International holding structure and the income tax law: Ramifications of Vodafone case

A transaction of the shares of an upstream overseas company, where the company was in a position to exercise control over a Mauritian company, took place. However, a few related persons lived within Indian jurisdiction, and on that strength the Revenue India stretched its arms to impose capital gains tax on a foreign corporation (CFC) on the plea that the transfer of shares resulted in consequential transfer of control over an Indian entity. Thereby gave rise to a cause of tax on capital gains within the Indian jurisdiction.
M/s Vodafone, the aggrieved party, pleaded before the Bombay High Court that on the passing of control of downstream companies, commercial arrangements, common to such a transaction, were put in place and the transaction represented a transfer of capital assets viz, the share of a company, namely CGP and any gain arising out of that transferor to any other party is not taxable in India, because the asset is not situated in India, hence there is no sum chargeable as a tax in India.
The Revenue (India) pleaded that the value of the transfer of the enterprise is captured in the sale price of the shares and that the gain made by seller. It is a capital gain within the jurisdiction where the property is located, that is India, and hence the transaction is liable to be taxed in India.
M/s Vodafone pleaded that being foreign entity having no presence in India, not even a branch office, the company was not under any obligation to deduct and pay tax, as it was the recipient who is a potential assessor since he did receive chargeable sum.
In the light of propositions raised by the contesting parties, the settlement of the issue rested with the establishment of a nexus or a connection of the disputed transaction with India so as to bring the contested transaction within the framework of Indian jurisdiction. Nevertheless, the High Court did decide the issue in favour of Revenue India and M/s Vodafone was asked to pay the sum deductible.
The matter went before the Indian Supreme Court and the Indian Apex Court reversed the Bombay High Court's decision. The Court explained that corporation is an independent legal person and foreign holding companies are used to avoid the lengthy approval and registration process for direct transfer of an equity interest. The Court observed that holding structures have a place in legal structure and in order to invoke the substance over form principle; the Revenue authorities are required to establish the basis of sham or tax avoidance structure.
The Court was further of the view that Revenue will have to apply the look at test in order to ascertain the true nature of transaction and the onus will be on the Revenue to identify the scheme of tax avoidance and its dominant purpose. The Court was of the view that a legal fiction has a limited scope and cannot be expanded by a process of interpretation. Hence Revenue is required to ascertain the legal nature of the transaction. It has to examine the entire transaction holistically and the Revenue cannot adopt a dissecting approach.
The Court ruled that the fact that all shares of a company are owned by one person or by the parent company has nothing to do with its separate legal existence. The Court further ruled that it is important to realise that subsidiaries of an MNC have great deal of independence and that unit can no longer be regarded to perform those activities on the authority of its own executive directors.
The court emphasised that each subsidiary has to protect its own, separate commercial interests. The Court came to the conclusion that the concept of 'de facto' control conveys a state of being in control without having any legal right and it may be noted that enforceability is an important aspect of legal right. The Court ruled that the situs of the shares would be where the company is incorporated and where its shares can be transferred.
It was the Court's view that in structured investment concerns, the sale is of shares and not that of asset, and the control of a company resides in the voting power of its shareholders.
In their landmark judgement, Their Lordships of the Indian Supreme Court have held that:1
(i) The common law jurisdictions do invariably impose taxation against a corporation based on the legal principle that the corporation is a person that is separate from its members;2
(ii) The benefit of investing in local companies through an interposed foreign holding or operating company, such as Cayman Island or Mauritius based company (for both tax and business purposes) is that foreign investors are able to avoid the lengthy approval and registration process required for a direct transfer (ie, without a foreign holding or operating company) of an equity interest in a foreign invested Indian Company;
(iii) Holding structures are recognised in corporate as well as tax laws. Special purpose vehicles (SPVs) and holding companies have a place in legal structure, be it company law, take over codes or even under the income tax law;
(iv) When it comes to taxation of a holding structure, at the threshold, the burden is on the Revenue to allege and establish abuse, in the sense of tax avoidance in the creation and or use of such structures. In the application of a judicial anti-avoidance rule, the Revenue may invoke the substance over form principle or piercing the 'corporate veil' test only after it is able to establish on the basis of the facts and circumstances surrounding the transaction that impugned transaction is a sham or tax avoidance;
(v) Revenue or Court must look at a document it properly belongs to.3 Where a document or transaction is genuine, the Court cannot go behind it to some supposed underlying substance.4 The Revenue cannot start with the question as to whether the impugned transaction is a tax deferment or saving device but that it should apply the 'look at' test to ascertain its true legal nature;5
(vi) Every strategic foreign direct investment should be seen in a holistic manner. The onus will be on the Revenue to identify the scheme of tax avoidance and its dominant purpose. It is not necessary that income falling in one category under any one of the sub-clauses should also satisfy the requirements of the other sub-clauses to bring it within the expression "income deemed to accrue or arise in India.6 The law provides presence of three elements to attract penal action and these elements are transfer, existence of a capital asset, and situation of such asset in India. All three elements should exist in order to make the law applicable;7
(vii) The purpose of section 9(1)(i) of the Act is to tax that income which is accruing or arising to a non-resident outside Indian on transfer of a capital asset situate in India is fictionally deemed to accrue or rise in India;
(viii) A legal fiction has limited scope that cannot be expanded by giving purposive interpretation. The scope of section 9(1)(i) cannot be extended through interpretation. The words directly or indirectly used in section 9(1)(i) go with the income and not with the transfer of a capital asset (property). The question of providing "look through" in the statute or in the treaty is a matter of policy. It is to be expressly provided for in the statute or in the treaty. Similarly, limitation of benefits has to be expressly provided for in the treaty. Such clauses cannot be read into the section by interpretation.
(ix) The task of the Revenue is to ascertain the legal nature of the transaction and, while doing so, it has to look at the entire transaction holistically and not to adopt a dissecting approach. There is conceptual difference between pre-ordinate transaction, which is created for tax avoidance purposes, on the one hand, and a transaction, which evidences investment to participate, structure was created or used as a sham or tax avoidance. Where the court is satisfied that transaction satisfies all the parameter of 'participation in investment' then in such a case the court need not to go into questions such as de facto control v legal control, legal rights v practical rights, etc;
(x) No multinational company can operate in a foreign jurisdiction save by operating independently as a "good local citizen". A company is a separate legal persona and the fact that all its shares are owned by one person or by the parent company has nothing to do with its separate legal existence. If the owned company is wound up, the liquidator, and not its parent company, would get hold of the assets of the subsidiary. In none of the authorities have the assets of the subsidiary been held to be those of the parent unless it is acting as an agent. Thus, even though a subsidiary may normally comply with the request of a parent company it is not just a puppet of the parent company. The difference is between having power or having a persuasive position;
(xi) For instance, take the case of a one-man company, where only one man is the shareholder perhaps holding 99% of the shares, his wife holding 1%. In those circumstances, his control over the company may be so complete that it is his alter ego. But, in case of multinationals it is important to realise that their subsidiaries have a great deal of autonomy in the country concerned except where subsidiaries are created or used as a sham.
The fact that the parent company exercises shareholder's influence on its subsidiaries cannot obliterate the decision-making power or authority of its (subsidiary's) directors. Whether the parent company's management has such steering interference with the subsidiary's core activities that subsidiary can no longer be regarded to perform those activities on the authority of its own executive directors;
(xii) The difference is between having the power and having a persuasive position. A great deal depends on the facts of each case. Further, as stated above, a company is a separate legal persona, and the fact that all the shares are owned by one person or a company has nothing to do with the existence of a separate company. Therefore, though it may be advantageous for a parent and subsidiary companies to work as a group, each subsidiary has to protect its own separate commercial interests;
(xiii) Under the Hutchison structure the business was carried on by the Indian companies under the control of their Board of Directors, though HTIL as the Group holding company of a set of companies, which controlled 42% plus 10% (pro rata) shares, did influence or was in a position to persuade the working of such Board of Directors of the Indian companies and it is not in dispute that 15% out of 67% stakes in HEL was held by AS, AG and IDFC companies. That was one of the main reasons for entering into separate Shareholders and Framework Agreements in 2006, when Hutchison structure existed, with AS, AG and IDFC. HTIL was not a party to the agreements with AS and AG, though it was a party to the agreement with IDFC. That, the ownership structure of Hutchison clearly shows that AS, AG and SMMS (IDFC) group of companies, being Indian companies, possessed 15% control in HEL. Similarly, the term sheet with Essar dated 5.07.2003 gave Essar the RoFR and Right to Tag Along with HTIL and exit from HEL. Thus, if one keeps in mind the Hutchison structure in its entirety, HTIL as a Group holding company could have only persuaded its downstream companies to vote in a given manner. HTIL had neither power nor authority under the said structure to direct any of its downstream companies to vote in a manner directed by it;
(xiv) In this case, we are concerned with the expression "capital asset8" in the income tax law. Applying the test of enforceability, influence/persuasion cannot be construed as a right in the legal sense. The concept of "de facto" control, which existed in the Hutchison structure, conveys a state of being in control without any legal right to such state. This aspect is important while construing the words "capital asset" under the income tax law, as enforceability is an important aspect of a legal right;
(xv) HTIL, as a Group holding company, had no legal right to direct its downstream companies in the matter of voting, nomination of directors and management rights. As regards continuance of the 2006 Shareholders/Framework Agreements by SPA is concerned, one needs to keep in mind two relevant concepts, viz., participative and protective rights. As stated, this is a case of HTIL exercising its exit right under the holding structure and continuance of the telecom business operations in India by VIH by acquisition of shares. A minority investor has what is called as a "participative" right, which is a subset of "protective rights". It is important to note that "transition" is a wide concept. It is impossible for the acquirer to visualise all events that may take place between the date of execution of the SPA and completion of acquisition.
(xvi) When a business gets big enough, it does two things. First, it reconfigures itself into a corporate group by dividing itself into a multitude of commonly owned subsidiaries. Second, it causes various entities in the said group to guarantee each other's debts. A typical large business corporation consists of sub-incorporates. Such division is legal. It's recognised by company law, laws of taxation, take-over codes, etc;
(xvii) Under the Indian Companies Act, 1956, the situs of the shares would be where the company is incorporated and where its shares can be transferred. In the present case, it has been asserted by VIH that the transfer of the CGP share was recorded in the Cayman Islands, where the register of members of the CGP is maintained. This assertion has neither been rebutted in the impugned order of the Department dated 31.05.2010 nor traversed in the pleadings filed by the Revenue nor controverted before us. In the circumstances, we are not inclined to accept the arguments of the Revenue that the situs of the CGP share was situated in the place (India) where the underlying assets stood situated;
(xviii) Valuation is a matter of opinion. When the entire business or investment is sold, for valuation purposes, one may take into account the economic interest or realities.
(xix) An offshore transaction involving a structured investment concerns "a share sale" and not an asset sale. It concerns sale of an entire investment. A "sale" may take various forms. Accordingly, tax consequences will vary. The tax consequences of a share sale would be different from the tax consequences of an asset sale;
(xx) A controlling interest is an incident of ownership of shares in a company, something which flows out of the holding of shares. A controlling interest is, therefore, not an identifiable or distinct capital asset independent of the holding of shares;
(xxi) The control of a company resides in the voting power of its shareholders and shares represent an interest of a shareholder which is made up of various rights contained in the contract embedded in the Articles of Association;
(xxii) Shares in a company consist of a "congeries of rights and liabilities" which are a creature of the Companies Acts and the Memorandum and Articles of Association of the company;9
(xxiii) Shareholding in companies incorporated outside India (CGP) is a property located outside India. Where such shares become subject matter of offshore transfer between two non-residents, there is no liability for capital gains tax. In such a case, question of deduction of TAS would not arise. If in law the responsibility for payment is on a non-resident, the fact that the payment was made, under the instructions of the non-resident, to its Agent/Nominee in India or its PE/Branch Office will not absolve the payer of his liability under Section 195 to deduct TAS;10
(xxiv) The tax presence has to be viewed in the context of the transaction that is subjected to tax and not with reference to an entirely unrelated matter. The investment made by Vodafone Group companies in Bharat did not make all entities of that Group subject to the Indian Income Tax Act, 1961 and the jurisdiction of the tax authorities. Tax presence must be construed in the context, and in a manner that brings the non-resident assessor under the jurisdiction of the Indian tax authorities. In the present case, the Revenue has failed to establish any connection with Section 9(1)(i), and under the circumstances, Section 195 of the Income Tax Act, 1961 is not applicable; 11
(xxv) The Offshore Transaction is a bonafide structured FDI investment into India which falls outside India's territorial tax jurisdiction, hence not taxable.
(The writer is an advocate and is currently working as an associate with Azim-ud-Din Law Associates)
1. Vodafone International Holdings B.V v Union of India: Civil Appeal No 733 of 2012 decided on January 20, 2012, by the Supreme Court of India.
2. Salmon v Salmon (1897 A.C. 22.
3. W.T. Ramsay Ltd v. Inland Revenue Commissioners (1981) 1 All E.R 865.
4. CIR v HGD Duke of Westminster 1935 All E.R. 259.
5. Craven v White (1988) 3 All E.R. 495.
6. Section 9(1)(i) of the Indian Income Tax Act, 1961. It reads: 9(1) The following income shall be deemed to accrue or arise in India:
(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 situate in India.
7. Section 9(1)(i) of Indian Income Tax Act, 1961 applies to the assessment of income of non-residents, and in the case of non-resident, unless the place of accrual of income is within India, he cannot be subjected to tax. Once the fectum of such transfer is established then the income of non-resident is liable to tax under section 5(2)(b) of the Act.
8. S 2(14) of the Income Tax Act, 1961, it reads:
"2(14) "Capital asset" means property of any kind held by an assessor, whether or not connected with the business or profession, but does not include-
1. any stock-in-trade, consumable stores or raw materials held for the purposes of his business or profession; xxx"
9. IRC v. Crossman [1936] 1 All ER 762,
10. "Section 195. OTHER SUMS.- (1) Any person responsible for paying to a non-resident, not being a company, or to a foreign company, any interest or any other sum chargeable under the provisions of this Act (not being income chargeable under the head "Salaries" shall, at the time of credit of such income to the account of the payee or at the time of payment thereof in cash or by the issue of a cheque or draft or by any other mode, whichever is earlier, deduct income-tax thereon at the rates in force:
Provided that in the case of interest payable by the Government or a public sector bank within the meaning of clause (23D) of section 10 or a public financial institution within the meaning of that clause, deduction of tax shall be made only at the time of payment thereof in cash or by the issue of a cheque or draft or by any other mode:
Provided further that no such deduction shall be made in respect of any dividends referred to in section 115-O.
Explanation: For the purposes of this section, where any interest or other sum as aforesaid is credited to any account, whether called "Interest payable account" or "Suspense account" or by any other name, in the books of account of the person liable to pay such income, such crediting shall be deemed to be credit of such income to the account of the payee and the provisions of this section shall apply accordingly."
11. Section 163 does not relate to deduction of tax. It relates to treatment of a purchaser of an asset as a representative assessor. A conjoint reading of Section 160(1)(i), Section 161(1) and Section 163 of the Act shows that, under given circumstances, certain persons can be treated as "representative assessor" on behalf of non-resident specified in Section 9(1). This would include an agent of non-resident and also who is treated as an agent under Section 163 of the Act which in turn deals with special cases where a person can be regarded as an agent. Once a person comes within any of the clauses of Section 163(1), such a person would be the "Agent" of the non-resident for the purposes of the Act. However, merely because a person is an agent or is to be treated as an agent, would not lead to an automatic conclusion that he becomes liable to pay taxes on behalf of the non-resident. It would only mean that he is to be treated as a "representative assessor". Section 161 of the Act makes a "representative assessor" liable only "as regards the income in respect of which he is a representative assessor" (See: Section 161). Section 161 of the Act makes a representative assessor liable only if the eventualities stipulated in Section 161 are satisfied. This is the scope of Sections 9(1)(i), 160(1), 161(1) read with Sections 163(1) (a) to (d). In the present case, the Department has invoked Section 163(1)(c). Both Sections 163(1)(c) and Section 9(1)(i) state that income should be deemed to accrue or arise in India. Both these Sections have to be read together. On facts of this case, we hold that Section 163(1)(c) is not attracted as there is no transfer of a capital asset situated in India. Thus, Section 163(1)(c) is not attracted. Consequently, VIH cannot be proceeded against even under Section 163 of the Act as a representative assessor.