India: India Is Slaughtering Its Golden Goose

Last Updated: 23 May 2012
Article by Adriaan Struijk

Previously published in RAK Free Spirit Magazine

Adriaan Struijk, probes the new tax legislation developments in India that may negatively affect its foreign direct investment potential.

India's reputation as a country safe for investors received a boost when its Supreme Court ruled in favour of the taxpayer in the case of Vodafone vs Indian Tax Authority on 22 January this year.

The case concerned a tax dispute in relation to the acquisition by Vodafone International Holdings BV (VIH), a Dutch company, of CGP Investments (Holdings) Ltd (CGP), a Cayman Islands company, in 2007. As a result of this purchase, VIH indirectly acquired a 67% interest in Hutchison Essar Limited, an Indian company. The Indian tax authorities sought to tax the capital gains arising from the sale of the share capital of CGP on the basis that CGP, whilst not a tax resident in India, held the underlying Indian asset.

The decision by Indian Tax Department to issue a USD 2.5 billion assessment on Vodafone in relation to this acquisition dumbfounded tax professionals around the world. The reason is that there were no provisions in the Indian tax code that would allow the taxation of the gains on this indirect transfer of shares. It was widely considered that the tax authorities have overstepped their bounds and unreasonably stretched the law to achieve a policy objective. In 2010, High Court of Bombay upheld the assessment, which has now been overturned by the Supreme Court of India. The Supreme Court ruled that the Indian tax authorities have no jurisdiction in the case and that the transfers of shares outside India that indirectly transfer Indian shares cannot be taxed in India under the existing provisions of the law.

The Supreme Court's verdict was hailed around the world as a victory of India's fair, impartial and independent judicial system, where the rule of law prevails notwithstanding the amount of tax at stake. The Supreme Court called upon the tax administration to legislate with laws that lend certainty to the investors.

Nevertheless, the international publicity of the Vodafone tax case has negatively impacted the foreign direct investment and economic activity in India in the past few years. The court ruling affirmed India's commitment to the rule of law, i.e. that one can rely on what the law says, and with the tax uncertainty reduced, hopes were up that this would boost investment in India.

This sentiment was short-lived, however.

Unbelievably, the Indian government, being faced now with a shortfall in its budget that is USD 2.5 billon wider, announced on 16 March in this year's Finance Bill that it will retrospectively, from 1 April 1962, amend the Income Tax Law so that it can include tax gains on indirect transfers overseas, after all. The government can now file a curative petition and force the Supreme Court to reopen the case.

While it is bad for a country's reputation as being investor-friendly for tax authorities to capriciously bring up tax transactions on the basis of a farfetched re-interpretation of the law, it pales in comparison to a government enacting legislation with retroactive effect. The temptation to slaughter the sitting duck (Vodafone) was simply too big. It is, however, also slaughtering the 'golden goose' of foreign investment. But, it can only do this once, at least until it has rebuilt its reputation over many years.

Also announced in the Finance Bill was the long-awaited General Anti-Avoidance Rules (GAAR), which will now be effective from 1 April 2012. GAAR rules make it difficult for the investors to plan the tax implications of their transactions by creating uncertainty. A transaction might be in perfect accordance with the provisions of the law; but, if it is judged to be done for tax avoidance purposes, it can be voided. The problem is that this approach is highly subjective. It creates uncertainty, and is, therefore, not a good policy if attracting new investments is the purpose rather than getting as large a share as possible from the income of existing investors. Enacting anti-avoidance rules is like saying, 'there are certain things we do not like you to do; but, if I tell you which things they are, you are probably still going to do something else that I do not like but have not thought of yet. So, instead of setting out the rules, I will just tell you approximately what I do not like, which will be the case when you pay less tax than I think you should'.

Surely, India is not alone here, and India is arguably just jumping on the bandwagon of high-tax countries that are desperate to protect their tax base. But, taking as a starting point that people are free, and that whatever is not allowed should at least be specifically outlined in the laws, there is no place for GAAR.

Let investors contemplating investment in India be warned. In addition to an existing Exchange Control Law, which sets out in minute 2,000-plus pages, details of how foreign investors may or may not invest in India, they will now also have to deal with the uncertainty created by GAAR and a government that simply cannot control its urges.

Developments like this make you all the more aware of what a haven, a retreat from the socalled 'real' world, the United Arab Emirates is!

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Adriaan Struijk
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