The blog has discussed the Vodafone controversy in some detail, and commented on important extracts from the Bombay High Court’s judgment yesterday. This post discusses parts of the judgment in more detail, and suggests, with respect, that the judgment is incorrect. For the convenience of our readers, the paragraph number in question is indicated in brackets where appropriate.
Chandrachud J. begins by noting the exact nature of the transaction and the corporate entities involved in it (¶¶ 2 – 52). It is important to appreciate that, as a matter of law, there were two avenues open to the Revenue to charge the Vodafone transaction [“the Transaction”] to tax – under s. 5(2) r/w s. 45 of the Income Tax Act, 1961, or under s. 9(1)(i) r/w with s. 45. S. 5(2) provides that income that “accrues or arises in India” is chargeable, while s. 9(1)(i) covers all income arising “through or from any business connection in India” or “through the transfer of a capital asset situate in India”. The difference between the two provisions is that s. 5 pertains to actual receipt (or accrual) of income, while s. 9 is a deeming provision that, by legal fiction, determines that income is deemed to accrue or arise in India. In addition, the Revenue relied on s. 195 to engage withholding tax provisions, and on s. 201 to prove that Vodafone is an “assessee-in-default”.
To succeed under the first limb of chargeability, the Revenue needed to show that Vodafone acquired a “right to receive” income in India, for this is what the term “accrues or arises in India” means. Presumably, Chandrachud J. rejected this submission, for ¶ 78 moves swiftly to consider the law on the scope of the deeming provision – s. 9(1)(i). This is not surprising, for the Transaction involved the sale by a non-resident to a non-resident the share of a non-resident company, through an agreement executed outside India, subject to the laws of England, and for which payment was made outside India.
To succeed under the second limb, the Revenue was required to demonstrate that a “capital asset” was transferred, and that it was “situate” in India. Its case began with the interesting proposition that, in addition to shares, a “controlling interest” constitutes an independent capital asset. This, if true, would have concluded the case, for it is undeniable that Vodafone acquired an indirect “controlling interest” in Hutchison Essar Ltd. [“HEL”]. However, it is not, and a long line of cases has established that “controlling interest” is merely incidental to the ownership of shares. In ¶70, Chandrachud J. accepts this position and holds that “a controlling interest does not for the purpose of the Income Tax Act 1961 constitute a distinct capital asset”.
Thus, one avenue remained – that although the “share” sold was not situate in India, it in “reality” represented the transfer of capital assets situate in India. Chandrachud J. begins this part of the judgment with a comprehensive analysis of the scope of the deeming provision in s. 9 of the ITA, and refers with approval to one of the more important decisions on the point – CIT v. Qantas Airways. In Qantas, the assessee, an Australian airline, sold aircrafts outside India. Notably, the Revenue had not even suggested in that case that this was an indirect transfer of a capital asset “situate in India” but rather argued that the proceeds of the sale constituted income “from a business connection in India”. S.B. Sinha J. rejected this submission, noting that the intention of Parliament was to exclude “any any income derived out of sale or purchase of a capital asset effected outside India [emphasis mine].
In ¶63, Chandrachud J. summarises the position of law in India, noting that a “sham” is a transaction in which the parties “while ostensibly seeking to clothe the transaction with a legal form, actually engage in a different transaction altogether”. As we shall see, this point is of vital importance to the conclusion the Court draws later.
With this background, and after an analysis of extra-territoriality in taxation, Chandrachud J. applies these principles to the facts (¶ 120), and begins by noting that “the case of the Petitioner is that the transaction was only in respect of one share of CGP in Cayman Islands … this being a capital asset situate outside India…” To test this submission, Chandrachud J. looks to two types of facts– (a) the conduct of the parties and (b) the documents. The conduct of the parties revealed that both Vodafone and Hutchison had construed the transaction as a sale of telecom interests in India. For example, Vodafone and Hutchison had stated to the FIPB that the object of the transaction was the acquisition of a controlling interest in HEL, and the companies’ officers had made statements to this effect to the Stock Exchange and to the Press. Similarly, the documents in the Transaction were clearly designed to facilitate the transfer of control over HEL to Vodafone – for example, Framework Agreements entered into with companies holding a stake in HEL, a non-compete agreement with Hutchison vis a vis HEL and the sale deed itself (which referred to “Company interests” as a 66.9848 % stake in the issued share capital of HEL). Based on these factors, Chandrachud J. 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.
It is submitted that this is an unfortunate conclusion. As Chandrachud J. had himself observed in ¶63, a transaction is something other than what its legal form suggests it is only if that is the true intention of the parties themselves. In this case, Vodafone and Hutchison entered into a transaction that involved the sale of a share of a non-resident company, for a consideration of about $ 11 billion. Was the objective of the transaction the transfer of control over the Indian entity? Of course it was. But does it follow that the legal nature of the transaction was the transfer of shares in HEL? It is submitted, with great respect, that it does not.
The “legal nature” of a transaction is a manifestation of the intention of the parties. For example, if a transaction is termed a “sale” but in fact confers extremely limited rights on the buyer, it may be considered a “licence” notwithstanding the nomenclature, because that is the legal substance of the transaction. But if it is in “legal” reality a sale, it cannot be considered a “licence” because, for example, the “economic consequences” of the transaction are akin to a licence. For this reason, it is also submitted that the conduct of the parties, the submission to the FIPB, the statements to the Stock Exchange are of very limited relevance in determining the legal nature of the Agreement of 11 February 2007. Thus, the petitioner’s case was that the Transaction, in law, is the transfer of a single share of a non-resident company.
The point was put very well by Lord Diplock in Snook v. London and West Riding Investments:
I apprehend that, if it has any meaning in law, it means acts done or documents executed by the parties to the "sham" which are intended by them to give to third parties or to the court the appearance of creating between the parties legal rights and obligations different from the actual legal rights and obligations (if any) which the parties intend to create … for acts or documents to be a "sham," with whatever legal consequences follow from this, all the parties thereto must have a common intention that the acts or documents are not to create the legal rights and obligations which they give the appearance of creating. No unexpressed intentions of a "sham" affect the rights of a party whom he deceived [emphasis mine].”
Many find this somewhat inequitable – after all, why should India permit companies to take advantage of the corporate form and low-tax jurisdictions to avoid what would otherwise be payable on a simple transfer of HEL shares? The answer is that while nothing prevents the Indian legislature from enacting a General Anti Avoidance Rule, such as the one proposed in the Direct Taxes Code, courts cannot do so. As Lord Cairns observed, “if the Crown 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” [emphasis mine]. Despite ambiguous observations in McDowell, the Supreme Court has clarified in Azadi Bachao Andolan that Indian law adheres to this rule. What makes yesterday’s judgment even more ironic is that Chandrachud J. himself notes that an assessee who engages in such tax avoidance “does not tread upon a moral dilemma or risk a legal invalidation” (¶ 56).
Finally, the Court rejected the Samsung approach to s. 195, which has been independently confirmed by the Supreme Court today, and also held that it is open to the assessee to raise the plea of apportionment before the Assessing Officer. However, it is submitted with respect that this judgment is an unfortunate one, for it conflates “legal substance” with “objective of the transaction”. One hopes that the Supreme Court will take a different view.