The "Vodafone retrospective taxation" case in perspective

The favourable ruling in international arbitration at Hague against Indian tax authorities on the now famous $3 bn Vodafone taxation case has evoked demands that the government give up its claim and accept the arbitration judgement. This, it is argued, will send a strong signal about the government's intent on making the business climate attractive for foreign investors. 

I confess to not having followed the details of the issue, but the impression gathered from mainstream commentary has been that the government levied a massive tax, that too assessed through a retrospectively enacted legislation, which penalised and harassed a well-intentioned multi-national, Vodafone Plc, on a much-needed investment in India. Successive governments, Ministers and bureaucrats, none more than the late Pranab Mukherjee, have been pilloried for badly bungling on this issue and giving India a bad name before foreign investors. In fact, the Vodafone retrospective taxation issue has become totemic example of what's wrong with India's bureaucracy and business environment. 

This indictment of the government by Andy Mukherjee captures the popular perception,

One hopes that this becomes a moment when Indian politicians of all hues will come together to say, “Yes, we bungled. We should never have amended the tax law retrospectively to go after Vodafone. It cost us more in prestige than we could hope to win.”

So, what's the issue about? In a brilliant oped, Biswajit Bhattacharya cuts through the clutter and describes what actually happened,

India’s company in telecom business, Hutch Essar, changed ownership abroad indirectly from Hutchison Whampoa, Hong Kong, to Vodafone Netherlands. On February 20, 2007, Vodafone Netherlands filed an application with the Foreign Investment Promotion Board (FIPB), New Delhi. On May 7, 2007, the FIPB conveyed its approval to Vodafone subject to compliance to India’s laws. On the very next day, May 8, Vodafone remitted about $11billion from Cayman Islands to Hong Kong. This changed the ownership of Hutch Essar located in India... On January 20, 2012, the Supreme Court (SC) ruled that India had no territorial jurisdiction if non-residents transfer such assets indirectly. In March 2012, India’s parliament clarified to the contrary.

Here is another description, drawn from the earlier article by Andy Mukherjee,  

The quarrel goes back to Vodafone’s 2007 purchase of Li Ka-shing’s India wireless business. The Hong Kong tycoon sold a Cayman Islands-based investment firm to the U.K. operator. That firm controlled, via other offshore entities, CK Hutchison Holdings Ltd.’s 67% stake in Hutchison Essar Ltd., the Indian unit. The taxman wanted a share of CK’s vast capital gains and asked Vodafone to settle the bill from the amount it had withheld from Li’s check. But Vodafone’s lawyers had advised that no tax was applicable. The dispute went to India’s Supreme Court, which held that the government’s tax jurisdiction didn’t extend to the Cayman Islands.

Biswajit Bhattacharya puts the fundamental issue for consideration,

The issue simply is about India’s territorial jurisdiction over “assets located in India”... If assets located in India are bought and sold outside India by two non-residents through any device, then shouldn’t India’s authorities have the power to look into them? Does it happen in any other country in the world? Assume that $1 trillion, instead of $11 billion, had been transferred from Cayman Islands to Hong Kong with a booming value of “assets located in India”, would India still continue to deprive herself of her legitimate tax revenue? 

As Bhattacharya writes, the issue of retrospective amendment of the legislation in the Finance Act 2012 was "only clarified for the removal of doubts". It is irrelevant to the fundamental issue at hand.

One cannot but not come away with the impression that very few of the commentators who have written on this have taken the trouble to understand the issue itself. Rarely has such uniform misunderstanding of an issue lead to a uniform chorus which completely mislead and misrepresented the facts. 

It's impossible for any government to not appeal on this. For not doing so would be effectively giving up on one of the fundamental principles of national sovereignty, the right to tax economic activities undertaken on its soil. It would set a very wrong precedent that allows foreign companies to invest in an Indian business and then be able to sell their share with its capital gains externally to another foreign party and pay no tax in India. If uncontested now and in any such future episode if the government levies tax on such sales, the parties would only need to point to the government's acceptance of the Vodafone dispute to further fortify their claim before any arbitration.

Besides, it can also open up other similar tax cases which have been closed like the Vedanta's stake in Cairn Energy.  

In simple terms, opinion makers are asking the government to give up on a cardinal principle of national sovereignty (taxation of local activities) for some perceived notions of looking good before foreign investors!

In fact, even the jurisdiction of the arbitration under the provisions of the India-Netherlands Bilateral Investment Treaty is itself questionable to the extent that no such treaty overrides the domestic legislations of either country. 

As a side note, the original and subsequent government decisions on the issue would have been some of the most officially scrutinised ones - involving several officials, some very capable by any yardstick. That they all went ahead with it should count for something. It is a perfect example of the arrogance of opinion makers to assume they know better and derisively mock governments for every decision. For sure, governments get many things wrong. But here, the shoes appear to be on the other feet.