Opinion: Resolution of Vodafone tax case must to protect India's image

The Vodafone tax controversy is certainly one of the most high profile and most talked about tax disputes in India so far and has gained significant attention globally from investors, administrators as well as scholars. Let us put the dispute in context. In 2007, Vodafone acquired the stake of Hong Kong-based Hutchison Group in Hutchison Essar's telecom business in India.

It was an offshore deal where Vodafone Netherlands acquired ownership of a Cayman Island based entity called CGP Investments from a Hutch group entity also based in Cayman Island. So, while optically it was a pure offshore transaction between two non-resident entities (Vodafone and Hutchison) and they bought and sold shares of another non-resident entity (CGP), the Indian tax authorities took a position that by virtue of such an offshore deal, in effect and in substance, the parties have really sold stake in the Indian telecom business of Hutchison Essar. Therefore, they argued that profits realised from the indirect transfer of an Indian asset (telecom business in India) was taxable in the country and therefore, the buyer should have deducted applicable withholding tax while making payment of the purchase price of this business.

The Indian tax authorities are asserting their tax revenue claim. The apex court though did not uphold such a claim emphasising that the relevant law did not cover such an offshore transaction within its tax net in India and that certainty in tax laws is of paramount importance for foreign investors as well as for Indian residents.

The Supreme Court's interpretation of the provisions of the law in January 2012 (after about five years of the consummation of the transaction) in favour of Vodafone was followed by a retrospective amendment of the tax laws by the Indian government to overrule the apex court's verdict and lead to a revival of the tax demand against Vodafone. This has created significant uncertainty and has perhaps made the investor community wary of investing in India.

The story so far:

1. Offshore sale transaction between Hutchison Group, Hong Kong (Hutch) and Vodafone in the year 2007.

2. In the same year (2007), the tax authorities issued a show-cause notice to Vodafone, asking why it should not be treated as a defaulter for not deducting Indian withholding tax while making payments to Hutch. According to the tax authorities, this offshore transaction effectively resulted in transfer of an Indian asset and hence liable to capital gains tax in India.

3. The show-cause notice was challenged by Vodafone in a Writ Petition (WP) before the Bombay High Court (HC) which was dismissed in December 2008. The HC observed that prima facie Hutch had earned taxable capital gains in India as the income was earned from transfer of its business/ economic interest in the Indian company. The HC also took serious note of the fact that Vodafone did not produce some of the critical transaction documents which could have been instrumental in determining taxability of the transaction in India.   

4. Thereafter, a Special Leave Petition (SLP) was filed by Vodafone before the SC. This SLP was dismissed and the SC directed the tax authorities to decide whether they had jurisdiction to proceed against Vodafone in the matter. However, the SC permitted Vodafone to challenge the decision of the tax authorities directly before the HC rather than first going through the normal channels of Commissioner (Appeals) and the Income Tax Appellate Tribunal.  

5. In May 2010, the tax authorities passed an order taking the view that they had jurisdiction to proceed against Vodafone and accordingly treated the company as an 'assessee in default' for not withholding tax from payments made to Hutch even though it was an offshore deal between two non-resident parties.

6. Vodafone challenged this order of the tax authorities before the HC. The HC dismissed the case and ruled that the tax authorities indeed had jurisdiction to proceed against Vodafone as the income (capital gain) did accrue / arise in India by virtue of transfer of assets situated in India.

7. Aggrieved by the order of the HC, Vodafone approached the SC.

8. On 20 January 2012, the SC pronounced its ruling in favour of Vodafone holding that the transaction was not taxable in India and thus the company was not liable to withhold tax in India.

9. Soon thereafter, the Finance Act, 2012 amended Income Tax Act retrospectively to bring offshore indirect transfer of Indian assets (Vodafone like transactions) within the Indian tax net which triggered lot of criticism from the investor community globally.

10. Sensing the trouble and to allay fears of investors, the Prime Minister of India constituted an expert committee to review these retrospective amendments and to recommend changes to the government

11. The committee submitted its report in October 2012 to the government and since then there is no clarification or amendment as regards this provision

Since last year, the attempts to settle the tax dispute between Vodafone and the Indian government is another endless saga. According to recent media reports, the outcome of the settlement process seems to be uncertain.

The mechanics of the settlement process being adopted in Vodafone's case is shrouded in mystery. The settlement process began with Vodafone initiating a dispute resolution system under the Bilateral Investment Promotion and Protection Agreement (BIPA) between India and the Netherlands and then wanting to resort to conciliation under the United Nations Commission on International Trade Law (UNICATRAL) rules while the Indian government wanted to have it under Indian laws.

It is noteworthy that the ability to settle taxation matters under the Indian law is not free from doubt. Further, with Vodafone lately pressing for  widening of the scope for conciliation to include its transfer pricing dispute as well, it is believed that the government is seeking to withdraw the conciliation talks which may now pave way for international arbitration proceedings. Under the BIPA, the dispute can be referred to an arbitral tribunal by either party to the dispute in accordance with UNICATRAL rules if the investor (Vodafone) so agrees. Thus, Vodafone may initiate the arbitration proceedings.

According to the BIPA, the decision of the arbitral tribunal shall be final and binding and the parties shall abide by and comply with the terms of the award. One needs to wait and watch how this turns out. It is also understood that the Indian government may take a position that taxation matters are outside the purview of BIPA.     

From an equity and fairness perspective, Vodafone has a case to say that the position it took was based on its interpretation of the then existing law which even the apex court agreed to in its ruling delivered in January 2012. Importantly, where the tax authorities feel that it is demanding what is its rightful claim, the same is being demanded and enforced against the payer on account of its withholding tax non-compliance and not the payee to whom the income being taxed actually belongs. The expert committee constituted by the Prime Minister also recommended that the amendment which is not merely clarificatory in nature should be made prospectively and where it is made with retrospective effect, the payer should not be proceeded against and the provisions be applied to the payee to whom the income actually belongs.  

The way things stand currently, it is not quite clear as to in which direction this dispute is likely to move. Given that clarity and certainty in fiscal laws including tax laws is of paramount importance, one would like to believe that post the upcoming elections, the next government is likely to give full attention to this long outstanding issue and seek to resolve it on a priority basis to maintain and promote India's image as an investor friendly country.

To this outstanding dispute, the latest addition is the Rs 3,700 crore tax demand on Vodafone on account of a transfer pricing dispute with the tax authorities. The authorities have taken a position that transfer pricing adjustments need to be made in the context of sale of call centre business. This new controversy is now before the Income Tax Appellate Tribunal for adjudication and ruling. It appears from latest media reports that the Indian government will look at conciliation route in respect of indirect transfer dispute (Hutch Essar deal) once the Tax Tribunal has given its ruling on the latest transfer pricing related dispute.         

All in all, it seems imperative that the government will have to take this outstanding dispute head on and resolve it one way or other so as to send the clear message to international investors that India means business and that the government will do everything possible on its part to promote and encourage foreign investments in India.  

(The author is Partner, Khaitan and Co.)