If an asset is physically located within India, Indian Revenue has a legitimate tax claim on its disposition. But a recent case, involving the sale of a telecom company, challenged the taxability of such dispositions.
In 2005, Vodafone acquired a stake in India’s largest telecom operator, Airtel. India was a huge market, so when another Indian operator, Hutch, came up for sale, Vodafone bid almost $11 billion. To complete this transaction, Vodafone acquired interests in a Cayman Islands corporation, CGP, which owned a majority stake in HEL, which in turn owned Hutch.
Vodafone’s $11 billion represented 51.96% of effective shareholding and 67% of Hutch’s economic value. A prominent audit firm reviewed the deal’s tax implications and concluded there would be no Indian tax consequences, since the transaction involved sale of shares in a Cayman Islands corporation.
Noting that a major telecom operator had changed hands without any taxes on the transaction, the Indian Income Tax Department charged Vodafone, under S. 201 of the Income Tax Act 1961, with flouting S. 195. Under S. 195, anyone paying a foreign company which does not have a tax presence in India must withhold from the purchase price an amount equivalent to the tax chargeable on the transaction.
Vodafone petitioned the Bombay High Court against the charge. The court concluded that since the transaction had a ”direct effect” on India, it was taxable. The Supreme Court, however, ruled in favor of Vodafone, and chided the Union Government to establish clear tax policy in order to attract foreign investment.
Holdings of the Supreme Court:
1) S. 9 is not a look through provision.
The Court agreed with the purpose of S. 9: income accruing from activities in India must be taxable by India whether the income arises directly or indirectly. Nonetheless, the Tax Department cannot “look through” a transaction, but merely “look at” it to evaluate taxability. If the legislature intended to tax gains arising from transferring the shares of a corporation that owns Indian assets, an indirect accrual of income, then it must explicitly so provide.
2) The control premium exercised in HEL was not a property right extinguished by this transaction.
A parent corporation’s de-facto control over its subsidiaries cannot be equated with a legally enforceable right. This is especially true in a situation like Vodafone, where the subsidiary enjoys considerable autonomy. The rights transferred to Vodafone were protective or participative rights, transferred normally given to minority shareholders to address concerns of usurpation of control by majority. Such rights cannot be equated to a property transfer.
3) Legitimate use of multi-jurisdictional entity structures by multinationals is not unjustified.
After evaluating the maze of contractual agreements, the Indian Supreme Court found it vital to the transaction that Vodafone acquired an upstream corporation instead of directly acquiring a stake in HEL. Had Vodafone acquired a 67% direct equity stake, it would have breached India’s cap on foreign investment for the telecom sector.
4) Vodafone was not an assessee in default.
The Indian Supreme Court concluded that Vodafone’s transaction was between two non-residents, and transferred an asset situated outside India. There was no ground for India to tax the transaction, and hence no default by Vodafone.
The Indian Government was unhappy with the verdict, and introduced Finance Bill 2012. This bill amends S. 9, overruling the Court’s decision. The bill adds elements that were argued by Revenue before the Court:
- The rights and entitlements approach: An explanation was attached to S. 2(14), clarifying that “‘property’ includes and shall be deemed to have always included any rights in or in relation to an Indian company, including rights of management or control or any other rights whatsoever.” An explanation was also added to S. 2(47), broadening the definition of transfer to include transfers of rights associated with shares of an Indian corporation.
- Understanding “through” in S. 9: Explanation 4 has been attached to S. 9, and states that “through” shall be understood as “in consequence of,” “by reasons of,” or “by means of.”
- Explicit Clarification: If a foreign corporation derives, directly or indirectly, its value substantially from assets located in India, shares of that corporation are deemed situated in India. This amendment has been applied retrospectively from 1st April 1962.
Since the S. 9 amendment dates back to 1962, a series of high-profile acquisitions concerning non-resident parties are suddenly taxable. This is viewed as yet another decision by India to push away foreign investment instead of facilitating it. Though this is not the first time the 1961 Act or S. 9 has been retrospectively amended, this amendment has drawn immense criticism from tax practitioners.
Was the litigation necessary?
For Vodafone the litigation was unnecessary. As the buyer in the transaction, Vodafone was not liable for tax on capital gains. Vodafone was charged as an “assessee in default,” having failed to deduct tax payable by the seller. However, the safe harbor certificate under S. 195 allows the payee to proceed with payment with the assessing officer’s authorization. Thus, the S. 195 exemption could have prevented this litigation.
By Dan W. Puchniak, Assistant Professor, Faculty of Law, National University of Singapore. Author of the forthcoming article in the Berkeley Business Law Journal, “The Derivative Action in Asia: A Complex Reality.”
In this era of globalization, the field of comparative corporate law has come of age. With corporations and capital increasingly transcending national borders, academics have been on a quest to uncover grand universal truths about corporate law which similarly transcend national borders. Ostensibly, this quest for universal truths has produced impressive results. Indeed, the field of comparative corporate law has come to be defined by a series of grand theories which all claim universal applicability.
The theory that common law countries provide better protection for shareholders than their civil law counterparts (the “common law superiority theory”) has monopolized the minds of comparative corporate law scholars for over a decade and has been used to explain the postwar dominance of American and British capital markets. The theory that corporate law regimes around the world are converging on a single optimally efficient shareholder primacy model (the “convergence theory”) has similarly produced a cottage industry of experts and provided a rationale for America’s postwar rise to the position of the world’s leading economic superpower. The theory that shareholders will only sue when the financial benefit of suing exceeds the cost (the “economically motivated and rational shareholder theory”) has become the dominant approach for understanding shareholder litigation around the world and is a byproduct of the Chicago School’s law and economics movement, which has been a bulwark in modern American legal scholarship for the production of grand universal claims.
Indeed, the combined impact of these three grand universal theories has shaped a generation of comparative corporate law scholarship. However, in spite of their monumental impact and grand universal claims, these theories have been primarily derived from and/or evaluated based on the American corporate law and governance experience. More recently, some efforts have been made to test the robustness of these ostensibly universal (American-centric) theories by evaluating their explanatory and predictive value in the context of evidence from other leading Western countries. Thus far, however, limited efforts have been made to test the robustness of these ostensibly universal theories in the context of Asia—an oversight which has become glaring in the face of the immense shift in economic power towards Asia.
My forthcoming article in the Berkeley Business Law Journal, “The Derivative Action in Asia: A Complex Reality,”** which extends upon my forthcoming co-edited Cambridge University Press Book, The Derivative Action in Asia: A Comparative and Functional Approach, attempts to reduce this glaring oversight. The article (and book) uses derivative actions in Asia as a lens to re-evaluate the robustness of the grand universal theories. It demonstrates that in the context of Asia, the grand universal theories not only mislead, but are often turned on their heads. Indeed, based on evidence from derivative actions, civil law countries in Asia often appear to protect shareholders better than their common law counterparts; the corporate law appears more often to diverge than converge with the American corporate governance model; and the primary driver of derivative actions appears to be politics and not economics.
In this sense, the truth revealed in the article (and book) is an inconvenient one. The fact is that the forces that drive derivative actions in Asia’s leading economies are far too complex to conform to any one grand universal theory. This means that to accurately understand how derivative actions (and, most likely, all other areas of corporate law) function in Asia (and, most likely, everywhere else), it is necessary to consider a myriad of local factors that affect derivative actions in each individual jurisdiction, including the specific regulatory framework, case law, economic forces, corporate governance institutions, sociopolitical environment, and local (but not monolithic Asian) culture.
Such an approach may seem like common sense—because it is. Unfortunately, the field of comparative corporate law has increasingly shunned such an approach in its lust for elegant grand universal theories. Hopefully, the article (and book) will spark a new trend in comparative corporate law scholarship to embrace, rather than avoid, the complex reality that is comparative corporate law—for beautiful academic theories are sure to become historical footnotes unless they actually help explain the world in which we live.
**A link to this article will be added upon publication.
By Ana Amodaj, J.D. Candidate 2014, UC Berkeley School of Law
LegalZoom, the leading provider of non-lawyer online legal services to consumers, filed an S-1 form last month for an IPO seeking to raise as much as $120 million. Recent success and expansion of companies like LegalZoom into the market for affordable legal services has stirred up debate. The main points of disagreement relate to the sustainability of their business model, and whether such ventures should be allowed to operate outside of the bar regulations imposed on formal legal service providers.
LegalZoom has secured a very large consumer base (totaling over 2 million consumers in the past 10 years) thanks to its unorthodox business model that combines market-driven venture capital with the idea of providing limited, low-cost non-lawyer legal solutions. In essence, this model is a market-generated response to the troubling reality that many residents do not have access to the U.S. civil legal system. In fact, many modest-means and middle-class Americans fall into this “justice gap” because they do not qualify for free legal assistance, but at the same time cannot afford the high cost of retaining legal counsel.
Moreover, the combination of the recent economic downturn with the increasing cost of full-service legal representation has resulted in a surge in pro se litigants, which has slowed down courtrooms and caused procedural delays due to self-representing individuals’ unfamiliarity with the court system. While traditionally opposed to limited representation and quasi-legal services, courts and bar associations are now increasingly supportive of the self-help movement and are encouraging attorneys to perform unbundled services as a way to alleviate the justice gap and provide alternatives for pro se litigants. Several states, including California, even provide user-friendly limited representation forms and guides, rather than requiring filing of a more time-consuming formal pleading.
This change in policy has created an opportunity for companies like LegalZoom to enter the high-volume and high-demand market of consumers seeking any kind of legal assistance they can afford. In theory, these conditions make commoditization of legal services a very lucrative enterprise and even ensure high consumer satisfaction since the market is largely composed of individuals who would have little or no assistance at all, but for this low-cost alternative.
But there is a catch. Because LegalZoom is not exclusively owned by licensed attorneys, it cannot get a license to practice law in the U.S., or employ licensed attorneys to provide legal advice to its customers. Rule 5.4 of the U.S. Rules of Professional Responsibility (“USPR”) explicitly prohibits ownership and investment in U.S. law firms by non-lawyer entities in order to ensure professional independence of lawyers. Under the current regulatory scheme, non-lawyer entities can only distribute self-help materials and cannot provide any form of legal service.
LegalZoom self-identifies as an online service that helps consumers make their own legal documents. However, LegalZoom not only sells software but also employs 400 professional document reviewers. This blurs the line between a limited representation document preparation service and self-help software. Furthermore, whether this business model constitutes the practice of law is a controversial question because subjecting LegalZoom to strict bar regulations would severely limit access to legal services for those unable to afford full or limited representation by legal counsel. On the other hand, allowing investors to dictate the business of a high-volume legal service provider could damage credibility of the legal profession.
LegalZoom has recently settled several class action lawsuits alleging that its business amounts to an unauthorized practice of law, in violation of Rule 5.5 of USPR. The company has stated that losses from such lawsuits are expected to reach $16 million this year and are likely to continue in the future, causing many scholars and practitioners to doubt the practical sustainability of this business model.
Overall, venture capital has entered the high-demand market for affordable legal solutions and the question of whether it is there to stay or will eventually be pushed out by regulation or ethical challenges will have very significant consequences for the market and the legal profession in general.