There could be a less litigious solution to the stand-off between British telecom major Vodafone and the income tax department over the issue of paying capital gains tax on the purchase of 67 per cent in mobile service provider Hutchison Essar in 2007. Instead of arguing over the finer points of the structure of this offshore deal, it may be more constructive for the tax authorities to consider a more lasting legal solution, one that has precedents in the US, UK, Canada or Japan. Known as Controlled Foreign Corporation (CFC) legislation, it treats companies that exist in one jurisdiction but are owned or controlled by taxpayers of another jurisdiction as taxable entities. CFC legislation broadly prevents tax evasion through the use of tax havens or offshore companies. That is the burden of the tax authorities argument for taxing the $11.08 billion acquisition by the Netherlands-registered Vodafone of Hong Kong-based Hutchison Whampoas 67 per cent stake in Indias fourth-largest mobile services company. Although the deal was struck in the Cayman Islands, the income tax department has pointed out that the transfer of beneficial ownership concerns assets in India and, therefore, should be subject to tax in India. The reason Vodafones lawyers and tax experts have been able to argue the converse is that the concept of levying tax on cross-border transfers is not provided for in current tax legislation. The Central Board of Direct Taxes (CBDT) had, in fact, recommended an amendment to Section 9 (1)(i) of the Income Tax Act, which deals with the treatment of income arising or accruing in India, but the wording of the amendment was deemed too ambiguous.

Nevertheless, the issue is worth the next finance ministers consideration. The number of cross-border M&As involving companies based in India can be expected to rise as more foreign direct investment flows in. The Hutch-Vodafone deal is not the only one facing this tax controversy. A similar notice was sent to IT services provider Genpact after GE sold a 60 per cent shareholding to US-based private equity investors for $500 million in 2004. And the Tata group has been asked to pay withholding tax after US telecom major AT&T sold its stake in Idea Cellular to it through Mauritius, with which India has a double taxation avoidance treaty. The tax authorities have argued that the sale concerned an asset in India, resulting in a capital gains liability in India, which it said the Tata group should have provided for. This transaction prompted the CBDT to re-open some 400 cases going back six or seven years. But the Hutch-Vodafone deal is of a different order altogether, which is why the outcome is being closely tracked by corporate tax lawyers. At 10 per cent capital gains tax, the government stands to gain almost $2 billion (more than Rs 10,000 crore at the current exchange rate) from this deal alone.

Bringing such transactions under a CFC legislation raises a host of issues, not least of which is the need for an efficient tax credit regime. It has been argued that subjecting offshore deals like Vodafone-Hutch to capital gains tax would deter foreign investors from investing in India. These are valid concerns, and certainly need to be addressed. Alternatively, calling for a one-time settlement of current cases and amending Section 9(1)(i) prospectively might be a useful signal, to future investors, of the income tax departments intent. Right now, the Vodafone-Hutch transaction seems headed back to the courts.