Untying the legal knot

Prima facie, there is nothing arbitrary in the Union Budget proposal to amend the Income Tax (IT) Act retrospectively to bring all Vodafone-Hutchison type offshore deals under the tax net. The intent to tax was clear right from the beginning in this case – where the buyer, the seller as well as the company bought were technically incorporated overseas, though the underlying assets were located in India. But the revenue authorities' efforts suffered a setback, with the Supreme Court in January absolving Vodafone from any tax liability, on grounds that its acquisition was an offshore transaction involving only shares and the existing IT law only covered direct transfer of capital assets within India. The Act had to, then, be amended to explicitly provide for the “legislative intent” to tax all deals whose value derives, directly or directly, from assets situated in India. The latest Finance Bill has, in fact, termed the proposed amendments as being merely “clarificatory” in order to “restate the legislative intent”. Such restatement could only have applied retrospectively and there is no arbitrariness at least in that respect.

But the merits of the retrospective amendments do not still address a basic problem involving the Vodafone transaction. The IT department was going after Vodafone primarily on the count that it should have deducted tax at source on the purchase consideration paid to Hutchison. A potential consequence of the Supreme Court concurring with Vodafone's line of reasoning is that such an endorsement could be deemed, by a legal fiction, to have happened on the day the transaction took place. From here, it is but a short step to argue that there is no way the genie of ‘non-deduction of tax at source' could be put back after payment has actually been made for the retrospective nature of the “clarification” to take effect and all penal consequences that entail. Compounding the Government's difficulty in the situation is its own assurance to the industry associations that it would not go after all indirect asset transfers from April 1, 1962, even if the law now confers such a right. By implication, it is holding out that it is only after Vodafone or a few other cases of indirect transfers, exposing it to charges of arbitrariness in such selection.

Apart from all this, the Vodafone-Hutchison deal also needs to be viewed from a larger perspective of attracting foreign direct investment (FDI). Today, a Mauritius-registered foreign institutional investor (FII) making gains by selling shares in Indian exchanges pays no tax by availing benefits of a double-taxation avoidance treaty. Doesn't that privilege FIIs over those not only bringing in money, but even creating solid assets on the ground in the country? In this case, both the original investor (Hutchison) and the one that bought its business in India (Vodafone) have demonstrated their commitment in terms of building assets and generating employment. While clarity in tax laws and plugging loopholes to prevent round-tripping of investments is welcome, it should not be at the expense of promoting legitimate FDI activity, especially in core infrastructure sectors. Given the choice before them to go to other destinations, there may even be a case for extending favourable tax treatment on an explicit basis to such investors. That could promise ‘real' capital gains.

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