Vodafone Judgment: Impact on M&A

In a landmark judgment, the Bombay High Court ruled against Vodafone saying the the UK-based global telecom had to cough up capital gains tax of its controlling stake in Hutchison Essar . In 2007, the Indian IT department came down on Vodafone with a show-cause notice over its payments to Hutchison and how much of this could be taxable in India.

Dinesh Kanabar, Deputy CEO & Chariman-Tax, KPMG and Sudhir Kapadia, Partner at Ernst & Young, spoke about what the implications were for Vodafone as well as for other companies as this decision could affect other similar transactions in India.

Below is a verbatim transcript of their interview with CNBC-TV18's Menaka Doshi. For more details, watch the accompanying videos.

Q: They say when one door shuts the another one opens, what do you make of the twist in this tale considering the nexus that the High Court has established, by saying that this is not just an offshore transaction but an offshore transaction accompanied by contractual rights and entitlements which are capital and therefore can be taxed by the Indian tax authority?

Kanabar: Two limbs to the nexus, one is the limb regarding the requirement for Vodafone to withhold taxes and therefore the question that if there is indeed a nexus of the transaction, there is a nexus to withhold taxes.

The second is the taxability of the transaction per se. The latter part is very critical, where what the ,Vodafone  (BHC) held is, that the chargeability to tax arises not from the transfer of shares, but given the fact to consume the entire transaction apart from transferring one share of CGP, there are series of other transactions. Such as the non-compete right which was granted, the certain put and call options, there were certain non-voting non-convertible preference shares, certain loan obligations.

What the court observed is here were a series of other transactions which happened along with the transfer of that one share. What they said is that the other transactions, not the transaction relating to the transfer of that one share, indeed had a nexus with India and given that nexus, the value attributable to those transactions needed to be apportioned and that was what was liable to be taxed in India. At one level if you see the BHC has accepted that there is no tax arising on transfer of the one particular share, but the value which is ascribable to the other transactions is required to be taxed in India.

Q: What do you make of the fact that they have considered the other part of the transaction, that is the contractual rights and entitlements as capital, what kind of implication does that have not just on Vodafone type of transactions but other transactions which may take place?

Kapadia: I would regard this as a very novel approach in Indian jurisprudence. An attempt is being made to bifurcate the total consideration into what is attributable to a share transfer outside of India, which clearly is not subject to tax in India and other related assets of the business, which are situated in India and the direction, which seems to have been given to the assessing officer as to determine the portion of that consideration, which should be held taxable in India.

My own view is that this becomes practically a very difficult exercise. How do you attribute and bifurcate a bundle of consideration? When you do a transaction, a transaction value is for the entire business and the share valuation, which you are talking about, is arrived at on the basis of various considerations.

To artificially bifurcate, there is one uncertainty element, which comes in here for similar transactions. Going forward, because the direct tax code (DTC) at least has tried to specify and at least made the government's stand clear as to the circumstances under which an indirect transfer will be subject to tax in India, the 50% fair market value test. My own view is, whether we like it or not at least there is certainty about how India will tax such transactions. The difficulty is in respect of transactions already having been entered into as we speak today.

Q: You mentioned the fact that this transfer of share is not taxable. I want to understand what the precedence setting bit in this judgment is. Is it binding on similar deals that are taking place or taken place, where is the precedence setting bit?

Kanabar: The recognition is, that it is not the underlying value of assets in India, which is liable to tax and this is something which we need to focus on. The stand of the income tax department was that if there is an overseas transfer of shares, with an underlying value in India that is liable to tax in India. That is what seems to have been accepted by the BHC. In fact they have gone onto the attendant transactions which were manifested by maybe series of side documents.

That is first precedent which is to say that an overseas transfer of shares even though there is an underlying value in India is not liable to tax in India. In fact majority of the judgment of the BHC deals with international precedence and jurisprudence on this subject, so it is a very welcome thing.

On the impact of this on the other transactions, one would need to go to the facts of each case and if there is really a transfer of shares which give rise to whatever is that transaction and there is nothing more attendant there to. Ordinarily of course one does find non-compete etc, but if there is no significant value otherwise ascribable to India then there is no apportionment required in India and therefore the transaction could probably escape tax altogether.

What the issue is that this apportionment of value is not going to be an easy exercise and if it is not an easy exercise, the question which will come up is, is it just going to give rise to its own round of further litigation and how long will that litigation continue?

Q: I wanted to talk about the impact on other cross border M&As. Is there any single principle that emerges from today's BHC verdict that could impact the future taxability of other M&As?

Kanabar: Certainly yes. Unless a transaction is a sham and in this case it was accepted that the transaction is not a sham that merely because there was just one share of CGP investment does not make this transaction any sham at all. Therefore if there is a genuine transaction which is not regarded as a sham and that transaction results in a transfer of value overseas but there is an underlying value in India, unless there is any other attendant interest, which has got a territorial nexus with India that transaction would not be liable to tax. That seems to be one clear principle which is emerging. Having said that in most transactions there is some nexus with India in the form of non-compete or whatever else, then that value will be taxed in India and nothing more.

Q: How do you expect Vodafone to proceed now in the SC considering that the BHC has in a very briskly written 200 page order, cogently laid out all these principles that you have been talking about. What aspect of this can they hope to challenge in the SC especially this apportionment aspect and the nexus aspect?

Kapadia: I think the apportionment aspect obviously only comes in if one accepts the basic legal principle that a sale of share simplicitor of a foreign company is not subject to tax in India. Let's face it, the plain reading of the law of the income tax act today is what it is, that transfer of shares of a company which is located in a foreign country is not an asset situated in India.

In my view, the contention essentially remains the same that what is transferred is a share of a foreign company. The question of apportionment comes only when I lose on that argument. To say that no, this is not a question of a transfer of share simplicitor but you have sold something more and what is that something more its a bundle of intangible assets etc.

Q: Will the complicatedness of this apportionment in fact weigh in any fashion on how the SC looks at the matter saying how difficult is it to take a deal up into the sum of the parts so to speak and try and then tax some parts of that sum, will that weight at all as when the SC looks at this?

Kapadia: In my view, the judicial precedence in our country has been very clear that neither administrative difficulties nor quantification challenges can come in the way of establishing a principle of law. In my view any judiciary will look at the principle of law and determine on its own merits if they are persuaded by a particular school of thought or argument. I don't think the difficulty in apportionment will be a factor which any judiciary will consider as far as the judicial or the legal interpretation of the matter is concerned.