Revenue tries to pierce the corporate veil

Revenue tries to pierce the corporate veil

In the recent past, controversy in relation to taxability of offshore sale or transfer of security in a foreigncompany (offshore special purpose vehicle (SPV)) has been consuming the energy of taxpayers and taxadministrators, alike. A writ petition filed by Vodafone Essar in the Mumbai High Court will certainly be keenly watched. In this case, the controversy has arisen as a result of the Indian Revenue’s desire to tax transfer of ownership in an SPV located outside India, which has legal ownership in an Indian company. The Revenue’s contention is that as a result of such transfers (in an offshore SPV), there is a resultant change in ownership of an Indian company and hence, such transfers should attract Indian capital gains tax.

Applicability of Indian law: Simply stated, an accepted view, thus far, was that transfer of shares in an Indian incorporated company is liable for capital gains tax. As a corollary, it would mean that if the shares are in an Indian company, it would not be liable to tax. The concept of taxing the beneficial owner (and not the legal owner) does not have direct support under the Indian tax legislation, although the Indian company law recognises the concept of beneficial ownership. Specific to Hutch-Vodafone transaction, the Revenue’s claim is based on the contention that regulatory approvals were sought in relation to such transfer of ownership and hence, in the absence of such approval, the transaction is legally ineffective and incomplete.

Revenue’s contention: The Revenue is resting its case on the charging provision under the income tax law, particularly those that apply to non-residents. The law has defined the charging provisions, with respectto non-residents, to include not just income received in India, but, income “incurring or arising” or “deemingto accrue to arise” in India. There is fair bit of jurisprudence, with respect to interpretation of deeming provisions, particularly in relation to the term “business connection”. Whereas it is arguable if a parent subsidiary relationship creates a business connection, what is more important is the provision under whichthe income of a non-resident arising from transfer of a capital asset is “deemed to accrue or arise” in India.

The definition of “capital asset” is an all inclusive definition, with specified exclusions, such as agricultural land, personal effects etc. Hence, the Revenue’s case is based on the contention that beneficial ownershipin an Indian company constitutes a capital asset by way of beneficial right. Possibly, another contention could be that beneficial ownership of shares in an Indian company is an asset located in India and lastly, if the ownership in the Indian company yields dividends as a source of income to the beneficial owner, it constitutes an asset from which income is derived. Absence of double taxation treaty with Hong Kong will result in the Indian Revenue thrusting the domestic law provisions, which besides being restrictive; will not

afford the shield that treaties with tax-friendly jurisdictions shall offer.

Concept of beneficial ownership: The Indian Companies Act enjoins an obligation on a share holder, whois not holding beneficial interest in any share, to disclose requisite information to the company. The Indian company, in turn, has to file a declaration with the Registrar of Companies. In other words, if the shareholders fail to make such declaration, the company is not obligated to comply with the requisite filing requirement. Whether a share holder is holding beneficial interest or not, will depend on the facts of each case. Merely because the share holder is a special purpose vehicle and is held 100 per cent by its parent,would not mean that the beneficial ownership lies with the parent.If the Revenue is basing its case on beneficial ownership, can it rely upon the provisions of the Companies Act? I don’t think so and I am basing my conclusion on established principles that one cannot seek aid of

another statutory law to bring offshore transaction within the ambit of Indian taxation.

More importantly, the Indian income-tax law, unlike other international tax legislations, does not embrace theconcept of taxing transfer of beneficial ownership. Internationally, Controlled Foreign Corporation (CFC) legislation or specific anti-abuse provisions deal with taxability in such situations. For cases with treaty countries such as Mauritius and Cyprus, the absence of “limitation on benefits” clause, will act as an additional shield. However, if a treaty contains the relevant clause, determination of legal versus beneficial ownership would be under the relevant provisions. No wonder, India is exerting pressure on countries to include the “limitation on benefits” clause, which will restrict the benefit and dilute the concept of legal ownership.

Can anti-abuse provisions be evoked? First, there is no anti-abuse provision, which specifically targets to tax transfer of beneficial ownership of shares. The most celebrated decision on anti-abuse provision was in the case of McDowell & Co Ltd, wherein the Supreme Court held that any colourable device, used with the sole intention to evade tax, could result in the Revenue “lifting the corporate veil” and looking at the true intent of

 the transaction. The McDowell decision of 1985, though in the context of an Indirect tax matter, served as Bible for tax administrators. The Supreme Court, subsequently, did examine the rigours of McDowell’s decision and over the years, diluted its principles. Canadian courts have refused to follow the lead taken by the English courts, by rejecting an-across-the-board “business purpose test” as a judicial tool for combating tax avoidance. Views expressed by Indian courts seem to suggest that the taxing authority is entitled and is indeed bound to determine the legal relationship resulting from a transaction. Hence, the legal effect of a

transaction cannot be displaced by probing into the substance of the transaction.

Piercing the corporate veil: A potent weapon for the Revenue is to lift the corporate veil, ignoring the special purpose vehicle, which held legal ownership of shares in the Indian company and look at the beneficial owner. There are several decisions on “piercing the corporate veil” in situations of fraudulent conduct of business, liquidation process etc. However, with respect to tax avoidance, the most celebrated decision of the Supreme Court is in the case of Meenakshi Mills. The court held that Revenue authorities are entitled to pierce the veil of corporate entity and look at the reality of the transaction to examine if the

corporate entity is used for tax evasion. Of course, such right could be examined under exceptional circumstances. The court, while coming to its conclusion, intensively relied on international jurisprudence, particularly those of the US and UK courts to come to its conclusion. The judicial approach of cracking open the corporate shell, in situations of fraud, is understandable, though, the tax administrators’ action on tax matters could be somewhat cautious and circumspect. It is only if the legislative process justifies the adoption of such a course, that the veil can be lifted. The Revenue will have to give importance to both the

form and substance, while administering tax laws. Further, there is a limit to which the “doctrine of substance” could go. It is elusive and may sometimes encompass situations where tax planning with the framework of law could be defined. Article 25 of the Constitution declares that no taxes can be levied and collected except by authority of law. Application of the doctrine of substance, indiscriminately, without limit, may be violative of the Constitution.

The recent claim of the Revenue to bring such transactions within the Indian tax net could spell uncertainty and anxiety for those who planned their affairs in anticipation of sheltering such income from the Indian capital gains tax. I have not dealt with the Revenue’s case for treating the Indian firms as an agent of the foreign beneficial owner of shares. It is equally arguable, if the Revenue can bring such a case to treat the Indian firm as an agent of the foreign share holder. It is only after that that the act of fastening the tax liability on to the Indian firm, using anti-avoidance provisions, would arise. I see this to be a long drawn battle.