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Updated: June 14, 2012 13:15 IST

Capital gains, everyone else loses

Prashant Bhushan
Comment (33)   ·   print   ·   T  T  

In the Vodafone case, the Supreme Court has again made a wrong call on tax avoidance, setting a precedent that jeopardises thousands of crores of potential revenue for the exchequer.

Tax avoidance through artificial devices — holding companies, subsidiaries, treaty shopping and selling valuable properties indirectly by entering into a maze of framework agreements — has become a very lucrative industry today.

A large part of the income of the ‘Big 5' accountancy and consultancy firms derives from tax avoidance schemes which flourish in the name of tax planning. Their legality has agitated courts in India and abroad for a long time. In 1985, a 5-judge bench of the Supreme Court in the McDowell case settled the question decisively, observing:

“In that very country where the phrase ‘tax avoidance' originated, the judicial attitude towards [it] has changed and the smile, cynical or even affectionate though it might have been at one time, has now frozen into a deep frown. The courts are now concerning themselves not merely with the genuineness of a transaction, but with [its] intended effect for fiscal purposes. No one can now get away with a tax avoidance project with the mere statement that there is nothing illegal about it. In our view, the proper way to construe a taxing statute, while considering a device to avoid tax is … to ask … whether the transaction is a device to avoid tax, and whether the transaction is such that the judicial process may accord its approval to it.”

“It is neither fair not desirable to expect the legislature to … take care of every device and scheme to avoid taxation,” the ruling added. “It is up to the Court … to determine the nature of the new and sophisticated legal devices to avoid tax ... expose [them] for what they really are and refuse to give judicial benediction.”

‘Legitimate tax planning'

Despite such a clear pronouncement, two recent judgments of smaller Supreme Court benches have gone back to calling artificial tax avoidance devices “legitimate tax planning”.

Though the Income Tax Act obliges even non-residents to pay tax on incomes earned in India, many foreign institutional investors avoided paying taxes citing the Double Taxation Treaty with Mauritius. This treaty says a company will be taxed only in the country where it is domiciled. All these FIIs, though based in other countries and operating exclusively in India, claimed Mauritian domicile by virtue of being registered there under the Mauritius Offshore Business Activities Act (MOBA). Companies registered under MOBA are not allowed to acquire property, invest or conduct business in Mauritius.

Yet these ‘Post Box Companies' claimed to be domiciled there and the I-T department allowed them to get away with claiming the benefits of the treaty for many years. Given the benign attitude of the Indian tax authorities and the fact that there was no capital gains tax and virtually no tax at all on these companies in Mauritius, most FIIs and most of the foreign investment in India, by 2000, came to be routed through Mauritius.

The party finally ended when a proactive tax officer tried to stop this blatant evasion. Relying on McDowell, he lifted the corporate veil of MOBA companies to determine their place of management and actual place of residence. Since this happened to be in different countries in Europe or North America, the relevant Double Tax Avoidance treaty became the one between India and that country. All these treaties provided for capital gains to be taxed where the gains had accrued. Since the gains accrued in India, he levied capital gains tax on these FIIs.

The CBDT circular

Responding to the FIIs' distress calls, the then Finance Minister, Yashwant Sinha, got the Central Board of Direct Taxes to issue a circular stating that once a company had obtained a tax residence certificate from Mauritius, it would not be taxed in India.

The CBDT's circular was challenged in the Delhi High Court by Azadi Bachao Andolan and a retired Income Tax Commissioner. The petitioners also pleaded that the government be directed to amend the treaty with Mauritius since it had become a tax haven. The High Court allowed the writ petitions and quashed the CBDT circular, holding it violative of the I-T Act.

The government appealed, telling the Supreme Court that its circular — which effectively offered a tax holiday to FIIs — was needed to attract foreign investment. The petitioners responded that tax exemptions could only be granted by Parliament, either by amending the Income Tax Act or by the Budget passed each year, and not by the government in the guise of such a circular. However, a two judge bench in 2003 called this device an act of legitimate tax planning which could be promoted by the government to attract foreign investment, defied the Constitution bench judgment in McDowell and set aside the Delhi High Court judgment.

In the Vodafone tax case, which was heard by a 3-judge bench of the Supreme Court, the court had the opportunity to correct the transgression of the McDowell principle in the Mauritius case. In 2007, Hutchinson Telecom International (HTIL), which owned 67 per cent of Hutch Essar Limited (HEL), an Indian telecom company, sold its holding to Vodafone International (VIH BV). Both companies announced that Hutchinson had sold, and Vodafone had bought, 67 per cent of the shares and interest in the Indian company for over $11 billion.

Section 9(1) of the Income Tax Act says incomes which shall be deemed to accrue or arise in India include “all income accruing or arising, whether directly or indirectly, through … the transfer of a capital asset situated in India.”

Vodafone's claim

Since the transfer of the Indian telecom firm's shares and assets to Vodafone had led to capital gains for Hutch, the IT department demanded capital gains tax from Vodafone, which was liable to withhold this tax from the amount they paid Hutch. Vodafone claimed the transaction was not liable to tax since it was achieved by transferring the shares of a Cayman Island-based holding company and did not involve the transfer of a capital asset situated in India. The High Court rejected this contention by holding:

“The facts clearly establish that it would be simplistic to assume the entire transaction between HTIL and VIH BV was fulfilled merely upon the transfer of a single share of CGP in the Cayman Islands. The commercial and business understanding between the parties postulated that what was being transferred … was the controlling interest in HEL. HTIL had, through its investments in HEL, carried on operations in India which HTIL in its annual report of 2007 represented to be the Indian mobile telecommunication operations. The transaction between HTIL and VIH BV was structured so as to achieve the object of discontinuing the operations of HTIL in relation to the Indian mobile telecommunication operations by transferring the rights and entitlements of HTIL to VIH BV. 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.

“Ernst and Young who carried out due diligence of the telecommunications business carried on by HEL and its subsidiaries made the following disclosure in its report:

“The target structure now also includes a Cayman company, CGP Investments (Holdings) Ltd. CGP Investments (Holdings) Ltd was not originally within the target group. After our due diligence had commenced the seller proposed that CGP Investments (Holdings) Ltd should be added to the target group …”

The due diligence report emphasizes that the object and intent of the parties was to achieve the transfer of control over HEL and the transfer of the solitary share of CGP, a Cayman Islands company, was put into place at the behest of HTIL, subsequently as a mode of effectuating the goal.”

Following McDowell, where the Supreme Court had decisively frowned upon tax avoidance schemes, the High Court rejected Vodafone's contention that this transaction was not liable to tax. But in appeal, a Supreme Court bench of 3 judges headed by Chief Justice Kapadia accepted Vodafone's claim that the capital gain had arisen only from the transfer of the single share in the Cayman Island company and had nothing to do with the transfer of any asset situated in India.

Despite the fact that the entire object and purpose of the transaction between Hutch and Vodafone was to transfer the shares, assets and control of the Indian telecom company to Vodafone, the Supreme Court declared in January 2012 that the transaction has nothing to do with the transfer of any asset in India!

With such welcoming winks towards tax avoidance devices, it is unlikely that any foreign company would be called upon to pay tax or at least capital gains tax in future in India. Thousands of crores of tax revenue, and the future attitude of the courts towards innovative tax avoidance devices, will be shaped by these two judgments.

The Vodafone case is in the lineage of the Mauritius case inasmuch as both encourage tax avoidance devices ostensibly to attract foreign investment. The 2G judgment of the Supreme Court cancelling 122 telecom licences granted four years earlier, in sharp contrast, enforces the constitutional principle of equality and non-arbitrariness. The proponents of FDI are groaning that this will stem the flow of investment. Honest foreign companies should not be deterred by this judgment, which strikes a blow against crony capitalism. But even if FDI becomes a casualty in the enforcement of the rule of law, so be it.

Our courts must send a clear signal that India is not a banana republic where foreign companies can be invited to loot our resources and even avoid paying taxes on their windfall gains from the sale of those resources.

(The author is a Supreme Court advocate)

Arvind P. Datar's responds to this article

More In: Lead | Opinion

Supreme Court of India, or for that matter any of the so called
Courts of Justice, are essentially Courts of Law and not Courts of
Justice. While the Justice should be done and also seen to be done
but, if not done, there is nothing that can stop the learned Supreme
Court Advocate to seek review by SC Constitutional Bench. Further, if
his contention on avoidance of Tax is convincing, he should also take
up with the Govt to enact Law to stop Tax evasion.

from:  Babubhai Vaghela Ahmedabad
Posted on: Mar 5, 2012 at 19:05 IST

to resolve the problem of capital gain taxation, only method is exempt
capital gains on sale of long term holding of shares altogether,i.e.
both in the hands of residents and non residents. Have some mechanism to
tax undistributed profits so that people don't convert the dividend in
to L.T. capital gain rather than inventing new solutions. S.C. has
decided some principles based on the various principles decided
earlier.How can some one comment the decision of S.C is wrong or
incorrect if one believes in the Constitution of the country.

from:  t.p.ostwal
Posted on: Mar 5, 2012 at 17:58 IST

Some where reading along similar topic, I came to know that there are two departments held in this case one Justice & Parliament. As far as this Tax Evasion is considered Parliament is liable to create an ACT where such evasions cannot be done. Which has failed in the prowess of our beloved representatives in serving FIIs. And now everybody is mocking the Justice system. I am wondering if the CJI had to take all bashing, what about Parliament, IT department and CAG.

Before this matter reaching shores of already burdened Justice system why isn't this solved within DOT? They knew this transaction is going to happen they could have stepped in taking their role, but nah we are far better in pointing hands rather than doing things.

Now CJI's is all for blame as his son was working!!!!

from:  Arun Kumar
Posted on: Mar 2, 2012 at 15:45 IST

This is utter nonsense. If today you buy 10% of the shares of a particular company,
let us say Jet Airways, does this mean that you automatically own 10% of all of Jet
Airways' assets? Does this mean that 10% of the entire fleet of aircraft now belongs
to you? By buying out a company that holds 67% of HEL, it doesn't mean that
Vodafone now owns 67% of the assets of HEL. Those assets continue to belong to
HEL, which is a separate legal entity based in India. Because there has been no
transfer of assets, there has been no capital gain.

Plain and simple, there is absolutely no sense in what Mr. Bhushan is saying here.
With regards to McDowells case, the parts he is referring to formed part of the the
obiter of the case, and future judgements are not affected by it.

Obiter dictum is the Latin term for 'something said in passing'. Obiter dictum is an
observation made by a judge which, though included in the judgement, does not
form part of the decision.

from:  Gurmeet
Posted on: Mar 2, 2012 at 11:43 IST

Prashant Bhushan is dot on the money. The judgment Is a mockery of justice and seems
to be influenced by extraneous factors like FDI. The news about CJI's conflict of interest in
the case is disturbing. The CJI should have recused himself from the case...

from:  Obama
Posted on: Feb 24, 2012 at 16:22 IST

I am not aware of the detailed facts of the case. But the primary effect of this transaction has been that the business in India alongwith its assets and liabilities has been transferred. I personally think that the transaction should have been taxable in India with all the concessions available under law for long term capital gains tax.

from:  Subir Das
Posted on: Feb 24, 2012 at 13:50 IST

First of all MOBAA was abolished as far back as in 2001! Global business companies which have replaced the now defunct offshore companies are allowed and do trade with residents in Mauritius. they are not simple letter box but real companis with real persons as directors and file audited accounts and pay taxes in MAuritius.
Thanks to the treaty between Mauritius and India trillions of dollars of investments are routed into India through mauritius every year. Were it not for these investment India would certainly not have enjoyed the level of growth that it is enjoying.
Thanks to the treaty inidan companie get cheap source of equity financing which enable them to make profits which are TAXED in India. Indian resident shareholders also enjoy appreciation in their investment and pay capital gains tax.
No doubt India will be the biggest loser if the DTA with Mauritius goes away

from:  Muhammad
Posted on: Feb 24, 2012 at 12:39 IST

SC judgement is wrong in parts. Consideration and resultant gain was
for share and controlling interest in India. Bombay High Court was
right to ask tax Authorities to split gain and charge tax on portion
attributable to Assets in India. Sadly Supreme Court was influenced
by effect on FDI policy.

from:  Atma Gandhi
Posted on: Feb 24, 2012 at 11:12 IST

I am not an expert in the tax practices Can some professional comment on a question.
Today, non-residents of Indian origin are allowed to invest in one property in India. When he decides to sell the asset to another person resident in India , he is liable to pay tax on capital gains. If he sells the property to another Indian Non.resident, is or is not the transaction subjecy to tax on the capital gains?
Is this transaction similar to the case discussed in the article?

from:  B.Ratnam
Posted on: Feb 24, 2012 at 09:59 IST

I do not agree with Mr. Prashant Bhushan's view point. The issue relates not to the purported tax evasion, but to the lack of clarity in our tax law. The taxation law should not enunciate a mere principle but also state with unambigous clarity what is taxatble and what is not. Unless this is done, the transacting parties will not know in advance, before binding themselves into a business contract, where do they stand in respect of tax liability. We cannot blame the Courts for ambiguity in our laws. The Courts cannot step in the shoes of the Parliament and start enacting the laws. Their job is to examine,whether the enacted laws stand test of constitutionality. It is always open to the government to suitably amend the tax laws to plug the loopholes that encourage such tax avoidance. Why the government is not doing this?

from:  Pramod Patil
Posted on: Feb 24, 2012 at 06:14 IST

Income tax department should go for CURATIVE PETITION, if they really care for India. In my personal views and definitely I am not pinpointing or raising fingers on anyone, just wish to say that It has not been the year of digestable judgements so far.

from:  Subrat Shrivastava
Posted on: Feb 24, 2012 at 02:58 IST

One has to assume the judges took all relevant
factors into account when they issued the judgement. It is dangerous to
ask judges to go beyond the actual applicable law. That would lead to
anarchy.

from:  S. Atluru
Posted on: Feb 24, 2012 at 00:55 IST

This article is not just excellent, it's perfect. SC judgment in the Vodafone case is a
mockery of rule of law. While a poor person when he buys a soap pays sales tax on
it, here a big company has been able to defraud the public with great help from CJI's
bench that reversed the HC judgment.

from:  Pranav Sachdeva
Posted on: Feb 23, 2012 at 21:05 IST

I am amazed at the shortsightedness of the supreme court. I think they should change the decision.

from:  Vivek
Posted on: Feb 23, 2012 at 19:20 IST

The SC judgement unfortunately denies India of legitimate tax revenue. Yje judges who pronounced the judgement (as also others who advised the puisine judges) would do well to read this article by Mr Prashant Bhushan,

from:  abhishtu
Posted on: Feb 23, 2012 at 18:29 IST

Well said by the author. Unfortunately, tax evasion schemes is not just a problem in India, but all over the world. Global companies virtually own many governments, and have caused havoc with world economies. India should take heed, and nip the mischief in its buds. Profits made in India must be taxed in India, irrespective of the evasion schemes.

from:  Narinderpal S Sood
Posted on: Feb 23, 2012 at 18:06 IST

The entire arguement that Hutch India was never an Indian resource is false per se, it is was operating in India not in sky and it was indeed the transfer of assets in India then why should not it has been taxed. Rather than going on the spirit of letter of law it must have been better if there was adherence to the spirit of law which is to enrich the coffers of India that could be used for welfare.

from:  lawyerjourno
Posted on: Feb 23, 2012 at 17:24 IST

Great that our media is showing some grit. Much needed. If we are
going to lose FDI, in being righteous, so be it!

from:  Arthy
Posted on: Feb 23, 2012 at 16:09 IST

Judiciary activism of Prashant Bhushan brand like this needs to be
encouraged as it exposes the twisted versions of law, loot and loans
all getting manipulated to serve the 1%. Can Anna Team Help or it shall
also provide lip service only? There are several middle level business
houses who apply this trick of putting money in tax heaven and
claiming not to pay in India due to due to false interpretation of
double taxation.How can the taxation get blindfolded when the human
capital coverts the raw material into a valuable asset in India as in
the case of Vodafone Judgement where the media rumour is CJI son is
working in the same company which has carried forward the due
diligence.

from:  Rakesh Manchanda
Posted on: Feb 23, 2012 at 15:16 IST

Tax avoidance by individuals as well as companies by means of holding and post-
box companies is a big problem worldwide. The ease with which capital can be
moved around the world at least on paper and the unwillingness of governments
to do anything against this practice, often due to conflict of interests is costing the
honest taxpayers everywhere as a substantial part of the revenues now go missing.

It is high time to put an end to this practice and maybe even outlaw such sham
companies which exist only for the purpose of tax evasion! India should also force
the initiative on tax evasion by Indian citizens via tax havens abroad. Sadly, many
of the politicians and creme-de-la-creme of our society are the ones involved and
it may take a long while until anything is done about these malpractices.

from:  Vivek
Posted on: Feb 23, 2012 at 15:02 IST

Judiciary activism of Prashant Bhushan brand like this needs to be
encouraged as it exposes the twisted versions of law,loot and loans
all getting manipulated to serve the 1%.Can Anna Team Help or it shall
also provide lip service only? There are several middle level business
houses who apply this trick of putting money in tax heaven and
claiming not to pay in India due to due to false interpretation of
double taxation.How can the taxation get blindfolded when the human
capital coverts the raw material into a valuable asset in India as in
the case of Vodafone Judgement where the media rumour is CJI son is
working in the same company which has carried forward the due diligence.

from:  Rakesh Manchanda
Posted on: Feb 23, 2012 at 15:00 IST

When Mr.Bhushan says that "...even if FDI becomes a casualty in the
enforcement of the rule of law, so be it" I'm not sure he knows what
he's talking about. Attracting FDI is necessary towards maintaining a
high economic growth rate, that which provides the necessary tax base
to fund the (hare-brained) populist entitlement programmes being run
by a profligate government.It is very easy to take the high ground and
pronounce principles-based judgements when one is not a stakeholder in
the outcome of a decision. While the quantum of FDI will not make a
difference to the author's life, it has widespread ramifications for
the common man of this country whose priority is a better standard of
living and not fine-grained arguments over an ambiguous legal
provision. The author goes way off mark in the last para.Hutch India was never an Indian resource. It was foreign-owned then and it's foreign-owned now. The entire dispute is over capital gains tax.Nothing less,nothing more.

from:  Ankit Agrawal
Posted on: Feb 23, 2012 at 14:17 IST

In McDonald's judgement, SC had categorically stated that legislatures
might not be able to close all loop holes and if such loop holes were
evident, SC will act against the defaulters (here McDonald's). SC
contradicted itself saying Vodafone case is a test case. Too bad. SC is
a body and should stand firm and make judgement referring previous cases
and it should be non-arbitrary. Good piece of article. Shows clearly
that SC judgement can also go wrong...Keep this article in light.

from:  Mithun
Posted on: Feb 23, 2012 at 14:13 IST

This explains why the black money discussion in the parliament was a badly scripted fixed match.
Such treaties and circulars not only force honest Indian companies to go via the other country but also deems them if they don't follow these practice. A country which forces its own companies to follow the bad practice is simply saying Good Honest ppl are not welcomed. FOREIGN fund used to corrupt the country and destabilize it can only be called foreign invasion... This should be banned under Unfair Trade practice(FDI in other sectors precisely banned for this reason). IPL mess is precisely this problem and nobody talks about it in the media

from:  deepan patel
Posted on: Feb 23, 2012 at 13:53 IST

In my view the CJI must have relieved himself during the judgement as
there could be a conflict of Interest as CJI's son is woking in the same
company which has carried the due diligence. As the center has filed a
review petition it will be interesting to see if the judgement will be
reivewed by a expanded bench. At the same time the center should come
with a frame work to hinder such innovative tax avoidances.

from:  Sudhakar Matta, Executive Member, Lok Satta Party
Posted on: Feb 23, 2012 at 12:18 IST

I think this article is absolute nonsense.
There is no tax avoidance at all in this case. If left to the author even the air we breath should get taxed.

from:  rohit
Posted on: Feb 23, 2012 at 11:31 IST

Regarding the SC order on the Vodaphone case, I would like to to agree with the general feeling that except the ones like the 2G spectrum judgement, most of the judicial pronouncements reflect the moods of the powers-be.

from:  s.selvanathan
Posted on: Feb 23, 2012 at 11:26 IST

The thinking lawyer is bold and outspoken. He is very right. Written
words cannot spell out fully the intended purpose governing a rule
framed to comply with the laws of the land; that is the inadequacy of
the written language over the faculties of mind to fully convey the
full import of such a rule or law. It is here the clever and the
cunning, sniff and sift for loop holes in between the lines or look
for far-fetched interpretations to circumvent the legal compliance. It
is for the Judiciary that is endowed with intellectual minds to
appreciate the 'purpose’ and thwart any attempt by the scheming
'foxes' to subvert the administration of justice. Despite the critical
observations in an earlier judgment on avoidance of tax in the case of
McDowell, as precedence, Prashant Bhushan is rightly anguished at the
Supreme Court letting off Vodafone based mainly on the loop holes in
the rules, causing huge loss to the Exchequer and opening the flood
gates for such heists in the future.

from:  M.R.Sampath
Posted on: Feb 23, 2012 at 11:17 IST

A well written article. Intent is clear here. There is need to
understand the hidden intentions of Foreign companies in the name of
legitimate tax planning. We need an innovative approach to handle
these situations. Hopefully, citizens of these countries will see
holistic tax reforms in near future.

from:  Sumit
Posted on: Feb 23, 2012 at 11:05 IST

I am not sure if this is the case of judicial laziness or plain incompetence, but if the judgements become a sort of precedence, then every small, medium and large company will register themselves in Mauritius and refuse to pay tax here although they do their business in India.
If Legislative and Executive arms of the democracy attempt to weaken the constitution,people go to Judicial arm and if the Judicial arm too is incompetent or worse of being corrupt, where would the people of India go.

from:  vamsi
Posted on: Feb 23, 2012 at 11:01 IST

This is tax avoidance, as simple as that. As vodofone claims that the transaction was in cayman island, then they should do business there not here in India.

from:  Jose
Posted on: Feb 23, 2012 at 09:51 IST

I do not hold the judiciary in high respect. I have high respect for a good judgement.

from:  Hilary Pais
Posted on: Feb 23, 2012 at 09:41 IST

Prashant Bhushan is right on the money. Mere interpretation of the letter of the law in this case defeated the very purpose of the law in the first place. The spirit of the law must be upheld.

from:  Krishna Dammanna
Posted on: Feb 23, 2012 at 02:10 IST
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