Tax Analysts Blog

The Vodafone Case Sets Dangerous Precedent

Posted on Sep 16, 2010

How would you feel if the tax collectors in some foreign country -- one you never had any direct dealings with -- sent you a tax bill for $2 billion? To make matters worse, let's say the foreign taxes have nothing to do with your own personal earnings; the bill relates entirely to somebody else's capital gain income. Needless to say, you'd be outraged.

That's exactly how the U.K.-based telecom firm Vodafone feels these days. A while back they received just such an assessment from India's revenue agency and have been challenging it in the local courts ever since. Last week they received some bad news. The Mumbai High Court handed Vodafone a defeat that has tax attorneys on multiple continents scratching their heads in bewilderment. The oddball decision rests on rationale that runs contrary to the accepted norms of international taxation.

The litigation stems from Vodafone's 2007 acquisition of Hutchison Essar, one of India's leading providers of mobile phone services. The fact pattern is somewhat convoluted, but can be summarized as follows:

• Hutchison Essar is an Indian resident. It's owned by a company based in Mauritius, a tiny island nation that has a favorable tax treaty with India. Among other things, the treaty doesn't permit India to tax the capital gains of Mauritian residents when they trade shares in Indian firms. This is a classic example of a 'source country' (here India) giving up its taxing jurisdiction to a 'resident country' (here Mauritius).

• The Mauritian shareholder was owned (indirectly) by a firm called CGP Investments, based in the Cayman Islands. CGP, in turn, was owned by a company called HTIL that's based in Hong Kong.

• In the merger, Vodafone's Dutch affiliate (the purchaser) acquired the shares of CGP (the target) from HTIL (the seller). No Indian entity participated in the merger and -- critically -- no capital assets based in India were involved in the merger. Cash went from a purchaser in the Netherlands to a seller in Hong Kong; shares of stock went in the other direction.

• When the dust settled, nothing in India had changed. Hutchison Essar owns the same assets that it did pre-merger. And it continues to be owned by the same Mauritian shareholder, which is still owned by the same Cayman holding company. All that's changed is the identity of the holding company's foreign parent.

There's no doubt that HTIL's shares of stock in CGP constitute a capital asset. Under conventional tax rules, a taxable capital gain would arise if a capital asset were sold, exchanged, or otherwise disposed of. But Hong Kong -- where HTIL is a resident -- does not tax corporation's capital gains. Neither, for that matter, does the Cayman Islands or Mauritius. Thus, HTIL's capital gain went completely untaxed. If that result seems unfair, keep in mind that Hong Kong is perfectly capable of taxing its own residents on their capital gains, but has specifically chosen not to do so.

Nevertheless, India seemed perturbed by the fact nobody was taxing the capital gain. India is unable to tax HTIL directly (since the firm is not an Indian resident, conducts no business in India, and holds no assets in India) so it instead looked for a company that it could tax. Thus Vodafone was hit with a massive tax bill -- roughly $2 billion -- on the grounds that its affiliate should have withheld taxes when it cut the check to HTIL on the stock sale.

You read that properly, India's tax agency thinks Vodafone magically became a withholding agent when its Dutch affiliate acquired shares in a Cayman target from a seller based in Hong Kong. To say the court's logic is unorthodox is putting it mildly.

Neither of the two participants in the merger -- the Dutch purchaser and the Hong Kong seller -- have any nexus with India, other than indirect ties to Hutchison Essar via a network of intermediary firms in the Caymans and Mauritius. And those indirect ties have never been a sufficient basis for India to assert taxing jurisdiction over a nonresident foreign taxpayer. And even if there were a nexus, Hutchison Essar's immediate owner is a Mauritian entity protected by the favorable tax treaty provisions.

In summary, India has imposed domestic withholding tax obligations on a foreign-to-foreign share trade. In the process they've taken well established principles of cross-border taxation -- not to mention their treaty obligations -- and tossed them out the window. And here's the kicker, Vodafone isn't alone. Scores of multinationals have structured their Indian investments the same way. Unless the decision is reversed by India's Supreme Court, the case will have a chilling influence on cross-border investment decisions.

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