In our first post on the Vodafone judgment, we set out the issues of law arising from the Court’s findings, and discussed two of those – the approach to tax avoidance and the meaning of controlling interest. This post considers two other important issues – India’s approach to the corporate veil, and the scope the “extinguishment” provision under section 2(47) of the Income Tax Act, 1961 [“the 1961 Act”].
1. Corporate Veil
It is as easy to state that the origin of the separate entity principle is often traced to Salomon v Salomon as it is difficult to outline when a court will lift the veil. One of the best attempts in the literature to extract coherent principles in this branch of the law is Professor Ottolenghi’s essay published in the Modern Law Review in 1990, and perhaps the best judicial analysis is Slade LJ’s masterly treatment of the subject in Adams v Cape Industries. In Vodafone, there are important differences in the approach of the Chief Justice and K.S. Radhakrishnan J., and the Chief Justice’s judgment suggests that the court may more readily lift the veil than is commonly supposed. The Chief Justice begins by affirming that “a subsidiary and its parent are totally distinct taxpayers” (¶66), and that the fact that a parent exercises substantial control over the affairs of its subsidiary is not in itself a reason to depart from this principle. The Chief Justice then outlines important exceptions to this principle – in particular, that it is permissible to ignore the separate legal status of the subsidiary if its decision-making is “fully subordinate” to the holding company or if the parent company makes an “indirect transfer through abuse of legal form and without reasonable business purpose”, and clarifies that these are by no means exhaustive. At first sight, the “fully subordinate” language the Chief Justice uses may suggest that a court will readily lift the veil, but it is submitted that the better view is that the Chief Justice is simply referring to the well-known exception (accepted in Adams) in which the business of the subsidiary is in fact the business of the holding company.
The Chief Justice then holds that India has a “judicial anti-avoidance rule” (¶68) which allows the Revenue to invoke “substance over form” or “pierce the corporate veil” if it discharges its burden of establishing that the transaction in which the corporate entity is used is a “sham or tax avoidant”. While the word “tax avoidant” may give rise to the impression that every case in which the use of a corporate entity leads to a reduction in the tax liability of the assessee is covered, it is submitted that the better view, and one which is consistent with the rest of the Chief Justice’s analysis in ¶¶67 and 68, is that no substantial departure is intended from the limited grounds on which the veil may presently be lifted. That view is reinforced by the fact that “sham” is used in conjunction with “tax avoidant”, and by the examples given by the Chief Justice in the sentence that immediately follows – round tripping and payment of bribes. The example of lack of business purpose is also given, but the Chief Justice clarifies that this lack of business purpose must not be a result of “dissecting” the legal form of a transaction as the Revenue sought to do in Vodafone’s case. The most important part of the Chief Justice’s analysis is the list of six factors set out to assist the Court in determining on which side of this test a particular transaction falls: “participation in investment”, duration of existence of holding structure (prior to acquisition), period of business operations in India, generation of taxable revenues in India, timing of exit and continuity of business on exit. This analysis suggests that it may be a mistake to read this judgment as a complete victory for tax planning, because the “dominant purpose” of a transaction may easily be found, on the application of these factors, to lack commercial substance, even though it may not satisfy the traditional tests of lifting the corporate veil. It also suggests, so far as tax avoidance is concerned, that the test in India, unlike in English law after MacNiven and BMBF, is not simply statutory construction, which is difficult to reconcile with the Court’s subsequent finding that it is.
It is also interesting to contrast this with the analysis in Adams v Cape Industries. In that case, Slade LJ clearly stated that the fact that “justice so requires” is never a reason to treat a subsidiary as anything other than a separate legal entity; that certain observations of §Lord Denning MR in DHN Food Distributors may have gone too far; that it is settled in English law that a subsidiary can be ignored only if it is the alter ego or agent or part of a single economic entity with, the parent; and that it is such only if the business of the holding company is the business of the subsidiary. This test may be considerably narrower than the factors outlined in the Chief Justice’s judgment (duration of existence of holding structure etc.). Indeed, the application of the Adams test to the facts of that case so suggest – in that case, although the Court concluded that AMC (the Liechtenstein corporation) was a façade, it held that CPC (the American marketing company set up after NAAC was liquidated) was not the alter ego of Cape and Capasco even though Cape exercised substantial control over it, because CPC had control over its day to day activities, paid rent for its premises, paid income tax separately etc.
K.S. Radhakrishnan J.’s judgment appears to endorse Adams (but see below), and recognises that members of a company have no interest in its assets. More significantly, the judgment appears to implicitly hold that the separate entity will prevail except in very limited circumstances, for it repeatedly observes that the veil can be lifted only if the Revenue establishes that the corporation has been used for a fraudulent or dishonest purpose (as opposed, for example, to a benign purpose through an entity that is part of a single economic unit). It begins (¶44) by holding that many factors may guide the choice of a vehicle for doing business through a corporation, of which one can legitimately be a desire to minimise tax liabilities. K.S. Radhakrishnan J. then holds that the burden is on the Revenue (¶46) to show that the corporation was used for “a fraudulent, dishonest purpose, so as to defeat the law”. In ¶¶ 58 and 59, it is held that the fact that a parent and a subsidiary may have economic union of interest and a consolidated balance sheet does not mean that they are not “distinct legal entities” and that the veil can be lifted only if the Revenue shows that the company has been used to perpetrate “fraud or wrongdoing” (¶59). Even in approving Adams (¶60), K.S. Radhakrishnan J. specifically observes that the Court of Appeal emphasised in that case that a subsidiary can be ignored “where special circumstances exist indicating that it is a mere façade concealing true facts.” This theme is repeated subsequently, when K.S. Radhakrishnan states that the court will not permit a corporate entity to be used as “a means to carry out fraud or evade tax” (¶61). All of this indicates that K.S. Radhakrishnan J. has virtually rejected the single economic entity or alter ego grounds for lifting the veil (or confined its application to rare instances), although there is one reference to “sham” and “agent” (¶61).
It is submitted that K.S. Radhakrishnan J.’s approach, even if it perhaps goes too far, is, with respect, preferable to the approach of the Chief Justice, for the latter analysis would permit the veil to be lifted on a number of grounds that may not be entirely consistent with the sanctity of the separate entity principle. Indeed, the Chief Justice’s analysis leaves one with the impression that Vodafone prevailed not on the ground that the veil cannot be lifted except on Adams grounds, but on the ground that the veil should not be lifted for it had demonstrated business purpose and commercial substance.
2. Extinguishment under section 2(47)
The Revenue’s primary case in the Supreme Court was that there was a capital asset situate in India in the form of various rights that HTIL had which were “extinguished” when the SPA was entered into on 11.02.2007. For example, HTIL by virtue of its shareholding had the “right” to appoint directors, the right to use certain licences, redeem certain shares etc. The Chief Justice rejected this argument inter alia on the ground that the Court was concerned with the sale of shares, not the sale of assets, and that a sale of shares cannot be dissected as the sale of assets unless the six factors set out in para 68 (discussed above) are satisfied. It is implicit in this analysis that there cannot be, at the same time, a sale of property and the extinguishment of rights comprised in the bundle of rights that is sold. It is submitted that this conclusion is entirely correct – indeed, “extinguishment” did not exist in the 1922 Act, and was inserted by Parliament to widen the scope of section 2(47) in order to cover transactions in which there is no sale in the ordinary sense. Although section 2(47) does not so provide, it is submitted that it is not open to the Revenue to invoke “extinguishment” in a transaction in which there is admittedly a sale, simply because that sale is not taxable. The Chief Justice’s implicit approval of this proposition is, it is submitted, to be welcomed.
To put it differently, the Revenue was attempting to convert the sale of a “non-taxable whole” (situate outside India) into the sale of its “taxable component parts” (situate in India). There is an interesting parallel to be drawn with the analysis of the Court of Appeal in IRC v Rysaffe Trustee Co [2003] EWCA Civ 356, in which Mummery LJ held that it is not open to the Revenue to invoke a legal fiction when there is a “disposition of property in its ordinary and natural sense”. In this case, the transaction was a “disposition in its ordinary and natural sense” of an asset situate outside India – the Revenue could not invoke a legal fiction to overcome this fact.
We will continue to discuss other this judgment in subsequent posts, and in particular the analysis of section 9.