Foreign buyers beware

The Vodafone decision, as expected, was appealed to the Supreme Court where the Attorney General reportedly wanted Vodafone to deposit 50 per cent of the tax demand of Rs 12,000 crore. For the time being, the Supreme Court had asked the apportionment to be done by the Income Tax Department before the question of stay could be decided. The case may be taken up for an early hearing in view of the enormous tax liability and the far-reaching consequences that the Bombay High Court decision may have for other acquisitions of business interests in India.

The recent decision of the Bombay High Court was the second round of litigation. The basic issue concerned the purchase of one share in a Cayman Islands company which, through more than 20 offshore companies, held indirect interest to the extent of more than 50 per cent in Hutchison Essar Ltd. (HEL). This overseas purchase of one share by a Vodafone company from a Hutch company resulted in Vodafone stepping into the shoes of Hutch in HEL. The name of the Indian joint venture company was then changed to Vodafone Essar Ltd. In the past, the Income Tax Department had never questioned such transfer of shares even where the consequence was the transfer of business interests in India.

EXISTING LAW

COURT'S VIEW

"Controlling interest" cannot be transferred separately Transfer of even 100% shares does not amount to transfer of the assets of the undertaking A composite contract or an indivisible contract cannot be divided into its component parts Transfer of shares by one non-resident to another non-resident will not be treated as a transfer of assets or transfer of an undertaking in India

Controlling interest has been transferred and should be reckoned for taxation Transfer of 67% shares in Hutchison Essar Ltd. has resulted in transfer of assets The principle of apportionment can be used to determine the assets that have been transferred in India Entitlements that flow out of holding of share can be dissected from the ownership of a share: the transfer of one share was not enough to consummate the transaction

Transfer of shares of an overseas company by one non-resident to another interest never resulted in any taxable income (or capital gains) in India. What perhaps attracted the attention of the Department was the sheer size of the transaction and it alleged that Vodafone should have deducted tax at source on the $11 billion paid to Hutch because the gains made by Hutch were chargeable to income tax in India. The stand of Vodafone was that it had only purchased the shares from Hutch and the consideration was paid abroad. As no assets were transferred in India and no income accrued or arose to Hutch in India, there was no liability.

Vodafone cited several decisions in its favour that had clearly held that even if all the shares of a company are purchased, it would not amount to acquiring assets of the undertaking. Shareholders are not the owners of a company's assets and even the purchase of a 100 per cent shareholding would not make the buyer of shares the "owner" of the company's assets.

Interestingly, under Section 29(1)(b) of the old Foreign Exchange Regulation Act, 1973, a non-resident could not acquire any part of an undertaking in India without the prior permission of the Reserve Bank of India. About 40 per cent of the shares of Shaw Wallace were held by four companies in the United Kingdom.

These shares were acquired by a Hong Kong company owned by the late Manu Chhabria and the agreement itself stated that the purchase of these shares would result in indirect control of 40 per cent of the share capital of Shaw Wallace in India. The Enforcement Directorate argued that the purchase of these shares resulted in acquisition or control of Shaw Wallace without the permission of the Reserve Bank of India. But the plea that such purchase of shares, in effect, amounted to acquiring the assets was rejected.

As regards controlling interest, the Madras High Court and the Madhya Pradesh High Court had held that a controlling interest was an incidence of shareholding and would enhance the value of shares but "controlling interest" had no independent existence. A number of other cases clearly demonstrated that a sale of shares in Cayman Islands would not amount to transfer of assets in India.

Without any discussion of how these cases were inapplicable to the Vodafone case, the Bombay High Court held that the payment of $11 billion was for the acquisition of a panoply of entitlements, including a control premium, the use of and rights to the Hutch Brand in India, a non-compete agreement with the Hutch Group, the value of non-voting non-convertible preference shares, various loan obligations and entitlement to acquire a further 15 per cent indirect interest in HEL. Therefore, it would be too simplistic to assume that the transaction involved the transfer of just one share in a Cayman Islands company. In fact, it was a composite transaction covering a complex web of structures and arrangements.

After accepting that controlling interest is not a separate asset, the court later held that there was a transfer of controlling interest. There is a serious disconnect between the earlier parts of the judgment, which reiterate all the legal principles involved, and the latter part, which proceeds to hold that part of the income of Hutch arose in India. For example, if a foreign company has an independent subsidiary that owns several hotels in India, and shares of the holding company abroad are purchased by another foreign company outside India, can anyone say that what has been transferred in law is a complex web that includes immovable property, bar licences, other permits and so on?

What the foreign company has purchased is just a share and the consequence of such purchase is the acquisition of control over the Indian assets. Similarly, if an Indian company owns assets or undertakings in five countries and shares of these are purchased by another Indian company in India, can anyone say that there is a transfer of individual factories, warehouses and other business assets situated in the five countries?

Can it be further argued that capital gains arise in India on the sale and purchase of these shares and further income arises in each of those five countries as a result of consequent acquisition of control over the assets in the five countries? The Bombay High Court decision is seriously out of line with the basic principles of company and tax laws. The court then spelt out the "doctrine of apportionment".

When there are composite activities and one component of an income arises in India, the Indian tax authorities have the jurisdiction to tax that amount. Having said that, the court observed that it was for the income tax authorities to apportion the income and determine what portion arose as a result of a nexus with the Indian tax jurisdiction and what arose outside. The net result is that the entire amount of $11 billion will not be liable to tax but only a portion thereof will be liable.

What that portion will be is, literally, a billion-dollar question. Below are some consequences of this verdict, and the precautionary steps that must be taken by foreign companies who wish to acquire businesses in India.

If the purchase of shares or assets takes place within India, then the seller/transferee will be liable to Indian income tax. The foreign buyer will have to deduct tax at source under section 195(1) of the Income tax Act, 1961.

If only a part of the payment is taxable, the foreign purchaser should make an application to the assessing officer under section 195(2). At this juncture, care must be taken to examine the relevant provisions of the Double Tax Avoidance Agreement.

A share purchase agreement should preferably confine itself to the shares alone. If there are other assets distinct from shares that are transferred, they should be dealt with in a separate agreement.

If the acquisition of shares in a foreign company results in control of the undertaking in India and other countries, what is the apportionment of profits that are attributable to the Indian undertaking?

The verdict of the Supreme Court is now eagerly awaited all over the world. It must lay down clear principles that can determine, with reasonable certainty, the tax liability in India. Till then, those acquiring business interests through the purchase of shares in a foreign company must take into account tax disputes as an unwanted part of the baggage.

- The author is a Senior Advocate of the Madras High Court