Remember the time when the pug went Red? The advertisement showing the cute puppy moving into a new house caught everyone’s eyes. May 2007, cellular giant Vodafone Plc acquired 67% stake in Hutch, making it one of the biggest headlines of the time. Well, even after thirteen years, the case remains a headline!

The acquisition seemed fairly simple on the face but was followed by a series of controversies that are alive even today. This piece attempts to de-clutter the entire saga bit-by-bit, explaining how the deal became a classic case study.

Telecommunication Industry (2004–2009)

If we pay attention to the trends around the time of the acquisition, the numbers show that the industry was booming. The sales were growing and subscriber base trends, year-on-year, showed a steep increase. The cellular penetration was increasing and 3G was set to take off. Hence, it was not surprising why this industry tempted foreign players to enter the Indian Market. Therefore, this period saw a strong uptick in the Foreign Direct Investments in the sector.

What did Vodafone look for?

Hutchison Essar was one of the leading players in the industry with strong financials. Vodafone Plc entered the deal to gain access to Hutch’s existing 23.3 million subscribers and 16.4% of the market share. This was also in line with its vision of investing in emerging markets with lucrative opportunities.

Understanding the acquisition

Hutchison Telecommunications International Limited (HTIL) was a Hongkong based company. It fully owned a company called CGP Investments based in the Cayman Islands. This company held 67% stake in the Joint Venture in India called Hutchison Essar Ltd (HEL) while 33% was owned by the Essar group.

Now that Vodafone wanted to enter the Indian Market, instead of forming a new company from scratch, it decided to buy an already existing company. Therefore, it acquired 100% shares of CGP Investments for $11 billion. The result was that Vodafone indirectly gained a controlling stake over its subsidiary, Hutchison Essar Limited (Hutch). The structure of the deal can be understood through this flow diagram.

So where is the problem? Looks fair, isn’t it? Not to the Indian Tax Department at least. Well, let’s dig a little deeper. What was this CGP investment? It was simply like an empty house where 67% of shares of HEL were lying. It was a buffer company situated in a ‘tax haven’ country, formed only for such deals. Before moving further with the story, let us first understand the kind of tax involved in the case.

Capital Gains Tax

The gain earned on the sale of Capital assets like property, plant or shares is a Capital Gain. Under the Income Tax Act 1961, such a gain is taxable. Further, section 9 of the Act says that any income accruing from the transfer of capital assets situated in India, even for a non-resident, is taxable. The heart of the problem was the fact that the word ‘indirect transfer’ was missing here.

Another important part was section 195 which mentions that if any amount has been paid to a non-resident, which is chargeable to tax, the buyer must collect TDS on it.

The Story Forward…

After the deal in 2007 only, the Indian IT department sent a show-cause notice to Vodafone asking for an explanation about why the tax was not retained on the transaction. Vodafone’s position was that the amount was not chargeable in India as the deal happened between two foreign companies. While the Indian Government asserted that the deal involved the transfer of an Indian company, hence Rs 8,000 crore of tax was payable. The case was taken to the Bombay High Court which, in 2010, ruled in favor of the Government of India. But then, when it was appealed to the Supreme Court, the judgment was overruled in 2012. The decision was based on whether it was a case of ‘tax avoidance’ or just an intelligent ‘tax panning’.

Tax Evasion Vs Tax Avoidance Vs Tax Planning

The three terms are closely related and are often confusing. Tax Evasion is an illegal attempt to reduce the tax, for example, manipulation of profits to reduce tax liability. Tax Avoidance means making use of loopholes in the law to minimize tax. It is not a violation of law but a disregard to the intent of the law. It may sometimes be as bad as tax evasion. And finally, Tax Planning is making use of the provisions of the law to save taxes. In other words, it means planning the financial activities in such a way so as to take maximum advantage of the provisions of the IT Act, like exemptions, deductions, etc.

The Supreme court in the judgment found it to be a case of prudent tax planning which the law of India failed to prove illegal. Hence, they could not be held liable to pay tax.

After the judgment, the Government of India did something unforeseeable. In an attempt to circumvent the ruling, they decided to amend the law with a ‘retrospective effect’.

Retrospective Taxation

Based on the specified date of application, an amendment can be either ‘prospective’ or ‘retrospective’. A prospective amendment simply becomes applicable from the date of the amendment itself or some future date. Whereas, ‘retrospective amendment’ becomes applicable from a past date.

This case was a landmark example of ‘retrospective taxation’ where the amendment became applicable from 1st April 1962. The change was made in exactly the manner that could hold Vodafone liable for the tax. So there was no point for the company to now appeal in the Supreme Court. Therefore, it went to the Permanent Court Of Arbitration in the Hague. The company claimed that the conduct of the Indian Government violated the Bilateral Investment treaty signed between India and Netherlands in 1995.

Verdict — Permanent Court of Arbitration (PCA), The Hague

In September 2020, a verdict came from the Permanent Court of Arbitration in favor of Vodafone International Holding stating that the demand for tax (which ballooned to Rs20,000 crore with the interest and penalties) was not justifiable since it was a breach of ‘fair and equitable treatment’ according to the agreement between the two countries. In addition, the court also directed the Indian government to reimburse the company a sum of Rs40.3 crores which is approximately 60% of the legal cost incurred by the company. The Indian Government can now approach the High Court of Singapore since the seat of the arbitration was in Singapore.

Timeline of the Case

Dilemma for India

The retrospective taxation was widely criticized by the business community within and outside India. Now the country stands at a crossroad. It can challenge the verdict or not honor it at all. The drawback is that it will end up hurting the business sentiments at the time when it is trying to entice foreign investments. On the other hand, it can let go of the tax demand and pay the directed reimbursement. A very similar case of UK’S Cairn Energy PLC for a levy of about Rs10,000 crore is pending for arbitration. Like these, there are dozens of cases pending with various companies on retrospective tax settlement issues, so if the government gives up on the verdict, it will end up losing out on millions as a penalty.

So, does the story end here? Well, it depends on the government’s move ahead, but the case so far has been a historic example of the artful financial strategies that can be adopted by companies which can make even the experts scratch their heads in drawing the line between ‘tax avoidance’ and ‘tax planning’.

By Riya Anand
Class of ’22 | Indian Institute Of Management Tiruchirappalli

References:

1. Agrawal, H.A.(2019), The Vodafone Case: A Critical Analysis, http://www.ramauniversityjournal.com/law/pdf_dec2019/03.pdf

2. BBCIncop(2020),https://bbcincorp.com/resources/differences-between-tax-evasion-tax-avoidance-and-tax-planning

3. Cleartax (2020), Retrospective amendment and retrospective taxes, https://cleartax.in/s/retrospective-tax

4. Gupta, CA Anuj (2018), Who is responsible for TDS on sale of shares by NRI’s, https://taxguru.in/income-tax/responsible-tds-sale-shares-nris.html

5. Jagannath, J.J (2020), https://www.livemint.com/companies/people/rs-20-000-cr-retro-tax-case-vodafone-wins-arbitration-against-india-11601026663522.html

6. Knowledge@Wharton (2017), https://knowledge.wharton.upenn.edu/article/vodafone-hutch-deal-is-indias-mobile-phone-market-growing-too-hot/

7. The Indian Express (2020), Retrospective taxation: the Vodafone case and the Hague court ruling, https://indianexpress.com/article/explained/retrospective-taxation-the-vodafone-case-and-the-hague-court-ruling-6613799/

Finance & Investment Club of IIM Trichy