The limits of territorial nexus requirement in light of Vodafone case and the Finance Act, 2012

The limits of territorial nexus requirement in light of Vodafone case and the Finance Act, 2012

The dispute between the Vodafone International Holdings B.V and Indian tax authority raised the question of the territorial nexus of the Indian taxation authority on the foreign company’s transactions.

 What is the dispute?

Brief facts of the case are: In December, 2006, Hutchison Essar Ltd. (HEL) is a company which is registered in India and having all the capital assets as well as providing services to 23 telecom circles in India along with subsidiary alliances. The share distribution of the HEL is 33% and was held by the Essar Group of Companies which is also an Indian Registered company. But the remaining 67% interest of  Hutchison Essar Ltd. (HEL) was held by Hutchison Telecommunications International Ltd. (HTIL), which is a Hong Kong based company and through a maze of subsidiaries in British Virgin Islands, Cayman Islands and Mauritius (around 15 offshore companies) and through complicated ‘option’ agreements with a number of Indian companies.

 Hutchison Telecommunications International Ltd. (HTIL), is a foreign company as far as tax liability on company is concerned.

Vodafone International Holdings B.V is also a Foreign company whose operations are based in Netherlands is said to have entered into an agreement with HTIL through HTIL subsidiary Cayman Island company of the Hutch Group [viz., CGP Investments (Holdings) Ltd. (CGP)] to acquire an Interest in 67% share of HEL, thereby overtaking the control and operations of HEL which is an Indian company.

In the context of aforementioned transaction between the two foreign companies the Vodafone company is liable to pay capital gain tax as it has acquired an Interest in an Indian company and Indian Tax authority have a jurisdiction over the Indian company HEL and Vodafone by acquiring the shares have a full control over the assets of the HEL and held to have gained a capital asset thereby. This is the subject matter of the dispute.

The Vodafone contended that the Indian Taxing authority have no territorial nexus over the subject matter as the transaction happened between the two foreign companies and on the foreign land .Also the transfer of shares is between CGP and Vodafone and there is no capital gains as alleged since the operation and management of both the companies are outside India, since there is no transfer of assets between HEL and Vodafone there is no question of capital gains.

There is a tax evasion of about 12000 crores as alleged by Income tax authority.

Key contentions by the parties on Dispute.

The Indian taxation authority issued a notice to Vodafone BV for the payment of Capital gain tax which was due on them as now after the aforementioned dealings the company has started operations in India under the flagship of Vodafone as it now holds majority shares in HEL, Aggrieved by the said notice the Vodafone BV approached the High court through a writ petition.

The main contentions of the taxation authority were that subject matter is not limited to transfer of share from CGP to Vodafone but also includes transfer of rights of HTIL vested in HEL thereby facilitating Vodafone operations in India which is proved by share agreement between HTIL and Vodafone and also by other purchase documents, Such transaction has a sufficient territorial nexus to India and is chargeable to tax under the Income-tax Act, 1961.

The Vodafone on the other hand contended that such transaction represents a transfer of a share (which is a capital asset) of a Cayman Island company, i.e., CGP. CGP through its downstream subsidiaries, directly or indirectly controlled equity interest in HEL. Any gain arising to the transferor or to any other person out of this transfer of a share of CGP is not taxable in India because the asset (i.e., share) is not situated in India.

The Bombay HC rejected the petition of Vodafone on the grounds, The HC first found that there is a nexus between the Indian fiscal jurisdiction and the said transaction in issue, The court held that the transfer of share between the Vodafone BV and CGP was for a motive of discontinuing the operations of HTIL through HEL in India and replacing with Vodafone BV, along with the transfer of shares there was also transfer of certain Interests of HTIL to Vodafone BV in order to complete the transaction and these Interests of HTIL is a capital assets which was held in India and was transferred to the Vodafone. Thus since the territorial nexus was established the provision of s195 IT Act was applicable on the transaction.

Again Aggrieved by the order of High court the Vodafone company approached the Supreme Court, The supreme court remanded the assessing officer (AO) over the jurisdiction issue whether the AO has a Jurisdiction to adjudicate the issue, to which AO affirms and passed an preliminary order u/s 201 of the IT Act.

The Vodafone company again approached the high court against the impugned order of the AO to which the Income Tax department contended on mainly two grounds, Firstly on the basis of sec 9 of the IT act, they contended that CGP is only a stock holding company and “underlying assets are

Situated i.e. in India .Further, HTIL had extinguished its right of control over HEL and extinguishment of „rights and entitlements‟ constituted as „Capital Assets‟.

Secondly, The term „any person‟ also includes „foreign company‟. Further, VIH has a presence in India on account of its shareholding and joint venture with another Indian telecom company. Based on the above two contentions the Indian taxation authority have a full territorial nexus over the Vodafone even if it is a foreign company. The high court Agreed with the contentions of Indian taxation authority and announced its judgement in favour of the Tax authorities.

So there are two law points which were primarily considered in this case which was to be decided by the Supreme Court, section 9 of the IT act and section 195 of the act.

Again an appeal was filed to the supreme court against the impugned order of the high court.

Supreme court observations

1. The SC adopted “look at” approach instead of “look through approach in order to interpret sec-9 of the I-T act, for fulfilling the requirements of sec 9 three things are mandatory „transfer‟, „existence of a capital asset‟ and „location of such assets in India‟ s, In this case, There is no existence of any existence of capital assets here in India or outside India, Further section 9 does not Include “underlying capital asset”

2. The SC observed that Vodafone had only acquired certain percentage of shares in HTIL which made them influence over HEL in terms of voting, nomination of directors and management rights. Hence, there was no extinguishment of rights. Moreover sale of shares of HEL was not made directly and it occurred indirectly by virtue of change of shareholding of HTIL.

3. Further Transfer of shares does not amount to separate entitlement of HEL shares and HEL capital asset should not be separated in order to satisfy conditions in sec-9.

4. The offshore transaction was between two foreign companies (non-residents in India) entered into on principal to principal basis. It is outside India’s territorial tax jurisdiction and hence not taxable in India so should not be subjected to withholding tax obligations in India.

Comments

The SC was right in its approach and since these type of transactions are commonly aimed in saving taxation in India and are practice, just because the amount of tax was 12000 crore, it does not change the law. The primary crux of these type of transaction are that since both the firms are foreign companies and also there was no involvement of any capital asset transfer, however since the company has “indirectly” acquired the capital assets in India that’s why the Sec9 is not applicable unless it is amended, Sec 195 does not have a wide scope as it applies on Resident companies and not on foreign companies .The Vodafone case was a precedent for tax saving tactics by the FII’s. However still the Indian government is in no loss position considering the jobs creation done by these FII’s, further the employees of these FII’s pay taxation in terms of crores. Which is enough to compensate the loss, but still the government is against this tax saving tactics and has announced a Finance Act-2012.

Finance Act-2012 and territorial nexus of Income tax Authorities

The Indian government after facing a defeat in Vodafone case have amended section 9 of the IT act which retrospectively amended the law and have inserted many provisions in including below mentioned clause-:

Explanation 5.—For the removal of doubts, it is hereby clarified that an asset or a capital

asset being any share or interest in a company or entity registered or incorporated outside

India shall be deemed to be and shall always be deemed to have been situated in India, if

the share or interest derives, directly or indirectly, its value substantially from the assets

located in India

.

Impact of the Amended clause on Vodafone judgement

Previously the scope of Section 9(i) was limited to “capital assets” and direct as well as indirect interest in it, by any Indian as well as foreign company, also the “capital asset” must be situated in India.

In the Vodafone case there was no involvement of capital assets. However the Interest on the capital assets were acquired through “shares” which were not earlier deemed to be as Capital Assets. That’s why the Vodafone was successful as Indian taxation authorities failed to prove transfer or entitlement of “capital Assets”. However the transaction of acquiring share does involve transfer of capital asset as Vodafone acquired full control over the management of HEL but it does not means that it has acquired the assets. The loopholes in the law help Vodafone to save the tax.

The territorial nexus of Indian Authorities were limited to involvement of “capital assets”, As far as “capital shares” are concerned they have no jurisdiction. In order to fill this void they have introduced the above mentioned explanation in a retrospective manner. The explanation will overrule the judgement of the Vodafone case in which the supreme court had clearly figured out that the transfer of share does not means separate entitlement of capital assets .The link between the capital shares and capital asset was clearly broken as both were separate entities in their respective spheres, but indirectly they both had a hidden link, the law was not clear to its point on this link as there was void.

Now with recent amendment, if the “capital shares” has a direct or indirect interest which is deriving in India on any “capital asset”, then the company acquiring that “capital shares” is deemed to be Indian.

Now Vodafone has acquired a capital share which is Indirectly linked to a capital asset which is in situated in India, However Vodafone did not acquired any direct or Indirect interest in capital asset but has acquired “capital share” which clearly are not “capital asset”, but the value of these “capital Share” is derived indirectly from the “capital assets” which are situated in India. Thus the liability on Vodafone arises as per the above mentioned amendment.

The Amendment of Section 9 overruled the SC judgement, since the company is now deemed to be a resident company; the provisions of Section 195 are now applicable, thereby increasing the nexus of the Indian taxation authority over the foreign company’s agreement.

The Amendment has clearly filled the void between the “capital Asset” and the “capital share”, if the value of “capital share” is proportional to the “capital asset” then the test has been established and the territorial nexus of the Indian taxing authorities will hold the neck of those who have purchased the share in capital assets, since the amendment is retrospective it will impact the Vodafone judgement.

Conclusion.

The amendment re-establishes the residential status of the foreign firms, even if they are directly not operating in the territorial limits of India, still they are liable. The amendment is aimed at discouraging the sentiments of foreign investors and is really a bad move by the government.

India is among the preferred place for investment and is looked forward by global investors and this type of step will taint the image of India as a preferred destination of investment, by increasing the territorial nexus of Indian taxation authority the step will further slowdown the economy of an already struggling economy.

Sec-9(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;

 Sec 195 (1) Any person responsible for paying to a non-resident, not being a company, or to a foreign company, any interest (not being interest on securities) 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 :

Sec 201 (1) If any such person and in the cases referred to in section 194, the principal officer and the company of which he is the principal officer does not deduct or after deducting fails to pay the tax as required by or under this Act, he or it shall, without prejudice to any other consequences which he or it may incur, be deemed to be an assessee in default in respect of the tax :Provided that no penalty shall be charged under section 221 from such person, principal officer or company unless the Assessing Officer is satisfied that such person or principal officer or company, as the case may be, has without good and sufficient reasons failed to deduct and pay the tax.

By-Nitish Banka