The Vodafone Supreme Court ruling from January 20 provided important criteria to determine taxability in India of capital gains arising on an indirect transfer of Indian assets in an offshore transaction between two foreign entities.
The court laid down tests for determining whether the transaction was sham or for tax avoidance and has ruled that the scope of charging section (section 9) under the Indian Income Tax Act, 1961 (IT Act) is not wide enough to cover such indirect transfer of Indian assets.
In the past, similar issues have been dealt with in the case of Aditya Birla Nuvo where gains arising from transfer of an intermediary company, which held shares in an Indian company, have been held to be prima facie taxable in India by the Bombay High Court.
Aditya Birla Nuvo - background
AT&T Wireless Services Inc, US (AWS) and the Birla Group (together referred to as the founders) held shares in Idea Cellular, an Indian telecom company. As per the joint venture agreement (JVA) entered into between the founders, they were to exercise their rights as shareholders of Idea Cellular and the shares were to be held either by the founders in their own name or through a permitted transferee. AT&T Mauritius, a wholly owned subsidiary of the AT&T group, was the permitted transferee through which AWS was holding shares in Idea Cellular. The shares held by AT&T Mauritius carried the endorsement that the holder of the shares cannot sell, assign or pledge the shares in a manner which is contrary to the terms of the JVA. Further, all the rights under the JVA like voting rights, rights of management, right of sale etc. continued to vest with the Founders i.e. AWS and the Birla Group. Subsequently, a group company of Tata Industries Limited (TIL) merged with Idea Cellular due to which TIL acquired a stake in Idea Cellular. Cingular Wireless LLC acquired shares of AWS from AT&T US thereby acquiring all control and ownership of AT&T Mauritius. AWS was then renamed as New Cingular Wireless Services Inc (NCWS).
NCWS, wishing to exit from Idea Cellular, made an offer to sell its stake in the company to Birla Group and also to TIL. The Birla Group bought the shares held by AT&T Mauritius in Idea Cellular and TIL purchased shares of AT&T Mauritius from NCWS. In other words, there was an indirect transfer of Indian assets (such as shares of Idea Cellular) when TIL purchased shares of AT&T Mauritius from NCWS. TIL contended that the transaction involving sale of shares of AT&T Mauritius by NCWS was not taxable in India and accordingly, did not withhold tax while making payments for the same. The Indian tax authorities passed an order treating TIL as an assessee-in-default for not withholding taxes from payments made to NCWS as according to them, the transaction resulted in taxable capital gains in India as it effectively resulted in transfer of ownership of an underlying Indian company (Idea Cellular).
The Bombay High Court while approving the stand of the tax authorities held that TIL, in the garb of acquiring shares in AT&T Mauritius, had acquired shares in Idea Cellular. The court also held that, prima facie, the transaction was a colourable device and accordingly, the stand of the tax authorities treating TIL as an assessee-in-default was justified.
In light of principles laid down in Vodafone case
The Supreme Court in the case of Vodafone has observed that the provisions of section 9 of the IT Act do not cover within their ambit, offshore transactions between two non-resident parties involving an indirect transfer of Indian assets. It was also held that that for charge of capital gains in India, there should be transfer of a capital asset situated in India. Charge of capital gains would fail in the absence of any of the three essential elements, such as transfer, existence of capital asset and the asset being situated in India. Further, the Supreme Court also emphasised on ‘look at’ approach as against a ‘look through’ approach when the statutory provisions do not justify the latter approach. It was held that a look through approach could not be read into a provision where it has not been specifically provided for.
The Supreme Court also emphasised the separate entity principle to determine whether the offshore transaction structure was bona fide one. For this purpose, the court has laid down tests like duration of the structure, period of business operations in India, generation of tax revenues, timing of exit, continuity of business on such exit, etc. However, the court also cautioned that the principles of lifting the corporate veil and the doctrine of substance over form would be applicable in a case which involves a colourable device or dubious methods to defraud the Revenue. In such cases, it would be open to the tax authorities to ignore the intermediary company and levy tax as per the real nature of the transaction. The court also observed that if the tax authorities find that an entity has no commercial/business substance and that it was interposed in a holding structure only to avoid tax, then the tax authorities could discard the inter-positioning of such conduit entity and levy tax as applicable.
Considering the above observations and the approach suggested in Vodafone ruling, it is likely that the Supreme Court in Aditya Birla Nuvo would first consider whether the business structure is bona fide having regard to the facts and surrounding circumstances of the case. It would be pertinent to note here that in Vodafone, the Supreme Court after very elaborate analysis and consideration of the facts of that case, came to a conclusion that the Hutchison structure was a genuine structure driven by various business and commercial requirements and was not really an afterthought to defraud the Revenue. The court is likely to consider the commercial substance of the structure. If the transaction is viewed as one for sale of shares of Idea Cellular by NCWS (through sale of the Mauritius based intermediate entity), then it could perhaps lead to taxability of capital gains in India in the hands of NCWS.
It may be worthwhile to note that the Direct Taxes Code Bill, 2010 (DTC), proposed to be introduced from April 1 2012, seeks to tax indirect transfer of Indian assets in an offshore transaction between two non-resident parties subject to certain conditions and to also introduce comprehensive general anti-avoidance rules (GAAR) which would empower Tax Commissioners to disregard a transaction if it is found that the main purpose of the transaction was to get a tax advantage and re-characterise the same as per its economic reality and levy tax accordingly. While it is not certain whether the DTC will indeed come into force from April 1 2012, the government is likely to amend the provisions of the IT Act (section 9) to provide for taxability of Vodafone like transactions in India coupled with GAAR provisions which would apply to both pure domestic transactions as well as to offshore transactions having nexus with India.
Sanjay Sanghvi (firstname.lastname@example.org) & Surajkumar Shetty (email@example.com), of Khaitan & Co, India.