It's investment, not tax

Taxing Issue: Embroiled in tax cases, mobile major Vodafone emerges victorious at the Bombay High Court

Vodafone, the leading British telecom operator, perhaps never expected the continuous (and unwanted) tax battles with Indian revenue authorities.  It is still defending its success in the capital gains tax dispute on acquiring Hutchison Essar in India. It was all hoped that this war will come to an end with a new government willing to accept the recommendations of Shome Committee report. Now, Vodafone is all set to take the issue off-shore in an international arbitration which could be potentially embarrassing for the Government of India. It is also embroiled in another dispute with the Indian revenue authorities: the liability of transfer pricing adjustments on the issue of shares to its holding company.

In August and November 2008 Vodafone India Services Private Limited India issued 2,89,224 equity shares of face value of Rs 10 each at a premium of Rs 8,509 per share to its Mauritius holding company Vodafone Tele-Services (India) Holdings Limited, Mauritius. The price of Rs 8,519 was arrived at by incorporating the method prescribed under the Capital Issues (Control) Act, 1947 and necessary disclosures were made in the return as required by transfer pricing norms.

The revenue authorities referred the transaction to the Transfer Pricing Officer who arrived at a price of Rs 53,775 per share under a different valuation method (determination of the fair value of the business). He then treated the difference as income of the Indian subsidiary. How is it “income”? The difference is treated as “deemed loan”. Even more fantastic is the proposal to levy interest which ought to have been paid by the Indian company. Thus, by making these astonishing transfer pricing adjustments, Vodafone India was asked to pay Rs 3,200 crore.

The Dispute Resolution Panel (DRP) dismissed the objections raised by Vodafone and confirmed the transfer pricing adjustment on issue of shares. It held that the term “income” is not defined for the purpose of transfer pricing adjustments. Therefore, it has to be construed in the widest possible manner and will embrace all receipts. What is the “receipt”? The amount that would have been received if the foreign (parent) company had paid Rs 53,775 per share.

Vodafone challenged the order of the DRP before the Bombay High Court. It argued that transfer pricing provisions would apply only if “taxable income” arose from an international transaction. Vodafone pleaded that no “income” could arise when shares were issued and the amount received is a capital receipt. Thus, no transfer pricing adjustment could be made. The revenue authorities supported the order of the DRP on totally new grounds before the High Court and claimed that what is sought to be taxed is the cost incurred by the Indian company to make available the shares to its holding company at a price less that of the arms length price (ALP).
The Bombay High Court rightly concluded that “income” must be earned before the mechanics of transfer pricing provisions can apply. The issue of shares at a premium by Vodafone India to its parent company did not generate any “income”.

The stand of the department is contrary to elementary principles of income tax. If an Indian subsidiary company issued shares at a premium to its holding company, can there be any “income” that arises just because the book value of the shares is higher? On the contrary, if the book value is lower, can the Indian subsidiary claim it as a “loss”? How does it become income just because the shares are issued to a foreign holding company?

The Bombay High Court’s decision is indeed welcome and will directly impact similar cases wherein such an absurd stand has been taken. One only hopes that the Income Tax Act, 1961, is not amended, even prospectively, to nullify the Bombay High Court decision.

Cayman Island to The Hague
The purchase of one share of the Cayman Island Company by Vodafone from Hutchison Essar, Hong Kong, gave birth to an epic tax battle. The controversy arose because the revenue authorities claimed that the purchase of one share resulted in transfer of underlying assets of Hutchison Essar in India. Finally, the Supreme Court in January 2012, ruled in favour of Vodafone that the transfer of shares between two non-residents of a foreign company is not taxable in India. Pranab Mukherjee, now President of India and the then finance minister, made a monumental blunder by retrospectively amending the law existing since 1962. The world was horrified and India faced a serious drop in foreign direct investments.

Vodafone has invoked the arbitration clause under the India-Netherlands Bilateral Investment Promotion and Protection Agreement, 1996 alleging, among other things, expropriation of its investment, denial of justice and breach of assurance.  A PIL was also filed by a former additional solicitor general to restrain the Government of India from participating in arbitration on the ground that tax disputes under the Income Tax Act, 1961, cannot be brought under the ambit of bilateral treaty, but it was withdrawn.

Vodafone has nominated L Yves Fortier, a leading international arbitrator while the Government of India nominee is former Chief Justice of India R C Lahoti. The third arbitrator is to be nominated by the two and till date, no consensus has been arrived at. Two months’ time for nominating the third arbitrator provided under Article 9(4) of the agreement has already lapsed and only recourse is to approach the International Court of Justice at the Hague.

It is seen that wherever there has been investment, the revenue authorities have resorted to superfluous approach to demand tax. In transfer pricing alone, the number of disputes in India are more than the rest of the world combined. Foreign investors do not want to be locked-up in litigation over issues which by any rational standard are untenable. The assertion by the Bombay High Court on fundamental aspects of transfer pricing will resolve many disputes.

(The writer is  advocate, Madras High Court)