India: Cairn Energy Loses Retrospective Tax Case Before Indian Appellate Tribunal

1. INTRODUCTION

The Income Tax Appellate Tribunal (the "ITAT") recently upheld a capital gains tax levy of INR 10,247 Crore (approximately USD 1.56 billion) against Cairn U.K Holdings Limited, a wholly owned subsidiary of UK based Cairn Energy PLC, in an order dated 9 March 20171 (the "ITAT Order") in relation to a group restructuring of Indian operating assets.

This article discusses and analyses the ITAT Order, though before we turn to the substantive conclusions reached by the ITAT and its determination of the transaction, it's important to understand the broader context and approach by the Tax Authorities and the Government of India to the thorny issue of the indirect transfer of revenue generating business in India.

2. CONTEXT

In early 2012, the Supreme Court of India delivered a landmark judgement in Vodafone International Holdings BV v. Union of India2 ("Vodafone") ruling that the transfer of shares of a foreign company from one non-resident to another would not attract tax in India, even if the object of the transfer is to acquire the Indian assets of the foreign company.

Critical to the judgment of the Supreme Court in Vodafone was an analysis of section 9(1) (i) of the Income Tax Act, 1961 (the "Act") which dealt with income accruing or arising, whether directly or indirectly, through the transfer of a capital asset situate in India. The Supreme Court, correctly stated that section 9(1)(i) of the Act would only apply to capital assets situated in India and since there was no transfer of a capital asset situated in India, the section did not apply. It therefore rejected the look through argument.

While the judgment was technically correct and reflected general principles of the international taxation regime concerning cross border mergers and acquisitions, the judgement nevertheless dealt a massive blow to the Government, which believed that such indirect transfers of assets situated in India ought to be taxable under Section 9(1)(i) of the Act.

Post Vodafone, the Government therefore amended Section 9(1) (i) of the Act through the Finance Act, 2012 to explicitly clarify that indirect transfers which derive substantial value from assets located in India will be subject to tax in India.

This amendment effectively and controversially overruled the Supreme Court's decision in Vodafone. However, the larger controversy that surrounded this amendment was that it was enacted with retrospective effect from 1st April, 1962.

This retrospective amendment created negative sentiment amongst investors and the current Prime Minister of India labelled the practices of the tax authorities under the previous administration as "tax terrorism"3 and has provided various oral assurances to investors regarding the tax-friendly nature of his administration.

Despite these oral assurances, the retrospective amendment has neither been repealed nor amended in any way whatsoever and is currently being used by the Tax Authorities to levy taxes on past transactions.

It is under this retrospective amendment that the Income Tax Department has levied a claim of INR 29,102 crores (approximately USD 2.87 billion) against Cairn, consisting of INR 10,247 crores (approximately USD 1.56 billion) as capital gains taxes and the remainder as back dated penalties and interest from 2006.

3. THE TRANSACTION

Prior to the initial public offering ("IPO") of Cairn India Limited ("CIL") in 2006, Cairn U.K. Holdings Ltd. (the "Appellant") transferred its entire shareholding in 9 Indian subsidiaries to Cairn India Holding Limited ("CIHL"), a company incorporated in Jersey, in return for 100% shareholding in CIHL. Through share purchase and subscription agreements, CIL acquired 100% shareholding of CIHL from the Appellant and in return, paid cash and issued shares of CIL to the Appellant (the "Transaction").

The Assessing Officer reassessed the Appellant in 2015 and held that short term capital gains arose from the sale of shares of CIHL by the Appellant to CIL and hence, chargeable to tax in India at the rate of 40%, amounting to INR 10,247 Crore (approximately USD 1.56 billion) excluding interest for the assessment year 2007-2008.

This assessment was upheld by an order dated 25 January 2016 of the dispute resolution panel constituted under the Income Tax Act. The Appellant appealed against this order before the ITAT.

The decision of the ITAT is discussed below under the following five headings.

  • Whether the transaction entered into by the Appellant, transferring its 100% shareholding in CIHL to CIL in October 2006 was liable to be taxed in India, in light of the retrospective amendment to the Income Tax Act as introduced by the Finance Act 2012? ("Issue 1")
  • Whether an internal reorganization within group companies, without any change in controlling interest or increase in wealth, was taxable? ("Issue 2")
  • If a capital gain was applicable, how is the cost of acquisition of the Appellant to be determined? ("Issue 3")
  • Given that the Appellant is resident in the UK, did the taxation of any determined capital gain benefit from the provisions of the 1994 India UK Double Taxation Avoidance Agreement (the "DTAA") and would Indian law applicable before the enactment of the Finance Act, 2012 determine the issue in light of the DTAA? ("Issue 4")
  • Whether the Appellant was liable to pay any interest under Section 234-A and 234-B of the Income Tax Act? ("Issue 5")

4. ISSUE 1

The ITAT began by noting that the question as to whether the transaction entered into by the Appellant, transferring its 100% shareholding in CIHL to CIL in October 2006 was liable to be taxed in India, in light of the retrospective amendment to the Income Tax Act as introduced by the Finance Act 2012 was the precise issue which lay before them.

The ITAT gave preliminary consideration to whether the retrospective amendment to the Income Tax Act introduced by the Finance Act 2012 was bad in law and ultra vires, but rejected this contention on the ground that the ITAT was not the appropriate forum for challenging the validity of the provisions of the Income Tax Act.4

5. ISSUE 2

The ITAT went on to consider whether an internal reorganization within group companies, without any change in controlling interest or increase in wealth, was taxable.

The Appellant contended that the transaction was part of a series of transactions to internally reorganize its group companies, with the view of bringing the entire Indian business operations of the Cairn group under one Indian company. The Appellant further contended that there was no third party involved in the transaction whatsoever besides the group companies. The Appellant also highlighted that there was no change in controlling interest or increase in wealth as a result of this internal reorganization.

The ITAT however, found that the Appellant held rights in the control and management of 9 Indian subsidiaries engaged in the core business in India, and this property was transferred to CIL for a combination of cash and shares. These series of transactions entered into by the group culminated with the IPO of CIL. Part of the purchase price for CIHL paid by CIL to the Appellant arose out of the proceeds from the IPO. Besides this, the Appellant also divested a portion of its stake in CIL to institutional investors and the general public.

The ITAT, hence, rejected the claim that there was no increase in wealth of the Appellant as it unlocked the value of its holdings of CIL through the IPO and the increased value is derived from the book building process. The ITAT, therefore, further rejected the contention of the Appellant that the transaction was part of a mere internal reorganization of its group companies.5

The ITAT further considered whether there was an accrual of real income and referred to the Appellant's financial statements for the years ending 2006 and 2007, which stated that the sale of CIHL to CIL generated an exceptional gain of GBP 1.361 billion for the Appellant.6

Furthermore, the Appellant's financial statements also disclosed that no tax had been provided for this exceptional gain. The ITAT observed that:

"In view of this, the argument of the assessee that there is no increase in the wealth of the appellant and there is no real income earned by the assessee does not deserve to be accepted. In fact, the assessee has earned substantial gain on sale of the shares and also has gained on account of taxes too as according to the assessee itself such gain is not chargeable to tax. Therefore, the assessee has earned the real income on account of sale of its shares in Cairn India Holdings Ltd to Cairn India Ltd."

Hence, the ITAT rejected the contention of the Appellant that no real income was earned.7

6. ISSUE 3

In considering the computation of capital gains and the determination of the cost of acquisition, the ITAT considered whether an exchange or a sale had occurred, though concluded that it was irrelevant, since the full value of the consideration amount was not disputed.

The ITAT clarified further that even when the agreements do not specify the consideration in monetary terms alone, it would be possible to calculate the cost and sale consideration of the transaction and compute the capital gains, observing that:

"....merely because the consideration is not stated in monetary terms in the various agreements and deed, it cannot be said that sales consideration as well as the cost cannot be determined of the transfer of the property for working capital gain."8

In determining the cost of acquisition, section 48 of the Act sets out the calculation for capital gains on the transfer of an asset by essentially taking the difference between: (1) the cost of acquisition of the asset plus costs spent on improving it; and (2) the full value of the consideration received.

The Appellant contended that the cost of acquisition was equal to the full value of the consideration received, resulting in zero capital gains. The Appellant further claimed that as there was no timing difference between the acquisition and disposal of shares, the full value of the consideration received and the cost of acquisition were equal.

In contrast, the Assessing Officer argued that the cost of acquisition was far less than the full value of the consideration received, resulting in large capital gains.

The ITAT noted that section 55 of the Act provides for the definition of cost of acquisition for specialized scenarios under section 48 and 49 of the Act. However, the ITAT held that since the present scenario did not fit in with these provisions, the prescribed formula in section 48 applied.

The ITAT thereafter disagreed with the Appellant's contention that the cost of acquisition and the full value of the consideration were the same as there was no timing difference between them. The ITAT then concluded that the computation made by the Assessing Officer was deemed to be correct.9

7. ISSUE 4

The ITAT went on to consider whether the taxability of the capital gain should be determined under the DTAA, or Indian law applicable prior to the enactment of the Finance Act, 2012, though it dismissed the contentions of the Appellant on the ground that the DTAA merely provided that capital gains tax will be levied according to each country's domestic laws.

The ITAT further observed that the interpretation taken by the Appellant would be absurd and result in the DTAA making domestic law static with respect to taxability of capital gains, even when both countries have unequivocally left it to domestic law to determine the issues in this regard.10

8. ISSUE 5

In addressing the question as to whether the Appellant was liable to pay any interest under Section 234-A and 234-B of the Income Tax Act (and whether the Appellant was liable to pay any interest on taxes, which arose due to the retrospective amendment made by the Finance Act 2012), the ITAT accepted the contention of the Appellant.

The ITAT held that the Appellant neither could have, nor could have been expected to visualize its liability for payment of advance tax in the year of the transaction. Therefore, the ITAT ruled that the Appellant could not be called upon to pay any interest under section 234-A and 234-B of the Act.11

9. CONCLUSION

The ITAT's approach reveals that despite oral assurances from the new Central Government on the retrospective tax amendment, companies, especially multinationals, continue to be vulnerable to potential prosecution for past transactions by the Tax Department.

It's indeed interesting that the ITAT rejected the demand for default interest on the basis that the Appellant could not have known about the liability at the time of entering into the Transaction. Arguably, the same logic might apply to the general question of retrospective taxation.

One of the key takeaways from this case is that the Tax Department is leveraging admissions in financial statements of companies to contradict arguments advanced by the companies. To illustrate, in this case, the following two items in the Appellant's financial statements proved fatal to its claims.

Firstly, the ITAT focused on where the subsidiary companies were incorporated and operated, concluding that the capital assets of CIHL were deemed to be situated in India, as they derived their value substantially from the assets situated in India. As a result, the ITAT ruled it fell within the amended Section 9 of the Income Tax Act.

Secondly, the admission of an exceptional gain by the Appellant on the sale of CIHL to CIL, formed the basis for the ITAT's finding that the Appellant had contradicted its own claim that the transaction was a mere internal reorganization without any real gain in income or wealth.

This will have repercussions for multi-national corporate filings in particular. A much more conservative and prudent approach to drafting and disclosing only statutorily mandated and necessary details in financial statements is likely to follow.

Out of abundant caution and towards being better prepared against any potential tax recovery proceedings, it may also be advisable to review financial statements and other relevant records pertaining to transactions of a similar nature and contingency plan for similar claims.

Another key takeaway from this matter is that it might be advisable to allow for a cooling off period of at least one year (i.e. falling within the definition of long term capital gains) between such internal reorganizations and an event such as an IPO. This might bolster counter-arguments and mitigate harsh levies for short-term capital gains taxes.

It's perhaps also important to highlight the limitations of the DTAA. One of the factors that the ITAT used to determine the levy of capital gains tax on the Appellant in India was the exemption of tax in the UK.12 Essentially, the ITAT reiterated that the DTAA is simply a mechanism to avoid the multiplicity of taxation globally of an assessee. Since the transaction may have been tax exempt under the laws of jurisdiction of incorporation of the Appellant that does not mean that it would be tax exempt in other jurisdictions. Put otherwise, the Appellant would only have been able to take the benefit of tax paid in other jurisdictions to off-set its liabilities in India. Having no liabilities elsewhere, therefore, essentially increased its taxable liability in India.

Would a similar conclusion have been reached if the transaction had been subject to a tax (even a nominal amount) in the UK? Our view is that the Appellant would have benefitted from any tax payable in the UK, which would potentially have off-set its total liabilities in India. Needless to say, this opens up a Pandora's box in terms of tax planning for multinational entities.

Lastly, another interesting question that is left open is whether similar internal reorganizations by multinationals, if not followed by an IPO, would be treated similarly to the Appellant when a similar contention of no real income or gain accrual is argued? It might be said that the IPO itself was a red herring and the key issue was that cash (or cash equivalents) were paid for the Transaction and that a gain was recorded in the books of account. The IPO was simply a source of funds for part of the Transaction (and one of potentially many other sources).

The ITAT's order does seem to provide an insight into the Tax Department's mindset, in targeting what it considers to be untaxed profiteering of the public through the IPO, essentially underpinned by the value of Indian assets. The filing with the Jersey Financial Services Commission clearly stated that CIL would purchase a substantial amount of the shares of CIHL through the funds raised from the IPO of CIL. The ITAT, therefore, chose to look at the transaction as a whole (including the subsequent increase in value of CIL's shares through the IPO) before upholding the demand for over USD 1.5 billion from the Appellant.

The decision will no doubt reverberate in the boardrooms of multi-nationals and it remains to be seen to what international arbitration under the UK-India Bilateral Investment Treaty will say generally on the retrospective application of domestic legislation.

Footnotes

1. Cairn U.K. Holdings v. DCIT, (International Tax) Delhi ITA no. 1669/Del/2016; available at: http://119.226.207.85:8080/itat/upload/-200506499233809084113$5%5E1REFNOCairn_U_K_holdings_Limited_ITA_No_1669_del_2016_AY_2007-08_Final.pdf. Last Accessed on 4th April 2017.

2. Vodafone International Holdings BV v. Union of India (2012) 6 SCC 613

3. All you wanted to know about Tax terrorism HINDU BUSINESSLINE, 13th October, 2014.

Available at: http://www.thehindubusinessline.com/opinion/columns/all-you-wanted-to-know-about-tax-terrorism/article6497495.ece. Last Accessed on 23 March 2017.

4. ITAT Order page 133 Paragraph 36 i.

5. ITAT Order page 135-136, Paragraph 36 ii.

6. ITAT Order page 137-138, Paragraph 36 iii.

7. ITAT Order page 138, Paragraph 36 iii.

8. ITAT Order page 143, Paragraph 36 iv.

9. ITAT Order page 149-150, Paragraph 36 iv.

10. ITAT Order page 153, Paragraph 36 v.

11. ITAT order page 165-166, Paragraph 41.

12. ITAT Order page 152, Paragraph 36 v.

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