The Hindu Business Line : Who’ll shell out the tax?

The recent Bombay High Court’s judgment in Vodafone Essar might have vindicated the unexceptionable stand of the income-tax administration that is founded on the correct understanding of the law as laid down in Section 9(1)(i) of the Income-Tax Act, 1961, but may not be enough to pin down the company for its alleged default in being remiss in not deducting tax at source on the transaction carried out by its foreign holding company.

On the substantive matter of whether the sale of shares, albeit outside India, by a non-resident to another non-resident attracts capital gains tax in India, the I-T department seems to have marshalled its arguments well and their lordships have appreciated the nub of the issue.

Shares aren’t independent assets any more than a firm has an independent existence apart from the collective existence of its partners. Shares’ underlying assets are the net assets of a company, though neither the share market nor independent valuers set much store by it in their gushing enthusiasm for future earning potential. But this in any case is irrelevant for tax purposes. For tax purposes, the clincher is the fact that the underlying assets of the shares are located in India.

The relevant portion of Section 9(1)(i) the clincher reads thus: “All income accruing or arising, whether directly or indirectly, through or from any business connection in India, or through or from any property in India, or through or from any asset or source of income in India, or through the transfer of a capital asset situate in India” is deemed to accrue or arise in India.

No blanket bailout

Section 47(viia) does not bailout all capital gains arising out of transfer of shares in Indian companies made outside India from the clutches of capital gains tax — it bails out only FCCB and GDR. The reason is obvious — to encourage non-residents to subscribe to the share capital of well managed Indian companies in foreign exchange vicariously through depository receipts that can be traded transparently in a foreign stock exchange where the FCCB or GDR is listed. Private deals don’t get any tax immunity.

It is now the in thing to control a company through a multi-layered and convoluted holding-subsidiary company relationship. The operating company, may be a telecom service provider, is controlled by a holding company that is not into any operations apart from investment. And in a takeover, the shares of such holding company are purchased which naturally vests the acquirer with control in the operating company as well. And this is squarely covered by Section 9(1)(i) which in retrospect has proved to be prescient and resilient enough to overcome subterfuges. Its tentacles are strong and wide enough to rope in transactions consummated in distant locales between companies incorporated in tax havens involving in the ultimate analysis the assets located in India.

Indeed shares are only a veneer — their underlying assets are machinery, licence, land and buildings, etc. The deeming provisions of Section 9(1)(i) reach out to such indirect and convoluted acquisitions.

Loose ends

The Bombay High Court verdict dismissing Vodafone Essar’s writ petition challenging the notice of the department in asking it to cough up the capital gains tax that it did not deduct at source may therefore not be the end of the vexatious matter because while there is no denying the fact that the capital gains are taxable in India, one is not sure whether there is anyone in India who can be burdened with the onerous duty to deduct tax at source given the language of Section 195 as it stands.

The problem is that in cases of takeover it is a shell company that makes the payment which invariably doesn’t have an Indian presence.

It is the operating company that has the Indian presence. Section 195 must be amended to fasten the operating company with the duty to deduct tax at source even in respect of payments made by its distantly located but closely related parent.

This amendment must be retrospective and for once for a good cause, though courts are allergic to retrospective amendments especially to those that fasten one with a financial liability without notice.

A sound substantive provision could be rendered ineffective by a weak machinery provision. The urgency is all the more now that there have been a slew of telecom licences transfer for hefty amounts — bordering on the scandalous — all consummated outside India.

While whether the exchequer was robbed of its licence fee due to the first-come-first-served principle is a separate issue, what is germane here is the tax part of it — the sellers of the licences must be brought to book under the I-T Act for the simple reason that these licences were in respect of operating telecom licences in India.

Nobody can seriously dispute the fact that shares in question represent the underlying assets located in India. Shell companies would of course be shell-shocked by the retrospective amendment. But there is no other way to recover the tax.

(The author is a Delhi-based chartered accountant. blfeedback@thehindu.co.in)

Related Stories:
HC dismisses Vodafone challenge in tax case
Income-tax law only covers cos incorporated in India: Vodafone
Vodafone tax case

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