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High Court Judgment May Adversely Affect Flow of Foreign Direct Investment into India - International Law Office

International Law Office

Litigation - India

High Court Judgment May Adversely Affect Flow of Foreign Direct Investment into India

March 03 2009

Facts
Decision
Comment


In Vodafone International Holdings BV v Union of India the Bombay High Court observed that the transfer of share capital from one non-resident company to another non-resident company with the sole intention of acquiring interests in India would amount to a transfer of capital assets and would hence be liable for capital gains tax.(1)

Facts

In 2007 Vodafone International Holdings BV acquired a stake in CGP Investments (Holdings) Limited, a company incorporated in the Cayman Islands and wholly held by Hutchison Telecommunications International Ltd (HTIL). CGP directly and indirectly (through its downstream subsidiaries) held a 67% stake in HEL (India). HEL was a joint venture company of the Hutch group (foreign investor) with the Essar group (Indian partner). Therefore, the transaction involved the sale of all shares held by HTIL in CGP to Vodafone.

Pursuant to the acquisition, the assistant director of income tax issued a show-cause notice to Vodafone, assailing it as an assessee in default under the Income Tax Act for its failure to withhold income tax in respect of the purported capital gains earned by HTIL from the sale of the 67% controlling interest in Vodafone Essar Ltd. Vodafone appealed against the show-cause notice, challenging the applicability of Indian tax law to a non-resident to non-resident transaction. Vodafone claimed that in a transaction of this nature it was under no obligation to withhold tax from HTIL, as the purported transfer was of share capital of one non-resident company to another non-resident company and not a transfer of a capital asset situated in India. The controlling interest was not an asset separate and distinct from the shares, but an incidence arising from the holding of a particular number of shares in a company.

Decision

The court opined that:

"the very purpose of entering into agreements between the two foreigners is to acquire the controlling interest which one foreign company held in the Indian company, by the other foreign company. This being the dominant purpose of the transaction, the transaction would certainly be subject to municipal laws of India, including the Indian Income Tax Act. The petitioner has admitted that HTIL has transferred their 67% interests in HEL qua their shareholders, qua the regulatory authorities in India (FIPB), qua the statutory authorities in the United States and Hong Kong and the petitioner has also admitted acquiring 67% held by HTIL in HEL. This being the case, a different stand cannot be taken before the tax authorities in India and a different stand cannot be put forth by either HTIL or the petitioner."

Thus, according to the court, through the joint venture Vodafone not only had become the successor in interest to HTIL, but also had acquired a beneficial interest in the license granted by the Department of Telecommunications in India to its group companies, now known as Vodafone Essar Limited.

Comment

This approach suggests that if Indian assets are owned in a company down the chain from the non-Indian company whose shares are transferred outside of India, the seller is subject to Indian capital gains tax. This is based on the proposition that the transactional value (partly or wholly) stems from the underlying Indian assets. It further suggests that the buyer is subject to withholding the tax from the seller's proceeds even if the buyer and seller have no connection with India. The consequences of not withholding have also been affected through the government's introduction of retrospective tax law in 2008.

If this ruling stands unaltered and is upheld by the Supreme Court of India as the law of the land, there will be significant ramifications. Such an interpretation of Indian tax law and the use of retrospective changes in law expose many previous buyers and sellers of shares outside India to significant amounts of tax and create significant uncertainty for such transactions going forward. Companies will undoubtedly face underlying issues regarding this taxation on two levels: in India and in the holding company's jurisdiction. In many cases tax treaties will provide no protection from such a double tax liability.

At a time when companies worldwide are rethinking their strategies and risk aversion is growing, the judgment sends powerful signals which may adversely affect the flow of foreign direct investment into India.

Although the ruling - if confirmed by the Supreme Court - will generate significant revenue for the government, this will be in the short term only. In the long term it will act as a deterrent for investors that view India as a good business prospect (particularly in the current market conditions), resulting in a significant slowdown of investment into the country in the form of both foreign direct investment and foreign institutional investment.

For further information on this topic please contact Saloni Gupta or Smarika Singh at Amarchand & Mangaldas & Suresh A Shroff & Co by telephone (+91 11 2692 0500) or by fax (+ 91 11 2692 4900) or by email(saloni.gupta@amarchand.com or smarika.singh@amarchand.com).

Endnotes

(1) Writ Petition 2550 of 2007, decided on December 3 2008.


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