Integrity of tax system threatened by prospect of retrospective action

Author: | Published: 1 Aug 2012
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The tax dispute between Vodafone International Holdings and the Indian Tax Authority was initially settled in January 2012 when the Supreme Court of India pronounced that the Government of India (GOI) did not have jurisdiction to tax the offshore transaction between Vodafone and Hutchison. The Tax Authority was required to refund the Rs 25 billion (US$455 million) tax payment already deposited by Vodafone, and the judgment helped ease the fears of investors about their offshore M&A activities.

However, following the Supreme Court judgment, the GOI took various initiatives to upturn the verdict by amending legislation. In particular, in the Union Budget 2012-13, the finance minister proposed to amend the 1961 Income Tax Act in order to tax offshore transactions involving any Indian assets. Most significantly, the amendment would be implemented with retrospective effect, dating back to April 1 1962.

Under this amendment, all persons, whether resident or not, would be required to deduct tax at source and pay it to the GOI if they had business connections in India, even if a transaction was executed offshore. The retrospective amendment would enable the GOI to collect tax amounting to approximately Rs 400 billion (US$7.28 billion).

Moral objection

The GOI has claimed that the amendments have to come with retrospective effect as they are clarifications in nature. But this argument has been rejected by many investors and legal practitioners. They say that interpretation of the law has been mutually understood between the regulators and businesses over a long period of time, and the 'clarifications' challenge the basic assumption of both parties towards the provisions.

Amarchand Mangaldas managing partner Shardul Shroff says: "The greatest controversy on the income tax amendment is the fact that changes are made retrospectively. In this case, there is a strong moral objection against the government for neglecting the integrity of legal provisions that were established earlier. Over the years, both investors and the regulators have established common consent towards how the law should be interpreted. Suddenly, such interpretations are disregarded and can be overturned anytime in the parliament."

Godrej Consumer Product's executive vice-president of legal Rajiv Bakshi says it is understandable that the GOI is tightening up the Income Tax Act in order to prevent tax avoidance, as this is common international practice in the current global financial climate. However, he says it is unfair to investors when earlier agreements are overturned.

"There is a difference between tax saving and tax evasion," he says. "When the Indian regulations state the tax free options for corporations to carry out their transactions, then surely they have the right to plan their transactions with the most tax-efficient options. If the government is disregarding such rights of businesses by amending the law retrospectively, it is very disrespectful towards investors."

For current and prospective investors, the GOI's initiative to amend legislation retrospectively has added to the risks and uncertainty of doing business in India. Strategically, the financial implications of such risks are hard to quantify as the GOI could upturn previous rulings at any given time.

Ernst & Young tax partner Rajan Vora says that tax risks in India have now become a huge hurdle for many potential investors. "The retrospective regulatory risks in India are recognised among investors. However, it is the first time that retrospective amendments are made that will have implications to such an extent."

He adds: "The amendment, if really passed, will be disastrous towards the integrity of the Indian tax system. Investors are very worried about the reliability of the regulations. The legal compliances they have prepared might mean nothing in the end if the government decides to upturn the earlier terms agreed upon."

Vodafone is currently in talks with the GOI and has said that it might invoke a bilateral trade treaty between India and the Netherlands if the GOI does not decide to reduce its tax liabilities following the potential amendments. The Bilateral Investment Promotion & Protection Agreement (BIPAs) was signed between India and the Netherlands to promote and protect investments on a reciprocal basis. The Agreement allows companies to claim back taxes in cases where they are unreasonably charged by the other country.

The Netherlands government is also likely to intervene in the case as it may have to bear the tax liabilities of Vodafone under the terms in the bilateral trade agreement. In addition, affected parties might decide to bring this case to international arbitration should the retrospective amendments be passed.

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