Lifting the Corporate Veil for Tax Purposes

The judgment of the Bombay High Court rendered last year in the Vodafone Case favours the revenue when it comes to imposition of tax by the Indian authorities on sale of shares in an offshore company that has a substantial stake in an Indian company. While an appeal in the Vodafone Case is pending before the Supreme Court, the Karnataka High Court recently had the opportunity to pronounce a judgment in Richter Holding v. The Assistant Director of Income Tax on a similar fact situation. Although the Karnataka High Court too sided the revenue, the reasoning substantially deviates from Vodafone.

Richter Holding (a Cyprus company) and West Globe Limited acquired 100% shares in Finsider International Company Limited (registered in the UK). Finsider in turn held 51% shares in Sesa Goa Limited, an Indian company. The Indian tax authorities sought to tax the transaction under the head of capital gains, and sought further information from the parties. In turn, Richter Holding filed a writ petition before the Karnataka High Court.

Richter Holding relied on the Vodafone Case to argue that acquisition of shares in an offshore company does not amount to acquisition of immovable property or control of management in an Indian company, and “it is only an incident of ownership of the shares in a company which flows out of holding of shares”. Moreover, it was argued that controlling interest in a company is not identifiable as a distinct asset capable of being held. The tax authorities, on the other hand, argued that the transaction resulted in an indirect transfer of 51% interest held by Finsider in Sesa Goa, which is subject to Indian taxation.

In its judgment, the Karnataka High Court refused to be drawn into the merits of the taxation dispute. The court left it to Richter Holding to urge contentions on the merit of taxation before the authorities. It also found that the agreement produced before the court was insufficient to determine the exact nature of the transaction. Most importantly, the court allowed the tax authority to lift the corporate veil to ascertain the true transaction:

It may be necessary for the fact finding authority to lift the corporate veil to look into the real nature of [the] transaction to ascertain virtual facts. It is also to be ascertained whether [the] petitioner, as a majority share holder, enjoys the power by way of interest and capital gains in the assets of the company and whether transfer of shares in the case on hand includes indirect transfer of assets and interest in the company.

There has been a great amount of discussion regarding the Richter judgment by commentators (here, here and here).

The aspect that deserves greater attention is that the Karnataka High Court demonstrates a keen interest in lifting the corporate veil. This has a number of implications. First, the Richter Holding Case extends even further the scope of the principles laid down in the Vodafone Case. For example, in Vodafone the Bombay High Court did not consider lifting the corporate veil to impose taxation in case of indirect transfers, as we have previously noted. In that sense, the Richter Holding Case arguably provides an additional ground to the tax authorities to tax indirect transfers. Second, it is not clear from the judgment itself whether the tax authorities advanced the argument regarding lifting the corporate veil and, if so, how it was countered by Richter Holding. Third, the Karnataka High Court appears to have readily permitted lifting the corporate veil without at all alluding to the jurisprudence on the subject-matter. Generally, courts defer to the sanctity of the corporate form as a separate legal personality and are slow to lift the corporate veil, as evidenced by Adams v. Cape Industries, unless one of the established grounds exist.

From a macro-perspective, the legal position seems to have been confounded even further, as a column on MoneyControl notes:

… While, the intention of the legislature to tax such transactions is clear, the implications under the current income tax law become critical for completed transactions and existing structures. Notices alleging liability to tax on such indirect transfers have already been issued to Sanofi, Tata, Vedanta, SABmiller, Cadbury etc. and appear to be a growing trend.

The changed approach of the tax department and the consequent uncertainty of taxation is creating apprehensions in the minds of the investors. Tax risks are increasingly being discussed at the time of concluding deals and are a cause of great concern. In the meantime, deal makers are opting for mechanisms like escrow accounts, insurance policy, etc. to conclude transactions already in pipeline.

However the prevailing tax uncertainty coupled with aggressive tax approach adopted by revenue authorities does not augur well for new investments into India. The actual impact of aggressive tax policies on inbound investment will need assessment and perhaps a relook, given the huge investment needs particularly in infrastructure sector.

As one moves ahead, the next hurdle to be crossed is the mechanism and basis of computing gains arising as a result of the transaction being taxable in India. This is going to be the next bout of litigation in case the tax authorities view is eventually upheld by the Courts.