Curious conclusion

Print edition : March 23, 2012

AT A VODAFONE store in Agartala in Tripura. The emphasis on creating a corporate-friendly climate has resulted in a permissive environment, eroding the state's capacity to discipline private capital.-JAYANTA DEY/REUTERS

The Vodafone judgment upholds the principle of maintaining a sharp separation between companies and their shareholders.

THE ramifications of the Supreme Court verdict in the Vodafone case could be much wider than what is obvious at first sight, with implications not just for taxation but for the much broader issue of corporate regulation in general. In order to appreciate this, it is necessary to set the premises used by the court to arrive at the conclusion that the demand imposed by the tax authorities on Vodafone was illegitimate against some of the realities of the Indian corporate sector. These premises are not necessarily crystal clear in the judgment, but that only makes it more amenable to interpretations of the kind that are highlighted here.

The substantive facts of the Vodafone-Hutch transaction that even though it was an offshore transaction, its ultimate purpose as well as result was the transfer of control over a company, now called Vodafone Essar Limited (VEL), which was registered in India, which owned capital assets located in India and whose business was in India are well known and the parties concerned never made a secret of it. The Supreme Court judgment, too, does not dispute these substantive facts.

By denying the legal significance of some crucial facts, however, the court has concluded that the provisions of the Income Tax Act, according to which income arising from the transfer of capital assets located in India would be deemed to be income originating in India and be subject to capital gains tax, were not applicable to the Vodafone-Hutch transaction.

To arrive at this conclusion the judgment appears to have relied on not one but two different premises, though both have a common underlying basis. Either of these, if correct, would be sufficient for the court's conclusion to be valid. It is their correctness, however, that needs to be scrutinised with reference to their larger implications and not only in relation to the particular case at hand.

The first premise was that the transaction between Vodafone and Hutch was a share transfer (sale) rather than a transfer of capital assets and that the ownership of the capital assets remained vested in the Indian company. The judgment took recourse to the legal distinction between a company and its shareholders and the fact that the de facto controlling right enjoyed by those holding a large block of shares in a company is not in the nature of a legally enforceable right. The judgment, however, carries these to the point where it ended up ignoring the real distinction between a shareholding that constituted a controlling interest and that which was a pure financial investment.

It is entirely immaterial here that the share(s) actually transferred were not of the company located in India but of offshore companies that ultimately controlled the shares that constituted the controlling interest in the Indian company. Even if the shares were of the company located in India, in the court's view it would not constitute a transfer of capital assets.

Once it is accepted that the shareholders of a company have a distinct legal identity from the company, no matter what the proportion of shares that they hold is, it follows that two companies would have distinct identities even if one held a controlling share in the other. The Supreme Court judgment makes it a point to emphasise that even a subsidiary has an identity distinct from its parent holding company. Stretched so far, this argument must mean that the law be blind to the essential connection linking the offshore transaction between Vodafone and Hutch and the company located in India.

This connection existed because what was sold to Vodafone was the company at the apex of a structure of holding and subsidiary companies located abroad, through which more than half the shareholding of the company in India was ultimately controlled. The denial of any legal significance of this chain of holdings underlies the second premise of the Supreme Court's verdict, namely that nothing located in India changed hands as a result of the Hutch-Vodafone transaction. In the court's view, since the asset (share) actually transferred had a foreign location it was outside the jurisdiction of Indian tax authorities.

To arrive at the judgment, the Supreme Court had to find a way around the 1985 judgment of the same court in the McDowell case, which upheld the principle of going behind the corporate veil to thwart illegitimate tax avoidance. The way in which the Vodafone judgment achieves this appears in effect to be a case of applying a particular logic only in order to deny its applicability in the same breath.

What the judgment argues is that such going behind the corporate veil or looking through would be legitimate only in cases where it can be established that there is a deliberate intention of evading taxes. In the Supreme Court's view no such conclusion was warranted in this case if the steps that led to the creation of the complex holding structure of VEL and the eventual Vodafone-Hutch transaction were seen in their proper context. The paradoxical result of this reasoning is the following once the legality of the structure has been established, its existence cannot be recognised! The conclusion that counts, according to the Supreme Court, is that the structuring of the transfer of control from Hutch to Vodafone was not done in a particular way with the intention of avoiding taxes. Since, therefore, the corporate veil cannot be pierced, the fact that there was a transfer of control from Hutch to Vodafone must be ignored. An additional implication would be that as long as it can be established that a mechanism was not originally created with the intention of avoiding taxes, it does not matter if it eventually has such a result.

The Supreme Court judgment in the Vodafone case has thus upheld the principles of maintaining a very sharp separation between companies and between companies and their shareholders and laid down very stringent standards for determining when these fine legal distinctions can be overlooked in favour of a more realistic approach. It is this that makes the judgment, given the realities of the Indian corporate sector, amenable to be used for undermining the much-needed regulation of that sector. It is not surprising, therefore, that it has been welcomed so heartily in corporate circles.

Lack of enforcement has long been a feature of corporate regulation in India, and tax evasion is only one expression of this larger phenomenon. Apart from undertaking actions that are purely illegal, finding and using legal loopholes to circumvent or manipulate regulations and defeat their purpose has been an entrenched feature of corporate culture in India. Aiding in the subversion of regulation has been a second important feature of the Indian corporate sector, which also has a long history. This is the prevalence of multi-company structures whereby a common control is exercised over a number of legally separate companies, often taking advantage of the right of these companies to own each other's shares. The deliberate creation of such structures and undertaking business activities through them rather than single companies, sometimes precisely to bypass regulations, has been the pattern in India.

Multi-company structures and corporate malpractices have gone together in many different ways other than in the case of tax evasion. For instance, in an earlier era, Indian business groups used multiple companies to try and corner licences in individual industries. Indian and foreign firms also used separate companies controlled by them to get around the reservation of some sectors for small-scale industries.

The diversion of funds raised from financial institutions or capital markets through one company with a particular activity to other group companies with different activities has been quite regularly practised in the Indian corporate sector. Insider trading or share-price rigging through companies legally independent of the companies whose shares were being transacted is also known to have happened. Such examples can be multiplied. The ones cited are, however, sufficient to establish that for proper regulatory enforcement the legal recognition of the common identity binding legally independent companies, derived from the fact that they are controlled by the same actors, is crucial. This has never been easy the explicit provisions for such recognition that once existed in the Monopolies and Restrictive Trade Practices (MRTP) Act, 1969, were themselves circumvented in ingenious ways by business firms in India. The Supreme Court judgment in the Vodafone case makes it even more difficult.

Even before the Vodafone verdict, the liberalisation measures since the early 1990s have contributed to weakening corporate regulation. Liberalisation has not meant the end of all regulation. The emphasis on creating a corporate-friendly climate has, however, resulted in a more permissive environment, further eroding the state's capacity to discipline private capital. At the same time, restrictions on the use of multi-company structures that flowed from the earlier anti-monopoly laws have been withdrawn. These have happened alongside the opening up of the economy and increasing cross-border transactions.

One consequence is that multi-company structures have increasingly come to include within themselves offshore corporate entities, many registered in tax havens. Indian affiliates of foreign multinational firms, of course, always had cross-border connections with corporate entities registered elsewhere, but these have now become common even in the case of Indian firms. In other words, the scope for using multi-company structures spread across many jurisdictions to get around regulations in India has increased.

If the Vodafone verdict is seen in such a context, then the need to invalidate its serious implications becomes even more pressing.

Whether the undoing of the major repercussions of the Vodafone verdict will result through the Income Tax Department's successfully appealing for a review of the judgment remains to be seen. If it does not, and perhaps even if it does, an appropriate legislative response may be necessary. It is not, however, sufficient for legislation to merely explicitly provide for taxing capital gains arising from transactions of the Hutch-Vodafone kind. What is required is the opening up of the web of connections between myriad corporate entities spread across a variety of jurisdictions to legal scrutiny and recognition of the purposes for which they exist.

Surajit Mazumdar is an Associate Professor of Economics at Ambedkar University, New Delhi.

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