India: The Indian Income Tax Department Follows You… Wherever You Go

Last Updated: 23 February 2009
Article by Sakate Khaitan

The tax authorities in India are now attempting to tax gains on sale of offshore holding companies of Indian entities. The first of such cases is the Vodafone International Holdings B.V. transaction. The transaction involved the purchase by Vodafone of the foreign holding company of an Indian celluar phone operator.

The Income Tax Department issued a show cause notice to Vodafone asking, inter alia, why Vodafone had not withheld tax at the time of paying the purchase consideration, and consequently, why Vodafone should not be treated as an assessee-indefault under the Income Tax Act, 1961. Vodafone has challenged the validity of the show cause notice issued by the Income Tax Department. The writ filed by Vodafone challenging the said show cause notice has recently been dismissed. It is expected that Vodafone will appeal this decision.

Arguments

The main arguments put forward by Vodafone are:

  1. The show cause notice issued by the Income Tax Department was without jurisdiction, since the provisions of the Act do not have extra-territorial operation and hence, would not apply to Vodafone as an offshore entity not having any presence in India.
  2. The transaction itself does not attract capital gains tax and hence there can be no withholding obligation.

In response, apart from the technical arguments of alternate remedy, the Indian Income Tax Department's main contention is that the show cause notice was not extra-territorial in nature, as the moment Vodafone signed the agreement to acquire interests in India, it automatically acquired a nexus to a source of income in India. As regards the transaction being liable to tax, the authorities are relying on the principle of lifting the corporate veil of going with the intent of the transaction rather than its form.

Subsequent to the issue of the show cause notice, amendments were made to the Act retrospectively from 2003 thereby indicating the intent of the Indian Government to treat non-withholders as assesses in default and liable to the same level of prosecutions and penalties as the actual income earner.

Implications Of The Case

Offshore funds and multinational companies used to channelise their investments into India through recognised tax favourable jurisdictions. The main reasons for such structures were to provide flexibility of exit i.e. negate the applicability of India's foreign exchange regulations to transfers from one non-resident to another, and to avoid the applicability of the Act and consequently payment of Indian capital gains tax.

The outcome of Vodafone's case will determine how, and the manner in which such holding structures are created and exits structured. The uncertainty that has arisen by reason of such lack of clarity, pending final decision on Vodafone's case is now requiring a rethink by foreign corporations and individuals making investments into India.

Given the certainty of the favourable tax treatment given to Mauritus holding companies under the India-Mauritius double taxation avoidance agreement, a structure being adopted by many investors is to hold Indian shares through a Mauritian holding company structure and exit such investments through sale of the shares of the Indian company rather than sale of the holding company itself. The problem with such a structure is that Indian foreign exchange regulations still need to be complied with. Such extra layers of regulatory compliances increases both costs and time to complete transactions.

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.

Accordingly, despite the availability of the above structure, it will be good for the Indian courts to provide certainty to Indian tax treatement for transfers of foreign parents/holding companies of Indian subsidiary companies. The final ruling on the issue is thus eagerly awaited. "The uncertainty that has arisen by reason of such lack of clarity, pending decision on Vodafone's case is now requiring a rethink by foreign corporations and individuals making investments into India."

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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