Vodafone Income Tax case - Bombay HC arguments

The Hutch-Vodafone tax controversy presently pending before the Bombay High Court can have important legal implications not just for Vodafone (which faces a US$2 Billion tax bill) and the Indian Revenue (which stands to gain an opportunity for taxing several similar transactions); but may have an impact on several other players. For instance, the decision of the Court is likely to affect and decisions on investments in India by foreign investors; and may well have an impact on domestic tax-payers in the form of re-igniting the “substance versus form” debate in Indian tax administration. The importance of the issues led to long arguments in the Bombay High Court over a period of over ten days before a Bench headed by Justice Radhakrishnan. Senior Advocate Iqbal Chagla appeared for Vodafone; while Additional Solicitor General M. Parasaran appeared for the Department of Income Tax. A detailed discussion of the issue will be posted once the judgment is out. Presently, this post will note the arguments of both sides in brief.

The dispute arose because of the acquisition of shares in a Mauritius company by Vodafone from Hutchinson. The Income Tax Department’s claim is that the capital gains derived by Hutchinson through this transaction are taxable in India; because the shares of the Mauritius entity were valuable only because the Mauritius company held shares in an Indian mobile operator, Hutch Essar. Thus, the Department claims, what has actually been transferred is the controlling interest in an Indian entity – Hutch Essar; and the transaction is not one of a simple sale of shares in a Mauritius company.

The capital gains arising out of a sale of a capital asset situate in India are taxable under S. 9 of the Indian Income Tax Act, 1961. Accordingly, the Department issued a show-cause notice to Vodafone for failing to withhold tax at source while making payment to Hutchinson. The Finance Act, 2008, introduced a further retrospective change in law casting liability on Vodafone. Vodafone filed a petition before the Bombay High Court challenging the constitutional validity of the retrospective change introduced by the Finance Act, 2008; and also the validity of the show-cause notice.

Vodafone’s arguments in the Court proceeded at the following levels:

The retrospective change in law is constitutionally invalid as it is arbitrary under Article 14.

In any event, the transaction being a sale of shares of a Mauritius entity, there has been no transfer of a capital asset situate in India. Therefore, the question of application of S. 9 of the Income Tax Act does not arise.

In any event, the provisions of the Income Tax Act dealing with deduction of tax at source do not apply to non-resident companies. That being the case, even if the capital gains accruing in the hands of Hutchinson are deemed to be taxable in India, Vodafone does not have any liability to deduct tax at source. The word ‘person’ occurring in S. 195 of the Act must be construed to mean ‘resident’; as any other reading will lead to an extra-territorial application of the act.

The Department in its oral arguments argued the following:

The petition is not maintainable at the stage of show-cause notice because it is premature and because Vodafone has an alternative remedy in terms of departmental appeals and appeals under the Income Tax Act once the assessment proceedings are over.

The transfer of the sale of the Mauritius shares has in fact resulted in the transfer of a capital asset situate in India. In fact, the parties intended to achieve this result; in light of the fact that they sought the approval of the Indian Foreign Investment Promotion Board (FIPB) before the transaction; which was unnecessary had no transfer of a capital asset situate in India been contemplated.

No distinction can be drawn between residents and non-residents in the matter of withholding tax at source. The word ‘person’ cannot be read as ‘resident’; as that would be reading down a procedural section which is a tool for recovery of tax.

On the maintainability issue, it is hard to see which alternative forum Vodafone could have approached given that the constitutionality of a statute is called in question. While there appears to be some merit in the argument that the petition for quashing the show-cause notice is premature, it appears that the Court is unlikely to accept this plea either, particularly since detailed hearings were heard on the merits. On the merits, the Department’s strongest point was that the arrangement had been referred to the FIPB. To this, the Senior Advocate for Vodafone stated that the matter was referred to the FIPB merely as a precaution and not as a legal necessity. It will be interesting to find out what view the Court will take of the matter on this issue; particularly given that the learned ASG stated that the Department was not alleging any fraud or evasion. Now, if the Court takes this statement to mean that this was only a case of tax avoidance, the ratio of the Supreme Court’s judgment in Azadi Bachao Andolan might preclude the Bombay High Court from looking at the substance of the transaction while ignoring the form. Thus, it appears that the Court ought to hold that there has been no transfer of a capital asset situate in India; and consequently no question of tax liability arises. The judgment may be out in a few weeks, and the views of the Judges will be awaited with interest by several tax consultants. Another discussion of the arguments can be found on the Indian Corporate Law blog here.

(Update: The judgment is now out, and not quite as I predicted. See this post.)