AT&T rings bell on permissibility of tax arbitrage
May, 23rd 2008
A recent decision of the Indian Revenue to tax capital gains earned by an American arm of AT&T has ruffled many feathers. It has added fuel to the ongoing debate with respect to taxability of capital gains earned from sale of shares of a foreign holding company, whose principal assets consist of underlying shares in an Indian company.
As it stands, Vodafone and GE have been seeking relief from stay of similar proceedings in the Mumbai and Delhi High Court, respectively. Hence, AT&T's case goes a step further, given the fact that no tax has been demanded on the two cases lying with the state High Courts.
Facts of the Case Idea Cellular (an Indian company) was owned proportionately by Indian group companies of the Tata's, Birla's and Mauritian subsidiary of AT&T US. AT&T US exited Idea Cellular by selling (to the Tata's) shares of its Mauritian subsidiary.
The tax administrators have taken a view that AT&T US was taxable on such transaction and the principal contention has been that the Mauritian entity is a shell, whose sole assets comprised of holdings in Idea Cellular, an Indian company.
Therefore, the gains had an economic and territorial nexus' with India and gains arise for a "capital asset" situated in India. Tax treaty between India and the US provides that the right to tax capital gains is in accordance with domestic tax laws of country where the gain arises.
Interestingly, the pillar on which the entire contention of the Revenue rests is that while determining taxability of the transaction, the Revenue is well within its right to pierce the veil or ignore shell structure.
Substance over Form The issue on taxability based on "substance" over "form" has plethora of contradictory judicial decisions. Historically, Indian Courts have followed ratio of two famous English Court decisions rendered in Fisher's Executors and Westminster case.
The broad principles being that each business is entitled to arrange their affairs in a manner so as to minimise the tax incidence including taking advantage of lacunae or express benefits in the law. Views of English Courts gained general acceptance by the Indian Courts over the years until the Supreme Court in McDowell's case circumscribed the leeway allowed to tax payers.
In the mid 80's, the court took a view that tax planning was legitimate so long as it was strictly within the four corners of the law and any "colourable" device to minimse tax incidence were not legally permissible. Numerous court decisions followed and the McDowell principles served as a Bible' for the taxman to look beyond the "smoke screen" at the real purpose or substance behind the transaction. Result was that each case stood on its own merit, besides risk of arbitrary decisions by the tax administrators.
In 2004, the law of land was settled by the Supreme Court in Azadi Bachao case on use of the Mauritius tax treaty, wherein the position expounded was aimed at giving greater latitude to the tax payer to organise his tax affairs.
The court reaffirming the view of English cases while examining a legally valid transaction held that the Revenue should proceed objectively and not hypothetically attribute "motives" behind the tax payer's action. The court however accepted use of colourable devices or dubious methods to avoid tax as being impermissible.
Interestingly, the Revenue in AT&T's case by implication has equated the use of Mauritian holding company akin to use of colourable device and hence questioned the substance.
Tax Avoidance versus Tax Evasion The acceptability of tax planning lies in whether it leads to "tax avoidance" or "tax evasion".
Typically, tax avoidance involves benefiting from legal loopholes (what tax advisors term as "creative planning" ), use of tax concessions, value shifting etc. So long as tax avoidance is within the letter of law and is essentially a by-product of the ingenuity of a tax payer, it should be permissible, however unpalatable to the Revenue and perhaps immoral !
As an eminent tax professional was recently heard saying "If levying tax is not immoral, so is tax avoidance". I certainly don't subscribe to the view, given the focus on transparent disclosure norms and corporate governance in today's environment.
In situations where the tax payer indulges in tax evasion, no clemency is shown by the Revenue Authorities or the courts. Tax evasion essentially entails outright concealment of transactions, non- disclosure of income or similar acts. The Indian law over the years has enacted anti avoidance rules, predominantly focusing upon shifting of income by means of transfer of assets. Hence, specific provisions for tax avoidance if legislated would protect government's interest.
What kind of precedent will AT&T set? AT&T's argument is that the divestment structure is not a product of concealment or subterfuge, but ingenious utilization of a legitimate tax planning tool.
Though, it is the prerogative of the government to legislate anti-avoidance measures under treaties and domestic law, the question is if such rules can be read in absence of a legislative framework? The answer is a clear "No". Having said that, right to lift the corporate veil' under common law is bestowed upon the Executive and the Judiciary.
The caution being that such rights ought to be exercised under exceptional circumstances, particularly in situations such as fraud or gross negligence. If tax treaties or domestic tax laws do not contain specific anti avoidance measures, such tax planning methods should ordinarily not be decried as "colourable" devices.
India-Mauritius tax treaty has existed for years and encouraged as an avenue for tax planning opportunities in a bid to encourage investments into India. If in the view of the government, such tax planning tools have outlived their utility, they must be plugged by way of legislative enactment or treaty renegotiations as the case maybe. However, till such time it is outlawed, in the interest of certainty and equity, its use should be permitted.
In summary, besides prolonged litigation in AT&T case, it is important to ponder upon the question whether the tax administration can take actions and raise tax demands on matters which are before the courts.
The Revenue's stand seem to suggest that since both the writ petitions have yet to be admitted by the respective High Courts, each case has to be examined on its merits. Tax payers with similar facts will anxiously await outcome of the courts decision in Vodafone and GE's case, wherein arguments are expected to resume after the summer vacation!
Mukesh Butani The author is a partner with BMR Advisors and views expressed are personal