Global impact of Vodafone case

Tax policy varies widely from one jurisdiction to another. The global head of tax policy of a tax consulting firm points out how there is a clear line between developed and emerging markets with regard to laying down of tax policy. For developed markets, the goal is to restore overall competitiveness and develop policies that do not hinder investment in their countries.

Tax environment must be conducive to foreign investment. It is for this reason that Ireland persists with a low corporate-tax rate. Large emerging markets on the other hand are more focused on internal considerations, rather than international competitiveness. They take a more aggressive approach to raising tax revenue. Tax policy is often exported from one country to another. The Vodafone case has attracted international attention from 2008 onwards. Several countries started amending their laws to plug loop holes in similar cases.

China's Bold Bid

The international legal fraternity is excited about the adoption of a highly controversial “Vodafone-style extraterritorial tax and disclosure rule” by the People's Republic of China (PRC). In December, 2009 China introduced Circular No. 698, which takes an amazing leap. Foreign entities are required to disclose all indirect transfers of PRC-resident enterprises to the Chinese tax authorities in cases where an intermediate holding company, through which such transfers are made, is located in a low-tax jurisdiction or in such a jurisdiction that exempts income tax on foreign-sourced income (our Supreme Court had said that the Indian law will not apply to indirect taxes; also remember Cayman Islands and Mauritius are low-tax jurisdictions).

Foreign enterprises making indirect transfers must disclose within 30 days such details as equity transfer agreement, relationship between the foreign entity and the holding company (in terms of capital, operation, sales and purchase, etc.), assets of the holding companies being transferred by the ultimate foreign entity, relationship between the holding company being transferred by the ultimate foreign entity and the Chinese resident enterprise (in terms of capital, operation, sales and purchases) and the reasonable business purpose with respect to the transfer of the holding company.

The Circular raised furore about its legality. No guidance was available as to what constituted legitimate or substantial business in an offshore jurisdiction. The earlier Circular No. 601 had made a distinction between a ‘beneficial owner' and a ‘conduit' company for the purpose of judging who can benefit from China's tax-treaty coverage. In January 2010, the Carlyle Group, a leading global private-equity player, indirectly transferred shares of a Jiangsu-based company in which it held a 49 per cent stake by selling its Hong Kong-based subsidiary to an American private-equity firm.

Despite the transaction taking place entirely offshore, the Jiangsu tax authorities raised a demand of $25 million in taxes invoking Circular No. 698 against a major offshore investor. It shows that China's tax authorities are aggressively pursuing offshore entities. Serious concerns have been raised about the lack of clarity on the definition of indirect transfers and the possibility of double taxation.

Uncertain tax policies will mean that companies may find that their investments are not as viable as they first thought. The Chinese Circular applies when there is an intermediary country company between the foreign investor and the Chinese investment and the intermediary is sold rather than the investment itself. Similarity with Vodafone is so obvious.

Australia

Australia is having a new look on the question of limiting tax concessions on cross-border investments made in Australia. The Australian Taxation Office finalised two draft rulings in 2010 declaring that gains on Australian investments made by foreign investors (including private-equity firms) may be considered as revenue profits rather than capital gains.

They are subject to ordinary rates of income tax if they have an Australian source, instead of being tax-free capital gains. Australia's anti-avoidance rules provide that any attempt to interpose a holding company in a tax-treaty country to access a tax exemption without a sound commercial purpose will be regarded as treaty shopping (Mr Justice Radhakrishnan, one of the judges on the bench that gave the Vodafone verdict, said: “Levy capital gains tax in this case will amount to imposing capital punishment”).

Indonesia

In November 2009, the Indonesian Government released two regulations designed to combat treaty abuse. Director General of Taxation's Regulations 61 and 62 set out a series of new procedures that must be followed in order that reduced rates of withholding tax may apply to payments made to foreign residents under various treaties.

In 2010, the Indonesian Government released a new Regulation making it obligatory for any foreign entity to report any merger or acquisition, exceeding a certain size, to the Commission for the Supervision for Business Competition within 30 days.

It is for the non-resident party to prove that the intermediary treaty party is in fact the beneficial owner of the income. The treaty partner must show that the transaction has economic substance and that a certain degree of genuine business activity is taking place.

We can expect the Finance Bill 2012 to bring in the limitation-of-benefits rule in the Income-Tax Act itself. We can also expect amendment about the term ‘transfer' to include indirect transfers.

(The author is a former Chief Commissioner of Income-Tax.)