Pritha Ghosh is a fourth-year student at Ajeenkya D Y Patil University, Pune, Maharashtra.
Taxation has historically been a controversial exercise. The imposition of retrospective taxation during the British Era in India was highly resented. Since the introduction of retrospective tax in India through the Income Tax Act 1961, there have been more than sixty-six amendments. While tax laws are amenable to challenge on the grounds of legislative competence, the Supreme Court of India has given reasoned decisions to uphold the taxpayer’s rights. The Apex Court concurred in 1963 that if retrospective taxation is so unreasonable that it contravenes the fundamental right to carry on business (Article 19 (1) (g)), a party affected by such an operation can dispute the legislation. While the Court subjected tax laws to the discipline of Part III of the Constitution, there were only a few occasions on which the Court actually struck down laws as discriminatory. As a consequence of these decisions, the Parliament retrospectively amended the statutory provisions, bypassing the Apex Court’s decisions. Retrospective taxation has an adverse effect on business undertakings. It is important to reflect on the consequences of legislative amendments which have led to a steep decline in foreign direct investments in recent years. Corporate taxes being one of the largest sources of revenue, the government must ensure that good governance is not deterred by political compulsions, ensuring the fundamental paradigms of taxation.
What the Laws Say
The Income Tax Act, 1961 & the Finance Act, 2012:
The Taxation (Amendment) Act, 2021 amends the Income Tax Act, 1961, and the Finance Act, 2012. The 2012 amendment clarified that for a company that is registered and incorporated outside India but derives substantial value from assets located within India, the company’s shares will be deemed to have always been situated in India. Thus, the income earned from such a sale is liable to be taxed before the enactment of the act.
The Taxation (Amendment) Act, 2021 (“the Act”) proposes to nullify the retrospectivity of the tax imposed on such persons, provided that they fulfill the following conditions:
(i) all litigations in this regard must be withdrawn, the persons must sign an undertaking to withdraw the applications,
(ii) all arbitration, conciliation or mediation proceedings must be withdrawn,
(iii) the persons undertake to waive off their right to seek or pursue any remedy or raise a claim available under any bilateral agreement,
(iv) other conditions, as may be prescribed by the government.
If the person fulfills these conditions, any and all tax liability will be waived off. Moreover, the government will refund the tax amount to eligible persons.
In 2007, the Indian tax authorities raised a demand of over $2 Billion or Rs. 7 crores in capital gains and withholding tax from Vodafone Essar. The government contended a case of tax avoidance stating that the transaction between Hutchison and Vodafone involved the acquisition of a share of Indian assets, thus any gains from the transaction would be taxable in India as capital gains.
Vodafone International Holdings, a Dutch firm, had bought a 67% share in Hutchison Telecommunications International Limited (HTIL) in May 2007. The company was based in the tax haven of the Cayman Islands. HTIL had an established telecommunication consumer base in India. CGP investments, a company based in the Cayman Islands and fully owned by Hutchison, owned small entities based in Mauritius. These Mauritius-based entities owned the 67% stake in Hutchison Essar Ltd. Business between India and Mauritius-based entities was convenient due to the existing bilateral treaties. As HTIL planned to exit from India, it sought to sell its shares. Vodafone International Holdings paid $11 billion to HTIL to acquire CGP Investments, in turn gaining full control over Hutchison’s operations in India.
The Supreme Court ruled that Vodafone was not liable to pay taxes. In an unprecedented move, the government introduced a new amendment to the tax legislation in 2012 in an attempt to recover the allegedly due taxes from Vodafone, by way of retrospective legislation. Tax authorities could now levy taxes on transactions dating back to 1962.
Under Article 9 of the India-Netherlands Bilateral Investment Treaty and the India-United Kingdom Bilateral Investment Treaty (BIT), Vodafone filed a case at the Permanent Court of Arbitration (PCA), The Hague in 2014. Vodafone contested the new tax amendment, amounting to a violation of fair and equitable treatment. The demand for retrospective taxation on capital gains was in breach of the United Nations Commission on International Trade Law (UNCITRAL).
Revocation of Retrospectivity: The Good, the Bad, and the Future
The objective of retrospective taxation is to cure the defect in the law when the past and the present-day tax obligations are so vastly different that the tax levied before under the old law is too less. Retrospective operation would correct the situation and charge tax under the existing legislation.
When the Indian tax department suggested that Vodafone had resorted to impermissible tax avoidance practices, the Supreme Court summarily rejected the contention, finding that the creation of Hutchison and Vodafone’s corporate structure was commercially driven. What followed in the consequent amendment of the Finance Act overturned the Court’s decision. The provisions were supported by an explanation that stated that since recent judicial decisions had questioned the scope and purpose of Section 9 of the Income Tax Act, the amendment would provide clarification on the legislative intent of the policy.
The amendment being ‘clarificatory’ in nature had the implication that the decisions of the High Court and the Supreme Court were proved wrong. In India, the Apex Court has the final authority in case of statutory interpretation. The reversal of policy not only undermines the decision of the judiciary but also raises a question on the separation of powers. The disregard for the Court’s judgment and implementation of retrospectivity led to a significant drop in FDIs. An expert committee was constituted, headed by Mr. Parthasarthy Shome, which concluded that, “...[R]etrospective application of tax law should occur in exceptional or rarest of rare cases, and with particular objectives: to correct the anomalies in the statute, clarify the details, or protect the tax base from abusive tax planning schemes.”
The problem with the government’s approach to taxation is that it fails to pass the test of certainty and continuity. Retrospective taxation is violative of the fundamental paradigms for fair taxation: equity and fairness, tax neutrality, efficiency, economic growth, transparency, certainty, and visibility. Applying taxes on transactions executed in the past is like changing the air traffic routes after the airplane has already landed at the airport. The Indian government’s approach can at best be described with the expression used by the eminent jurist, Mr. Nani Palkhiwala as “a triumph of bureaucratic obstinacy over good sense.”
If the Indian Government disregarded the ruling of the PCA, it would have adversely affected the corporations based in India as well as the confidence of investors around the world. As the ruling marks a setback for the country’s retrospective legislation, it also marks a new beginning of certainty in the Indian market. As the Government tries to grapple with the recovery phase post-COVID-19, the greetings of the global investor community are warmly welcome. The amendment will ensure more certainty in the market as no more legislation would be passed on a retrospective basis.
Implementation of ‘Look Through’ Provision
Revocation of retrospective tax is not the end-all-be-all of taxation. Successful taxation on capital gains requires the government to take action with foresight. In the age of advanced digital technology, international trade and transactions are commonplace. Accurate imposition of tax obligations requires that the authorities have knowledge about the location of the ultimate assets and jurisdiction in the matter.
‘Look through’ provisions provide an alternative in the matter. According to this rule, the transfer gains taxed on an entity are looked through beyond the entity itself to determine the entity which has real ownership of the property. Much like the principle of ‘lifting of corporate veil’, this rule seeks to look through the company in order to find the real beneficiary of the property or assets. Look – Through provision is an earnout right, which traces the earnout of the business sale. Earnout arrangements are usually used when the parties to the agreement do not reach a consensus on the transaction amount of a business sale.
The issue in Vodafone and Hutchison transactions arose because the government was unsure whether the capital gain accrued upon acquisition of gains through a company outside India is taxable or not. In such cases, countries like Australia and Canada have inserted “look-through” provisions in contracts in order to ensure transparency in international commercial transactions. Thus, the introduction of “look-through” earnout provisions would prove to be helpful in prospective taxation cases.
The revocation of retrospective taxation marks a new beginning for business as usual in India. Companies and investors are equally protected from indirect taxes on capital gains on the international sale of assets. The move is a welcome step toward encouraging foreign direct investments in India as well as for the growth of the new generation of global investors economy in the country. The GoI’s decision to bypass the Apex Court’s decision may be seen as a threat to the principle of separation of powers in India. Uncertainty and inequity in the market increase the cost and risk of doing business. The tax amendment introduced by the GoI will have a cross-sectoral impact. Globalization has catalyzed the income of capital and developmental growth in India. With global evolution comes global morality. The norms of fairness, transparency and equity are the fundamental principles of this morality. The capacity of the government to uphold these principles in the face of populism and political compulsions will mark the test of good governance and a true democracy.