Sunday ET: How taxmen are profiting from Vodafone ruling

The Supreme Court verdict in the Vodafone case was unambiguous and widely celebrated by business. It was also seen as such a major setback to the government that finance minister Pranab Mukherjee rewrote the tax law — with retrospective effect — to ensure that such deals were covered.

Yet ironically, one of the earliest beneficiaries of the Vodafone judgement has been the tax department itself. In a series of at least three separate decisions, the Authority for Advance Rulings (AAR), a judicial body which rules on the taxes applicable in cross-border deals or transactions, has used the Vodafone case to rule in favour of the tax department.

Taxpayers use the AAR to get clarity (in terms of taxes due) not on transactions they have already done, but on a deal they want to do in future. The AAR then rules on the kinds of taxes they can be expected to pay on such a deal. Such an ‘advance’ ruling is intended to help taxpayers avoid a long-drawn and costly battle with the tax department after the deal goes through.

All three AAR rulings were about a specific type of contract widely used in turnkey infrastructure projects, where a supplier is responsible not just for delivering goods, but also installing and testing the goods on site where the buyer wants it. But the judgements have wider implications.

Signalling a ‘Shift’?

In one of the cases, Alstom Transport, a French company was part of a consortium to manufacture, supply, test and commission a signalling and communication system for trains for the Bangalore Metro.
According to the terms of the contract, the ‘supply’ leg of the contract actually took place outside India. In other words, Bangalore Metro paid for, and took possession of the signalling system from Alstom outside Indian borders, and it was only the testing and installation of the system which took place on site in Bangalore by engineers of the consortium.

Alstom pointed out to AAR that since the sale of the systems (and the profits made) were offshore or outside India, they couldn’t be taxed on that part of the contract at least, by the Indian tax department. To back them up, they relied on what till the Vodafone case came along, had been a fairly well-established precedent. Courts had ruled that contracts such as the one that the Alstom consortium signed could be ‘dissected’ into separate bits.

The parts which concerned transactions outside India were not within the ambit of the Indian tax department. The ones that took place within India, such as the payments to the consortium for installing and testing the system, could be taxed here. And because the supply leg is usually a very lucrative part of the overall turnkey contract, this was a big plus point for suppliers to such projects.

Vodafone Upsets the Applecart

But the Vodafone case has upset this consensus. The tax department in that case argued that the only reason the Cayman Islands Company had any value at all, was because it was the ultimate owner of Hutch’s Indian telecom business. Therefore, irrespective of where the company itself was located, profits on its sale should be taxed in India.

What the tax department argued in effect, was that you had to ‘look through’ what seemed to be ostensibly a sale of shares in a Cayman Islands company to another foreign company, and drill down to the real reason for that sale — the deal to buy the Indian telecom business of Hutch. The real ‘substance’ of the Vodafone-Hutch deal was in this intention to buy the telecom business. The sale of shares was merely a means to an end — the legal ‘form’ of the deal.