In a landmark tax case, the Bombay High Court found Vodafone liable for tax on its 2007 acquisition of a $10.7 billion controlling stake in one of India’s largest mobile phone companies. What is remarkable about this decision is that the deal occurred outside of India and neither the buyer, seller, nor the target company were Indian companies. India is not the only country to pursue such tax revenue. China is also taxing sales of stakes in Chinese ventures by offshore taxpayers. This territorial-type approach to taxation that is emerging from the world’s fastest growing economies is a wake-up call for private equity and MNCs to re-examine their structures and plan for the risks and costs of taxation where none was assumed to exist.
In the case, the India tax authority contended that Vodafone was obligated to withhold tax at the source because the transaction involved underlying business assets that were located in India. Vodafone countered that it was not obligated to withhold Indian tax because the parties involved were both offshore companies and the target was registered in the Cayman Islands. The court sided with the Indian tax authority. The tax bill could be as high as $2.6 billion, though the court suggested that a portion of the sale price may not be taxable. In a statement, Vodafone said it was reviewing the judgment and considering appealing to the Supreme Court.
The ruling is a game-changer for investing in India. Most foreign investors use offshore entities, often incorporated in zero tax jurisdictions like the Cayman Islands, to invest in Indian businesses. A significant reason for that structure was to gain the ability to sell the investment without triggering Indian taxation.
In addition to the ruling, the Indian government has introduced proposed legislation to fix what it views as a loophole for offshore acquisitions. The proposal, introduced in August, would allow the government to impose a capital gains tax, on a proportional basis, on offshore acquisitions if the acquired company holds more than 50% of its assets in India.
India’s actions appear to be part of a trend developing in the world’s most-successful emerging markets: to tax the economic gains, wherever realized, attributable to business assets based in the territory. China is already doing this.
Last year, the PRC State Administration of Taxation issued a “Notification on Strengthening Corporate Income Tax Management on Non-resident Enterprises Equity Transfer Income,” commonly known as “Circular 698.” Circular 698 authorizes a capital gains tax on the sale of a Chinese resident enterprise by a non-resident company (a direct transfer) and the sale of an offshore intermediary holding company that owns a Chinese resident enterprise by a non-resident company (an indirect transfer). With respect to an indirect transfer, like the Vodafone transaction in India, an offshore deal between two foreign companies would be subject to Chinese taxation if the tax authority finds a tax evasion purpose. Circular 698, effective retroactively as of January 1, 2008, imposes a self-reporting requirement on foreign investors for certain types of indirect transfers.
This year, the first public case involving the taxation of an indirect equity transfer was posted on website of the Jiangdu State Tax Bureau. In the Jiangdu case, a well-known foreign investment group sold a 49% interest in a Chinese joint venture by transferring its shares in an offshore holding company. Since neither the seller, the buyer, nor the holding company was a Chinese resident enterprise, it was anticipated that the capital gains derived from the sale would not be subject to Chinese tax. The taxing authority disagreed, citing the lack of employees, assets, and business activity in the holding company (other than the investment in the JV) as grounds for finding no economic substance at the holding company level. The taxing authority disregarded the holding company and collected a tax payment of RMB 173 million on the gain realized by the seller.
While India and China will remain among the most attractive places to invest, the taxation of offshore deals by India and China will directly raise the cost of acquisitions and thus reduce the return on such investments. Foreign investors (as well as the domestic entrepreneurs) are advised to re-examine their tax strategies and structures when undertaking acquisition through their offshore companies.