The Supreme Court in the Vodafone case seeks to strike a balance between legitimate tax minimisation and abusive tax avoidance
The Supreme Court has pronounced its decision n the much-awaited ‘Vodafone case'. This case concerns the taxability, under the Indian tax laws, of gains arising to a foreign company from transfer of shares of a foreign holding company that indirectly held underlying Indian assets.
In one of India's biggest tax controversies, the tax authority had demanded about $2.5 billion in capital gains tax from Vodafone on the 2007 transaction. The apex court, in a historic judgment, has set aside the decision of the Bombay High Court, which had held the transaction to be taxable in India. Further, the court accepted that tax planning within the framework of law is permissible, unless the planning is a sham or a colorable device.
The source rule provisions under the tax law needs to be strictly construed and, accordingly, in the absence of a ‘look-through' provision, an indirect transfer would not be taxable in India. The situs of the capital asset, being shares, would be situated where the company is incorporated and where the register of members is maintained. The court also observed that in the absence of a statutory anti-abuse rule, the same cannot be implied.
Cross-border acquisition of Indian companies has been a focus of the tax authority in the last couple of years. The ruling of the apex court would set a binding precedent for other similar transactions as well, which are now being investigated by the tax authority or are in various stages of litigation.
The court has reiterated that while tax planning is legitimate, structures that are subterfuges need not be respected for tax purposes. The ruling also acknowledges that use of holding companies and investment structures as well as use of offshore financial centres can often be driven by business/commercial purpose and use of these elements in international structures does not imply tax avoidance.
One of the concerns expressed by several foreign investors in the context of the Vodafone case is the uncertainty created by the approach of the tax authority. The court's order echo's these concerns of the investor community.
The Supreme Court has observed that certainty and stability form the basic foundation of any fiscal system and integral to the rule of law.
The decision of the Supreme Court is a milestone development in the taxation of international transactions and on the judicial approach to tax avoidance. This case is, perhaps, the first in the world where the issue of taxation on indirect transfer of shares was being litigated before a country's highest judicial forum. The principles emanating from this ruling could, therefore, have ramifications beyond India.
It could also be of relevance in shaping India's tax policy on international taxation and tax avoidance in the future.
The proposed Direct Taxes Code (DTC), 2010, contains a provision which seeks to give exemption from taxation of indirect transfer if the fair market value of the underlying Indian assets is not greater than 50 per cent of the total value of the company's assets. The exemption seems to have been granted on the presumption that an indirect transfer is taxable under the general rules relating to source of income. With the apex court now confirming that the source of income rules does not bring to tax an indirect transfer, it is uncertain whether the exemption seeks to achieve its desired objective. With regard to tax avoidance, the court seems to have reiterated that arrangements can be disregarded under the judicial anti-avoidance rule in case of sham or colourable devices.
The court has also acknowledged that taxpayers may arrange their affairs to minimize tax as long as it is within the framework of law. The Supreme Court has sought to strike a balance between legitimate tax minimisation and abusive tax avoidance. However, the general anti-avoidance rule (GAAR) of the DTC could apply to legitimate transactions which do not constitute abusive tax avoidance. Moreover, the discretion to invoke GAAR on the tax authority runs the risk of it being invoked in a frivolous manner. This would, therefore, go against the principles of certainty and stability which the Supreme Court recognised is crucial for taxpayers to make rational economic choices in the most efficient manner.
In framing legislation that is sufficiently all-embracing to deter tax avoidance, there is always the danger of penalising those who have genuine reasons for entering into a bona fide transaction.
The Government should therefore revisit the need for codifying GAAR in view of the acknowledgement of the judicial anti-avoidance rule by the court.
(The author works with Ernst & Young).