The rulings of the Bombay High Court in the famous US$2.5 billion tax assessment case against Vodafone in Vodafone v. Union of India and the rulings more recently in Aditya Birla Nuvo Limited v. DDIT and Union of India, New Cingular Wireless Services Inc. v. DDIT and Tata Industries Ltd. v. DDIT are all full of cautionary tales for foreign investors looking to buy Indian-related assets. All of these cases are multiple examples of the aggressive drive that the Indian tax authorities have embarked on in assessing taxes on transactions that they believe have a nexus with India, and how they continue to repeatedly attempt to narrow the protection afforded by the India-Mauritius tax treaty.
For all those doing business in India or who have invested there, these cases offer a stark reminder of the high tax risks and costs of doing business in India and exemplify how poor tax structuring of India-related transactions can result in a hefty cost to buyers and sellers alike. For the Indian government, these cases constitute a growing problem as they are having a negative impact on foreign investment in the country.
The Vodafone Case
Vodafone’s troubles in India commenced in February 2007, when it entered into an agreement to acquire a majority interest in Hutchison Essar Limited (HEL), an Indian telecom joint venture between Hutchison Telecommunication International Limited (Hutch) and the Essar Group for a total purchase price of approximately US$11.1 billion. Hutch, a Hong Kong company, held its stake in HEL indirectly through a series of holding companies in the Cayman Islands and Mauritius. Vodafone, through a Netherlands subsidiary, acquired its interest in HEL from Hutch indirectly, by purchasing all of the shares of CGP, Hutch’s holding company in the Cayman Islands. A few weeks following the signing of the transaction, the Indian tax authorities issued a letter to HEL intimating that as Hutch would make substantial gains in the transaction, tax should be paid in India. The transaction closed in May 2007. Vodafone paid the purchase price to Hutch without making any withholdings on the account of Indian taxes. In September 2007, the Indian tax authorities issued a notice to Vodafone to show cause as to why it should not be treated as an assessee-in-default for failure to withhold tax on the purchase price for the transaction. Subsequently, the Indian tax authorities commenced legal proceedings against Vodafone for failure to withhold tax on the purchase price and assessed tax liability in the amount of approximately US$2.5 billion. The matter was brought before the Bombay High Court in 2008.
Based on the Indian tax code provisions to the effect that it is the buyer’s responsibility to withhold tax on the purchase price paid to a foreign seller, the Indian tax authorities argued before the Bombay High Court that the sale was effectively an indirect transfer of a controlling interest in an Indian operating company by a foreign seller. The transaction, they argued, was not a mere transfer of shares of a foreign company, but in reality a transfer of a compendium of rights, including effective control and management, which constituted the totality of Hutch’s rights into an Indian company. They emphasized in support of this argument the existence of a control premium in the transaction, an agreement over the right to use the Hutch brand in India, a non-compete agreement with the Hutch group, the assignment of intra-group loan obligations, and certain option rights in relation to specific Indian entities. They concluded that all of these arrangements and rights created sufficient territorial or economic nexus with India to subject the entire transaction to tax in India. Accordingly, the buyer (Vodafone) should have withheld taxes on the purchase price it paid to Hutch.
Vodafone’s arguments were chiefly that the transaction involved the transfer of shares of a Cayman company between two non-Indian resident entities, and as a result, should not give rise to any tax withholding obligations or tax liability in India, because the shares of CGP were not assets located in India, payment of the purchase price was paid outside India between two entities also located outside India, and there was no nexus with India. Vodafone also claimed that neither the ancillary agreements entered into in connection with the purchase (non-compete, right to use the Hutch brand, etc.), nor the need to obtain FIPB approval of the transaction were sufficient to bring the totality of the transaction under the scope of Indian tax laws. It further argued that if any of the shares held by the Mauritius holding companies in HEL had been sold instead of a sale of the shares of the upstream parent CGP, there would be no capital gains tax payable in India by reason of the India-Mauritius tax treaty. Finally, it argued that because no look-through or extra-territorial applicability provisions had been expressly included in India’s tax rules, such provisions could not be introduced through judicial interpretation by the courts.
On September 8, 2010, the Bombay High Court dismissed Vodafone’s petition and ruled that the transfer of the shares of CGP reflected only a part of the arrangement in achieving the object of transferring control of HEL to Vodafone and that the controlling interest, diverse rights and entitlements acquired by Vodafone from Hutch over HEL constituted sufficient nexus with India for the Indian tax authorities to assess tax on the transaction proceeds and institute proceedings against Vodafone for failure to withhold applicable taxes as the buyer in the transaction. In its decision, the High Court acknowledged the tax protection usually afforded by the India-Mauritius tax treaty, and emphasized the fact that because the transaction involved more than a share transfer of an upstream parent of a Mauritius entity, the argument that the transaction should be exempt from tax in India was not sustainable. Finally, the High Court delegated to the tax assessing officers the task of apportioning India-sourced taxable income from the transaction.
The Aditya Birla, Tata Industries and Cingular Wireless Cases
The Bombay High Court maintained a similar view in its July 2011 decisions involving Aditya Birla, Tata Industries and Cingular Wireless.
Those three related cases involved a sale by Cingular Wireless’ subsidiaries of their interest in an Indian telecom joint venture company with Aditya Birla and Tata Industries. The joint venture agreement had been initially entered into by AT&T Corp. and a Birla Group entity in 1995. At the time, AT&T Corp. structured its interest in the joint venture through a Mauritius holding company, AT&T Mauritius, as permitted transferee under the joint venture agreement in order to be able to rely on the favorable provisions of the India-Mauritius tax treaty. In 2000, Tata Industries became a party to the joint venture. In 2004, Cingular Wireless took over AT&T’s interest in the joint venture and decided to exit the venture by selling the interest to third parties. Pursuant to the exercise of their right of first refusal in the joint venture documentation, both Aditya Birla and Tata Industries purchased Cingular Wireless’ stake in the joint venture as follows: Aditya Birla purchased a portion of Cingular Wireless’ shares in the joint venture from AT&T Mauritius. Following that purchase, Tata Industries purchased all of the shares of AT&T Mauritius, which effectively gave it the remainder of the shares of Cingular Wireless into the joint venture. Prior to consummating the purchase Aditya Birla sought and obtained a no-withholding tax certificate from the Indian tax authorities. Tata Industries did not seek such a certificate.
Following closing of the transactions, the Indian tax authorities commenced legal proceedings against all three entities for failure to withhold tax on the purchase price for the purchases. The matters were brought before the Bombay High Court.
In July 2011, the Bombay High Court sided with the Indian tax authorities in all three cases.
In the Aditya Birla matter, the High Court effectively disregarded the existence of the no-withholding tax certificate on the basis that the certificate had been obtained through misrepresentations as to the actual ownership of the shares and that the delivery of such certificate did not preclude tax officers from changing their position if they had not received full information upon application for the certificate. It also ignored the fact that the sale was by a Mauritius seller to a foreign seller and should be exempt from withholding tax under the India-Mauritius tax treaty. The High Court found that AT&T Mauritius was not a party to the initial joint venture agreement between AT&T Corp. and Aditya Birla and was only brought on to hold the shares as a permitted transferee under the original joint venture agreement, and that while money was funneled through AT&T Mauritius to pay for the shares, beneficial ownership of the shares had not vested in AT&T Mauritius as all rights and obligations under the joint venture agreement ultimately resided in the U.S. parent Cingular Wireless. The High Court based its findings in particular on the lack of documentation evidencing an active role of AT&T Mauritius as an owner of the shares. Therefore the High Court found that AT&T Mauritius was not the actual owner and seller of the shares and deemed the India-Mauritius tax treaty inapplicable where the seller was a non-Mauritius entity. In this decision, the High Court again asserted its position enunciated in the Vodafone case that form may not prevail over substance in tax planning matters and that the court will disregard transactions that are seen as colored and schemes to evade taxes.
In the Tata Industries matter, Tata’s arguments were similar to those of Vodafone in its case, namely that the transaction only involved the transfer of shares of a foreign company abroad, and as a result, should not give rise to any tax withholding obligations or tax liability in India as there was no nexus with India. Not surprisingly, as in the Vodafone matter, the High Court found that the transaction did have a nexus with India since the underlying asset was the shares of an Indian company and therefore income had accrued in India.
All these decisions (and many other similar cases pending) are clear marks of a trend to tax in India international transactions that have an India nexus, however remote, and are full of lessons for international investors in India.
Lesson No. 1 – It is imperative to structure any investment in India through a company located in a treaty jurisdiction.
While the India-Mauritius tax treaty remains the preferred source for equity investments into India, various other countries (e.g., Singapore, Cyprus, The Netherlands, etc.) have entered into favorable tax treaties with India, which may offer various degrees of protection from taxes in India, especially upon an exit from the investment. In the Vodafone case or the Tata Industries case, neither Hong Kong (residence of the seller in the Vodafone case) nor the United States (residence of what the courts deemed to be the real seller in the Tata case) have favorable tax treaties with India and therefore the direct protection of treaties could not be invoked. While the Aditya Birla case and related cases have significantly weakened the protection afforded by the treaties, the Supreme Court of India has upheld the sanctity of India’s international tax treaties in its landmark case Union of India v. Azadi Bachao Andolan and it is expected that it will continue to support this position.
Lesson No. 2 – While structuring investments through a treaty jurisdiction, it is equally imperative that substance be created in those jurisdictions.
Substance bolsters the applicability of the protection afforded by these treaties. As evidenced in all of these cases, the courts in India will treat the treaty as inapplicable where they believe that there is no substance to the company relying on treaty benefits. Shell holding companies are especially vulnerable to being disregarded by the authorities in India. Effective management and control over the investment must be vested in the treaty jurisdiction holding company so as to be recognized by Indian tax authorities. In that respect, Singapore holding companies may fare better than companies from other treaty jurisdictions because of the requirements of the Singapore treaty that the Singapore entity show total annual expenditure of at least S$200,000 in operations, in the immediately preceding two years.
Lesson No. 3 – Legal documentation and information disseminated publicly relating to the transaction must be carefully crafted by the parties so that the rights and obligations come to vest in the treaty jurisdiction entity.
Routing payment through the Mauritius holding company and having the Mauritius holding company be the holder of record of the shares in the joint venture was not sufficient, for example, in the Cingular Wireless matter and related matters. The High Court pointed to the fact that the Mauritius holding company was not a party to the original joint venture agreement and that all obligations and liabilities under the agreement ultimately were of its parent. It also pointed to the shareholders’ agreement amongst the founders of the joint venture to support its findings that the Mauritius holding company was only a conduit with no substance. The paper trail of these transactions should be carefully established. Similarly, it is worth noting that in both the Vodafone and the Aditya Birla case, the High Court commented extensively on the public disclosures made by Vodafone and Cingular Wireless in their filings with the U.S. Securities and Exchange Commission to characterize the transactions. It is important therefore to ensure those documents are carefully crafted with these considerations in mind.
Lesson No. 4 – When the timing of the transaction permits, interested parties should approach the Indian tax authorities for an advance ruling as to the applicability of tax in India to the transaction.
While the Aditya Birla case has significantly weakened the reliability of these advance rulings, they offer the opportunity to commence discussions with the Indian tax authorities prior to the consummation of a transaction. This process, which can last from a few weeks to several months depending on the case, may give the parties the ability to adjust the economics of the deal between them prior to closing, and set up pre-closing mechanisms to handle the issue post-closing (for example, through escrow and indemnification arrangements if the findings of the Indian tax authorities are contested). It is worth noting that in the Vodafone case, the High Court did note the availability of these procedures and remarked that the parties chose not to use those procedures.
Lesson No. 5 – Buyers should seek indemnification with respect to any Indian taxes applicable to the transaction from sellers.
Such indemnification should be supported by an escrow when possible under the terms of the deal. Note that because under Indian law it is the buyer’s obligation to withhold and remit the tax to the Indian authorities, indemnification would need to cover any penalties and fines that may be imposed on the buyer as a result of a failure to withhold.
Lesson No. 6 – Investors should consider segregating India-related assets and rights from other aspects of the transaction in transactions in which multiple assets and rights are involved.
Doing so may limit any tax liability to those assets and rights that have a true India nexus. This is particularly true in transactions in which the value of the Indian-related assets being transferred is only a small portion of the total value of all assets being transferred. For example, in cases of a purchase of a global company with a small India subsidiary operation. The New York Times on January 3, 2011 reported of a public-interest litigation filed last year in the Delhi High Court against Kraft Foods for tax evasion relating to its $19 billion takeover of Cadbury. According to The New York Times, a finance ministry official in India mentioned that "action has been initiated in the matter under the Income Tax laws." Kraft Foods’ acquisition of Cadbury is an example of sale of shares of a foreign company to another foreign company with just a small portion of the deal connected to India. According to the lawsuit, the brands, goodwill, franchise, market share, customer lists, relationship and the value of market, etc. are capital assets being transferred in India and therefore Kraft is under an obligation to deduct the income tax while making payment for the acquisition.
Lesson No. 7 – These cases are evidence of a sweeping interpretation by the courts of the concept of nexus with India.
In each case, the High Court disregarded the parties’ argument that the transactions were offshore transactions, and effectively pierced through the corporate veil to find nexus with India where indirect ownership of Indian assets was concerned. The implications of this are vast, as Adidas AG found out recently that it was assessed tax on insurance payments it had received under a global insurance policy with respect to damages that occurred at facilities in India owned by its Indian subsidiary. The Indian tax authorities took the position that even though premiums on the policy had been paid by the parent company, the payments received from the insurer should be allocated to the Indian subsidiary since the damage occurred in India.
Lesson No. 8 – Buyers should be ready to withhold and negotiate the economics of the transaction with sellers when it seems that the treaty protection is not going to be available.
Part of these negotiations should include tax planning with sellers to determine how the impact of the withholding may be mitigated through the use of foreign tax credits or otherwise.
Lesson No. 9 – Beware of any language in the documentation that provides for payments to be subject to applicable withholding taxes.
In any transaction relating to India, it is important for the buyer and seller to have a clear understanding of the scope of the withholding prior to entering into any agreement.
Lesson No. 10 (perhaps the most important one) – When dealing with India, always remember that Indian tax laws are a constantly evolving landscape shaped by policies as much as by politics and therefore one is never too cautious.
Update on Vodafone and Indirect Taxation of Sale of Indian Companies
Vodafone, Aditya Birla and others have appealed to the Supreme Court of India against the Bombay High Court’s decisions. Hearing of the Vodafone appeal has already commenced and is ongoing, and the Supreme Court is expected to make a decision sometime in the next few months.
This decision will be closely watched not so much for its impact on Vodafone and Hutch but more importantly because there is a growing series of cases presenting similar issues (such as the Aditya Birla, Cingular Wireless, Tata Industries and Kraft Food cases discussed above and many others pending in India) and foreign investors will be looking for more certainty with respect to tax matters as they make decisions to invest in India.
In a related ongoing development, India also is in the process of replacing its existing Indian Income Tax Act, 1961 with a new Direct Tax Code. If approved by the Indian Parliament, this new Direct Tax Code will become effective on April 1, 2012. The current draft of the Direct Tax Code contains sweeping provisions on general anti-avoidance rules. Under this new Direct Tax Code, the Commissioner of Income Tax will have authority to declare any arrangement as an impermissible avoidance arrangement. The effectiveness of these provisions will be another arrow in the quiver of the Indian tax authorities to assess tax on international transactions with an India nexus and could further modify the foreign investment landscape.
Steven D. Bortnick, Valérie Demont and Bipul K. Mainali