Vodafone Judgement and its Implications

S.R. Wadhwa

Direct Taxes

The Issue

The recent judgment of the three judges bench of the Supreme Court (SC) for short in Vodafone’s case has very significant implications. The issue involved the liability to capital gains tax under the Income tax Act, 1961 (“the Act”) in relation to the acquisition by one Vodafone International Holdings (for short Vodafone) – a company resident for tax purposes in Netherlands, of the entire share capital of CGP Investments (Holdings) Ltd ( for short “CGP”) – a company resident for tax purposes in the Cayman Islands. The transaction was entered on 11-2-2007, whose stated aim, according to the Revenue, was the “acquisition of 67% controlling interest in Hutchison Essar Ltd. (HEL for short) - a company registered in India. The assessee’s case, in brief, was that Vodafone did not acquire the controlling interest in HEL, but agreed to acquire companies which in turn controlled a 67% interest in HEL. CGP held, indirectly, through other companies, 52% shareholding interest in HEL as well as Options to acquire 15% shareholding interest in HEL, subject to relaxation of FDI norms. The Revenue, in substance, sought to tax capital gains arising from the sale of share capital of CGP on the basis that CGP, though not a tax resident in India, held the underlying Indian assets.

  1. Disagreeing with the Revenue and holding that the sale of shares of a non-resident holding company by one non-resident to another non-resident, outside India, though resulting in indirect transfer of underlying assets in India, did not give rise to capital gains taxable under the Act, the Hon’ble Supreme Court of India (SC for short), in the process, laid down some very important legal principles, notably in the following areas:-

  1. Tax avoidance/ evasion – Correctness of Azadi Bachao case

  2. Parent – Subsidiary company relationship

  3. Holding – Investment structures

  4. Whether section 9(1) is a look through provision?

  5. Transfer of HTIL's property rights in HEL by Extinguishment: (vi)

  6. Role of CGP share in the transaction.

  7. Scope and applicability of sections 195 and 163 of the Act to non-resident taxpayers

Corporate structure and nature of controversy

  1. The Hutchison Group of Hong Kong (HK) had first invested into telecom business in India in 1992 through a joint venture Indian company, with the Indian Essar Group - presently known as Hutchison Essar Ltd. (HEL). Vodafone – a company resident for tax purposes in the Netherlands, acquired the entire share capital of one CGP – a company in the Cayman Islands, whose object, according to the Revenue, was the acquisition of 67% controlling interest in HEL. CGP was incorporated in Cayman Islands on 12-1-1996. It was the wholly owned subsidiary of the Hutchison Group through another company; namely, Hutchison Telecommunication International Ltd (HTIL). CG

  2. CGP held 42.34% shares in HEL through wholly owned subsidiaries (WOS) in Mauritius, 9.62% shares through HTIL and Omega which were not subsidiaries, and 15.03% through unrelated companies of Asim Ghosh (AG), AS (Analjit Singh) and some others through credit support provided by HTIL by virtue of which HTIL had the indirect right to exercise call and put options therein.

  3. Vodafone, a UK based mobile phone group through its Netherlands based Special Purpose Vehicle (SPV); viz. Vodafone International Holdings BV (Vodafone) acquired the stake of HTIL in CGP for a sum of 11.2 billion dollars.

  4. With the consent of the Essar Group, a new joint venture company called Vodafone Essar Ltd (new name of HEL) came into existence. About 2 billion dollars of capital gain arose to HTIL in the above transaction. The structure so built up in the manner described above- though far more elaborately explained in the SC judgement, is briefly stated in the following diagram for facility of understanding the corporate structure:-


  1. The said offshore transaction between HTIL (the vendor) and Vodafone (the vendee) for transfer of the entire shareholding of CGP was the subject matter of dispute before the Revenue. It was the claim of the Revenue that HTlL transferred the controlling interest to the extent of 67% in HEL by way of sale of the share of CGP. Revenue, being of the view that since the above transaction resulted in the extinguishment of certain rights of HTIL in HEL and, alternatively in indirect transfer of assets in India, capital gains chargeable to tax in India arose and Vodafone was thus under an obligation to withhold tax at source while making the payment of the sale consideration as required by section 195 of the the Act.

  2. In response to the show cause as to why it should not be treated as an "assessee-in-default" for failing to withhold the Indian capital gains tax, Vodafone moved the Bombay High Court challenging the jurisdiction of the Revenue to examine the transaction of transfer of shares of a foreign company entered into between two non-resident companies.

  3. Bombay HC dismissed the writ petition, against which Vodafone preferred an appeal to the SC which also dismissed the appeal directing that the jurisdictional issue of whether the Revenue had the jurisdiction to examine the above transaction, should first be determined by the concerned income-tax authority after Vodafone had submitted all the documents.

  4. Pursuant to the SC order, the Revenue passed an order reiterating its jurisdiction to examine the above transaction and treated Vodafone as an assessee-in-default under section 201 (I) of the Act for not deducting tax at source from the sale consideration.

  5. Revenue’s order was challenged by Vodafone before the Bombay HC. According to the Revenue, the sale consideration received by HTIL was towards the transfer of its business/economic interests as a group in India and that the subject-matter of the transaction was transfer of various intangible rights / interests of HTIL in HEL and not an innocuous acquisition of the share of the CGP – a Cayman Islands company. Vodafone, on the other hand, pleaded that the aforesaid transaction was a transfer of the share capital of a non-resident company and was not the transfer of any capital asset situated in India. There was no transfer of a controlling interest in India. Such an interest in a Company was not separate and distinct from the shares but was incidental to the holding of a particular number of shares. Since by virtue of the acquisition of the share of the Cayman Islands Company, Vodafone acquired the controlling interest only indirectly, there was no direct transfer of a capital asset situated in India so as to give rise to any tax liability. Section 9 of the Act, which deems income arising, inter alia, through the transfer of a capital asset situated in India, was also not attracted on the facts of the case. The provisions of section 195 of the Act relating to the deduction of tax at source were, therefore, not applicable.

  6. The Bombay HC, vide order dated September 8, 2010, dismissed the writ petition and upheld the jurisdiction of the Revenue on the ground that the transaction in question had a significant nexus with India because of the change in the controlling interest in HEL and transfer of diverse rights and entitlements. It introduced the theory of apportionment, according to which that part of the consideration which had direct and sufficient territorial nexus with India could be brought to tax. The HC, therefore, set-aside the matter to the Revenue for apportionment of the sale consideration and levy of tax according to law. Vodafone moved the SC challenging the judgment of the Bombay HC.

The decision by the SC

  1. The SC, vide its order dated January 20, 2012, reversed the decision of the Bombay HC and held that Vodafone was not required to withhold any tax from the payments made to HTIL. Its view was that the offshore transaction of the acquisition of share of CGP by Vodafone from HTIL was a bonafide, structured FDI investment in India which fell outside the Revenue's territorial tax jurisdiction and was, therefore, not taxable to tax.

Important principles of law and their implications.

  1. The important principles of law enunciated by the Supreme Court in arriving at the above conclusion and their implications are discussed below:

(i) Tax avoidance/ evasion – Correctness of Azadi Bachao case

  1. Revenue contended that the Union of India vs. Azadi Bachao Andolan, 263 ITR 706(SC), should be over ruled as it departs from McDowell and Co. Ltd. vs. CTO (1985) 3 SCC 230, in that the introduction of CGP in the HTIL structure was an after thought and its interpretation was a device to evade tax which ought to be disregarded for tax purposes. According to the Revenue, in Azadi Bachao, para 46 of Macdowell’s judgment was missed where in the majority agreed with the separate opinion of Chinnepa Reddy, J. as to how in certain circumstances, tax avoidance should be brought within the tax net. Paras 41-45 and 46 of Macdowell were not read. Subsequent to Macdowell, the Westminster principle quoted in Mathuram Agarwal vs. State of Madhya Pradesh (1999) 8 SCC 667 was also not noticed in Azadi Bachao.

  2. The SC, in McDowell's case in paragraph 45, had held that "tax planning may be legitimate provided it is within the framework of law". In the latter part of para 45, it held that "colourable device cannot be a part of tax planning and it is wrong to encourage the belief that it is honourable to avoid payment of tax by resorting to dubious methods." In Azadi Bachao Andolan, apart from the issue of the validity of circular(s) issued by the Central Board of Direct Taxes (CBDT) in relation to Indo - Mauritius DTAA, the SC extensively dealt with the concept of tax avoidance / evasion. It followed the principle laid down by the House of Lords in the case of Commissioner of Inland Revenue vs. His Grace the Duke of Westminster 1935 All E.R. 259, that "Every man is entitled if he can to order his affairs so that the tax attracting under the appropriate Acts is less than it otherwise would be given that a document or transaction is genuine, the Court cannot go behind it to some supposed underlying substance." In the later decision of House of Lords in the case of W. T. Ramsay Ltd. vs. Inland Revenue Commissioner (1981) I AII E.R. 865. it was held that "Westminster did not compel the Court to look at a document or a transaction, isolated from the context to which it properly belonged. It is the task of the Court to ascertain the legal nature of the transaction and while doing so, it has to look at the entire transaction as a whole and not to adopt a dissecting approach." The SC did not agree with Justice Chinnapa Reddy's observations in McDowells's case that the Duke of Westminster's case was dead. It, therefore, did not accept the Revenue’s submissions that Azadi Bachao should be over-ruled. It further observed that there was no conflict between the two decisions. The decision of House of Lords in Ramsay did not discard the principle in Westminster's case but reading it in the proper context, the “device” which was colourable in nature had to be ignored as fiscal nullity. The SC further observed that “Ramsay lays down the principle of statutory interprtation rather than an over-reaching anti-avoidance doctrine imposed upon tax laws." Tracing the development of jurisprudence in England over the years on this issue, it agreed with the state of law established there [Craven (Inspector of taxes) vs. White (Stephen) (1988) 3 All. E.R. 495], that the “Revenue cannot start with the question as to whether the transaction was a tax deferment / saving device but that the Revenue should apply the look at test to ascertain its true legal nature”. It observed that genuine strategic planning had not been abandoned by any decision of the English Courts till date.

  3. The implication is that tax planning within the framework of law is not to be frowned upon and only if artificial/colourable devices, sham transactions, are resorted to with the sole purpose of evading tax, the Revenue could ignore the same. The onus is on the Revenue to establish that the transaction was sham. In Azadi Bachao's case, routing of investments in India from Mauritius was not considered as a colourable device to evade tax and treaty shopping was not disapproved in absence of anti-avoidance legislation. The same position would thus continue to prevail in terms of the decision of the SC in Vodafone's case.

(ii) Parent-Subsidiary company relationship

  1. Tracing the origin of the theory of legal fiction in the case of corporate bodies to the Pope Innocent IV in the thirteenth century, the SC noted that in law and for tax treaty purposes a subsidiary and parent are separate and distinct tax payers. This is notwithstanding that the autonomy of directors of a subsidiary may be restricted, because of shareholders' influence; that being an inevitable consequence of any group structure. The Court explained that there is difference between having power and having persuasive position and held that the directors and not the shareholders are the managers of a company and their powers are not obliterated because of shareholders’ influence, except where subsidiaries are created as sham entities. Where the subsidiary’s directors are no more than puppets, then the turning point in respect of the subsidiary’s place of residence comes out. Similarly, if there is an “abuse of organisation form / legal form and without reasonable business purpose” and which results in tax avoidance or avoidance of withholding tax, then the Revenue may disregard the form of arrangement and re-characterise the equity transfer according to its economic substance and impose the tax on the actual controlling Non- Resident Enterprise.

(iii) Holding- Investment structures

  1. The Court duly recognized the existence and validity of holding or parent company structures in corporate as well as in tax laws, observing that Special Purpose Vehicles (SPVs) and holding companies have a place in legal structures in India – be it company law, takeover code, SEBI and even the income-tax law.

  2. The SC noted that foreign investors investing in India through companies interposed in Mauritius, is common practice for both tax and business purposes. For example, such companies are interposed to avoid lengthy approval and registration process, which is required in case of direct transfers. Thus, it facilitates exit of a foreign investor. In terms of the SC’s decision, it appears that this reason may well afford a business/commercial purpose for  having intermediary entity(ies) in an investment structure.

  3. According to the Court, when it comes to the taxation of a holding structure, the burden is on the Revenue to allege and establish abuse, in the sense of tax avoidance in the creation and/or the use of such structure(s). Such structures are to be otherwise respected.

  4. The SC further held that on application of judicial anti-avoidance rule, the Revenue may invoke the "substance over form" principle or "piercing the corporate veil" test, only if indirect transfer is made by the non-resident enterprise through the "abuse of organization/legal form and without reasonable business purpose", which results in tax avoidance, and disregard the transaction/structure. The Court gave examples of the application of such anti avoidance rules in situations, such as, circular trading, round tripping, payment of bribes, wherein the structure though having a legal form, could be discarded.

  5. The SC further held that, where an entity which has no commercial / business substance and has been interposed only to avoid tax then it would be open to the Revenue to discard such entity by applying the test of fiscal nullity. However, the structure/ transaction needs to be disregarded at the threshold. It further cautioned that while doing so, the Revenue should look at the documents or the transaction in the context to which it properly belongs and as a whole instead of adopting dissecting approach.

  6. Applying the above tests, the SC concluded that strategic foreign direct investment coming to India, as an investment destination, should be seen in a holistic manner. While doing so, the Revenue / Courts should keep in mind the following factors:

concept of participation in investment;
• duration of time during which the Holding Structure exists;
• period of business operations in India;
• generation of taxable revenues in India;
• timing of the exit;
• the continuity of business on such exit.

In fact, the exit coupled with the continuity of business was held to be an important tell-tale circumstance to indicate commercial/business substance of the transaction.

25. The Court further observed that there is a conceptual difference between pre-ordained transactions created for tax avoidance and transactions which evidence investments to participate in India. It observed that the Hutchison structure was in place since 1994 and was put up for 'participation in investment' in India and was not a 'preordained' transaction. The Court noted that Hutchison has paid huge amount of taxes in India over the year and that HTIL or Vodafone were not fly by night operators / short time investor. The issue of defacto vs. legal control, legal rights vs. participation rights, etc., were not material in such a situation.

26. In short, the onus will be on the Revenue to identify the scheme and its dominant purpose. “The corporate business purpose of a transaction is evidence of the fact that the transaction is not undertaken as a colourable or artificial device. The stronger the evidence of a device, the stronger the corporate business purpose must exist to overcome the evidence of a device.” Generally, a structure involving intermediaries in one or more tax jurisdictions, put in place for making investment in India, would be considered as having commercial/business purpose.

  1. Whether section 9(I)(i) is a “look through” provision?

  1. Section 9(1) of the Act deems certain incomes to accrue or arise in India. Clause (i) of section 9(1) deems, inter alia, "all income accruing or arising, whether directly or indirectly through the transfer of capital assets situate in India", to accrue or arise in India and hence is taxable. It consists of three elements all of which should exist to make this clause applicable, namely, transfer, existence of a capital asset and situation of such asset in India.

  2. It was the contention of the Revenue that income from the sale of CGP share would fall within section 9(I)(i) of the Act, as the said section provides for a "look through" approach, in view of the use of words "through" and 'indirect' in the said section. It was contended that there was the transfer of control over HEL in consequence of the through transfer of CGP share outside India, and the same resulted in indirect transfer of asset, viz., controlling/management right in HEL, etc., and hence there was deemed accrual of income in India. The Supreme Court disagreeing with the arguments advanced by the Revenue, held as under:

  1. Section 9(l)(i) is a deeming provision. A legal fiction has limited scope and cannot be expanded by giving purposive interpretation particularly if the result of such interpretation is to transform the concept of changeability altogether.

  2. The word 'indirect' qualifies income and not transfer. Section 9(l)(i) of the Act cannot, by a process of interpretation, be extended to cover indirect transfers of capital asset / property situate in India. To do so, would amount to changing the content and ambit of that section.

  3. If indirect transfer of a capital asset is read into section 9(I)(i), then the words "capital asset situate in India" would be rendered nugatory.

  4. The words “underlying asset” do not find place in section 9(I)(i) and cannot be read therein.

  5. The provision for subjecting to tax transfer of shares of a foreign company by a non resident, which represents at least 50% of the fair market value of assets in India in the proposed DTC Bill, 2010, indicates that indirect transfers are not covered by the existing section 9(I)(i) of the Act.

  1. The Court noted that provisions like "look through" and "limitations of benefits" have to be expressly provided in the Statute and cannot be read into it by the process of interpretation, as they are policy matters. Section 9(1)(i) was, therefore, held to be not a “look through” provision. The implication of this finding is that the section has to read in its common parlance meaning and nothing beyond as urged by the Revenue.

  1. Transfer of HTIL's property rights in HEL by Extinguishment ?

  1. Revenue contended that HTIL, under the Share Purchase Agreement with Vodafone (SPA), extinguished its rights of control and management in HEL, which were "property rights", and hence there was the transfer of a capital asset chargeable to capital gains tax in India. According to the Revenue such extinguishment took place dehors the CGP share by virtue of the various clauses of SPA, which itself dis-regarded the corporate structure and the legal entities interposed between HTIL and HEL. It was also contended that HTIL had de facto control over such downstream subsidiaries, which control was the subject matter of SPA, dehors the holding in CGP.

  2. The SC held that the case, when looked at holistically, was concerned with the sale of shares and not with the sale of assets. There was the sale of entire investment made by HTIL through a top tier company, namely the CGP.

In any case, HTIL had no legal right to direct its downstream companies in the matter of voting, nomination of directors, etc. The Court accordingly concluded that applying the 'look at' test and without resorting to the dissecting approach, extinguishment of rights, if any, took place because of the transfer of the CGP share and not by virtue of various clauses of SPA. The Court noted that such rights flowed from Shareholder Agreement and even without the SPA, the transaction could ensue.The Court also refuted the Revenue's contention that CGP was a late entrant in the HTIL structure and interposed for avoiding tax. The Court explained the commercial purpose of CGP and the sale of shares at the level of CGP and not the subsidiaries below. It held that “the entire investment was sold to Vodafone through the investment vehicle (CGP). Consequently, there was no extinguishment of the rights as alleged by the Revenue.

  1. Role of CGP share in the transaction

  1. The Bombay HC had held that the transfer of shares of CGP in itself was not adequate to achieve the object of consummating the transactions between HTIL and Vodafone. There was transfer of other rights and entitlements which constituted capital assets within the meaning of section 2(14) of the Act and hence the sale consideration of the extent relatable to such capital assets was liable to tax in India.

  2. The SC reversing the decision of the Bombay HC, held that considering the subject matter of the transaction from a commercial and realistic perspective, there was a share sale and not asset sale. The SC further held that a controlling interest is an incidence of ownership of shares in a company which flows out of the holding of shares. The controlling interest is, therefore, not identifiable or a distinct capital asset independent of holding of the shares. Rights of shareholders may assume character of a controlling interest where the extent of the shareholding enables the shareholder to control the management. Shares and the rights which emanate from them flow together and cannot be disected.

  3. The SC reiterated that a holistic approach needs to be adopted as opposed to disecting approach and as a general rule, in a case where a transaction involves transfer of shares, lock, stock and barrel, such a transaction cannot be broken up into separate individual components, assets or rights such as the right to vote, right to participate in company meetings, management rights, controlling rights, control premium, brand licences and so on, as shares constitute a bundle of rights. Besides, CGP was set up as early as 1996 in the Cayman Islands and was in the Hutchison structure since then. The sole purpose of CGP was not only to hold shares in subsidiary companies but also to enable a smooth transition of business which was the basis of the SPA. It could not therefore be said that CGP had no business or commercial purpose.

  4. The Court held that situs of CGP share was in Cayman Islands only and would not shift to India, even if the underlying assets were in India. It made clear that the “situs of the shares would be where the company is incorporated and where its shares can be transferred” In the present case, it was the Cayman Islands.

  1. Scope and applicability of sections 195 and 163 of the Act

  1. The SC held that since shareholding in CGP- a non resident, was property located outside India, there was no liability for capital gains tax arising in India on offshore transfer of such shares between two non residents, and consequently the question of deduction of tax at source under section 195 of the Act did not arise.

  2. More importantly, the Court observed that if a person does not have tax presence in India, then liability for tax deduction under section 195 does not arise, even if the transaction is liable to tax in India. It was further observed, that the tax presence has to be seen vis-a-vis the transaction subjected to tax and not generally or with reference to an entirely un-related transaction. Mr. Justice K. S. Radhakrishnam, in a separate but concurring judgement, went a step further and held that section 195 of the Act is applicable to payments made by a resident to non-residents and not to payment by a non-resident to another non-resident outside India.

  3. While dealing with the alternate contention of the Revenue that Vodafone could be proceeded against as a "representative assessee" under section 163 of the Act, the SC held that merely because a person is an agent or is to be treated as an agent, would not lead to the automatic conclusion that he becomes liable to tax on behalf of the non-resident. A "representative assessee" is liable only "as regards the income in respect of which he is a representative assessee". On facts, as there was no transfer of a capital asset in India, section 163(I)(c) of the Act did not apply.

Summary of the Findings and their Implications.

  1. If a document or transaction is genuine, the court cannot go behind it to some supposed underlying substance. It is the task of the Court to ascertain the legal nature of the transaction and while doing so it has to look at the entire transaction as a whole and not to adopt a disecting approach. Tax planning may be legitimate provided it is within the framework of law. There is no conflict between McDowell 154 ITR 148 (SC) and Azadi Bachao Andolan 263 ITR 706 (SC).

  2. The fact that a parent company exercises shareholder’s influence on its subsidiaries does not imply that the subsidiaries are to be deemed residents of the State in which the parent company resides.

  3. It is a common practice for foreign investors to invest in Indian companies through an interposed foreign holding or an operating company, such as Cayman Islands or Mauritius based company for both tax and business purposes. This is legitimate to avoid lengthy approvals and registration processes required for a direct transfer of an equity interest in a foreign invested Indian company.

  4. A colourable device for the distribution of earnings, profits and gains, has to be determined by a review of all the facts and circumstances surrounding the transaction. The issue should be viewed in a holistic manner. While doing so, the Revenue/Courts should keep in mind the following factors:-

  1. concept of participation in investment;

  2. duration of time during which the Holding Structure exists;

  3. period of business operations in India;

  4. generation of taxable revenues in India;

  5. timing of the exit.

  6. Continuity of business on such exit.

  1. In the taxation of a holding structure, at the threshold, the burden is on the Revenue to allege and establish abuse. 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 the impugned transaction is a sham or tax avoidant.

  2. Three elements must all exist for the section 9(1)(i) to apply, namely, “transfer”, “existence of a capital asset” and “situation in India”. The purchaser and vendor are offshore companies and since the sale took place outside India, applying the source test, the source is also outside India. Though the purchaser paid consideration to the vendor based on the enterprise value of the Indian assets, valuation cannot be the basis of taxation. The basis of taxation is profits or income or receipt.

  3. If the sum paid or credited by the payer is not chargeable to tax then no obligation to deduct the tax arises u/s 195 of the Act. A "representative assessee", under section 163 of the Act, is liable only "as regards the income in respect of which he is a representative assessee".

  4. Legal doctrines like “limitation of benefits” and “look through” are matters of policy. It is for the Government to have them incorporated in the tax treaties and in the laws so as to avoid conflicting views and to bring about certainty in their administration.

[Source : Article printed in souvenir at National Tax Conference held on 17th & 18th March, 2012 at Guwahati]