New Delhi: The Permanent Court of Arbitration (PCA) at The Hague has ruled in favour of the Vodafone Group Plc in its long pending case against the Indian income tax department’s tax liability demand for Rs 22,100 crore that dates back to a transaction in 2007.
Vodafone International Holdings (VIH), an Amsterdam-based subsidiary of the UK-based Vodafone group, had then entered into an agreement with Hutchinson Telecommunications International Limited (HTIL), a company based in Hong Kong. As per the agreement, VIH acquired a Cayman Islands-based entity named CGP Investments (Holdings) Ltd, a subsidiary of HTIL. CGP owned approximately 52% of the share capital of Hutchinson Essar Limited (HEL), an Indian entity. The transaction resulted in VIH becoming the owner of CGP, and through it, HEL.
According to the income tax department, the aim of this transaction was to acquire a 67% controlling interest in HEL. The department, therefore, sought to tax capital gains arising from the sale of share capital of CGP on the basis that CGP, while not a tax resident in India, holds the underlying Indian assets. The tax demand was for Rs 11,000 crore in 2012.
While the Bombay high court (by a bench presided by Justice D.Y. Chandrachud, who is currently a judge of the Supreme Court) in 2010 had ruled in favour of the IT department, saying that the transfer of the controlling interest in HEL was the purpose achieved by this transaction. The Supreme Court in 2012 set aside the high court judgment, reasoning that the transaction concerned a share sale rather than asset sale.
The Supreme Court’s judgment triggered the Centre’s amendment of the Income Tax Act in March 2012 to provide that income arising from the sale of shares or units shall be deemed to accrue or arise in India if the transaction had taken place outside India, and its value depended primarily on assets in India. The amendment effectively overruled the Supreme Court’s judgment, restoring the tax liability of Vodafone. Vodafone was left with no option but to seek international arbitration.
On Friday, the PCA found India to be guilty of breaching the guarantee of fair and equitable treatment (FET) laid down in Article 4(1) of the agreement between Netherlands and India for the promotion and protection of investments (1995). India, therefore, has an obligation to cease the conduct in question (breaching of FET), the PCA warned, failure to comply with which will engage “international responsibility”.
To unravel the PCA’s award, The Wire interviewed professor Surajit Mazumdar at the Centre for Economic Studies and Planning (CESP), Jawaharlal Nehru University, New Delhi. Mazumdar’s research has focussed on the Indian corporate sector, the political economy of Indian industrialisation, and the impact of globalisation on the Indian economy.
What, according to you, are the implications of the PCA’s award in favour of Vodafone?
A full assessment of the implications of the award can only be arrived at if the complete judgment of the PCA is available, and the details of the reasoning it has used to arrive at the conclusions it has, are clear. From the summary of the decision, it seems that the PCA has found the Government of India’s action following the 2012 Supreme Court order to be in contravention of the ‘fair and equitable treatment’ provision of Article 4 (1) of the India-Netherlands Bilateral Investment Treaty (BIT). There are at least a few troubling questions arising from this award which may or may not be allayed by what is there in the more detailed judgment.
It is noteworthy that the reference in the award is not to Article 4 in its entirety, nor to the subsequent clause under it, i.e. 4 (2).
The reason this appears important is that while in the India-UK BIT these are combined in Article 4(1), in the India-Netherlands BIT 4 (1) only refers to fair and equitable treatment in broad terms while it is 4 (2) which gives it a more specific meaning. This specific meaning is that treatment of any foreign investment should not be less favourable than that accorded to domestic investment or that by investors from any third state. So, did the PCA conclude that the Government of India’s decision was violative of 4 (1) without violating 4 (2) or was it because it breached 4 (2)?
A second question is whether the PCA award is actually conditional on the Supreme Court of India’s 2012 judgment or is it independent of it? In other words, would Vodafone, in the PCA’s reasoning, still have had a case of unfair and inequitable treatment if the Supreme Court of India had upheld the high court judgment on the validity of the Indian government’s original tax claim? Alternatively, since retrospective amendments of tax laws have been held to be valid by Indian courts, could the PCA award be in conflict with such judgments?
Answers to these questions are important in understanding the kind of precedent about jurisdiction that has been set by the PCA award and what it reveals about the consequences of bilateral investment treaties for the autonomy of India’s corporate regulation and taxation policies.
In your article in 2012, you drew attention to the Supreme Court’s failure to recognise the distinction between a shareholding that constituted a controlling interest and that which was purely a financial investment. This resulted in missing the essential connection linking the offshore transaction between Vodafone and Hutch and the company located in India. Can we say that the 2012 SC judgment weakened India’s ability to convince the PCA in this case, because it would have been embarrassing to critique one’s own Supreme Court before an international forum?
On the 2012 judgment, my position is clear and remains unchanged – that the substance of the case was completely overlooked in favour of an excessively narrow emphasis on pure technicalities. The judgment was unfortunate not only for its implications on the specific case at hand but because of its larger implications for corporate regulation and taxation in India.
In addition to the failure to make the distinction you refer to, the delinking of the share transfer from the transfer of control over real capital assets by the Supreme Court also allowed it to treat that transfer as an offshore transaction and outside the jurisdiction of Indian tax authorities, even though the capital assets which changed hands were located in India. It in effect gave ‘favourable’ treatment to foreign investment and thereby also reinforced incentives for domestic investors to use the round-tripping method to reduce tax burdens.
Precisely because its larger implications needed to be neutralised, it was important to formulate a legally valid and effective legislative response to the 2012 Supreme Court judgment. The PCA award certainly is a blow to the response actually undertaken and therefore resurrects the implications of the Supreme Court order. This failure could be attributed to either one or a combination of several factors, apart from the fact that the PCA itself may have erred. It could be that the specific route that the government took to address the fallout of the Supreme Court’s 2012 order was not the most appropriate and not well thought through. It could also be that the Government of India failed to present its case well before the PCA, including because it was constrained in arguing against the judgment of its own Supreme Court.
Finally, it could be that the fate of the arbitration proceedings was sealed by the weaknesses of the 2012 order itself. Legal experts will have to apply their minds to the detailed PCA judgment to give us a clear answer to this. Whatever it is, while the PCA award might give Vodafone cause to cheer, for the country it means that more serious efforts are still needed to frame laws that would plug loopholes that can be exploited by corporations and foreign investors to circumvent tax obligations and other regulations.
The 2012 judgment is criticised because it had misread the judgment delivered by a five-judge bench in 1985 in the McDowell case which upheld the principle of going behind the corporate veil to thwart illegitimate tax avoidance. Is the dividing line between tax avoidance and tax evasion blurred?
The 2012 verdict of the Supreme Court certainly contributed to blurring this distinction by legitimising the use of certain corporate structures to avoid taxes unless it could be established that that structure was created specifically to avoid a particular tax in question. In other words, whether a reduction of tax liability was evasion or avoidance, in the Supreme Court’s view, depended neither on the substance of the result nor on its consistency with the ‘intent’ of the laws being used to achieve that result. Even the motive behind using a particular structure was not relevant, only that behind its original creation. It was like saying that a murder would not be a murder if the weapon used had not been specifically acquired with the objective of committing it (or this could not be proved).
Were you satisfied with the retrospective amendment carried out in 2012? You had observed then that what was required was the opening up of the web of connections between myriad corporate entities spread across a variety of jurisdictions to legal scrutiny.
Certainly, more than simply a retrospective amendment was necessary in terms of a legislative response to open up this web of connections – which required an approach of going beyond the one individual case at hand. In that sense, the response to the Supreme Court order was definitely inadequate.
What will be the consequences of this award for corporate regulation? Will it further erode the state’s capacity to discipline ‘crony capitalism’?
Corporate regulation in India has always been weak and has become more so after liberalisation. This is not only because the laws constraining corporate activity have been liberalised but also because corporate influence over both lawmaking and enforcement tends to structurally increase with liberalisation. It must be remembered here that the essence of the ‘corporate’ sector is the concentration of control over large resources in a few hands, which then facilitates their control over the levers of the economy, and more so unless regulation curbs this.
At the same time, the privatisation of several important sectors where competitive markets cannot function, telecom itself being one of them, necessitates regulation of these sectors. In a sense, therefore, liberalisation increased the significance of the ability to discipline private capital even as the capacity to do so was weakened and the scope for corruption and cronyism enhanced, making the challenge greater. This loss of the Indian government in the PCA can only add to these difficulties.
Was the Modi government – which did not agree with the merits of the retrospective amendment carried by its predecessor government – weaken its own case before the international tribunal?
It would not be surprising if it was the case that the government did not take this matter as seriously as it should have, or chose to allow it to slip by, since the pro-corporate attitude of the present government and its keenness to attract FDI is evident from several of its actions (though I may add that this was also true of the previous government and the difference may be only a matter of degree).
On the other hand, within this broad pro-corporate stance there seems to be also some unevenness, a distinct tendency for its outcomes to eventually favour some corporate houses. This could also potentially translate into the approach of the government in proceedings of the kind that were before the PCA being contingent on who the other party was or the implications of the verdict for others.
How all of these played out in the making of what happened, one does not know, and it may be a long time before the full story comes out, if at all it does. What certainly can be said is that the outcome at the PCA is a serious loss of face for the country in a matter where at least in principle, the issue was of ensuring that foreign investors meet their tax obligations. This cannot be something to be happy about, no matter how one views the specific measures that the previous government took which led to these proceedings.
In the Azadi Bachao Andolan case (2003), the Supreme Court’s two-judge bench upheld the validity of the circular issued by the then government making it easy for foreign companies to claim fake residential status in Mauritius in order to avoid tax under India’s Double Taxation Avoidance Convention (DTAC), 1983. Now, with the PCA’s award favouring Vodafone, will Indian and foreign companies be encouraged to have holding companies in foreign countries, and transfer the assets and shares of Indian companies to others without any tax liability? Can foreign companies be given tax holiday to encourage FDI?
With globalisation and the existence of several tax havens around the world, the possibilities of both foreign and domestic entities using structures spread across several jurisdictions to evade taxes also became a global problem. Tax legislation and jurisprudence also needed to account for this phenomenon and fortify nations against such abuse. Unfortunately, the government of India and the Supreme Court have been found wanting on this count on several occasions and the PCA award only adds to that misfortune, the ultimate price for which has to be paid for by Indian citizens whose wait for development to transform their lives has only been made longer.
Does India have any option but to comply with the award, to demonstrate its respect for international treaty obligations? Is appeal against the verdict feasible and preferable, given the costs involved?
If India’s treaty obligations imply abject helplessness in such a matter, then those treaties must be revisited, and other measures taken, to ensure that such a situation will never be repeated again. Let us not forget that at the end of the day, someone is being allowed to escape from paying a tax that under Indian law would have become payable had the same transaction (transfer of capital assets located in India) been in a different form and the transacting parties been both Indian. This amounts to preferential treatment being given to a foreign investor rather than being a breach of fair and equitable treatment as suggested by the PCA award.
What lessons can India derive from this case in the context of corporate regulation and promotion of investment climate?
As I have said earlier, regulation of the corporate sector in order to ensure that its occupancy of the commanding heights of the economy is not abused is essential even if one accepts that they can play an important role in national economic development. Laxity in such regulation in the name of improving the investment climate is not only ill-advised, it is more likely to be both a reflection as well as reinforcement of corporate power than a necessity.
Shoring up profitability through laxity in regulation does not also necessarily increase the quantum of investment because profitability depends on a host of other factors. Indeed, tax losses could lead to cutting down of public investment and therefore also the private investment it would have induced.
A decade of stagnation in corporate investment in India stands testimony to all of these – and yet the old approach is not being abandoned. Indeed, in the measures being taken in the background of the COVID-19 crisis, the common thread is creation of regulations that would strengthen the position of the corporate sector, which is like rewarding it for its failure to keep the engine of the Indian economy going.
What further steps, legal or otherwise, would be required in terms of tightening of loopholes in the existing regulatory framework, so that the government does not lose legitimate tax revenue?
We are in a moment when the fiscal crisis has assumed a significant magnitude. While the pandemic has contributed to this, the crisis predates it and has served to belie the expectations that demonetisation and the introduction of the GST would be the magic bullets to solve India’s long-term problem of a low tax-GDP ratio.
What is needed is a serious effort to improve the realisation of direct taxes. If there is any serious intent in that direction, and it does not honestly appear that there is, one of the important steps would be to recognise how the law permits the creation of corporate structures facilitating and enabling tax evasion in which several legally independent entities are inter-connected with each other, but does not quite recognise their existence.
Ending this mismatch would involve on the one hand restrictions on the creation of such structures when they serve no other meaningful or worthwhile purpose, and facilitation of legal recognition of the entities created on the other.
This has to be an ongoing and dynamic process, one that involves also a continuous study of the corporate sector, because the attempts to evade will continue as will the search for newer ways of achieving that objective.