In our post on the judgment of the Bombay High Court, we expressed the hope that the Supreme Court would take a different view. That the Court has now done so has been welcomed as much needed respite in bad times. Even more importantly, it is heartening that the Court has taken what it is submitted is the correct view especially on the facts of Vodafone’s case. But from that qualification it follows that the prevailing assumption that this judgment is a complete victory for tax planning over a more robust approach may not be entirely accurate. As we discuss below, much of the Court’s reasoning, particularly in the judgment of the Chief Justice, is premised on a factual finding that the Vodafone-Hutch deal did not lack commercial substance or business purpose, and its analysis of the legal principles suggests that a finding for the assessee is not a foregone conclusion in “similar” cases.
It is easiest to analyse the two judgments by identifying seven issues of law that emerge from it. This post deals with the two of these issues. The seven issues are: (i) the law on lifting the corporate veil; (ii) the law on tax avoidance; (iii) the meaning of “extinguishment” under section 2(14) of the Income Tax Act, 1961 [“ITA 1961”]; (iv) section 9 of the ITA 1961; (v) section 195 of the ITA 1961; (vi) controlling interest and the situs of shares; and (vii) important factual points in the Vodafone case that illustrate the application of some of these principles. In addition, there are the observations of K.S. Radhakrishnan J. on VB Rangaraj v VB Gopalakrishnan.
Before we turn to these issues, it should be noted that two crucial findings on fact are at the heart of the conclusion of the Chief Justice and K.S. Radhakrishnan J. that the IT Department lacked jurisdiction – first, the rejection of the Revenue’s argument that CGP was “fished out” at the last minute from the HTIL structure solely to avoid tax and secondly, the explanation given in respect of an application made by VIH to the FIPB. As far as CGP is concerned, the Revenue relied on a Due Diligence report submitted by Ernst & Young in which it was stated that the parties had originally envisaged transferring Array Holdings Ltd. [“Array”], a company incorporated in Mauritius, and later decided to instead transfer CGP. The Chief Justice (¶81) and K.S. Radhakrishnan J. (¶124) explain that this change was for an important commercial reason and not simply a device to avoid tax – Global Services Pvt Ltd. [“GSPL”], one of the entities which held call options in respect of HEL shares held by companies controlled by Mr Asim Ghosh and Mr Analjit Singh, was a wholly owned subsidiary of Hutchison Teleservices Holdings Ltd. [“HTIHL”], which was in turn a wholly owned subsidiary of CGP, but not a wholly owned subsidiary of Array. Therefore, as both judgments note, transferring CGP instead of Array had distinct commercial advantages. As for FIPB, the Revenue relied on a letter dated 19.03.2007 addressed by it to VIH asking why VIH proposed to pay $11.08 billion for acquiring approximately 67 % of the equity of HEL when in fact its equity acquisition was only 51.96 %. To this VIH replied that the $11.08 billion was paid not only for the 51.96 % equity but also for control premium, the entitlement to acquire an indirect 15 % interest (through the GSPL call options) and stated that it in sum represented payment for 67 % of the economic value of HEL. The Chief Justice rightly notes that some of these differences arose out of the different accounting standards prevalent in the USA and India, and that in any event, “valuation cannot be the basis of taxation” (¶85).
There are many other important questions of fact which illustrate the scope of the legal principles set out by the Court, and we will discuss some of these in Part II of this post. It is worth bearing in mind, however, that the assessee appears to have prevailed largely because it was able to persuade the Court that there was commercial substance and business purpose, and not on the ground that business purpose is irrelevant. That is especially apparent from ¶68 of the judgment of the Chief Justice, which we will discuss in Part II of this post in the context of the corporate veil.
1. Approach to Tax Avoidance
The correct approach to cases involving tax avoidance has historically been a contentious issue. In India, this has come to consist of two distinct questions: first, whether the approach of the Court in Azadi Bachao Andolan is contrary to the Constitution Bench’s judgment in McDowell’s case; and secondly, independent of this question, the proper approach to tax avoidance. On the first question, doubts had arisen because of the exiguous observation in paragraph 46 of the majority judgment in McDowell endorsing “on this aspect” the concurring judgment of Chinnappa Reddy J., in which the ghost of the Duke of Westminster had been duly exorcised.
While the Chief Justice and K.S. Radhakrishnan J. reach the same conclusion that Azadi Bachao remains good law, there are some differences in the reasoning. The Chief Justice holds (¶46) that the words “this aspect” indicate that the majority’s agreement with Reddy J. was confined to the use of “tax evasion through the use of colourable devices”. The final sentence in that paragraph reiterates that “in cases of treaty shopping and/or tax avoidance” there is no conflict at all. While it may be suggested that this means that the Chief Justice has equated treaty shopping and tax avoidance with “colourable devices”, it is submitted that the better view is that the Chief Justice has distinguished between tax avoidance/treaty shopping on the one hand and the use of “colourable devices” on the other, especially since the expression tax evasion has been used with reference to the former in the same paragraph. K.S. Radhakrishnan J. has gone considerably further, and has clearly stated that: (i) the judgment of Ranganath Misra J. constitutes the ratio of McDowell; and (ii) Reddy J.’s remark that the Duke of Westminster is not good law is incorrect even as a matter of English law.
Having clarified that it was therefore unnecessary to overrule Azadi or refer McDowell to a larger Bench, the Court considered the question of tax avoidance independently. This involved an analysis of the English case law, which has had considerable influence on this subject in India (as elsewhere). In English law, despite many caustic remarks about the Duke of Westminster’s case (perhaps none better than Templeman L.J.’s famous description of it in the Court of Appeal in Ramsay), the recent cases suggest that Ramsay and perhaps even Furniss v Dawson is not an overarching principle of construction, but simply a result of the usual process of interpreting legislation. The Chief Justice accepts this. K.S. Radhakrishnan J. examines it in more detail and interestingly appears to suggest that the distinction between Ramsay and IRC v Plummer lies in the fact that Ramsay was a “readymade” scheme (see ¶ 78). While this is not implausible, the force of the suggestion is diminished by the fact that Plummer was a readymade scheme too, as the judgment of Walton J. at first instance suggests, and also by a subsequent decision of the House of Lords (Moodie v IRC 65 TC 610), in which Lord Templeman expressed the view that Plummer would have been decided differently had “the Ramsay principle” been applied.
One more point must be made about K.S. Radhakrishnan J.’s approach to this issue. His judgment appears to endorse (¶ 87) Lord Hoffmann’s celebrated analysis of the law on tax avoidance in his speech in MacNiven v Westmoreland Investments, in which it was suggested that the apparent difficulty in reconciling the cases on tax avoidance was a failure to appreciate that the legislature sometimes defines a term in a “legal” sense and sometimes in a “commercial” sense. That formulation has subsequently been criticised, and the UK Supreme Court has virtually rejected it in a recent case– Tower MCashback v Revenue and Customs Commissioners (not cited in Vodafone). It is submitted, however, that Lord Hoffmann’s approach is in fact a most useful way of analysing this issue, and some of the criticism is perhaps a result of the belief that Lord Hoffmann intended a formulaic classification of definitions as “legal” or “commercial”. While it is not possible to develop this point in more detail here, it suffices to state that what Lord Hoffmann really appears to have intended is a test to distinguish cases in which legislative intent is consistent with a degree of artificiality (for instance Lord Hoffmann’s own example of conveyancing) from those in which it is not. It is therefore submitted that K.S. Radhakrishnan J.’s remarks on this test are to be welcomed, notwithstanding, with respect, the comments of Lord Walker in Tower MCashback.
2. Controlling Interest and Situs of Shares
The judgment of the Bombay High Court had accepted that in principle “controlling interest” is not an independent capital asset, although it had eventually found that there was “something other than” the transfer of a single share of CGP. On this issue, the Chief Justice’s judgment is especially interesting. It begins by observing that controlling interest is a “mixed question of fact and law” (¶83), and rejects the Revenue’s case not only on the ground that controlling interest is not a distinct capital asset, but also on the ground that Vodafone did not acquire 67 % controlling interest. The Chief Justice reaches the latter conclusion by holding that GSPL’s right under the Call Options with the Asim Ghosh and Analjit Singh companies is “at the highest” analogous to a “potential share” because “till exercised it cannot provide right to vote or management or control”. Similarly, the practice before the SPA was that HTIL would appoint six directors, Essar (which held 33 %) would appoint four, and TII (which indirectly held 19.54 % in HEL) would appoint two directors, who “in practice” were Mr Ghosh and Mr Singh. In a “Term Sheet” Agreement entered into between VIH and Essar on 15.03.2007, it was agreed that this “practice” would continue (ie VIH would appoint 8, and Essar 4). The Chief Justice holds that an agreement to “continue the “practice” concerning nomination of directors on the Board of Directors of HEL which in law is different from a right or power to control and manage…” did not give VIH “controlling interest”. In ¶88, the Chief Justice holds that in any event a sale of shares cannot “as a general rule” be “broken up into separate individual components” and that such components are not distinct capital assets (approving in this respect the well-known judgments in Maharani Ushadevi and Venkatesh (Minor) v CIT). It is submitted that this conclusion is entirely correct – as a matter of law, if it were possible in every circumstance to vivisect the sale of the whole into the sale of its component parts, it would have been entirely unnecessary for Parliament to expressly provide that the sale of the whole is taxable if certain conditions are satisfied.
In subsequent posts, we will consider the other important issues set out above.
1.”As we discuss below, much of the Court’s reasoning, particularly in the judgment of the Chief Justice, IS PREMISED ON A FACTUAL FINDING that the Vodafone-Hutch deal did not lack commercial substance or business purpose, and ITS ANALYSIS OF LEGAL PRINCIPLES SUGGESTS that a finding for the assessee is not a foregone conclusion in “similar” cases.” (opening paragraph)
According to a different perception, and perspective, one would say that the court has simply and rightly reiterated the well established basic principle/strict rule of guidance that every ruling of court on a ‘point of law’ (including a mixed question of law and facts, or ‘a substantial question of law’) cannot hold good or blindly be taken to apply and be applied, unless the facts (and circumstances)of the case on hand are convincingly found to be on “ALL FOURS”(within the legally understood meaning of the expression). Barring, of course, without going into the implications of the other two known concepts of ‘ratio decidendi’ and ‘obiter dicta’, which have always seem to have proved even for outstanding and truly eminent advocates, and forever remained to be so, areas of hair-splitting or mindboggling controversy. The plethora of case law and expert commentary in text books, if studied in-depth, might be of use to clarify one’s own thoughts on the foregoing aspect, cryptically covered by the graphic term-‘PRECEDENT’.
2. “…..and rejects the Revenue’s case not only on the ground that controlling interest is not a distinct capital asset, but also on the ground that…”
(a) In this context, one may wish to draw attention to the tribunal case >ACIT vs. R.K.B.K Fiscal Services Ltd (ITAT Kolkata) in which the view taken is that : “Share sale price cannot be apportioned towards transfer of “controlling interest”; albeit, the matrix of facts , so also stance of both sides are distinguishable; yet the arguments put forth relied on the observations of HC ‘s earlier judgment, since overruled by the apex court.
(b) The court’s observations in paragraphs 30 and 31, in which the appellant, in its explanation of the noted difference of the documented ‘percentage of share holding’ as adopted for ‘pricing’, has relied on basically the varying modalities called for by the US GAAP and Indian GAAP. The explanation, as is seen, was not gone into further but satisfied the FIPB for its purposes. Be that as it should, on the first blush, one is left with a lurking doubt whether or not any such variance in modalities in accounting principles, giving rise to any significant effect on the ‘result’,- not only between India and the US, but also between India and any other Country,- has the necessary potentials for a controversy in the realm of taxation of cross-border transactions ; e.g. in the matter of implementing the domestic ‘transfer pricing’ rules. Obviously, this is a complicated and too involved a matter, to requiring an in-depth / incisive study by accounting experts, also by legal pundits. In view of the seeming complicity, it might be worthwhile also for the ICAI , being the regulatory authority for the professional accountants, to do likewise, and come out with useful guidance for its constituents, sooner than later.
(< paragraph 2. Controlling Interest and Situs of Shares)
That is so true Niranjan. As an author and business man, I can relate to how you said "On the first question, doubts had arisen because of the exiguous observation in paragraph 46 of the majority judgment in McDowell endorsing “on this aspect” the concurring judgment of Chinnappa Reddy J., in which the ghost of the Duke of Westminster had been duly exorcised". I hope more people discover your blog because you really know what you're talking about. Can't wait to read more from you!