Retrospective Amendments – Turning the clock back?
Codhai Raghavan May 16, 2012
The Government seems to be attempting to turn the clock back through its proposals in the Finance Bill 2012 (“Budget” or “Bill”), made with the objective of ‘reiterating the intent of the legislature’. Read in the light of the recent decision of the Supreme Court (“SC”) in January 2012 on the 2007 USD 11 Billion Vodafone-Hutch deal, the Budget gives rise to new controversies concerning income tax liability of non-residents on the transfer of Indian assets through overseas transactions.
Let us put this in perspective and look at the changes that the Budget makes to the existing tax regime. The Income Tax Act, 1961 (“ITA”) at present taxes non-residents on income that accrues or arises, directly or indirectly, from the transfer of a capital asset situated in India. The Budget expands the scope of this charging provision by clarifying that a share in a foreign company shall always be deemed to have been a capital asset situated in India, if the share derives its value substantially from assets located in India. In addition, the Budget also amends the definition of the term ‘capital asset’ to include rights of management or control over an Indian company. The implication of these amendments is that when a share in a foreign company is transferred and it indirectly causes the transfer of control over an Indian Company, any capital gains in the hands of the foreign investor arising from such transfer becomes liable to be taxed in India.
To fully appreciate the effect of the retrospective character of this amendment, we must revisit the decision of the SC in Vodafone International Holdings B.V. vs. Union of India (“Vodafone judgment”), where the SC rejected the jurisdiction of the Indian tax authorities (“Revenue”) to tax capital gains arising from a purely offshore transaction and quashed a tax demand of USD 2 Billion against Vodafone. The facts are, briefly, that Hong Kong based Hutchison Telecommunications International transferred shares held by it in a Mauritius based company, which indirectly held shares in an Indian Company – Hutchison Essar, to U.K. based Vodafone. The sale resulted in Vodafone acquiring control over the Mauritius Company as well its subsidiaries, which included Hutchison Essar. The Revenue argued, adopting a purposive construction of the provisions of the ITA, that the charging provision taxes non-residents on income arising out of direct as well as indirect transfers of capital assets, and that the control over the Indian Company is a capital asset situated in India, thus making the transaction liable to tax in India. The SC ruled that such indirect transfers of assets would not be chargeable to tax in India since it was a purely offshore transaction involving only non-resident entities, although the underlying assets were in India.
The ‘clarificatory’ retrospective amendments in the Budget, which will come into effect from 1st April, 1962 if the Bill is passed by the Parliament, were clearly proposed with the intention of defeating the ruling of the SC in the Vodafone judgment. In fact, the Budget has gone so far as to draft the amendments along the lines of the arguments made by the Revenue which were expressly rejected by the SC.
The question we must answer is: What is the legal status of such retrospective amendments? The general rule, as discussed by the SC in National Agricultural Co-operative Marketing Federation vs. Union of India (2003), is that the legislature cannot ‘statutorily overrule’ a court’s decision through a retrospective amendment. This view is supported by a recent Press Release (“PR”) issued by the Ministry of Finance (“FM”), where the FM asserted that tax cases which have been assessed and finalized up to April 1, 2012 would not be reopened. However, the Explanatory Memorandum to the Budget declares that the amendments “shall operate notwithstanding anything contained in any judgment, decree or order of any Court, Tribunal or Authority.” This validation clause makes it possible for the Revenue to demand tax in cases which are currently in various stages of litigation, including cases where Courts have already ruled against the Revenue. As a result, Vodafone now faces a tax demand of an estimated USD 3.7 Billion, including interest and a penalty, on its 2007 deal.
The Bill, if enacted will have serious consequences for a wide range of Indian and International businesses. The industry fears tax uncertainty and is apprehensive that these amendments will discourage foreign investments in India, severely affecting India’s growth prospects. Furthermore, foreign investors are beginning to question the stability of the Indian tax regime. This does not bode well for the image India has been projecting so far – one of a stable and progressive economy based on the rule of law. The Government’s response to these concerns is that the amendments are not substantive in nature, but merely clarify the ‘original intent of the legislators’, defending its move on the ground that many other countries such as the U.K. and China have also made retrospective amendments to their tax legislations. The U.K. had amended its tax rules retrospectively because it feared losing revenues to tax havens, while China, like India, tightened its laws to tax offshore transfers of assets located in the country.
The FM has taken the stand that companies earning capital gains from the assets located in India will have to pay taxes, either in the country of their origin or in India, stating in a PR that “it is not a case of double taxation but ensuring that companies that are liable to pay tax must pay some tax.” All things considered, the Revenue seems to be the biggest (and only!) winner, netting an estimated gain of approximately USD 7 Billion, while the country loses out on foreign investments, which are indispensable for a growing economy like India. In my view, India has compromised on its image as an investor friendly nation at the cost of reaping short-term gains, and the Budget proposals will sooner or later adversely affect the Indian economy.
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