Vodafone and Cairns: same yet different

The words “retrospective tax” — dreaded by foreign investors and hated by Indian companies seeking foreign investment — are once again making headlines, this time due to the income tax department slapping a huge tax demand on Cairn India and its erstwhile parent, Cairn Energy PLC. The demand was for failing to pay capital gains tax on profits made when the Indian assets were transferred to Cairn India. Is it the Vodafone tax dispute all over again?

Yes and no. The structuring of the Vodafone and Cairn deal is similar in many respects. Both involved transfer of assets based in India but owned by a company based in an offshore tax haven. Ownership of the Indian assets changed hands through the sale of shares in the offshore entity.

In the Vodafone tax dispute, Vodafone International Holdings BV, a Dutch company, could buy 67 per cent stake in the Indian company, Hutchinson Essar Limited (HEL), by buying 100 per cent stake in CGP (Holdings) Limited, a Cayman Islands company. CGP, a subsidiary of Hutchinson Telecommunications International Limited, owned the Indian assets of HEL through a complicated network of intermediate entities.

The Cairn deal is less complicated but it also involved an offshore entity. Before the IPO, the Indian assets of Cairn were held by Cairn India Holdings, a Channel Islands-based subsidiary of Cairn UK Holdings, that was in turn a fully owned by Cairn Energy PLC. Cairn Energy wanted to exit its stake in the Indian exploration operations by listing its Indian assets. To enable that, the assets held by Cairn India Holdings had to be transferred to a company registered in India. This was achieved by Cairn India (a group company registered in India) buying 100 per cent stake in Cairn India Holdings from Cairn UK Holdings.

Cairn UK Holdings was allotted shares in Cairn India in lieu of the shares of Cairn India Holdings. This ensured that Cairn Energy PLC held 69 per cent stake in Cairn India after the IPO.

Both the tax demands arise due to the amendment to section 9 of the Income Tax Act in the Finance Bill of 2012. The amendment clarified that a company located outside India will be deemed to be situated in India if it derives its value from assets located in India. It followed that if shares of the company (situated outside India) were transferred to another entity, whether Indian or not, the Indian IT authorities could claim capital gains tax on the profit from the transaction.

The amendment was brought about immediately after the Supreme Court ruled in favour of Vodafone in January 2012. The tax department had held that since the transfer constituted an indirect transfer of assets that were situated in India, it was taxable. The Court in January 2012 had ruled in Vodafone’s favour stating that the tax laws did not include the words “indirect transfer” in section 9(1)(i) of the IT Act. The Court also held that the Act did not allow the tax department to “look through” transactions at any underlying motive or interest.

But since the retrospective tax amendment has been made valid from 1962, the tax authorities have now applied it in the Cairn tax demand too.

However, the deals do differ. Both the parties to the transaction in the Vodafone deal were non-Indian. In the Cairn case, one of the parties, Cairn India, is an Indian entity. But this does not hamper the applicability of the 2012 amendment to the Cairn India transaction.

While the transfer of Hutchinson’s stake in the Vodafone deal, through a web of entities located in offshore business centres, was clearly an arrangement to reduce tax liability, the intent is slightly different in the Cairn deal. The latter was an internal re-structuring wherein the assets of an offshore subsidiary were transferred to the Indian entity to enable it to list.

But it is obvious that Cairn Energy has made a profit from the share transfer. The oil fields in Rajasthan had not been developed in 2006. The IT department has estimated the cost incurred in those fields at just ₹2,178 crore when the share transfer took place. But the value of shares transferred to Cairn UK Holdings was ₹26,682 crore. It is to be seen if the IT department accepts the company’s claim that it did not pay capital gains tax on the profit since they applied transfer pricing rules on the deal.

It can be argued that since the retrospective tax amendment was put through only in 2012, the tax authorities cannot penalise an entity for not deducting withholding tax on a transaction that took place prior to February 2012. So neither Cairn India nor Vodafone can be held accountable for not paying withholding tax to the IT department. Hence both the tax component (₹10,248 crore) and the interest (₹10,247 crore) cannot really be charged to Cairn.

The counter argument is that since the amendment in 2012 only clarified an existing law, Cairn India and Vodafone should have been aware of it and should have deducted withholding tax.

The second question that arises is that as part of the payment for the shares of Cairn India Holding was made by issuing shares of Cairn India to Cairn UK Holding, how can withholding tax be deducted when payment is made in kind?

Finally, the IT department has slapped capital gains tax of ₹10,248 crore on Cairn Energy PLC. If the UK-based company pays the tax demanded, will Cairn India still be liable to penalty for not deducting the withholding tax?