Tax avoidance through artificial devices — holding companies, subsidiaries, treaty shopping and selling valuable properties indirectly by entering into a maze of framework agreements — has become a very lucrative industry today.

A large part of the income of the ‘Big 5′ accountancy and consultancy firms derives from tax avoidance schemes which flourish in the name of tax planning. Their legality has agitated courts in India and abroad for a long time. In 1985, a 5-judge bench of the Supreme Court in the McDowell case settled the question decisively, observing:

“In that very country where the phrase ‘tax avoidance’ originated, the judicial attitude towards [it] has changed and the smile, cynical or even affectionate though it might have been at one time, has now frozen into a deep frown. The courts are now concerning themselves not merely with the genuineness of a transaction, but with [its] intended effect for fiscal purposes. No one can now get away with a tax avoidance project with the mere statement that there is nothing illegal about it. In our view, the proper way to construe a taxing statute, while considering a device to avoid tax is … to ask … whether the transaction is a device to avoid tax, and whether the transaction is such that the judicial process may accord its approval to it.”

“It is neither fair not desirable to expect the legislature to … take care of every device and scheme to avoid taxation,” the ruling added. “It is up to the Court … to determine the nature of the new and sophisticated legal devices to avoid tax … expose [them] for what they really are and refuse to give judicial benediction.”

‘Legitimate tax planning’

Despite such a clear pronouncement, two recent judgments of smaller Supreme Court benches have gone back to calling artificial tax avoidance devices “legitimate tax planning”.

Though the Income Tax Act obliges even non-residents to pay tax on incomes earned in India, many foreign institutional investors avoided paying taxes citing the Double Taxation Treaty with Mauritius. This treaty says a company will be taxed only in the country where it is domiciled. All these FIIs, though based in other countries and operating exclusively in India, claimed Mauritian domicile by virtue of being registered there under the Mauritius Offshore Business Activities Act (MOBA). Companies registered under MOBA are not allowed to acquire property, invest or conduct business in Mauritius.

Yet these ‘Post Box Companies’ claimed to be domiciled there and the I-T department allowed them to get away with claiming the benefits of the treaty for many years. Given the benign attitude of the Indian tax authorities and the fact that there was no capital gains tax and virtually no tax at all on these companies in Mauritius, most FIIs and most of the foreign investment in India, by 2000, came to be routed through Mauritius.

The party finally ended when a proactive tax officer tried to stop this blatant evasion. Relying onMcDowell, he lifted the corporate veil of MOBA companies to determine their place of management and actual place of residence. Since this happened to be in different countries in Europe or North America, the relevant Double Tax Avoidance treaty became the one between India and that country. All these treaties provided for capital gains to be taxed where the gains had accrued. Since the gains accrued in India, he levied capital gains tax on these FIIs.

The CBDT circular

Responding to the FIIs’ distress calls, the then Finance Minister, Yashwant Sinha, got the Central Board of Direct Taxes to issue a circular stating that once a company had obtained a tax residence certificate from Mauritius, it would not be taxed in India.

The CBDT’s circular was challenged in the Delhi High Court by Azadi Bachao Andolan and a retired Income Tax Commissioner. The petitioners also pleaded that the government be directed to amend the treaty with Mauritius since it had become a tax haven. The High Court allowed the writ petitions and quashed the CBDT circular, holding it violative of the I-T Act.

The government appealed, telling the Supreme Court that its circular — which effectively offered a tax holiday to FIIs — was needed to attract foreign investment. The petitioners responded that tax exemptions could only be granted by Parliament, either by amending the Income Tax Act or by the Budget passed each year, and not by the government in the guise of such a circular. However, a two judge bench in 2003 called this device an act of legitimate tax planning which could be promoted by the government to attract foreign investment, defied the Constitution bench judgment in McDowell and set aside the Delhi High Court judgment.

In the Vodafone tax case, which was heard by a 3-judge bench of the Supreme Court, the court had the opportunity to correct the transgression of the McDowell principle in the Mauritius case. In 2007, Hutchinson Telecom International (HTIL), which owned 67 per cent of Hutch Essar Limited (HEL), an Indian telecom company, sold its holding to Vodafone International (VIH BV). Both companies announced that Hutchinson had sold, and Vodafone had bought, 67 per cent of the shares and interest in the Indian company for over $11 billion.

Section 9(1) of the Income Tax Act says incomes which shall be deemed to accrue or arise in India include “all income accruing or arising, whether directly or indirectly, through … the transfer of a capital asset situated in India.”

Vodafone’s claim

Since the transfer of the Indian telecom firm’s shares and assets to Vodafone had led to capital gains for Hutch, the IT department demanded capital gains tax from Vodafone, which was liable to withhold this tax from the amount they paid Hutch. Vodafone claimed the transaction was not liable to tax since it was achieved by transferring the shares of a Cayman Island-based holding company and did not involve the transfer of a capital asset situated in India. The High Court rejected this contention by holding:

“The facts clearly establish that it would be simplistic to assume the entire transaction between HTIL and VIH BV was fulfilled merely upon the transfer of a single share of CGP in the Cayman Islands. The commercial and business understanding between the parties postulated that what was being transferred … was the controlling interest in HEL. HTIL had, through its investments in HEL, carried on operations in India which HTIL in its annual report of 2007 represented to be the Indian mobile telecommunication operations. The transaction between HTIL and VIH BV was structured so as to achieve the object of discontinuing the operations of HTIL in relation to the Indian mobile telecommunication operations by transferring the rights and entitlements of HTIL to VIH BV. HEL was at all times intended to be the target company and a transfer of the controlling interest in HEL was the purpose which was achieved by the transaction.

“Ernst and Young who carried out due diligence of the telecommunications business carried on by HEL and its subsidiaries made the following disclosure in its report:

“The target structure now also includes a Cayman company, CGP Investments (Holdings) Ltd. CGP Investments (Holdings) Ltd was not originally within the target group. After our due diligence had commenced the seller proposed that CGP Investments (Holdings) Ltd should be added to the target group …”

The due diligence report emphasizes that the object and intent of the parties was to achieve the transfer of control over HEL and the transfer of the solitary share of CGP, a Cayman Islands company, was put into place at the behest of HTIL, subsequently as a mode of effectuating the goal.”

Following McDowell, where the Supreme Court had decisively frowned upon tax avoidance schemes, the High Court rejected Vodafone’s contention that this transaction was not liable to tax. But in appeal, a Supreme Court bench of 3 judges headed by Chief Justice Kapadia accepted Vodafone’s claim that the capital gain had arisen only from the transfer of the single share in the Cayman Island company and had nothing to do with the transfer of any asset situated in India.

Despite the fact that the entire object and purpose of the transaction between Hutch and Vodafone was to transfer the shares, assets and control of the Indian telecom company to Vodafone, the Supreme Court declared in January 2012 that the transaction has nothing to do with the transfer of any asset in India!

With such welcoming winks towards tax avoidance devices, it is unlikely that any foreign company would be called upon to pay tax or at least capital gains tax in future in India. Thousands of crores of tax revenue, and the future attitude of the courts towards innovative tax avoidance devices, will be shaped by these two judgments.

The Vodafone case is in the lineage of the Mauritius case inasmuch as both encourage tax avoidance devices ostensibly to attract foreign investment. The 2G judgment of the Supreme Court cancelling 122 telecom licences granted four years earlier, in sharp contrast, enforces the constitutional principle of equality and non-arbitrariness. The proponents of FDI are groaning that this will stem the flow of investment. Honest foreign companies should not be deterred by this judgment, which strikes a blow against crony capitalism. But even if FDI becomes a casualty in the enforcement of the rule of law, so be it.

Our courts must send a clear signal that India is not a banana republic where foreign companies can be invited to loot our resources and even avoid paying taxes on their windfall gains from the sale of those resources.

(The author is a Supreme Court advocate)

Arvind P. Datar’s responds to this article