Don't shoot the interpreter

Print edition : March 23, 2012

MARTEN PIETERS, MANAGING director, Vodafone Essar Ltd after Vodafone launched its 3G service in Mumbai in October 2010.-SHASHI ASHIWAL

The Supreme Court judgment is a godsend for the government, which can now pretend that the court is responsible for a lax tax policy.

THE Supreme Court verdict quashing the Income Tax Department's claim on Vodafone in the Hutchison-Essar acquisition case is significant not just because of the Rs.11,200-crore loss of revenue implied in the case. It also paves the way for other foreign companies to exploit the interpretation of the law implied by the judgment to avoid tax payment on capital gains that accrue from the transfer of assets located in India. Given the sum involved in this case and likely to be involved in future instances, the loss is nothing but a national shame in a country whose government claims that there are inadequate resources to ensure food security, address deprivation and provide employment. Not surprisingly, the government is making it appear that it is the court, and not its own inclinations and policies, that is tying its hands.

In this it has been helped by the controversy surrounding the judgment, centred on the perception that the Bench has stretched itself in multiple directions when interpreting the law on what constitutes tax evasion. There is only one reason why investors would choose to locate the ultimate ownership of a company in a shell based in a country that is a tax haven or is a low-tax host that has a suitable tax treaty with the country in which operations are based. That is tax avoidance. This is what Hutchison had done when it located the ultimate ownership of its majority stake in Hutchison Essar Ltd (HEL) in a shell called CGP located in the Cayman Islands. CGP in turn was owned by Hutchison Telecommunications International (Cayman) Holdings, another Cayman Islands company. The issue was not whether this structure was adopted with the express intention of selling CGP in order to garner capital gains that would not be subject to taxation. It is enough if the intent was that in case Hutchison chose to sell at any point it should evade tax on capital gains.

Not surprisingly, when Hutchison did sell CGP to Vodafone Netherlands in 2007 for a sum of $11 billion, both companies acted as if the transaction was not subject to Indian tax law even though Vodafone was in essence acquiring an entity that earned its revenues from operations in India. If Vodafone believed that Indian tax law would apply, it would have withheld capital gains tax to hand over to the Indian authorities. Vodafone did not, because it was convinced and argued (subsequently) that the company's ownership was structured in a manner that the transaction did not fall under the jurisdiction of Indian tax law. The Indian tax authorities challenged that order on the grounds that the operations and revenues that underlie CGP's valuation occurred in India. In that sense this was not an unrelated transfer of CGP shares. It involved the transfer of the future revenue stream from the operations of HEL (renamed Vodafone-Essar). This was also supported by the fact that Vodafone had also acquired CGP's rights and entitlements' in HEL, involving elements such as the use of the Hutch brand, loan obligations, and the option to acquire an additional 15 per cent stakeholding in HEL. This too would have affected the valuation. The High Court upheld that view. The Supreme Court struck it down.

There are two ways in which this Supreme Court judgment has implicitly favoured entities that indulge in tax avoidance practices. First, it has held that if loopholes in the law, even if unintended, permit these entities to use such practices to avoid tax payments, and they indulge in legitimate tax planning, then they are not in violation of any code. Second, it has suggested that when assessing whether an entity is evading (not avoiding) the tax law, the authorities have to examine whether the means of evasion (which here, is the creation of CGP) was originally intended for this purpose. Since Hutchison made its investments and engaged in activities in India (in collaboration with Essar) for some time, and during that period CGP existed, the latter is not seen as primarily created to avoid capital gains.

For a court, the first of these positions seems warranted, inasmuch as it is for the executive to ensure that its laws do not have loopholes that result in tax avoidance. In the case of income, this requires ensuring that nothing in the law or in treaties signed between governments permits a company to avoid paying tax on income to the government of the country in which those receipts originate. In the case of capital gains the issue is more complicated. The government cannot prevent foreign investors from routing their investments through shell companies located in tax havens or in countries like Mauritius, with which India has signed a double taxation treaty. Any transfer of that shell company to another foreign owner outside the country would transfer the shares it owns in the entity holding and operating assets and deriving revenues in India.

The point then is to ensure that the transfer of share ownership of any entity operating in India, earning incomes from assets located in India, is subject to the tax laws applicable in this country. This would prevent any distinction between share sale and assets sale to be made. That would be fair because the value of the shares depend on the value of the assets that underlie them, and the value of those assets located in India depend, in turn, on the future profile of net revenues expected from the operation of those assets.

What the Supreme Court has done is declare that as the law stands, unless it can be shown that the investment and subsequent transfer was made with the express purpose of avoiding tax, this would also be a legitimate transaction. There may be some justification in declaring this to be an error on the part of the Supreme Court. But that error is in keeping with the tendency on the part of the government to propagate the view that the development effort (led by the executive) needs a special dispensation favouring foreign investors in this country.

The most obvious case of this tendency was the way in which the issue of the right of companies that had obtained a tax residence certificate in Mauritius to be exempt (ostensibly under the double taxation treaty with that country) from income tax in India was established. Many of these companies are not even originally registered in Mauritius and headquartered in that country. It was on that basis that the Income Tax Department had slapped taxes on those companies. But claiming that this would discourage foreign investment in the country, the then Finance Minister Yashwant Sinha reportedly ensured that the Central Board of Direct Taxes issued a circular saying that this was indeed acceptable. Clearly, the reading of both what the law should be and the law was different by those in the Tax Department and those responsible for fiscal policy in the Finance Ministry.

At that time, civil society activists challenged in the courts this interpretation of the law by the government. And that time, too, the High Court delivered a judgment that quashed the government's interpretation, which was subsequently reversed by the Supreme Court (Azadi Bachao Andolan case). To recall, the argument of the government was that it was adopting the position notified in the circular because that was necessary to attract foreign investment into the country. That is, attracting foreign investment using the tax concession route was an acceptable principle from the point of view of the executive. In essence the court was taking the position that it was up to the executive to ensure that the law on the matter was clear.

There have been other instances where the executive has very obviously favoured foreign investors on the capital gains front. For example, the Budget for 2003-04 stated: In order to give a further fillip to the capital markets, it is now proposed to exempt all listed equities that are acquired on or after March 1, 2003, and sold after the lapse of a year, or more, from the incidence of capital gains tax. Long-term capital gains tax will, therefore, not hereafter apply to such transactions. This proposal should facilitate investment in equities. Long-term capital gains tax was being levied at the rate of 10 per cent up to that point of time. The very next year, the Finance Minister of the United Progressive Alliance (UPA) government endorsed this move. In his 2004 Budget speech, P. Chidambaram announced his decision to abolish the tax on long-term capital gains from securities transactions altogether. These changes were geared to coaxing foreign institutional investors to invest more in India's stock markets. And they did, now that the Indian stock market was a tax haven.

Given this background, the ambiguity with regard to the right to tax capital gains accruing abroad on equity linked to assets located in India and earning revenues from the Indian market is understandable. The Finance Ministry, which does not mind giving tax concessions favouring foreign finance to attract investment into the country, would prefer that this ambiguity goes unnoticed. It is clearly engaged in an effort to offer competitive tax concessions to attract foreign investors away from other locations. But the pressure on the Tax Department to implement increasingly weak laws to garner additional revenues and improve tax collection forces it to read the law as it sees it. The net result is a divergence in viewpoints that leads to instances like that observed in the Vodafone case.

Seen in that light, the Supreme Court judgment is a godsend for the government. It can pretend that it is the court that is responsible for an increasingly lax tax policy in a country that the government claims has little public money for crucial capital and social expenditures. It is no doubt true that the judiciary includes members who are part of the epistemic community that believes that favouring foreign investors with tax concessions is in the national interest. But the fact is that the judiciary has invoked the ambiguity inherent in the law when arriving at judgments such as those reflected in both the Mauritius and the Vodafone instances. It is for the executive to remove that ambiguity. But it will not, because over the last two decades and more it has worked to slant policy in favour of foreign investment as part of the policy of economic reform and liberalisation. Claiming to be helpless because of a court order is a feeble excuse.

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