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as the British Courts have done and to disso-
Legitimising Tax Avoidance
ciate ourselves from the observations of Shah, J and similar observations made elsewhere. The evil consequences of tax avoidance are manifold. First there is substantial loss of Prashant Bhushan much needed public revenue, particularly in
The Vodafone tax case in which the Supreme Court overturned a Bombay High Court ruling on the validity of the income tax department claim on capital gains incurred in the sale transaction between Hutch and Vodafone has been hailed as a boost for corporate investment. However, what the ruling does is favour tax avoidance strategies. Indeed, it goes against the Supreme Court’s own ruling in 1986 in opposition to such strategies.
Prashant Bhushan (prashantbhush@gmail.com) is a public interest lawyer in the Supreme Court.
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T
Tax planning may be legitimate provided it is within the framework of law. Colourable devices cannot be part of tax planning and it is wrong to encourage or entertain the belief that it is honourable to avoid the payment of tax by resorting to dubious methods. It is the obligation of every citizen to pay the taxes honestly without resorting to subterfuges. On this aspect one of us, J Chinnappa Reddy, has proposed a separate and detailed opinion with which we agree.
Justice Reddy wrote:
I have referred to the English cases, at some length, only to show that in the very country of its birth, the principle of Westminster has been given a decent burial and in that very country where the phrase ‘tax avoidance’ originated the judicial attitude towards tax avoidance has changed and the smile, cynical or even affectionate though it might have been at one time, has now frozen into a deep frown. The Courts are now concerning themselves not merely with the genuineness of a transaction, but with the intended effect of it for fiscal purposes. No one can now get away with a tax avoidance project with the mere statement that there is nothing illegal about it. We think that time has come for us to depart from the Westminster principle as emphatically
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a welfare State like ours. Next there is the serious disturbance caused to the economy of the country by the piling up of mountains of black money, directly causing inflation. Then there is “the large hidden loss” to the community (as pointed out by Master Sheatcroft in 18 Modern Law Review 209) by some of the best brains in the country being involved in the perpetual war waged between the tax-avoider and his expert team of advisers, lawyers and accountants on one side and the tax-gatherer and his perhaps not so skillful advisers on the other side. Then again there is the “sense of injustice and inequality which tax avoidance arouses in the breasts of those who are unwilling or unable to profit by it”. Last but not the least is the ethics (to be precise, the lack of it) of transferring the burden of tax liability to the shoulders of the guileless good citizens from those of the “artful dodgers”. It may, indeed, be difficult for lesser mortals to attain the state of mind of Mr. Justice Holmes, who said, “Taxes are what we pay for civilized society. I like to pay taxes. With them I buy civilization.” But, surely, it is high time for the judiciary in India too to part its ways from the principle of Westminster and the alluring logic of tax avoidance, we now live in a welfare State whose financial needs, if backed by the law, have to be respected and met. We must recognise that there is behind taxation laws as much moral sanction as behind any other welfare legislation and it is a pretence to say that avoidance of taxation is not unethical and that it stands on no less moral plane than honest payment of taxation. In our view, the proper way to construe a taxing statute, while considering a device to avoid tax, is not to ask whether the provisions should be construed literally or liberally, nor whether the transaction is not unreal and not prohibited by the statute, but whether the transaction is a device to avoid tax, and whether the transaction is such that the judicial process may accord its approval to it. A hint of this approach is to be found in the judgment of Desai, J in Wood Polymer Ltd and Bengal Hotels Limited (1977) 47 Com Cas 597 (Guj) where the learned Judge refused to accord sanction to the amalgamation of companies as it would lead to avoidance of tax. It is neither fair nor desirable to expect the legislature to intervene and take care of every device and scheme to avoid taxation. It is up to the Court to take stock to determine the nature of the new and sophisticated legal devices to avoid tax and consider whether the
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situation created by the devices could be related to the existing legislation with the aid of “emerging” techniques of interpretation was done in Ramsay (1982 AC 300), Burma Oil (1982 STC 30) and Dawson (1984-1 All ER 530), “to expose the devices for what they really are and to refuse to give judicial benediction”.
Azaadi Bachao Andolan
Despite such a clear and authoritiative pronouncement by a five-judge bench of the Supreme Court mandating that the courts must sternly frown upon any artificial device adopted by corporations to avoid tax, two recent judgments of smaller benches of the Supreme Court have tried to overturn it by winking at such artificial tax avoidance devices and calling them legitimate tax planning. The first case is that of Azaadi Bachao Andolan of 2004. Consider the facts. On 29 March 2000, an intrepid income tax officer of Mumbai issued a remarkably bold assessment order in respect of several foreign institutional investors (FIIs) which were playing the stock market in India and making huge profits, mainly capital gains, and yet not paying any taxes in India. Though the Indian Income Tax Act obliges even a non-resident to pay taxes on incomes earned in India, these FIIs were avoiding paying those taxes by claiming the benefit of the Double Taxation Avoidance Treaty with Mauritius. This treaty signed in 1983, which applies to residents of India, or Mauritius essentially provides that a company would be taxed only in the country where it is domiciled. All these FIIs, though based in other countries and operating exclusively in India, claimed to be domiciled in Mauritius by virtue of being registered there under the Mauritius Offshore Business Activities Act (MOBA). Companies registered under this Act are not allowed to acquire any property in, deal with any resident in, raise any funds in, make any investment in or conduct any business in Mauritius. Yet these “Post Box Companies” had been claiming to be domiciled in Mauritius and therefore claiming the benefit of the treaty. The IT department allowed them to get away with it for many years. And there was no capital gains tax and virtually no tax at all on these companies in Mauritius. So all that a foreign company had to do in order to do business in India without paying any tax was to register itself or a subsidiary as an offshore company under MOBA in Mauritius. Naturally, seeing the benign attitude of the Indian tax autho rities, by the year 2000, most of the FIIs and most of the foreign investment in India (in the stock market or otherwise) came to be routed through Mauritius.
Then this proactive ITO tried to put a stop to this blatant tax evasion. He cited Supreme Court judgments to say that the tax authorities must frown upon tax evasion and lifted the corporate veil of these companies to see their actual place of residence or domicile. This happened to be in different countries in Europe or the United States. Thus the relevant double tax avoidance treaty would be the one between India and that country. All these treaties provided that capital gains tax would be levied in the country where the gains had accrued. Since the gains had accrued in India, he levied capital gains tax and also issued penalty notices to these FIIs.
All hell broke loose with this order of the ITO. Panicky FIIs having gotten used to tax-free lunches in India approached the then finance minister Yashwant Sinha. He immediately promised them that he would get the order of the ITO reversed and even announced it the next day. And he delivered on that promise. On 13 April 2000, the Central Board of Direct Taxes (CBDT) (directly under the finance minister, and directly above the income tax authorities) issued a circular to all tax authorities in India that once a company had obtained a tax residence certificate from Mauritius, it would not be taxed in India. Of course Sinha’s decision, as he claimed, was motivated entirely by fears of foreign investment drying up in India. It obviously had nothing to do with the fact that his daughter-in-law, Puneeta Sinha, was in charge of one of the largest such foreign funds operating in the Indian stock market (The India Fund) and her company had earned several million dollars as commission on the profits made by her fund during the previous year.
The CBDT’s circular was challenged in the Delhi High Court in PILs filed by the Azaadi Bachao Andolan and a retired chief commissioner of income tax, S K Jha. It was argued that the circular violated the Income Tax Act inasmuch as it mandated the ITO to accept the certificate issued by the Mauritius authorities and prohibited the Indian authorities from examining the real domicile of these companies. It thus effectively subordinated the Indian tax authorities to the Mauritius authorities, which was not permitted by Indian law. It also encouraged “treaty shopping” and tax evasion by these companies, which had nothing to do with Mauritius. It had been estimated that the tax thus evaded by these foreign companies in 1999-2000 alone ran into several thousands of crores of rupees. It was also pleaded by Jha that the Indian government be directed to amend the treaty with Mauritius, especially after it had become a tax haven with characteristic opaqueness about the nature of the companies registered there.
A division bench of Chief Justice S B Sinha and Justice A K Sikri allowed the writ petitions on 31 May 2002 and quashed the CBDT circular holding that it was violative of the Income Tax Act and would encourage treaty shopping and tax avoidance by companies, which had nothing to do with Mauritius. A double taxation avoidance treaty can only be for avoiding double taxation and not for political expediency or for tax avoidance altogether.
The government went to the Supreme Court where it argued that such a circular, which effectively allowed a tax holiday to foreign companies, was needed to attract
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foreign investment in India. The public interest petitioners in the court pointed out that tax exemptions to anyone could only be granted by Parliament by either amending the Income Tax Act or by the Finance Act (budget) passed each year. But the government could not by itself grant such exemption in the guise of such a circular promoting such an artificial device of a company registered as a “nonresident” company in Mauritius being recognised as a Mauritius resident. However, a bench of Justice Srikrishna and Justice Ruma Pal in the Supreme Court, by calling this device an act of legitimate tax planning which could be promoted by the government to attract foreign investment, defied the Constitution bench judgment in McDowell, winked at the CBDT circular and set aside the Delhi High Court judgment.
Vodafone Tax Case
In the Vodafone tax case, which was heard by a three-judge bench of the Supreme Court, the Court had the opportunity to correct the transgression of the McDowell principle in the Mauritius case. Consider the facts of this case.
In 2007, Hutchinson Telecom International which was directly or indirectly holding 67% of the shareholding of Hutch Essar Limited, an Indian telecom company, sold its entire holding to Vodafone International (another foreign company) for an amount of over $11 billion. Both companies issued press releases announcing that Hutchinson had sold and Vodafone had bought 67% of the shares and interest in the Indian company for over $11 billion. The Bombay High Court in the following words has described how this was achieved:
A Sale Purchase Agreement (“SPA”) was entered into on 11 February 2007 between Hutchison Telecommunications International Limited (HTIL) and Vodafone International Holdings B V (VIH BV). The Agreement contains the following two recitals: “(A) CGP is an indirect wholly-owned subsidiary of the Vendor. CGP owns, directly or indirectly, companies which control the Company Interests, (B) The Vendor has agreed to procure the sale of and the Purchaser has agreed to purchase the entire issued share capital of CGP on the terms and conditions set out in this Agreement. The Vendor has further agreed to procure the assignment of,
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and the Purchaser has agreed to accept an assignment of, the Loans on the terms and conditions set out in this Agreement and the Loan Assignments.” ‘Company interests’ are defined to be the aggregate interests in 66.9848% of the issued share capital of Hutchison Essar Limited (HEL). The diverse clauses of the SPA are indicative of the fact that parties were conscious of the composite nature of the transaction and created reciprocal rights and obligations that included, but were not confined to the transfer of the CGP share. The commercial understanding of the parties was that the transaction related to the transfer of a controlling interest in HEL from HTIL to VIH BV. The transfer of control was not relatable merely to the transfer of the CGP share. Inextricably woven with the transfer of control were other rights and entitlements which HTIL and/or its subsidiaries had assumed in pursuance of contractual arrangements with its Indian partners and the benefit of which would now stand transferred to VIH BV. By and as a result of the SPA, HTIL was relinquishing its interest in the telecommunications business in India and VIH BV was acquiring the interest which was held earlier by HTIL.
Subsection (1) of Section 9 of the Indian
Income Tax Act stipulates incomes which
shall be deemed to accrue or arise in
India. Clause (i) of subsection (1) is to
the following effect:
“(i) all income accruing or arising,
whether directly or indirectly, through
or from any business connection in India,
or through or from any property in India,
or through or from any asset or source of
income in India, or through the transfer
of a capital asset situated in India.”
Claiming that the capital gain to Hutch had accrued from the transfer of the shares and assets of the Indian telecom business to Vodafone, the income tax department demanded capital gains tax on this transaction and pursued Vodafone which was liable to withhold this tax from the amount they paid to Hutch and pay to the income tax department. Vodafone, however, claimed that the transaction was not liable to tax since it was achieved by transferring the shares of a Cayman Island based holding company. Thus it said that the transaction did not involve the transfer of a capital asset situated in India. The high court rejected this contention by holding:
132. The facts clearly establish that it would be simplistic to assume that the entire
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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. HTIL had through its investments in HEL carried on operations in India which HTIL in its annual report of 2007 represented to be the Indian mobile telecommunication operations. The transaction between HTIL and VIH BV was structured so as to achieve the object of discontinuing the operations of HTIL in relation to the Indian mobile telecommunication operations by transferring the rights and entitlements of HTIL to VIH BV. HEL was at all times intended to be the target company and a transfer of the controlling interest in HEL was the purpose which was achieved by the transaction. Ernst and Young who carried out a due diligence of the telecommunications business carried on by HEL and its subsidiaries have made the following disclosure in its report: The target structure now also includes a Cayman company, CGP Investments (Holdings) Limited. CGP Investments (Holdings) Limited was not originally within the target group. After our due diligence had commenced the seller proposed that CGP Investments (Holdings) Limited should be added to the target group and made available certain limited information about the company. Although we have reviewed this information, it is not sufficient for us to be able to comment on any tax risks associated with the company. The due diligence report emphasizes that the object and intent of the parties was to achieve the transfer of control over HEL and the transfer of the solitary share of CGP, a Cayman Islands company was put into place at the behest of HTIL, subsequently as a mode of effectuating the goal.
133. The true nature of the transaction as it emerges from the transactional documents is that the transfer of the solitary share of the Cayman Islands company reflected only a part of the arrangement put into place by the parties in achieving the object of transferring control of HEL to VIH BV. HTIL had put into place, during the period when it was in control of HEL, a complex structure including the financing of Indian companies which in turn had holdings directly or indirectly in HEL. In consideration call and put options were created and the benefit of those options had to be transferred to the purchaser as an integral part of the transfer of control over HEL. Hence, it is from that perspective that the framework agreements pertaining to the Analjit Singh and Asim Ghosh group of companies and IDFC have to be perceived. These were agreements with Indian companies
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and the transaction between HTIL and VIH BV takes due account of the benefit of those agreements.
134. The price paid by VIH BV to HTIL of US $11.01 billion factored in, as part of the consideration, diverse rights and entitlements that were being transferred to VIH BV. Many of these entitlements were not relatable to the transfer of the CGP share. Indeed, if the transfer of the solitary share of CGP could have effectuated the purpose it was not necessary for the parties to enter into a complex structure of business documentation. The transactional documents are not merely incidental or consequential to the transfer of the CGP share, but recognised independently the rights and entitlements of HTIL in relation to the Indian business which were being transferred to VIH BV. The diverse clauses of the SPA are indicative of the fact that parties were conscious of the composite nature of the transaction and created reciprocal rights and obligations that included, but were not confined to the transfer of the CGP share. The commercial understanding of the parties was that the transaction related to the transfer of a controlling interest in HEL from HTIL to VIH BV. The transfer of control was not relatable merely to the transfer of the CGP share. Inextricably woven with the transfer of control were other rights and entitlements which HTIL and/or its subsidiaries had assumed in pursuance of contractual arrangements with its Indian partners and the benefit of which would now stand transferred to VIH BV. By and as a result of the SPA, HTIL was relinquishing its interest in the telecommunications business in India and VIH BV was acquiring the interest, which was held earlier by HTIL.
The high court thus rejected the contention of Vodafone that this transaction was not liable to tax. The approach of the high court was perfectly in line with the binding judgment of the Constitution Bench in McDowell and Co (AIR 1986 SC 649), where the Court decisively frowned upon tax avoidance schemes.
But despite it being clear that Hutch had created this corporate structure only to avoid paying tax on the capital gains accruing from the sale of its stake in the Indian telecom company and its assets, the Supreme Court bench of three judges headed by Chief Justice Kapadia accepted Vodafone’s claim that the capital gain had arisen only from the transfer of the single share in the Cayman Island company and therefore had nothing to do with the transfer of any asset situated in India and therefore does not fall within Section 9 of the Income Tax Act. He said:
This problem has arisen also because of the reason that this case deals with share sale and not asset sale. This case does not involve sale of assets on itemised basis. The High Court ought to have applied the look at test in which the entire Hutchison structure, as it existed, ought to have been looked at holistically. This case concerns investment into India by a holding company (parent company), HTIL through a maze of subsidiaries. When one applies the “nature and character of the transaction test, confusion arises if a dissecting approach of examining each individual asset is adopted. As stated, CGP was treated in the Hutchison structure as an investment vehicle. As a general rule, in a case where a transaction involves transfer of shares lock, stock and barrel, such a transaction cannot be broken up into separate individual components, assets or rights such as right to vote, right to participate in company meetings, management rights, controlling rights, control premium, brand licences and so on as shares constitute a bundle of rights. Further, the High Court has failed to examine the nature of the following items, namely, non-compete agreement, control premium, call and put options, consultancy support, customer base, brand licences etc. On facts, we are of the view that the High Court, in the present case, ought to have examined the entire transaction holistically. VIH has rightly contended that the transaction in question should be looked at as an entire package. The items mentioned hereinabove, like control premium, non-compete agreement, consultancy support, customer base, brand licences, operating licences, etc, were all an integral part of the Holding Subsidiary Structure which existed for almost 13 years, generating huge revenues, as indicated above. Merely because at the time of exit capital gains tax becomes not payable or exigible to tax would not make the entire “share sale” (investment) a sham or a tax avoidant. The High Court has failed to appreciate that the payment of $11.08 bn was for purchase of the entire investment made by HTIL in India. The payment was for the entire package. The parties to the transaction have not agreed upon a separate price for the CGP share and for what the High Court calls as “other rights and entitlements” (including options, right to non-compete, control premium, customer base, etc). Thus, it was not open to the Revenue to split the payment and consider a part of such payments for each of the above items. The essential character of the transaction as an alienation cannot be altered by the form of the consideration, the payment of the consideration
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in instalments or on the basis that the payment is related to a contingency (‘options’, in this case), particularly when the transaction does not contemplate such a split up. Where the parties have agreed for a lump sum consideration without placing separate values for each of the above items which go to make up the entire investment in participation, merely because certain values are indicated in the correspondence with FIPB which had raised the query, would not mean that the parties had agreed for the price payable for each of the above items. The transaction remained a contract of outright sale of the entire investment for a lump sum consideration.
Thus, despite the fact that it was clear that the entire object and purpose of the transaction between Hutch and Vodafone was to transfer the shares, assets and control of the Indian telecom company to Vodafone, the Supreme Court declares that the transaction has nothing to do with the transfer of any asset in India! This judgment enshrines the use of artificial devices for tax avoidance as legitimate “tax planning” which the Court should allow and even encourage for “attracting foreign direct investment”. Justice Radhakrishnan begins his judgment by extolling the virtues of FDI. In his words:
The question involved in this case is of considerable public importance, especially on Foreign Direct Investment (FDI), which is indispensable for a growing economy like India. Foreign investments in India are generally routed through Offshore Finance Centres (OFC) also through the countries with whom India has entered into treaties. Overseas investments in Joint Ventures (JV) and Wholly Owned Subsidiaries (WOS) have been recognised as important avenues of global business in India. Potential users of off-shore finance are: international companies, individuals, investors and others and capital flows through FDI, Portfolio Debt Investment and Foreign Portfolio Equity Investment and so on.
With such benign, indeed welcoming winking towards tax avoidance devices, it is unlikely that any foreign company would be called upon to pay tax or at least capital gains tax in future in India. Lakhs of crores of tax revenue of this country and the future attitude of the courts towards innovative tax avoidance devices being adopted more and more by international corporations would be shaped by these two judgments.
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