Vodafone ruling — Supreme Court shows the way

The Supreme Court, in its recent path-breaking ruling on Vodafone, has accepted certain time-tested fundamental principles and set up new principles.

Though Vodafone ruling was for the taxation of capital gains arising out of sale of shares outside India between two non-residents, the principles laid down by Supreme Court in the areas of (i) tax planning vs tax avoidance (ii) holding-subsidiary relation (iii) sale of shares vs allocation principle (iv) validity of Mauritius treaty (v) look at and look through approach, and so on. Some of the important principles laid down by Supreme Court in this ruling are:

It is the task of the Court to ascertain the legal nature of the transaction and, while doing so, it has to look at the entire transaction as a whole and not adopt a dissecting approach;

If an actual controlling Non-Resident Enterprise (NRE) makes an indirect transfer through “abuse of organisation form/legal form and without reasonable business purpose” which results in tax avoidance or avoidance of withholding tax, then the Revenue may disregard the form of the arrangement or the impugned action through use of Non-Resident Holding Company, re-characterise the equity transfer according to its economic substance and impose the tax on the actual controlling Non-Resident Enterprise;

When it comes to taxation of a Holding Structure, at the threshold, the burden is on the Revenue to allege and establish abuse, in the sense of tax avoidance in the creation and/or use of such structure(s).

The Revenue may invoke the “substance over form” principle or “piercing the corporate veil” test only after it is able to establish on the basis of the facts and circumstances surrounding the transaction that the impugned transaction is a sham or tax avoidant;

The Revenue cannot start with the question as to whether the impugned transaction is a tax deferment/saving device but that it should apply the “look at” test to ascertain its true legal nature;

The Revenue should consider various factors (i) the concept of participation in investment, (ii) the duration of time during which the Holding Structure exists; (iii) the period of business operations in India; (iv) the generation of taxable revenues in India; (v) the timing of the exit; (vi) the continuity of business on such exit.

Section 9 does not support “look through approach”. The word “through” in Section 9 inter alia means “in consequence of”.

A legal fiction has a limited scope. A legal fiction cannot be expanded by giving purposive interpretation particularly if the result of such interpretation is to transform the concept of chargeability.

Section 9(1)(i) cannot by a process of interpretation be extended to cover indirect transfers of capital assets/property situate in India.

The limitation of benefits has to be expressly provided for in the treaty. Such clauses cannot be read into the Section by interpretation.

A controlling interest is an incident of ownership of shares in a company, something which flows out of the holding of shares.

A controlling interest is, therefore, not an identifiable or distinct capital asset independent of the holding of shares.

Tax presence must be construed in the context, and in a manner that brings the non-resident assessee under the jurisdiction of the Indian tax authorities.

Legal doctrines like “limitation of benefits” and “look through” are matters of policy. It is for the Government of the day to have them incorporated in the treaties and in the laws so as to avoid conflicting views.

Application of the principles

The application of the above principles on a regular basis should settle some of the following issues either under the present provisions of the Income-Tax Act or in the proposed GAAR, if the facts and commercial justification of the transaction can support the principles of SC in Vodafone.

Any transfer of shares relating to Indian company through an indirect transfer.

Change in the Indian company ownership due to global re-organisation or global restructuring.

The re-characterisation of the transaction is not possible as long as the commercial justification of transaction can be supported.

Tool of Tax Avoidance cannot be brought to nullify a valid transaction which is supported by a commercial justification.

No income can be taxed under the provisions of the Act through the process of interpretation without any express provisions.

The transaction is required to be examined in the manner in which the parties have agreed to and the courts are not empowered to follow “dissecting approach”.

In a case of transfer of shares, a share is an identifiable or distinct capital asset. Hence, that value can be taxed. If this value is not being taxed due to any reason, any asset that flows out of the holding of shares cannot be taxed. Prior to Supreme Court ruling on Vodafone, there was a sense of cynicism among the global investors on the approach adopted by revenue authorities in India and this ruling has nullified some of the cynicism and created a set of principles which will stand the test of time.

(The author is Partner, Deloitte Haskins & Sells.)

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