The tax aviodance debate

Print edition : March 23, 2012

The Supreme Court judgment in the Vodafone case, which has come under scrutiny, brings to the fore the issue of tax avoidance.

in New Delhi

Installing the Vodafone logo at the company's office in Mumbai in September 2007, after the deal with Hutchison Essar was completed.-PTI

We now live in a welfare state whose financial needs, if backed by the law, have to be respected and met. We must recognise that there is behind taxation laws as much moral sanction as behind any other welfare legislation and it is a pretence to say that avoidance of taxation is not unethical and that it stands on no less moral plane than honest payment of taxation.... It is neither fair nor desirable to expect the legislature to intervene and take care of every device and scheme to avoid taxation. It is up to the court to take stock to determine the nature of the new and sophisticated legal devices to avoid tax and... to avoid the devices for what they really are and to refuse to give judicial benediction.

Supreme Court Judge O. Chinnappa Reddy in McDowell and Company Limited vs Commercial Tax Officer (1985).

TAX revenues are an indispensable source of funding a government's development initiatives in an era in which governments often lament the lack of resources to secure for all citizens the right to an adequate means of livelihood and to minimise the inequalities in income.

Therefore, when individuals and companies resort to the use of illegitimate devices to avoid tax and find the political and legal climate conducive to that, it ought to arouse the nation's social conscience if only because plugging loopholes in tax collection cannot be left entirely to the executive and the legislature.

When the government understands its commitment to collect legitimate taxes but is not successful in convincing the judiciary to endorse it, it should mean a serious institutional failure on the part of the judiciary to safeguard the constitutional philosophy.

The Supreme Court's judgment in the Vodafone case, delivered on January 20, is an instance of such failure. Put simply, here was an unprecedented tax demand by the income tax authorities on Vodafone (to the tune of Rs.11,000 crore), on the basis of an equally unprecedented transaction between Vodafone and Hutch, with a clear nexus to the sale of the latter's assets in India.

As happens in any case, two legal views are certainly possible over whether the Indian tax authorities have jurisdiction to tax Vodafone for the transaction. The Bombay High Court had ruled in 2010 that the Income Tax Department had jurisdiction to tax Vodafone. The Supreme Court's judgment on January 20 set that aside, giving huge relief to Vodafone. The question being asked in legal circles is, if two equally valid but conflicting legal interpretations are possible, why not adopt the one that could help the government earn the requisite tax revenues rather than the one that has the potential to weaken governance and leave the citizens to the mercy of market forces.

It is possible to suggest, as some tax lawyers who defend Vodafone have done, that the law does not change if the tax demand is a large amount. But in the same breath, some of them suggest that if the Vodafone case had a tax implication of just Rs.10 crore, the case would have been over before the Income Tax Appellate Tribunal itself and would not have engaged the valuable time of the High Court and the Supreme Court.

It is precisely for this reason that it needs to be asked why Vodafone did not first approach the Tribunal for redress. As the stakes are high, both the transaction and the manner in which the judiciary understood and interpreted the issue are bound to come under intense scrutiny. And because it has huge implications (and possible setbacks for the I.T. Department in future) for similar tax demands involving foreign transactions with nexus to India, experts anticipate revenue losses to the Central government running into more than Rs.1 lakh crore.

This is not to suggest that the Supreme Court's judgment is scandalous; far from it. The government's advocates who argued the case before the Supreme Court and independent lawyers like Prashant Bhushan have refrained from calling it so. By convention, apex court rulings carry huge respect even among those disagreeing with them. Yet, it is essential to subject the Supreme Court's judgment to serious and well-informed criticism if only to prepare the ground for its review.

Put in this context, Justice O. Chinnappa Reddy's observations in the McDowell case, quoted above delivered six years before the beginning of the era of liberalisation and economic reforms in 1991 are prescient. Clearly, Justice Chinnappa Reddy envisaged a proactive role for the judiciary to see through the fraudulent tax avoidance devices employed by taxpayers at the cost of social justice.

Now in his nineties, Justice Chinnappa Reddy must be ruing the manner in which the Supreme Court misinterpreted twice (the first time in 2003 in the Azadi Bachao case and now in the Vodafone case) in the past 10 years his holding on how the court should be smart enough to expose the legal devices that companies adopt to avoid paying tax.

Justice Chinnappa Reddy was judge of the Supreme Court from 1978 to 1987, and was among the most distinguished members of the judiciary. His decision in the McDowell case was one of the most admired judgments on tax evasion.

McDowell was a licensed manufacturer of liquor in Hyderabad. The company had failed to disclose the excise duty paid on liquor sold by it to wholesalers. The taxing authority, through a notice, called upon the company to show cause why assessments made should not be reopened. The company challenged the validity of this notice and argued that the excise duty paid by the buyer did not become a part of the company's turnover.

The five-judge Constitution Bench dismissed McDowell's appeal through two judgments: one by four judges and another concurring, detailed and separate judgment by Justice Chinnappa Reddy.

Justice Ranganath Misra, on behalf of himself and three other judges on the Bench, namely, Chief Justice Y.V. Chandrachud and Justices D.A. Desai, and E.S. Venkataramiah, held as follows:

Tax planning may be legitimate provided it is within the framework of law. Colourable devices cannot be part of tax planning and it is wrong to encourage or entertain the belief that it is honourable to avoid the payment of tax by resorting to dubious methods. It is the obligation of every citizen to pay the taxes honestly without resorting to subterfuges.

Following this holding, the Bench said in Paragraph 27:

FEBRUARY 14, 2007: Vodafone chief executive officer Arun Sarin, right, and Hutchison Essar CEO Asim Ghosh at a press conference in New Delhi after Britain's Vodafone Group PLC had agreed to buy a 67 per cent controlling interest in Hutchison Essar Ltd for $11.1 billion.-GURINDER OSAN/AP

On this aspect one of us, Chinnappa Reddy, J., has proposed a separate and detailed opinion with which we agree.

The above sentence became the bone of contention in arriving at the ratio of the McDowell case. Did the four judges agree entirely with Justice Chinnappa Reddy, or only with regard to his observations against the use of colourable devices to avoid payment of tax? The Supreme Court has held in the Vodafone case that the ratio of McDowell is that the four judges agreed with Justice Chinnappa Reddy only in the context of use of colourable devices to avoid payment of tax. Justice Chinnappa Reddy, however, in his separate opinion, has clearly underlined the need to depart from the Westminster principle and tax avoidance.

According to this British principle (laid down in Inland Revenue Commissioners vs Duke of Westminster, 1936), every man is entitled if he can to order his affairs so as to diminish the burden of tax. Justice Chinnappa Reddy held that the principle of Westminster had been given a decent burial and in that very country where the phrase tax avoidance' originated, the judicial attitude towards tax avoidance had changed and the smile, cynical or even affectionate though it might have been at one time, had now frozen into a deep frown. No one could now get away with a tax avoidance project with the mere statement that there was nothing illegal about it, he had said.

In the Vodafone case decided by the Supreme Court's three-judge Bench on January 20, the McDowell ghost returned to haunt the judiciary. The Bench comprised of Chief Justice of India S.H. Kapadia and Justices Swatanter Kumar and K.S. Radhakrishnan. In two separate judgments (Chief Justice Kapadia and Justice Swatanter Kumar delivering one and Justice Radhakrishnan authoring the second), the Bench set aside the Bombay High Court judgment in the Vodafone case.

Briefly, the case concerns a tax dispute between the Vodafone Group and the Income Tax Department (hereafter referred to as Revenue) over the acquisition by Vodafone International Holdings BV (VIH), a company resident for tax purposes in the Netherlands, of the entire share capital of CGP Investments (Holdings) Ltd. (CGP), a company resident for tax purposes in the Cayman Islands on February 11, 2007.

According to Revenue, the aim of this transaction was to acquire 67 per cent controlling interest in Hutchison Essar Limited (HEL), a company resident in India. Revenue, therefore, sought to tax capital gains, arising from the sale of the share capital of CGP on the basis that CGP, while not a tax resident in India, holds the underlying Indian assets. The tax demand was a whopping Rs.11.000 crore.

VIH, on the contrary, argued that it acquired companies which, in turn, controlled a 67 per cent interest but not controlling interest, in HEL. Further, VIH contended that CGP held indirectly through other companies 52 per cent shareholding interest in HEL as well as Options to acquire a further 15 per cent shareholding interest in HEL, subject to relaxation of foreign direct investment (FDI) norms.

High Court verdict

The Bombay High Court Bench comprising Justices Dr D.Y. Chandrachud and J.P. Devadhar on September 8, 2010, upheld the Central government's contention that the Vodafone-Hutch transaction had a significant nexus with India. Once the nexus is established, income tax may extend to that person in respect of his foreign income, the Bench said. Such a nexus can be based on residence or business connection within the taxing state or the situation within the state of an asset or source of income from which the taxable income is derived, the Bench explained.

Even though the revenue laws of a country may not be enforceable in another, that does not imply that the courts of a country shall not enforce the law against the residents of another within their own territories, the High Court Bench held.

While concluding so, the High Court simply relied on the perception of Hutchison Telecommunication International Ltd. (HTIL), Cayman Islands, which had its shareholdings in HEL in terms of HTIL's Annual Report for 2007. The High Court found that for HTIL the transaction represented a discontinuation of its operations in India (paragraph 123).

In paragraph 124, the High Court went into the nature of the transaction from the perspective of how VIH BV looked at the events that led to the sale-purchase agreement dated February 11, 2007. The Bench then went on to analyse the relevant documents.

In paragraph 132, it concluded that it would be simplistic to assume that the entire transaction between HTIL and VIH BV was fulfilled merely upon the transfer of a single share of CGP in the Cayman Islands. The commercial and business understanding between the parties postulated that what was being transferred from HTIL to VIH BV was the controlling interest in HEL. HEL was at all times intended to be the target company and a transfer of the controlling interest in HEL was the purpose which was achieved by the transaction, the Bench noted.

More important, the High Court Bench also relied on the due diligence report of Ernst & Young to emphasise that the object and intent of the parties was to achieve the transfer of control over HEL. The transfer of the solitary share of CGP, a Cayman Islands company, was put into place subsequently at the behest of HTIL as a mode of effectuating the goal.

In paragraph 134, the High Court was very specific: The transactional documents are not merely incidental or consequential to the transfer of the CGP share, but recognised independently the rights and entitlements of HTIL in relation to the Indian business which were being transferred to VIH BV.

In paragraph 135, the High Court further noted: The transaction between VIH BV and HTIL was a composite transaction which covered a complex web of structures and arrangements, not referable to the transfer of one share of an upstream overseas company alone. The transfer of that one share alone would not have been sufficient to consummate the transaction.

In the Supreme Court

Unfortunately, the Supreme Court found no merit in the High Court's findings. In order to rebut these findings, the Supreme Court resorted to an academic discussion on why this case concerns a share sale rather than an asset sale.

The Supreme Court's judgment favours a look at test in which Revenue looks at the entire Hutchison structure as it existed, holistically, and not adopt a dissecting approach. In other words, Revenue should not ask whether the transaction is a tax deferment/saving device, but apply the look at test to ascertain its true legal nature.

The court then stretched this look at test to be applied to every strategic FDI coming to India, as an investment destination, in a holistic manner. While doing so, it said, Revenue/courts should keep in mind six factors, namely, the concept of participation in investment; the duration of time during 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 business on such exit. The onus is on Revenue to identify the scheme and its dominant purpose, it said.

The Supreme Court frowned upon the High Court's look through test because, it claimed, it was inconsistent with tax policy certainty, which was crucial for taxpayers (including foreign investors) to make rational economic choices in the most efficient manner.

While examining the question whether the Supreme Court must have chosen the dissecting/look through test of the High Court rather than the look at test, a return to the question of the ratio of the McDowell judgment is imperative. Delivered as part of the five-judge Constitution Bench, Justice Chinnappa Reddy's separate but concurring judgment in that case must have been considered binding on Supreme Court Benches comprising fewer than five judges.

Azadi Bachao case

In 2003, in the Azadi Bachao Andolan case, a two-judge Bench of the Supreme Court upheld the government's appeal against the Delhi High Court judgment quashing Circular No.789 of April 13, 2000. This circular stated that the Mauritius Tax Residency Certificate issued by the Mauritius Tax Office was a sufficient evidence for accepting the status of residence and beneficial ownership for applying the Convention on the Avoidance of Double Taxation between India and Mauritius executed on April 1, 1983.

The then National Democratic Alliance (NDA) government had issued the circular because the tax authorities in India had issued notices to some shell companies incorporated in Mauritius with the purpose to invest funds in India. But these companies were controlled and managed from countries other than India and Mauritius. The circular was ostensibly aimed at instilling confidence among foreign investors who used the Mauritius route.

In the Vodafone case, the Central government submitted before the Supreme Court that the two-judge Bench wrongly decided the Azadi case. The government continues to insist that Circular No.789 is legally valid. But it is unhappy that the Bench in the Azadi case applied the McDowell ratio incorrectly while restoring the circular.

The McDowell ratio is that artificial tax avoidance devices must be brought within the tax net. Both the Azadi and Vodafone Benches of the Supreme Court, however, interpreted the ratio to mean that only colourable tax avoidance devices could be brought within the tax net. If the tax authorities try to prove precisely that a particular device is colourable by adopting a look through test, the effort fails as in the Vodafone case. Therefore, there is considerable force in the Central government's plea that the Supreme Court decided wrongly the Azadi and Vodafone cases by its flawed interpretation of the McDowell ratio. If a device is apparently meant to avoid tax, then it should be brought under the tax net no matter whether it is colourable or not.

There is one more reason to worry about the Supreme Court's judgment in the Vodafone case. The court has held that the offshore transaction is a bona fide structured FDI investment into India which fell outside India's territorial tax jurisdiction and was hence not taxable.

In its review petition filed before the Supreme Court, the Central government pointed out that the Vodafone transaction did not involve any inflow of monies into India because the sale consideration was paid outside India and therefore was not a case of FDI into India at all. The government has pointed out that the court failed to appreciate that the FDI policy of the Government of India was unrelated to the instant case because it did not involve any investment or inflow of money into India. The government made it clear that its FDI policy and the interpretation of taxation statutes operate in two different realms.

Whatever the outcome of this review petition in the Supreme Court, the Vodafone judgment, with its myriad aspects, will have a profound influence on Indian tax jurisprudence.

It makes sense to conclude with what Justice Chinnappa Reddy said in the McDowell judgment: There is the sense of injustice and inequality which tax avoidance arouses in the breasts of those who are unwilling or unable to profit by it. Last but not the least is the ethics (to be precise, the lack of it) of transferring the burden of tax liability to the shoulders of the guileless good citizens from those of artful dodgers'.

To the defenders of the Vodafone-Hutch deal, these observations of Justice Chinnappa Reddy may appear to be totally unnecessary to decide the facts of the McDowell case. To many, however, he had the foresight to anticipate that tax avoidance could take ingenious forms, and that it was unfair to accord it any legitimacy.

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