The author clears the misconception in the minds of the public that the verdict of the Supreme Court in Vodafone had delivered a body blow to the Government by deciding in favour of the assessee. Instead, large parts of the verdict, when stripped out of context, are in the tax department’s favour and the Government has shrewdly nullified the parts that were against it whilst retaining the parts that are in its favour says the author
When the judgement of the Supreme Court in Vodafone International vs. UOI 341 ITR 1 came out, a lot of people were shocked and thrown into despondency. How could billions of dollars earned from India be said to be tax-free only because the investments were routed through a shell company in a tax haven perplexed everybody.
you must compliment the Government for its cunning. While it nullified the conclusion in Vodafone by a retrospective amendment, it used the reasoning thereof to argue without batting an eyelid that the earlier verdicts which were in the assessee’s favour were not good law
However, in the hullabaloo that followed the verdict, everyone lost sight of the fact that there were large sections in the judgement – part of the reasoning on the basis of which the judgement was delivered in favour of the assessee – which when stripped out of context – supported the tax department.
The “Look At & Not Look Through” Doctrine
To support its theory that the tax department had to respect the legal nature of the transaction and not go behind it seeking it to find the “motive“, the Court in Vodafone propounded the “Look at and not look through” theory. So, if the transaction has come through the Cayman Island, treat it as an investment from a Cayman Island company by “looking at” that company and not “looking through it“, the wise judges said. The tax department could not adopt a “dissecting approach” it was held.
Following up on the logic, the Court held that as the gains had arisen on sale of the shares of a Cayman Island company, the gains arose in the Cayman Island and not in India even though the only assets of the Cayman Island were all located in India.
Now, here, you must compliment the Government for its cunning. By a retrospective amendment in the Finance Act 2012, it nullified the verdict that a gain on sale of shares of an offshore company could not be assessed in India by inserting Explanation 5 to s. 9(1)(i) to provide that “a share or interest in a foreign company would be deemed to situated in India, if the share derives, directly or indirectly, its value substantially from the assets located in India“. But, at the same time, it argued before the AAR in Roxar & Alstom without batting an eyelid that the theory of “look at & not look through” meant that the earlier verdicts of the Supreme Court in Ishikawajima-Harima 288 ITR 408 (SC) & Hyundai 291 ITR 482 (SC) – which were all in favour of the assessee – stood overruled.
Now, this is called having the best of both worlds. In Ishikawajima-Harima & Hyundai, the Court (Hyundai was delivered by the same judge who delivered the Vodafone verdict (CJ S. H. Kapadia) and all three cases were argued by the same counsel – Harish Salve) held that following the principle of apportionment, a composite & turnkey contract for supply of equipment and installation and commissioning had to be split and only the operations carried out in India were taxable and those carried out outside India were not taxable.
These verdicts had secured a very important victory for the assessee’s because in large turnkey contracts, the supply portion is the largest component. The bulk of the profits are made in the offshore supply of equipment and the local installation and commissioning work is usually down on a break-even basis or even at a loss. If the offshore profits escaped tax, it meant that the entire transaction was virtually tax-free.
However, the department upset this cozy state of affairs by arguing that the theory of apportionment of a composite transaction so as to identify its taxable and non-taxable parts as laid down in Ishikawjima and Hyundai was incompatible with the theory in Vodafone that a “dissecting approach” was not permissible.
To the assessee’s despair and the department’s delight, the AAR lapped up the argument and solemnly declared that Ishikawajima-Harima & Hyundai, having been delivered by a two judge bench, was – impliedly if not expressly – overruled by the three judge bench verdict in Vodafone. A contract for installation and commissioning of a project cannot be split up into separate parts as consisting of independent supply or sale of goods and for installation at the work site ruled the AAR and held that even the profits on offshore supply arose in India and was taxable in India.
The “Colourable Device Is Not Tax Planning” Doctrine
.. in trying to reconcile the confusion, Vodafone is decidedly ambivalent and its observations are capable of supporting either stand. On the one hand, the learned judges ponderously held that the “legal nature” of the transaction had to be respected but in the same breath held that a tax planning transaction without any commercial substance could be ignored
The other aspect on which the department has been able to extract mileage out of the Vodafone verdict is the perpetually confusing debate between tax planning and tax evasion. While McDowell 154 ITR 148 went to one extreme and held that all tax planning devices were bad in law, Azadi Bachao Andolan 263 ITR 706 went to the other extreme to hold that if the transaction was legal and within the four corners of the law, the department could not question it.
The Vodafone verdict, in trying to reconcile the confusion arising out of these judgements, is decidedly ambivalent and its observations are capable of supporting either stand. On the one hand, the learned judges ponderously held that the “legal nature” of the transaction had to be respected and one could not go behind it to discover the “motive” behind the transaction but in the same breath they held that the “no court will recognize a colourable or dubious method to evade tax” and that the tax department can “ignore” the Tax Residency Certificate and deny treaty benefits to a Mauritius company if it was “interposed solely with a view to avoid tax without any commercial substance“.
So, what is the bottom-line? Nobody knows!
Anyway, the later part of the observations in Vodafone came very handy for the department in Killick Nixon. In that case, the assessee bought shares which were worth Rs. 24 for Rs. 150 and then sold it for Rs. 5. Relying on Azadi Bachao Andolan, the assessee brazenly claimed that as the transaction was “within the four corners of the law“, the short-term capital loss had to be allowed. However, the High Court relied on Vodafone to throw out the argument. The Vodafone principle was summed up in the pithy words “where the transaction is not genuine but a colourable device there could be no question of tax planning“.
So, the next time you feel sorry for the Department on account of the Vodafone verdict, think again!
Vellalapatti Swaminathan Iyer
On the same lines one may also like to read ‘How Vodafone International Has Overruled Azadi Bachao Andolan Decision?’