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Back to drawing board: Vodafone-Hutch tax judgment has major impact on M&A

Bombay High Court
Bombay High Court
Yesterday's Bombay High Court decision that the tax authorities are permitted to assess Vodafone for its Indian tax liability in its acquisition of Hutchison Essar in 2007, means that previous and future foreign investments into India would face legal uncertainty, according to tax and corporate lawyers.

Vodafone acquired Hutchison's Indian subsidiary in 2007 for $10.7bn, with the purchase having been effected through a sale of shares of the Indian mobile phone operator's controlling company that was based in the Cayman Islands. The companies argued that the transaction took place outside of India and was therefore not subject to tax.

Vodafone appealed against the Indian tax authorities' claim of $2bn in taxes but lost in the Bombay High Court in 2008 and the Supreme Court in January 2009, which referred the case back to the Bombay High Court.

The court decided yesterday that the Indian tax authorities were correct in assessing Vodafone for tax in India. Vodafone has said it would appeal the judgment to the Supreme Court.

On the original acquisition in 2007 Linklaters, Thalwar Thakore & Associates and Trilegal represented Vodafone, with Freshfields Bruckhaus Deringer, Khaitan & Co and Paul Weiss for the Hutchison companies, and AZB & Partners and Herbert Smith acting for Essar Group, which was a minority shareholder in the target. Amarchand Mangaldas advised Hutchison specifically on tax issues in relation to the transaction.

In 2007 Hutchison has indemnified Vodafone in respect of “taxation or transfer pricing liabilities” payable by group companies, including reasonable costs associated with a tax demand, according to paragraph 45 of the judgment.

Download the full 196 page judgment here.

Legal reactions

DSK Legal partner Balbir Singh said that the decision opened a Pandora's box, "as tax authorities will find a reason and basis to open the already closed transactions".

"So long as this high court ruling remains," added Economic Laws Practice (ELP) partner Pranay Bhatia, "the tax dept may certainly say, I do have a legal basis to examine withholding tax liability of every offshore transaction which results in a change of ownership."

Singh said: "The Vodafone judgment will have far reaching impact as it would certainly influence the way transactions are structured in terms of instruments and jurisdiction."

Lawyers would have to "go back to the drawing board" to come up with new and valid tax efficient structures, agreed ALMT Legal partner Hitesh Jain, who had previously also advised Vodafone on the case.

Bhatia commented that structures such as the one in the Vodafone Hutch acquisition were used in “some” cases but were not unique. "This decision is backed on a very specific factual matrix. Every case may not be pari passu to the Vodafone and Hutch transaction because here there is a controlling stake involved, a third telecoms regulator and in every case that may not be the situation."

"There are a number of factors which could make a case go one way or another but this Vodafone case is an important one but can not be a decider whether everything going forward will be looked at like that," he said.

Singh said the consequences of the case could negatively affect foreign investment. "It will impact the cost of acquisition and doing business in India. By charging tax on offshore transactions, tax authorities may garner more tax but will lose on larger FDI in India."

"The most critical part of this judgment is confirming liability to withhold tax by an offshore company while making payment to the seller in another offshore jurisdiction and treating the underlying entity as an 'assessee in default'," noted Singh.

The reasoning

"The transaction was of a composite nature and created reciprocal rights and obligations which included but were not limited to the transfer of the CGP share," explained ELP in its analysis of the decision:

"The High Court has laid great emphasis on the intention of the parties to transfer the controlling interest in the business. It observed that transfer of a single share was not the intent of the parties but it was to change the controlling interest in the business. While refuting the theory that the transaction was merely a transfer of a single share, it was observed that the rights and entitlements flowing out of holding a share cannot be dissected from the ownership of the share. The High Court was of the view that transfer of rights and entitlements is intrinsic to this transaction and that these rights in themselves constitute a capital asset. The nexus of capital asset with India was critical in determining the taxability of the transaction."

The principles

ELP summarised the judges’ main findings as:

  • "Transfer of interest in a business would in itself constitute a capital asset that may be subjected to tax;
  • Section 9 of the Income-tax Act, 1961 (‘Act’) is wide enough to cover within its ambit such transfer of interest; and
  • Tax Deduction at Source (‘TDS’) is merely based on provisional assessment and as long as nexus with Indian fiscal jurisdiction is established the requirement of deducting TDS would arise."

However, ELP added that the Bombay High Court had not dealt with several important aspects, such as:

  • the tax treatment of similar transactions between tax residents of a country such as Mauritius, with which India has a Double Taxation Avoidance Agreement (DTAA);
  • how much of the portion of income should be charged to tax, which the court expressly left to the assessing officer to decide although no final order could be made before eight weeks; and
  • the penalty that could be imposed on Vodafone for having failed to deduction of TDS, although under existing law the judge expressly permitted Vodafone to plead the defence of “reasonable cause and genuine belief” in having structured the transaction as it did.

The appeal

“While the matter would be appealed to the Supreme Court, it would be interesting to note that this decision of  the High Court has drawn reference to several landmark Supreme Court and other decisions. How the Supreme Court would deal with  the propositions outlined in this decision is something to look forward to - especially from the perspective of a foreign investor,” noted ELP.

Download the full 196 page judgment here.

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