The Vodafone Arbitration – A Dampener for Foreign Investors?

Amit Meharia, Ayushi Gupta | January 2018

THE OPENING STATEMENT

Genesis of the present arbitration proceedings can be traced back to the Finance Act of 2012, which sought to bring about a retrospective amendment in the Income Tax Act, 1961 (for short “IT Act”). An amendment that has not only fuelled political controversies but has also led to great confusion in the legal field with respect to well accepted taxation principles.

THE BACKGROUND

The Vodafone Group’s investment in India has resulted in it being tangled in a tax dispute with the Indian Tax Authorities in relation to the acquisition by Vodafone International Holdings BV (for short “VIH”), a Netherlands based company, of the entire share capital of Cayman Island based CGP Investments (Holdings) Ltd. (for short “CGP Investments”), vide transaction dated 11.02.2007. CGP Investments held 67% share in Hutchinson Essar Ltd (for short “HEL”) which is the Indian subsidiary of Hutchinson Telecommunications International Ltd, (for short “HTIL”), while HTIL held the remaining shares.

The two central issues that resulted in thelong drawn legal battle were:

Whether HTIL was liable to pay capital gains tax in India, since the income was earned towards sale consideration of transfer of its economic interest in India in favour of VIH?
Whether on the payment made by VIH to HTIL, VIH was liable for payment of Tax Deducted at Source as per Section 195 of the Income Tax Act, 1961from the sale consideration paid to HTIL?

A show cause notice was issued under Section 201 of the IT Act to VIH as to why it should not be treated as an assessee in default for not deducting TDS on payment made to HTIL as it is taxable in the hands of the latter as capital gains.

THE BATTLE BEHIND

VIH had filed a Writ Petition in the Hon’ble Bombay High Court against the demand raised by the Indian tax authorities on the premise that the Revenue Department lacked jurisdiction to impose tax on an offshore transaction between two non-resident entities with no territorial nexus or taxable assets in India. Such a claim was rejected and subsequently dismissed upon observation that:

Section 2(14) of the IT Act provides for an inclusive definition of capital assets and therefore, shares are capital assets, the transfer of which results in capital gains liable to be taxed.
Section 5 of the ITAct provides that for non-residents, the income which is received or deemed to have been received, or accrued or arisen or has been deemed to have accrued or arisen, in India, is taxable.
Section 9(1) of the IT Act provides that income is deemed to accrue or arise in India (directly or indirectly) through or from any business connection, property, asset, source of income, or transfer of a capital asset situated in India and adopting the ‘look through’ principle, the section can be made applicable to indirect transfers
Section 195 of the IT Act mandates payment made to a nonresident of a sum chargeable under the IT Act and the obligation to deduct tax arises when the above sum ischargeable.

Armed by the above statutory provisions, the Hon’ble Bombay HCruled that the transfer of shares of CGP Investments by HTIL to VIH amounts to transfer of controlling interest in HEL as the dominant purpose of the purported sale was to transfer the controlling interest. Therefore, VIH has acquired a source of income in India and HTIL by reason of this transaction had incurred capital gains taxable in India. As the subject matter of the concerned transfer is assets situated in India, VIH was therefore liable to deduct TDS on payment made to HTIL.

Being aggrieved by the above order of the Hon’ble Bombay High Court, VIHapproached theHon’ble Supreme Court where it was observed that:
The AssessingOfficer in India has no jurisdiction to tax a transaction where the subject matter of transaction was shares of a foreign company and the same had taken place outside the jurisdiction of India, even if such transfer indirectly transfers an asset in India.
Charges on capital gains arise on transfer of a capital asset situated in India upon fulfillment of a three pronged requirement: transfer, existence of a capital asset and situation of capital asset in India, where all the three elements must co-exist for an income to accrue or arise in India. Transfer of shares of CGPInvestmentswhich has an Indian company as its subsidiary does not amount to transfer of capital assets within the meaning of Section 9(1)(i)of the IT Act. It cannot be concluded that if a foreign company has a subsidiary in India, then shares of that foreign company are deemed to be situated in India. Section 9(1)(i) of the IT Act covers only the income arising from transfer of a capital assets situated in India and does not cover the income arising from indirect transfer of capital assets situated in India.
Section 195 of the IT Act applies to a resident payer in respect of payments made to a non-resident and that it cannot be applied to non-residents.

Accordingly, the Hon’ble Supreme Court held that VIH cannot be held liable for TDS from payment made to HTIL and furthersaid, thatcontrolling interest is neither an identifiable or a distinct capital asset and therefore, does not satisfy the definition of capital asset in 2(14) of the IT Act.

THE AMENDMENT

Post the culmination of the protracted legal battle with the decision of the Hon’ble SCrelieving VIH of tax burdens, the government brought the Finance Act, 2012 with retrospective implications which in turn nullified the verdict of the Hon’ble SC. It mooted the idea of an amendmentwith retrospective effect, which sought to modify the definitions of ‘capital asset’, ‘transfer’ and ‘income deemed to accrue or arise in India’. The noteworthy changes pertaining to the ongoing arbitration are as follows:

Explanation to Section 2(14): The term ‘property’ shall include “Any right in or in relation to an Indian company, including rights of management or control or any other rights whatsoever.” Putting in context, this effectively means that HTIL has transferred to VIH capital assets in India, the rights that it enjoyed as HEL’s parent company.
Explanation toSection 2(47): For removal of doubts, the definition of transfer has been clarified to include disposing or parting with an interest, creating any interest in any asset, directly or indirectly by way of an agreement notwithstanding that such transfer of rights has been characterized as being effected or flowing from the transfer of a share or shares of a company registered or incorporated outside India.1 Therefore, as per the amendment, HTIL has made a transfer to VIH of rights in an Indian company including rights of management and control since it has by transferring shares of CGP Investments disposed of or parted with the rights in Indian company and creating interest of VIH by transfer of shares pursuant to an agreement.
Explanation 4 and 5 to Section 9: The Explanations provide that an asset or capital asset, being any share or interest in a company registered or incorporated outside India, shall be deemed to have been situated in India if such share or interest derives, directly or indirectly, its value substantially from the assets located in India. Therefore, in effect CGP Investments being the share in a company registered/incorporated outside India shall be deemed to be situated in India as the share of CGP Investments derives its value substantially from the business of Indian Company located in India.2

As a result of the above amendment, VIH resorted to arbitration proceedings under the India-Netherlands Bilateral Investment Treaty (for short “India-Netherlands BIT”) on the premise that retrospective amendment amounted to a denial of justice and a breach of the Indian government’s obligations to accord a fair and equitable treatment to the investors.

THE ARBITRATION PROCEEDINGS

INDIA-NETHERLANDS BIT- The first arbitration proceeding has been initiated by serving notice in April 2014 upon the Government of India as per Article 9 of the India-Netherlands BIT3. VIH, being a company under the laws of Netherlands, qualifies as an investor within Article 1(d) and therefore, capable to invoke the clause4. It is claimed that as per the BIT which envisages to “extend and intensify the economic relations”5 with respect to investments, the Indian government is obliged, amongst other things, to “accord fair and equitable treatment”6, provide “full protection and security”7, andnot breach the legitimate expectations of investors in making investments andnot deny justice or breach previously provided assurances.8 Although primarily contested by India on the issue of jurisdiction, as taxation being a sovereign function, itis the exclusive domain of the host state, and that laws passed by the Parliament cannot be adjudicated by arbitral tribunals and do not fall within theambit of any international treaty, yet the tribunal ruled that the issue of jurisdiction and merit be heard together.9

Present status: Due to lack of consensus between the parties as to the appointment of the third member in the three-paneled arbitral tribunal10, the commencement of the Arbitration proceeding was much delayed. Subsequently, VIH had moved the International Court of Justice under Article 10 (4)for selection of the third arbitratorin the three-member panel of the arbitral tribunal. 11Conciliatory proceedings were also initiated to resolve the dispute as per Article 9 of the India-Netherland BIT, which provides for a multi-tiered dispute resolution mechanism, but, differences led to a breakdown following which the second arbitration was initiated under the India-UK Bilateral Investment Treaty (for short “India- UK BIT”) with the same cause and prayer, while the first proceeding was pending12
INDIA-UK BIT- Asecond arbitration notice was served upon the Indian government on June 2015 to invoke UNCITRAL arbitration under the India-UK BIT. The Hon’ble Delhi High Court videorder dated 22.08.2017 passed an ex-parte interim injunction restraining VIH from initiating investment arbitration against the Union of India under the India –UK BIT. The same would have resulted in abuse of legal process culminating in two independent arbitration proceedings initiated through separate entities,albeit part of the same group,therefore, being inequitable and unfair resulting in parallel proceedings. However, in its final Order dated 26.10.2017,13the Hon’ble Delhi High Court has given a green signal to commence the second arbitration proceedings against India and has allowed for an appointment of the Arbitrator. The above order was challenged in the Hon’ble Supreme Court.

Present status: The Hon’ble Supreme Courthas opined that the process for appointing a presiding arbitrator in the second arbitration for a tax demand of Rs 11,218 crore initiated by two entities of the Vodafone group will go on, but, the actual proceedings would not commence till the Hon’ble Delhi High Court decides on the matter.14 Such a view was accorded in the light of an absence of any anti-arbitration injunction and the presence of an explicit agreement to arbitrate in the event of dispute coupled with the dispute settlement clause in the India-UK BIT, which does not create any exception in taxation matters labeling it as sovereign function of the state. Further, the very purpose of a BIT is to allow foreign investors to challenge those acts of host state that allegedly breach the BIT and the India-UK BIT clearly allows for treaty arbitration without exhausting local remedies.15

IN A NUT SHELL

The current scenario is critiqued to portray India’s reluctance to be held accountable under the international law regime. It forms a ratherunattractive proposition for foreign investors on account of domestic laws being susceptible to sudden changes beingdependenton the agendas of ruling parties and because of the uninspiring nature of the Indian judicial system in speedy resolution of disputes. Nonetheless, the conclusion of the proceedings will bring into light new legal principles that will henceforth charter legal disputes of such nature.

About Author

Amit Meharia

Amit Mohaan Meharia is a Law Graduate from King’s College (London) and holds a Post Graduate Diploma in Law from School of Law (Store Street). He is a Solicitor and is on the Roles of the Law Society of England and Wales. He is the Managing Partner of MCO Legals. He has been the primary think-tank in designing the idea of ‘Paperless’ office where all the workings happen in cloud and transparency is guaranteed to all clients. He has more than 20 years’ experience in Corporate Law, Commercial Arbitration and Transactional Work.

Ayushi Gupta

Ayushi Gupta is a graduate from Campus Law Centre, Delhi University. She is an Associate with MCO Legals. She has been involved in Corporate Due Diligence, Transaction Documentations, Third Party Diligence, Compliances and Commercial Arbitrations. She has handled Clients like, Indian Oil Corporation Limited, GAIL, Telecom Communications India Limited, MTNL etc.