What’s Really At Stake In The Vodafone Tax Case
By Rahul Varman
10 May, 2012
The Supreme Court judgment in the Vodafone case argues that the 'corporate veil' cannot be pierced as long as there was no intention to avoid taxes.Rahul Varmanon how and why corporations in India manage to undermine the law and the public good for the sake of private profit
The case concerns a tax dispute between the Vodafone group and the Indian income tax (IT) authorities over the acquisition by Vodafone International Holdings BV (VIH) (part of the Vodafone group and a company resident for tax purposes in the Netherlands) of the entire share capital of CGP Investments (Holdings) Ltd (a company incorporated in Hong Kong but resident for tax purposes in the Cayman Islands) on February 11, 2007 for about $11 billion (Rs 55,000 crore) from Hutchison Telecommunications International Ltd (HTIL). CGP, through various intermediate companies/contractual arrangements, controlled 67% of Hutchison Essar Limited (HEL), an Indian company. The acquisition resulted in Vodafone acquiring control over Hutch-Essar, a joint venture between the Hutchison group and the Essar group, which had obtained telecom licences to provide cellular telephony in different circles in India in November 1994. Because the sale was supposed to have been made overseas, no taxes were paid in India.
The IT authorities in India contended that the primary aim of this transaction was to acquire 67% controlling interest in Hutchison Essar Limited, a company resident in India. They therefore sought to tax capital gains under Section 9(1)(i) of the Indian Income Tax Act 1961 (2) arising from the sale of the share capital of CGP on the basis that CGP, while not a tax resident in India, holds the underlying Indian asset. According to the tax authorities the profit made by Hutchison Hong Kong, while it sold its shares of Hutch-Essar to Vodafone, was generated in India. Therefore, Vodafone, the buyer of the shares, had an obligation to withhold and pay the tax in India, before making the payment to Hutchison. The tax demand was $2.5 billion (Rs 11,000 crore, as much as the entire MNREGA budget in 2007). Vodafone contested, stating that neither Vodafone nor Hutch was liable to pay the tax as both the companies were located outside India and the deal happened outside India.
Vodafone is a British multinational telecommunications company headquartered in London. It is the world's largest mobile telecommunications company measured by revenues ($73.5 billion in 2011) and the world's second-largest in terms of subscribers, with over 439 million subscribers as of December 2011. In 2011 it earned profits of $12.6 billion, while it owned assets worth $242 billion and had an employee base of 83,862 (3). Vodafone India currently is the third largest mobile network operator in India.
Vodafone filed a writ petition in the Bombay High Court challenging the jurisdiction of the tax authorities. In September 2008 the Bombay High Court held that the transaction was one of transfer of capital assets situated in India, and accordingly, the Indian income-tax authorities had jurisdiction over the matter. It concluded that it would be simplistic to assume that the entire transaction between HTIL and VIH was fulfilled merely upon the transfer of a single share of CGP in the Cayman Islands. The two-judge bench noted that "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…. 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" (4).
The Supreme Court verdict
The case went up to the Supreme Court and, based on two key but independent arguments, the highest court concluded that there was no merit in the High Court's verdict. The first line of reasoning was that the transaction between Vodafone and Hutch was a share transfer (sale) rather than a transfer of capital assets and that the ownership of the capital assets remained vested in the Indian company. The judgment took recourse to the legal distinction between a company and its shareholders and thus the judgment does not make a distinction between shareholding that constituted a controlling interest and that which was a pure financial investment. Consequently it becomes completely immaterial in this specific case that the share(s) actually transferred were not of the company located in India but of offshore companies that ultimately controlled the shares that constituted the controlling interest in the Indian company. Even if the shares were of a company located in India, in the court's view it would not have constituted a transfer of capital assets. Once it is accepted that the shareholders of a company have a legal identity distinct from the company, no matter what the proportion of shares they hold, it follows that the two companies would have distinct identities even if one held a controlling share in the other. The Supreme Court judgment makes it a point to emphasise that even a subsidiary has an identity that is distinct from its parent holding company (5).
The second interesting aspect of the Supreme Court judgment is that it argues for a "look at" test in which tax authorities consider the entire Hutchison structure as it existed, "holistically", at its face value, and not adopt a "dissecting approach". In other words, authorities should not ask whether the transaction is a tax avoidance method, but apply the "look at" test to ascertain its legal nature. The Supreme Court was not in favour of the High Court's "look through" test because, it claimed, this was inconsistent with the need for certainty and consistency of tax policies that are crucial for taxpayers' confidence (especially foreign investors). The judgment argues that such a going behind the "corporate veil" (6) or looking through would be legitimate only in cases where it can be established that there is a deliberate intention of evading taxes. In the Supreme Court's view no such inference can be made in this case if the steps that led to the creation of the complex holding structure of Vodafone and the eventual Vodafone-Hutch transaction were seen in the proper context. According to the court the structuring of the transfer of control from Hutch to Vodafone was not done with the specific intention of avoiding taxes. Hence the corporate veil need not be pierced and the fact that there was a transfer of control from Hutch to Vodafone must be ignored. And thus the tax authorities should concern themselves only with the corporate structure or "form" of a merger deal, and not the "substance" of what assets are changing hands.
An additional implication of the judgment is that as long as it can be established that a mechanism was not originally created with the intention of avoiding taxes, it does not matter if it eventually led to such a consequence. The court has directed that when assessing whether an entity is evading the tax law, the authorities have to examine whether the means of evasion (which here is the creation of CGP, Hutchison's Cayman Islands unit) was originally intended for this purpose. Since Hutchison made its investments and engaged in activities in India (in collaboration with Essar) for several years before the deal and during that period CGP existed, the latter is not to be seen as primarily created to avoid capital gains (7).
The underlying issues involved
For a layperson who is not concerned with the technicalities of tax law and jurisprudence, the case is significant for three important issues.
Why 'look at' and not 'look through'?
The first interesting issue that arises is why authorities should look at and not look through the transactions, especially if what is being examined are complex transactions of mammoth corporations like Vodafone? After all, even simple cases of wrongdoing may not be caught out without looking at the substance of the act beyond the mere form of what is being claimed by the parties. According to Girish Dave, retired chief commissioner of income tax, Mumbai, who was closely involved in scrutinising the Vodafone-Hutch deal:
"This entire investment was not in purchase of one share of one US dollar of CGP's only capital. The investment was in the Indian mobile telecommunication business. CGP had no balance sheet as it had no accounts, no profit and loss account, so a question arises how this value of US $11.2 billion was arrived at when no accounts of CGP were available even in the due diligence report of E(rnst)&Y(oung). If this investment was in the telecom business in India, a natural corollary would be that it was this investment in entirety which was in fact sold. Investment was not in one share of CGP, for which in the year 1998 Hutchison may have paid one US dollar to Ms Nicole Melia from whom it acquired that one share." (8)
Ostensibly this needs to be done to attract foreign investment, but as Supreme Court lawyer Prashant Bhushan points out, in this deal no foreign investment as such is involved, as the Indian telecom company has merely been transferred from one company to another without any additional foreign investment. (9)
Why Cayman Islands?
The second interesting aspect is that the court chooses to ignore the fact that the merger deal was structured through a corporate vehicle stationed in the tax haven (10) of Cayman Islands. In the Supreme Court's view, since Hutch-Essar existed for several years before the 2007 deal and was an active corporate and taxpaying subject, the deal was perfectly legal and it cannot be said that the Cayman Islands were brought into the loop with the express purpose of tax avoidance. But the point is that what else could be the possible purpose of bringing Cayman Islands and vehicle stationed there into the deal if not tax avoidance? It is hard to imagine any other strategic advantage that Cayman Islands can bring in for a corporation like Vodafone. The Cayman Islands (11) is a British Overseas Territory located in the western Caribbean Sea, which is just 264 km2 in area with a population of 55,000. Considered a refuge of pirates and deserters in the 17th century, the island has evolved into a tax haven which is now the fifth-largest banking centre in the world, with $1.5 trillion in banking liabilities.
But this is not the first time that corporations in India have undermined the law and its underlying intent of public good for the sake of private profits. After all, the tax havens have been legitimised way back in 1982 when India signed the double tax avoidance agreement (DTAA) with Mauritius in order to attract foreign investments at the time of the launch of the first wave of 'economic liberalisation'. According to the IT Act if India has signed a DTAA, the taxpayer can pay tax in either of the two countries. But the catch here is that Mauritius has no capital gains tax, so a company doing a Vodafone-like deal in Mauritius will escape without paying any tax whatsoever. This has resulted in large amounts of investments being routed through Mauritius to avoid taxes and regulatory regimes in more established nation-states. Hence, due to the absence of capital gains tax and low tax rates on corporate profits, over 15,000 international companies have set up affiliate or associate firms in Mauritius. Not surprisingly, an economy which is all of $11 billion (same as the merger deal being discussed here!) is the single largest source of foreign investment for India. In recent years, Mauritius has accounted for approximately half of the annual inflows of FDI to India and around 40% of FII money that has come into the country's stock exchanges. Prof Arun Kumar of Jawaharlal Nehru University (JNU) claims that a lot of this 'foreign investment' is the money that was laundered out of country and which is now being routed back through tax havens like Mauritius (12).
Compartmentalisation of the corporate form
Perhaps the most interesting and the least commented aspect of the Supreme Court judgment is that which takes us to the very heart of the contemporary debate regarding the nature of gigantic corporations like Vodafone. The judgment has upheld the principle of maintaining a clear-cut separation between companies and between companies and their shareholders (13). But the point is that if the holding companies, the subsidiaries and their respective shareholders are all different entities then how do we make sense of the complex and mammoth corporate structures like Vodafone that influence the lives of such large numbers of people and control enormous natural and public resources like spectrum globally?
A bit of history here may help us put things in perspective. To begin with it was not usual for early corporations even in the US (where they first came to the fore) to be able to hold interests in another corporation -- in fact it was illegal. The earliest forms of corporations were those that had the clearest public purpose – churches, schools, universities (Harvard was chartered in 1688) and cities. Over time, the institutional form was used for public needs with clear economic benefits – canals, banks, bridges, and turnpikes. In the 18th century, corporations could come up only in the public domain through special parliamentary charters – they were provided with privileges like eminent domain (14), tax breaks, or monopoly rights only because they were supposed to deliver public goods, like waterways, roads, canals, banking, and other tasks which governments felt could not or should not be conducted privately as they were too risky, too expensive, too unprofitable, or too public, that is, perform tasks that would not have got done if left to the 'efficient' operations of the markets. Thus corporation arose as quasi-government agencies -- some of its particular features, such as limited liability, perpetual life, and parcellised ownership were established in order to compensate for the 'inefficient' tasks that they were assigned, where market would not support them (15). The debate whether a company could own shares in other companies was intense, and continued for decades in the US, as holding companies appeared, and were outlawed, followed by trusts, which were then outlawed, and finally by conglomerates, which successfully completed the redefinition of the nature of corporate property. US states varied considerably in their laws permitting stock ownership -- at one extreme Virginia prohibited stock ownership by corporations in other companies in the 1880s, while Pennsylvania allowed manufacturing companies to own railroad stocks to create spur lines to link their factories. When New Jersey allowed any corporation that incorporated in the state to own interests in other companies in 1888, corporations flocked for registration. By 1901, 66% of US firms with $10 million in capital or more, and 71% of those with $25 million or more were incorporated in New Jersey (16).
Thus while we are debating the tax and welfare implications of the Vodafone case (and obviously they are far-reaching), the most basic question that ought to be asked is why such mergers should be allowed in the first place? Because the stark fact is that in the name of market forces and the law, what is driving such mergers is basically the intent to kill the possibilities of market competition, in the name of which, ironically, such mergers and consolidations are mostly sanctified. Thus it is interesting that while such mergers are done in the name of market, efficiency and public welfare, their tax liabilities are also discounted in the name of public welfare, this time for investments and economic growth! And all this can always be justified by asserting that corporations are a legal fiction and cannot be said to have any purposive intent, as in the present judgment. And yet when it is convenient corporations can take the form of a natural person and acquire basic human rights like free speech and due process (17) too! Historically, various arms of a democratic state have been complicit in this evolving form of corporations.
Thus mammoth corporations can apparently keep acquiring new forms, new faces, and even new logic depending upon the issues at hand, even while there is a fundamental conflict between the private profits of global elites, whose handmaiden modern corporations have become, and the public interest of common people across the globe. Witness for instance the never-ending ordeal of the lakhs of victims of the world's worst industrial disaster in Bhopal in 1984, which happened at a site of one of the largest chemical corporations in the world at the time, Union Carbide. Within 10 years the plant was sold off to a so-called 'Indian' company which in 2001 in turn passed it off to one of the largest chemical companies in the world, Dow Chemical of the US. Of course now Dow claims that it has nothing to do with the never-settled liabilities of the accident towards the people of Bhopal, while it has acquired all its assets (18)! So tomorrow if it is found that spectrum was allocated illegally to Hutch-Essar in earlier years, we should be prepared to hear that Vodafone has nothing to do with it (of course Hutch and Essar will also wash their hands of this!), while it profits from the same spectrum (19).
Framed in narrow legal terms and the limiting framework of the so-called welfare nation-states in the times of globalisation, it has become a continuously losing battle for the people at large. This tide can be turned only by a clear realisation that public good and modern corporations are inversely proportional to each other and this debate needs to be taken much beyond immediate tax and legal issues.
(1) Comments of Manali Chakrabarti on an earlier draft are gratefully acknowledged.
(2) "The following incomes 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 situated in India."
(3) http://en.wikipedia.org/wiki/Vodafone, accessed on April 22, 2012.
(4) http://www.frontlineonnet.com/fl2905/stories/20120323290500400.htm accessed on April 24, 2012.
(5) http://www.frontlineonnet.com/fl2905/stories/20120323290501400.htm accessed on April 23, 2012.
(6) To arrive at the judgment, the Supreme Court had to find a way around earlier precedents set by the same court which upheld the principle of going behind the 'corporate veil' to thwart illegitimate tax avoidance.
(7) http://www.frontlineonnet.com/fl2905/stories/20120323290502200.htm accessed on April 23, 2012.
(8) http://www.frontlineonnet.com/fl2905/stories/20120323290501100.htm accessed on April 24, 2012.
(9) http://www.frontlineonnet.com/fl2905/stories/20120323290502000.htm, accessed on April 24, 2012.
(10) According to Palan et al ([I]Tax Havens[/I], Supernova, New Delhi: 2010), tax havens are jurisdictions that deliberately create legislation to ease transactions undertaken by nonresidents with a purpose of avoiding taxation and/or regulation under a veil of secrecy.
(11) http://en.wikipedia.org/wiki/Cayman_Islands, accessed on April 22, 2012
(12) http://www.frontlineonnet.com/fl2905/stories/20120323290501700.htm, accessed on April 25, 2012; Kumar estimates that the total amount of money (with interest) that has been taken out of India illegally over the five decades since 1950 would be in the region of $1.5 trillion.
(13) http://www.flonnet.com/fl2905/stories/20120323290501400.htm, accessed on April 25, 2012.
(14) An action of the state to expropriate a citizen's private property (mostly land), with or without due monetary compensation, but without the owner's consent.
(15) Roy, William G. 1997. [I]Socializing Capital: The rise of the large industrial corporation in America[/I]. Princeton, NJ: Princeton Univ. Press.
(17) See for instance my short piece on cooperate personhood: http://infochangeindia.org/corporate-responsibility/analysis/corporate-personhood-rights-without-responsibilities.html
(18) See for instance a recent debate in the pages of HT:http://www.hindustantimes.com/News-Feed/KaranThapar/Our-s-to-Dow-or-die/Article1-823564.aspx, and http://www.hindustantimes.com/editorial-views-on/Edits/Dow-shalt-check-facts/Article1-824398.aspx
(19) Actually allocations to Hutch-Essar are under scrutiny at present: http://news.outlookindia.com/items.aspx?artid=750536
Rahul Varman is Professor, Department of Industrial and Management Engineering, IIT Kanpur firstname.lastname@example.org
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