The lengthening arm of the Indian taxman

A host of global corporations—Vodafone, Microsoft, Dassault, to name a few—struggle to comprehend the country's tax administration and its ways. How bad is it and what is the way out?

The afternoon of Monday, May 31, brought Vodafone International a letter it had been expecting for 16 months. A notice from the Indian Income Tax department, it marked the next milestone in a regulatory battle between the world's biggest mobile telephony provider by revenues and the Indian taxman—one that is expected to drag on for a few years at the least.

Already, the two sides have been competing on legal repartees. The department's last notice to the company was a fat 3,000-page plus. And the reply was equally voluminous at nearly 2,000 pages.


  • There has been a rising number of disputes between foreign companies and tax officials.
  • Most disputes are on whether any tax is payable at all, or at what rate.
  • Tax officials feel MNCs manage to avoid tax in far too many India-related transactions.
  • MNCs contend they follow the law as it exists, resolution process too lengthy.
  • The new Direct Taxes Code is likely to reduce the scope of such disputes.
At the core of the dispute is the right of the Indian tax authorities to tax a $10.9 billion buyout by Vodafone of twothirds control in Mumbai-based mobile operator Hutchison Essar. The deal was structured as an acquisition by Vodafone International, part of the UK's Vodafone Group, of a holding company controlled by Hong Kong's Hutchison Whampoa in the tax haven of Cayman Islands. In effect, it was a transaction forged overseas by two foreign companies of a business mostly based in India.

Vodafone, headquartered out of London, is clear that the deal is not taxable under Indian tax laws of the time. It is "fully confident that no tax is payable by Hutchison on this transaction and that Vodafone has no liability in any event", the company said in a statement after receiving the notice on Monday.

Senior tax officials say theirs is a "substance over form" approach and find the company's stance bizarre because the underlying value of the Cayman Islands holding company was almost entirely in India and, therefore, it is subject to capital gains tax. They point to the initial draft of the Direct Taxes Code, meant to overhaul India's personal and corporate direct tax structures, which addresses and taxes such transactions under a set of rules grouped under the General Anti-Avoidance Rules.

Though no tax demand has been made as of now (the latest notice claims India has jurisdiction over such deals structured overseas), if India's right to tax is affirmed by the courts of the land, the tab would be in the region of $2 billion. The Vodafone case is being watched keenly by the business community across the world—numerous ambassadors of countries such as the UK, the US and Australia have voiced their concerns with India—as the outcome will probably set the precedent for other such cases.

As India integrates with the world at a fast pace and more and more foreign companies find the world's second-fastest growing major economy a lucrative place to do business in, such disputes are sure to rise. Even so, several of those foreigners are finding the red tape a huge challenge. Administration of tax on foreign companies, the world over, is a maze of international treaties to avoid double taxation and local application of such agreements. In India, the pain points can be slotted into a few chunks, many of them inter-linked. (See Knock Knock... It's the Taxman.)

If there is one international law that gives the Indian taxman angst, it is the India-Mauritius Treaty—easily the most contentious set of rules and regulations as far as foreign companies are concerned. Signed in 1983, this treaty has a clause whereby India has committed to not taxing capital gains realised by Mauritius-registered companies.

And since Mauritius itself imposes no tax on capital gains or distributions, companies registered there go completely tax-free. Other tax havens such as Cayman Islands and Cyprus, too, have similar treaties with different countries making for a phenomenon called "treaty shopping" among global businesses looking out for the most favourable tax regime.

Infinite Interpretations
Some 44 per cent of foreign direct investment into India, for instance, is routed through Mauritius, leaving the tax department fuming and attempting at least a few times to challenge provisions in the tax avoidance treaty—prominent among these being an attempt made in 2000 when a taxavoidance accusation against Mauritius-registered companies led to a run on the stock markets because most foreign institutional investors take this route into India. That attempt was rescinded double quick.

Contentious issues in international taxation in India.
IssueMoot pointCaseStatus
Mauritius tax-avoidance treaty, treatment of inflows from tax havensCapital gains avoidanceAzadi Bachao Andolan, e*tradeSC says status quo stays, Direct Taxes Code to address it
Permanent establishmentAggressive application of definition by tax deptSeagate, Morgan StanleyMixed set of verdicts, rulings
Packaged software taxationTaxed or not taxed as royaltyMicrosoft, Dassault, SamsungBeing decided case by case
Transfer pricingRules often delayedDana Corp, Canoro ResourcesPrecedents still being set
Offshore supplies of equipment, services to EPC firmsHow to tax servicesIshikawa HyundaiCourts, AAR rulings allow tax on some services
(SC= Supreme Court, AAR = Authority for Advance Rulings, EPC = engineering, procurement and construction)

India's reputation as a difficult jurisdiction is not limited to interpretations and re-interpretations of the Mauritian tax treaty or tax treatment in other tax havens. India is often perceived to be aggressive in applying tax. This is most visible in cases seeking whether a company has a permanent establishment in India or not. Simply put, if the foreign company has a permanent establishment, it will be taxed; otherwise it is not liable to pay tax.

Says Jeffrey Owens, Director, Center for Tax Policy and Administration at the Organization for Economic Cooperation and Development: "We know that some businesses are concerned at the willingness of some assessors to find a permanent establishment even when the foreign company's presence in India is very tenuous."

This is evident in recent cases. Sample: in a February 2010 ruling, the Authority for Advance Rulings, or AAR, a quasi-judicial body that settles disputes in tax matters involving dues from foreign businesses and other non-residents, upheld the tax department's contention that a demarcated space in the warehouse of a logistics services provider can be considered a fixed place of business. The case concerns the Singapore unit of computer storage firm Seagate.

The judicial process has, however, more often been favourable to foreign companies. In a case of Morgan Stanley versus the Indian tax authorities, the Supreme Court in January 2008 upheld an AAR ruling that the US investment bank neither had a permanent establishment in India nor had to pay tax in India on global income that arose as a result of back-office transactions from its captive unit here.

The income at the back office or call centre unit in India, however, the court said, would be subject to corporate taxes levied on Indian companies. Then, this January, the AAR ruled that Dassault Systemes neither had a permanent establishment in India nor had received royalty from sales of its packaged software in India. If the judgment had been in the taxman's favour, classification of sales of packaged software as intellectual property would have entailed treatment of payments as royalty, which could be taxed.

Still, citing examples of a mindset out of sync with contemporary times, tax experts point to amendments that are applicable retrospectively and clarificatory or concessional circulars that are withdrawn. Or, indeed, the mass of demands that are typically bunched towards the end of an assessment or financial year to meet the stiff annual targets of tax mobilisation set in annual Union Budgets by finance ministers ambitiously attempting to bridge deficits.

The taxman's criticism of foreign companies is also, ironically, one of anachronism. A senior tax department official, who requests anonymity, criticises how foreign companies are clinging on to archaic definitions of a permanent establishment (any entity with a fixed place of doing business) even as they demand dynamism in the law. "Any international practice should be fair. Why should the definition of a (permanent establishment) not change when e-commerce and Internet have changed the rules of business engagement," the official asks. Experts point to the problem of how tax rules are applied.

"I do not think there is anything wrong with the law, it is more to do with the administration," says senior counsel Ajay Vohra, Managing Partner at New Delhi law firm Vaish Associates. In other jurisdictions, he points out, revenue officers have the powers to settle cases and there are very few appeals—not so in India. Other lawyers agree and most are sceptical that the administration will change even with the tax reform underway.

Foreign companies, on their part, say that they are not averse to paying a reasonable amount of tax but the uncertainty and litigious nature of the interaction makes life difficult. Says the tax head of one multinational: "All we want is certainty of costs. And the tax department does not offer those kinds of guarantees. The tax authorities are probably the least progressive of all entities in (postreforms) India." This executive did not want his or his employer's name taken.

Pace Hurts, Too
The other requirement of foreign (or, indeed, even Indian) corporations is speedy resolution of disputes. "In India, unfortunately, the litigation process is very slow. And nobody can envisage the timelines in India…," says Prashant Khatore, partner at tax consultancy firm Ernst & Young. "And even if you get a decision, then, there is no certainty that the same will not be reversed by way of a retrospective amendment, which happens."

The Agassi precedence

Indian taxmen believe retired tennis pro Andre Agassi could make for a key instance in their case for levying capital gains tax on the Vodafone-Hutchison transaction. "There are precedents in India from as early as 1946," says a senior tax official in New Delhi, "and from the UK and the US (in recent years)."

In May 2006, tennis pro Andre Agassi was asked to pay tax in the UK, on a portion of cash paid to him by foreign companies Nike and Head because he endorsed their products at Wimbledon and other UK tournaments.

Law Lords, the highest court of appeal in the UK for domestic matters, ruled that it made no difference that Oregon, US-based Nike and Amsterdam-headquartered Head were paying money to the star's company Agassi Enterprises Inc., based in Las Vegas.

A case in point is the famous ITC case: After a longwinded 17-year judicial process, the government attempted to overturn the judicial verdict which was favourable to the cigarette-maker by introducing a retrospective amendment. ITC agreed not to claim the refund of several hundred crores.

The uncertainty about the tax liabilities has a cascading impact on valuation of companies, their deal structuring and indemnity clauses, and, in the long term, even on investment decisions. In Vodafone's instance, people with knowledge of the case's development say that the British-domiciled firm approached the Bombay High Court first in 2007 seeking to avoid the tax department and AAR appeal route to shorten the lifespan of the case.

The estimated time for dispute resolution (tax tribunal, High Court and then the Supreme Court) is 10-15 years, while by bypassing the usual channels Vodafone can hope to crunch that to under five years and escape depositing half the tax claim with the government in case of challenges before the authority or courts.

An existing mechanism for settling cases, the Dispute Resolution Panel, has not found favour either with the tax department or taxpayers. Reason: The department is unhappy because the entire amount of tax payments is kept in abeyance till the panel decides on a petition, unlike other modes in which up to 50 per cent of tax due is paid pending final resolution. Tax payers dislike that the panel is constituted of tax officials.

Yet the tax department has its defence. As the senior official quoted earlier argues, companies invest money in India because they see profits here. "Today, there are few places in the world where you can make money. And if you are making money, why not pay taxes. Why defy common sense," he asks. Some 400 cases similar to the Vodafone one are said to be in the sights of the department.

As the presence and size of MNCs in India grows, so will their transactions—many of which will be cross border and raise the eyebrows of the tax authorities as to whether they are losing out on a legitimate source of revenue. But what is expected of them is more than raising of eyebrows—a complete clarity on the tax implication of such transaction and a substantially simplified and quicker dispute resolution mechanism.

Though a 2004 Supreme Court ruling had held the treaty shopping legitimate, India's rising discomfort with such provisions is matched by global concerns over tax havens post the 2008 financial crisis. OECD's Owens points out: "We are coming to the end of an era for tax havens. Political tolerance of offshore non-compliance is approaching zero."

More than 450 exchange information agreements have been signed with the tax haven countries by members of the OECD since the November 2010 meeting of the Group of 20 countries that decided to take active measures to counter offshore non-compliance.

What is interesting, according to Owens, is that China and India are leading developing countries in the negotiation of agreements among non-OECD countries. After the high-octane press coverage the Vodafone case got in India, China amended its rules in dealing with similar transactions, as did Indonesia.

The tax rate rises from 10 per cent to 25 per cent in China. Korea, too, had a few years ago, made similar demands on a few private equity firms. But, as multinationals point out, the big difference is that each of these law changes were made prospectively and not retrospectively, as the Indians seem to be attempting.

As the Indian tax department goes about tracking down taxes that it believes are legitimately due to the exchequer, ancient statesman-philosopher Kautilya's counsel may be useful for direction: "A wise Collector General shall conduct the work of revenue a manner that production and consumption should not be injuriously affected."

In other words, don't kill the goose that lays the golden egg. But, until the fighting department and international companies agree to see eye to eye, foreign businesses will stay on their toes.