Who is the real hero in the great Vodafone battle fought so bitterly up to the level of the Supreme Court? Not the Supreme Court. Not the non-resident company. It came to do business in India through a tedious route of financial intermediation with a tax haven as a spoke in between. Not the highly paid lawyers who argued for that company.

The real hero is the lowly paid anonymous income-tax officers who went through the maze of intricate financial structures created for obtaining control over shares in an Indian company. It was the same with reference to the Mauritius tax-free investment's case decided in the famous Azadi Bachao Ruling of the Supreme Court.

It is difficult to simplify the complicated arrangement entered into in this case for obtaining control of 67 per cent over Indian business assets. The British Company Vodafone plc had a Dutch subsidiary. The subsidiary purchased an interest in an offshore company called CGP based in Cayman Islands. CGP was owned by Hutchison Whampoa. Hutchison Essar was controlled by CGP. The buyer was incorporated in Netherlands. The sellers, Hutchison Telecommunication International and GCP Investments Holdings, were functioning from the Cayman Islands. The subject of the transaction related to shares of an overseas company. It resulted in change in the ownership of an Indian company, Hutchison Essar. Indian authorities insisted that the structured deal would attract capital-gains tax. The sellers should have deducted tax at source.

The asset was located in India though the transaction took place outside India. Vodafone argued that it was not a sale of asset. The transfer of the shares in the Indian company can only be incidental and this was not the object behind the structured deal.

Vodafone's argument was that it did not pay directly for an asset located in India. It paid for acquiring the controlling interest in a Cayman Islands-based holding company. The transaction was between two non-resident companies. The Supreme Court applied several well-established principles of tax jurisprudence in deciding the case in favour of Vodafone. The doctrine of form over substance, the source rule, the law relating to direct and indirect transfers, the concept of business assets, and the anti-abuse rules were all gone into in the 276-page judgment. Did the deal amount to questionable tax planning or tax avoidance device? The Supreme Court gave a firm ‘no' as the answer to this question. In its opinion, use of holding companies and the investment structure and also the use of offshore financial entities can be driven in certain cases by business and commercial purposes.

The use of such devices will not imply tax avoidance. Taxpayers are free to arrange their affairs to minimise tax within the framework of tax laws. There is a distinction between legitimate tax minimisation and abusive tax avoidance. The Court upheld the law laid down in the Azadi Bachao case and also distinguished the Mcdowell ruling.

Unwarranted dissection

The Supreme Court has ruled that the case concerned mere sale of shares simpliciter and there was no sale of assets. It was only by acquiring the shares of CGP that Vodafone got an indirect control over several kinds of companies in the group structure of Hutchison. True, sale of shares of a foreign company is not subject to tax in India. But what about other rights acquired by Vodafone by virtue of this complex transaction? What about control premium because of the 67 per cent acquisition?

What about the non-compete agreement? What about the brand licences, operating licences, customer base, etc.? According to the Supreme Court, these rights were acquired only as a consequence of the transfer of shares in CGP. The transaction cannot be dissected and the payment cannot be split into compartments. There was no anti-avoidance provision in the Indian law. The Court made the distinction between the look-to principle and the look-through principle. In the absence of anti-avoidance provisions in the law, it is not possible to invoke the theory of see through.

A major consideration that prevailed with the Supreme Court was that the complicated structures were put in place long before acquisition of the relevant shares. It rejected the Bombay High Court's view that applying the proportionality theory, a part of the transaction must be brought to tax. It concluded that the deal should be viewed as a consolidated transaction based on economic nexus. “Applying the ‘look at' test in order to ascertain the true nature and character of the transaction, we hold, that the offshore transaction herein is a bona fide structured FDI investment into India which fell outside India's territorial tax jurisdictions, hence not taxable.” This was not a sham transaction. Nor was it meant to avoid tax.

The issue is not peculiar to India alone. Other countries have tackled this problem in a more efficient manner.

(The author is a former Chief Commissioner of Income-Tax.)