issue of tax planning vs. tax evasion should hopefully give direction to the Indian tax department; who have been attempting to lift the corporate veil to examine the substance of the transaction in several cases. 

Supreme Court on certainty in tax matters

Lastly, the Supreme Court has sent out a very clear message to the legislators and the Indian tax department – to legislate and bring conclusive clarity in tax matters. It has stated that certainty is integral to rule of law; and this judgment emphasizes the need to provide certainty to foreign investors at the time of entry into India, in so far as taxation is concerned. The Apex Court has stated that certainty and stability form the basic foundation of any fiscal system. Tax policy certainty is crucial for tax payers (including foreign investors) to make rational economic choices in the most efficient manner.

After this verdict, the Indian tax department would have to reflect upon themselves and take a policy decision. The law as it stands today does not permit taxation of such transaction and hence Vodafone ought not to have been taxed; and if the same is intended to be taxed, it would have to be only by means of specific provisions in the legislature, after considering the impact such legislation would have on foreign investments.

How would the Revenue react?

Now the final mystery is – what would be the reaction by Revenue? There is a lot of speculation around whether there would be a retrospective amendment or would there be a curative recourse. We believe that legislative amendments, if any, ought to be made with prospective effect to ensure that the certainty and stability sought to be provided by the Hon’ble Supreme Court through this judgment is not disregarded.

Conclusion and way forward

The judicial principles laid down in this mammoth judgment would constitute the foundation of jurisprudence and tax planning in the years to come.  However, there is a lot of speculation on whether the upcoming Budget would mark the dawn of certain key clauses of the proposed DTC like Controlled Foreign Corporation (‘CFC’), indirect transfers, Place of Effective Management (‘POEM’) and General Anti-Avoidance Rules (‘GAAR’) by way of major amendments.

In our humble view, the tax regulators should accept this judgment gracefully and accordingly legislate to ensure that the sanctity of the Supreme Court is endorsed. Whether the Indian tax department now respects the spirit of this Apex Court decision, or decides to create some waves by legislative amendments in the forthcoming budget, is a matter only time would tell.

All-in-all, we can conclude that the Supreme Court has affirmed that sound tax planning, which is within the four corners of the law, never goes out of fashion. This masterpiece of Indian Judiciary should however not be seen as defeat of the Indian tax department; because it is indeed the victory of the justice! Maybe that’s what makes the Vodafone Verdict ‘Breaking News’!

Over the years there has been a constant debate over the issue of tax avoidance which could be said to transact between “substance over form” of a transaction. Determining whether the affairs planned by the taxpayer was legitimate enough to be strictly within the four corners of law or was a colorable device or a dubious method entered into with a purpose to minimize tax incidence has always been contentious. 

The Supreme Court (SC) in Azadi Bachhao had reiterated the principles as laid out in Duke of Westminster case by indicating that the same had acquired judicial benediction of the Constitutional Bench in India, notwithstanding the temporary turbulence created in the wake of McDowell’s case. the Supreme Court (SC) in Azadi Bachhao reiterated the principles as laid out in Duke of Westminster case by indicating that it was unable to read or comprehend the majority judgment in McDowell. The SC in Vodafone held that there was no conflict between in Azadi Bachhao and McDowell cases relating to treaty shopping and/or tax avoidance. The SC explained this in two pronged approach. 

• Firstly that the ruling in Ramsay did not discard the principle in Westminster, in that it laid down the principle of statutory interpretation rather than an over-arching anti-avoidance doctrine imposed upon tax laws(as even interpreted by latter rulings rendered by UK Courts). Further, the SC, stated that ruling in Ramsay “held that Westminster did not compel the court to ‘look at’ at document or a transaction, isolated from the context to which it properly belonged.”
• Secondly, the SC reading para 45 of the majority judgment in McDowell stated that the term “aspect” referred to therein was in relation to “tax evasion through the use of colourable devices and by resorting to dubious methods and subterfuges” and hence that all tax planning cannot be said to be illegal/ illegitimate/ impermissible.

While dealing with Substance over form principle the Supreme Court laid down certain important principles on Holding- Subsidiary relation and economic substance.

Holding and Subsidiary relation

The Supreme Court in this ruling almost accepted the position of Holding Company and Subsidiary Company structures and ruled that subsidiary company can be considered to be part of Holding company only if subsidiary company functions like a puppet. The power to appoint Directors or guiding the affairs of the subsidiary does not make the subsidiary company as part of holding company. Considering the same, the SC laid out principle that “dissecting approach” is not the approach to be adopted while dealing with Holding and Subsidiary relation but a more “look at” approach should be considered. In this context Supreme Court made a distinction between “having the power”: and “persuasive position”.

In the context of International Holding company structures the observations of Justice Radhakrishnan is relevant. The observations of Justice Radhakrishan in the context of India-Mauritius treaty is a clear pointer towards the acceptance of holding company structures in the International Investment arena. In the context of the Mauritian Treaty it was observed that to state that the Indo-Mauritian Treaty would recognize FDI and FII only if it originates from Mauritius, not the investors from third countries, incorporating company in Mauritius, is pitching it too high. Further it would also be relevant to note Justice K.S. Radhakrishnan’s observation that in the absence of LOB Clause and the presence of Circular No. 789 of 2000 and TRC certificate, on the residence and beneficial interest/ownership, the revenue authorities cannot at the time of sale/disinvestment/exit from such FDI, deny benefits to such Mauritius companies of the Treaty by stating “that FDI was only routed through a Mauritius company, by a company/principal resident in a third country; or the Mauritius company had received all its funds from a foreign principal/company; or the Mauritius subsidiary is controlled/managed by the Foreign Principal; or the Mauritius company had no assets or business other than holding the investment/shares in the Indian company; or the Foreign Principal/100% shareholder of Mauritius.”  However, in the context of the TRC certificate the Learned judge elaborated that such a certificate though can be accepted as a conclusive evidence for accepting status of residents as well as beneficial ownership for applying the tax treaty, it can be ignored if the treaty is abused for the fraudulent purpose of evasion of tax. This could be seen as explaining that the challenge, if any to a holding Co structure could be at the threshold and not subsequently.

Substance over form in the context of Tax Planning transactions

The Supreme Court made an all the more important observation that they are concerned with the Anti-Avoidance rules and not the issue of treaty shopping. In that context the SC stated that the approach for examining a transaction would be to ‘look at’ the transaction. In the case of foreign direct investment it should be seen in an holistic manner considering the concept of participation, the duration of time for which the holding structure exists; the period of business operations in India; the generation of taxable revenues in India; the timing of the exit and the continuity of the business on such exit. The Supreme Court also observed that “the onus will be on the revenue to identify the scheme and its dominant purpose. The Stronger the evidence of a device, the stronger corporate business purpose.

Thus, considering all the parameters of participation, the court need not go into the questions such as de facto control v. legal control, legal rights v. practical rights, etc. Thus while enumerating some examples wherein the doctrine of ‘substance over form’ could be invoked the SC has also outlined the methodology and indicative factors for invoking the doctrine. Further in the context of tax planning, the Supreme Court observed the following principles: 

• It is the task of revenue to ascertain the legal nature of transaction and while doing so it has to look at the entire transaction as a whole and not to adopt a dissecting approach.
• The revenue cannot start with the question as to whether the impugned transaction is a tax deferment or saving device but it should apply the “look at” test to ascertain the true legal nature of the transaction.

The principles laid down by SC as observed gives priority to legal form of the transaction and Supreme Court concluded that in application of judicial anti-avoidance rule, the revenue may invoke the “substance over form “principle or “piercing the corporate veil” principle only after it is able to establish on the basis of the facts and surrounding the transaction that the impugned transaction is a sham or tax avoidant. The observations of Supreme Court in the context of Anti-Avoidance is also in line with Canada Supreme Court ruling on GAAR.

Conclusion

The discussion paper on Direct Taxes Code 2009 equating tax avoidance to tax evasion indicates that “ tax  avoidance like tax evasion, certainly requires reconsideration in view of the Supreme Court ruling. Till such time, considering the views expressed by the SC, it seems that the Courts would rather apply the statute to the facts, and not take a realistic view of the facts (other than those which could fall under the parameters as indicated by the SC). Hence, the ability of the Courts tore-characterize transactions could be limited, subject to evidence to the contrary which would lead to invoking the final nullity test.

This article is written by K.R.Sekar, Deloitte Haskins & Sells and Kanwal Gupta, Deloitte Consulting

As the Hon’ble Supreme Court (‘SC’), set itself to writing its judgment in the Vodafone case, the tax pandits and professional all over the world were waiting expectantly on how the SC would rule in relation to three abiding  tax controversies:-

 I.  The issue of substance over form

II.  The issue of whether a strict or a purposive interpretation of taxing provisions (particularly       the charging provisions) is the correct on interpretational approach

III. The definition of the line between ‘tax planning’ an ‘tax avoidance’

The SC has in its seminal judgement in the Vodafone case offered clarity and ongoing guidance as to all three of the aforesaid issues.  

‘Look at’, not ‘through’: ‘Investment to participate’ or ‘pre-ordained transactions’

The SC has on its consideration of the ‘look at’ versus the ‘look through’ doctrine held “If government intends to tax such transaction, it must be reflected clearly in the provisions and tax treaties. It is important for the tax administration, as well as the Courts, to ‘look at’ the legal nature of the transaction, in its entirety and holistically."

The SC’s judgement in Vodafone is a ruling that will be closely considered, if not followed, in the development of global tax jurisprudence and policy. It is therefore relevant to reflect on the policy and precedents globally on the issues of ‘form’ vis-a-vis ‘substance’ and ‘tax planning’ vis-a-vis ‘tax avoidance’. Much of the approach globally, especially in OECD countries like Australia, Belgium, Canada, New Zealand and Spain, has been to frame anti-avoidance rules of varying degrees of specificity and intensity. Probably the strongest statutory anti-avoidance rule being paragraph 42 of the German Tax Code under which legal constructions that are inappropriate to achieving the economic result sought by the taxpayer can be disregarded for tax purposes. The United States has probably the greatest contemplation of economic and legal variable in the framing of its anti-avoidance doctrines to cover substance over form, step transaction, business purpose, sham transaction, and economic substance. The French courts have developed the doctrine of ‘abnormal management act’ under which transactions that deviate from what a prudent businessperson would do, can be disregarded for tax purposes.  An alternative anti-avoidance provision in France is L64 of the Tax Code which can be interpreted to cover both simulation and abuse of right. In the Netherlands, the rule of fraus legis (meaning a fraud upon law) is essentially similar to Germany’s paragraph 42 of German Tax Code with the essential difference that fraus legis is a judicially evolved doctrine and is not statutory prescription.

In UK, the law has evolved beyond the initial approach in Inland Revenue Commissioners v. Duke of Westminster, ([1936] A.C. 1, at pp. 19c20), where it was stated “Every man is entitled if he can to order his affairs so as that the tax attaching under the appropriate Acts is less than it otherwise would be. If he succeeds in ordering them so as to secure this result, then, however unappreciative the Commissioners of Inland Revenue or his fellow taxpayers may be of his ingenuity, he cannot be compelled to pay an increased tax”. More recent judgements have toned down the carte blanche offered under Duke of Westminster (supra). A more purposive interpretation has been seen in more recent judgement like in Bayfine UK vs HMRC ([2011] STC 717).

The SC has drawn the central thought in relation to any anti-avoidance approach and fused that approach with a dose of commercial and common sense, to articulate the distinction between ‘investment transactions for participation’ and ‘pre-ordained transaction for tax evasion’. The SC has cautioned against looking at transactions with undue suspicion, as also, against dissecting a transaction rather than looking at it holistically.  The SC has prescribed the following indices to help distinguish between an investment for participation and a pre-ordained transaction:

1)             The concept of participation in investment;

2)             The duration of time during which the Holding Structure exists;

3)             The period of business operations in India;

4)             The generation of taxable revenues in India; the timing of the exit;

5)             The continuity of business on such exit.

The five indices aforesaid would normally offer a good guidance in relation to the object or purpose of any investment transaction which is being examined to determine its intent.  Some may observe that there could have been a longer and more specific list. The indices set out will also be severely tested in the factual framework of transactional ingenuity. The indices however undeniably provide a robust commercial benchmark to help distinguish between a genuine investment transaction and a transaction actuated only with a intent to tax evasion.  As with any set of indices and benchmarks their abiding relevance will be determined in equal measure by how the tax regulator and the assessee embrace both, the letter and spirit of the Vodafone judgement.

The SC has managed to draw a fine balance between earlier SC decision in Gujarat State Financial vs M/S. Natson Manufacturing Co. (P) (1978 AIR 1765) which held that in a taxing statute the strict legal position as disclosed by the form and not the substance of the transaction is determinative of its taxability, and approach in the McDowell and Co. Ltd. v. CTO [(1985) 3 SCC 230] which led to the almost paranoiac mindset that every investment through a subsidiary or a SPV, which attracted a tax lower than the highest tax applicable, was a scheme of tax avoidance.  The SC, in holding that every transaction which is an investment to participate must be ‘looked at’ rather than ‘looked through’ - even if there are some related tax benefits, has offered definitive guidance  into the future on the entire ‘substance’ versus ‘form’ and ‘tax planning’ vis-a-vis ‘tax avoidance’ debate.

Interpretation of taxing statues - Strict interpretation versus purposive interpretation

The concept of literal interpretation of tax statues is not a new concept in the Indian jurisprudence.  Over a period of time, the Courts in India have evolved two primary principles for interpretation of Tax Statutes:

• Literal/ strict interpretation of the statues
• If the interpretation of a fiscal enactment is open to doubt, the construction beneficial or favourable to the assessee must be adopted

In A. V. Fernandes v State of Kerala (AIR 1957 SC 657), the Supreme Court stated the principle that if the revenue satisfies the court that t he case falls strictly within the provisions of the law, the subject can be taxed. If, on the other hand, the case does not fall within the four corners of the provisions of the taxing statute, no tax can be imposed by inference or by analogy or by trying to probe into the intentions of the Legislature and by considering what was the substance of the matter.  Similarly, in Innamuri Gopalam and others v State of A. P. (1964 2 SCR 888), the Supreme Court held that "In construing a statutory provision the first and foremost rule of construction is the literary construction. All that the court has to see at the very outset is what does the provision say. If the provision is unambiguous and if from the provision the legislative intent is clear, the court need not call into aid the other rules of construction of statutes. The other rules of construction are called into aid only when the legislative intent is not clear."

In C.I.T. v Madho Pd. Jatia (SC) (105 ITR 179) the Supreme Court held that If the provisions of a taxing statute are clear and unambiguous, full effect must be given to them irrespective of any consideration of equity. Where, however, the provisions are couched in language which is not free from ambiguity and admits of two interpretations a view which is favourable to the subject should be adopted. In State of Punjab v Jullundar Vegetables Syndicate,( 1966 SCR (2) 457), the Supreme Court observed that unless there is a specific provision for making an assessment, a taxing statute cannot be interpreted to widen its scope against the assessee; but on the contrary has to be so interpreted as to benefit the tax-payer. In the case of CIT vs. N.C.Budharaja & Co. (204 ITR 412), the Supreme Court held that “Liberal interpretation of an incentive provision should not do violence to plain language. The object of an enactment should be gathered from a reasonable interpretation of the language used therein. A liberal interpretation of a taxing provision cannot be adopted on the plea that this would advance the purported object of the Act”

The principle of strict interpretation has been given full play by the SC in its reading of charging provision in the Income Tax Act, 1961. The SC has held that Section 5 and Section 9 cannot be extended to cover indirect transfers of capital assets or property situated in India. The SC has held that the absent a specific taxing provision for indirect transfers such as in the Direct Tax Code (DTC) Bill 2010, Section 9 of cannot be extrapolated.

Global jurisprudence is in some instances leaning towards a more purposive interpretation rather than following the strict interpretation doctrine, as evidenced recently in the UK in Bayfine UK vs HMRC (supra).  

From an Indian perspective, the onus has rightly been left to the Legislature to articulate in its collective wisdom what it intends to tax in clear and unambiguous language.  There are no constraints on the will of Legislature other than those imposed by the Constitution of India. However, in terms of the SC in Vodafone judgement, absent a clear statutory provision to tax, no tax would normally be imposable on the adoption of any so called purposive interpretation of the legislative provisions.

Conclusion

The wisdom of SC in Vodafone judgement will be repeatedly tested on the threshold of commercial complexity and ingenuity. It will also be tested on the threshold of the interpretative ingenuity of tax administrator, whom the SC has invested with the onus of distinguishing between genuine investments of participation and pre-ordained transactions for evasion. 

We will surely reengage with these controversies in the future. The SC has, however, done its best to reduce the scope of future controversies.

This article is written by Rohan Shah & Bharath M., Economic Law Practice.