The 'Vodafone' amendment is more than a retrospective issue

The text of the Income tax amendment is so wide and so riddled with ambiguities that it deserves to be scrapped for those reasons alone, says N S Nigam.

Despite speculation to the contrary, the Narendra Modi government’s first Budget did not do away with the post-Vodafone tax amendments introduced by the United Progressive Alliance government in 2012. Of as much concern is the fact that the finance minister did not announce much-needed clarifications to the 2012 tax amendments either.

In fact, the retrospective application of tax legislation is not the only issue with the 2012 amendments. The text of the retrospective amendments is so wide and so riddled with ambiguities that it deserves to be scrapped for those reasons alone, never mind its retroactive application.

To understand why, consider the nub of the issue in the Vodafone case. In 2012, the Supreme Court was faced with a tax dispute that threatened to snowball into a major controversy regarding the extent to which multinational companies could mitigate their tax liability in India in the process of mergers and acquisitions.

India, like almost every other industrialised country in the world, imposes a tax on a transfer of assets situated in India. Therefore, multinationals that own property situated in India pay taxes to the Indian government on a transfer of that property if such a transfer has resulted in a gain, termed a “capital gain”.

The key factor here is that the property being transferred is situated in India; otherwise, the Indian government would have no jurisdiction to tax the transfer of property. Globally, countries do not tax capital gains unless there is some nexus with the country, such as the fact that the transferor is a resident of the taxing country or the fact that the property is situated in the taxing country.

What the Income Tax Act of 1961 did not make clear was the application of the capital gains rules to a situation where the foreign company did not sell any Indian property (i.e. property situated in India) directly. Instead, the foreign company sold Indian property indirectly by owning the Indian property though a foreign company and then transferring the shares of that foreign company. A foreign company is not considered as “situated” in India and, therefore, a transfer of the shares of a foreign company would not attract any Indian taxation.

This, simply put, was the issue in the Vodafone case. The buyer of the Indian property is usually indifferent to whether he will own the Indian property directly or indirectly through an acquisition of shares in a foreign company that owns the Indian property. Either way, the buyer is able to obtain economic control over the Indian property.

The Supreme Court decided that the Indian tax legislation did not tax indirect transfers of property. The Indian government disagreed and introduced a “clarificatory” amendment to the tax legislation that taxed the indirect transfer of property described above and had retrospective application from the inception of the Indian Income Tax Act, 1961.

The retrospective nature of the legislative amendment has attracted a fair amount of criticism and there were optimistic murmurs before the Budget that the new government would scrap it. The Modi government, however, refrained from making any such radical changes to the tax legislation, mindful, no doubt, of the fact that more than $2 billion in unpaid tax dues are at stake in the Vodafone case.

There are other ambiguities in the amendment that urgently required attention, however. The previous government was clearly dissatisfied with the inability of the tax legislation to tax indirect transfers of assets. The government could have adopted a narrow amendment addressing the facts of the Vodafone tax case and instituted more fundamental reforms in the forthcoming Direct Taxes Code (DTC).

Further, General Anti-Avoidance Rules would apply from 2015, which would have addressed tax avoidance structures on the lines of the Vodafone case. Nevertheless, the government took as broad an approach towards the issue as possible and instituted a multi-pronged amendment strategy to counter the Vodafone decision.

The intent was to stop multinationals from circumventing capital gains taxation but the wider the legislative approach to this problem, the more is the resulting confusion in the application of the new rules. Two of the post-Vodafone amendments described below are capable of creating much mischief.

First, the definition of “transfer” of property was amended, to make it clear that even an indirect transfer of property would be subject to capital gains taxation. However, there is no further guidance in the legislation on the meaning of “indirect” transfer. Can a person indirectly transfer Indian property if he transfers 10 per cent of the shares of a foreign company that owns the Indian property? No one has the definitive answer, and the legislation does not provide any clues.

Simultaneously, the government amended the definition of what it means for an asset to be situated in India. A foreign asset such as the shares of a foreign company would be considered as situated in India and, therefore, subject to the Indian tax jurisdiction if the foreign company’s shares derive, directly or indirectly, their value substantially from assets located in India.

What does “substantially” mean? Consider a situation in which a foreign company owns assets in India that represent 40 per cent of its worldwide assets. If a person transfers the shares of this company, will the Indian government have the jurisdiction to tax this transfer? Again, there is no definitive answer to this question. Curiously, the DTC has clearer guidelines on this matter. Under the DTC, a foreign company’s shares are deemed to be situated in India if 50 per cent or more of the company’s assets are situated in India.

The post-Vodafone tax amendments were made with good intentions, which were to thwart creative attempts to transfer control over Indian property without paying Indian taxes. But without more detailed rules, such amendments are overkill at best. The government must either add several clarifications to the current legislation through further statutory amendments or make sure the DTC becomes the law of the land as soon as possible.

N S Nigam is an Associate Professor of Law at Azim Premji University, Bangalore