The article “Capital gains, everyone else loses” by Prashant Bhushan (February 23, 20120) gives a wrong impression that the Vodafone case has resulted in a loss of several thousands to the exchequer and the Supreme Court has blessed a massive tax evasion scam. The truth is that the demand made by the Income Tax Department was wholly unsustainable. If the Vodafone case had a tax implication of just Rs.10 crore, the case would have been over before the Income Tax Appellate Tribunal itself and there would not even be a single comment in the press or electronic media. But the law does not change if the tax demand is of a large amount.
Shares and assets
The demand for tax in the Vodafone case was a result of failing to understand the difference between the sale of shares in a company and the sale of assets of that company. It is an elementary principle of company law that ownership of shares in a company does not mean ownership of the assets of the company. Thus, an individual who owns 45 per cent or 85 per cent of the share capital does not own 45 per cent or 85 per cent of that company's assets. The assets belong to that company which is a separate legal entity. In the Vodafone case, 51 per cent of Hutchison Essar Ltd. (HEL) was directly owned by the Hutchison group of Hong Kong through a multiple layer of companies and ultimately by a company incorporated in the Cayman Islands. This was not the result of any devious tax planning scheme but the consequences of the growth of Hutchison Essar Ltd. by acquiring several telecom companies over the years. Hutchison International decided to exit its Indian operations and a public announcement was made to this effect.
Vodafone was the successful buyer of the share of the Cayman Island company for $11-billion. Consequently, by purchasing one share of the Cayman Island company, Vodafone came to own 51 per cent of share capital of HEL. The transfer of shares of one non-resident company (Hutchison) to another non-resident company (Vodafone) did not result in the transfer of any asset of HEL in India. All the telecom licences and assets continued to belong to HEL or its subsidiaries.
The absurdity of the demand in the Vodafone case can be explained by two simple illustrations. Hyundai Motors India Ltd. is a wholly owned subsidiary of the parent Hyundai company in Korea. The Indian subsidiary has a large factory near Chennai and perhaps owns several other assets. If, for example, Samsung purchases 65 per cent of the share capital of the parent Korean company in Seoul can it be argued that Samsung has automatically purchased 67 per cent of the factory at Chennai? Consequently, can it be said that the sale of shares in Korea resulted in a capital gain in India which requires Samsung to deduct tax at source under the Indian Income Tax Act, 1961? Under Section 9(1)(i) of our Act, there is liability to tax only if there is a transfer of a capital asset in India. In this illustration, the capital asset that is transferred was the share in Korea and there is no transfer of assets in India. The Indian subsidiary continues to exist and continues to own the factory as well as other assets.
The absurdity can also be seen by a domestic illustration. Tata Motors Ltd. has its headquarters at Mumbai and factories at Jamshedpur and Pune. If another Indian group purchases 67 per cent of the shares of Tata Motors Ltd., the transfer of shares takes place in Mumbai which is the registered office of that company. Can any one say that there is a corresponding transfer of 67 per cent of its factory, lands and buildings at Pune and Jamshedpur as well? Can the local stamp authorities in Jharkhand and Maharastra demand stamp duty on the ground that there is also a transfer of underlying assets? It is elementary that what has been sold is only 67 per cent of the paid-up share capital of Tata Motors Ltd.
The assets of that company remain with that company and do not get transferred. The sale of the shares of Tata Motors cannot and does not result in the transfer of its “underlying assets.”
This is exactly what happened in Vodafone. The shares owned by Hutchison were sold to Vodafone indirectly purchasing 51 per cent of the share capital of Hutchison Essar Ltd., a company registered in Mumbai. Not a single asset of this Mumbai based company was transferred either in India or abroad. Indeed, there would be no transfer of any asset in India.
This is also exactly how several international transactions are concluded. Vodafone was not the first case where transfer of shares between non-resident overseas company resulted in a change in control of an Indian company. But controlling interest is not a capital asset; it is the consequence of the transfer of shares. The demand made by the Income Tax Department in the Vodafone case was thus contrary to elementary principles of company and tax law.
The McDowell case
Prashant Bhushan makes detailed reference to the decision of a five-judge bench in this case. The tragedy is that the observations in the McDowell case were wholly unnecessary. The only issue there was whether the excise duty directly paid by the purchasers of liquor could be included for the levy of sales tax. There was absolutely no need to get into the distinction between tax avoidance and tax evasion. The McDowell judgment had blurred the distinction between these two concepts by not correctly following the development on this subject in the United Kingdom. The true principle is that tax avoidance is perfectly legitimate, but tax evasion is not. For example, central excise duty is exempted for units located in Himachal Pradesh. If an assessee sets up his manufacturing unit in the exempted area, he is “avoiding the excise duty” by taking advantage of a lawful scheme. This is tax avoidance and not tax evasion. Similarly, there is no bar in one non-resident company selling its shares to another non-resident company outside the territory of India. The Indian Income Tax Act does not apply to such transactions and such a transaction cannot be treated as tax evasion.
There has been severe criticism of the India-Mauritius Treaty and it has been accused of depriving the Indian government of crores of rupees of tax revenue. If there is a policy decision to permit tax exemption for investments through Mauritus, one cannot blame the courts for any potential loss of revenue. The government is fully conscious of the so-called loss of direct tax revenue but these incentives are essential to foreign direct investments. The huge growth in the telecom and other sectors has been substantially done through the Mauritius route. One cannot forget the enormous employment generated by FOI and the substantial increase in excise duty, sales tax and other duties and cesses. To merely harp on loss of income tax is not correct.
In the end, the Supreme Court's decision is absolutely correct and adheres to the fundamental principles of company and tax laws. In the Vodafone case the demand was for capital gains tax which never arose in India. Once the hollowness of the department's claim was exposed, the absence of any liability became clear. One should not look at any judgment with a jaundiced eye and condemn it on the ground that it results in a loss of tax revenue.
The courts merely interpret the law and if a transaction is not liable to Indian income tax, one must graciously accept the result.
(The author is a senior lawyer of the Madras High Court.)