A court battle over capital gains tax between the Indian tax authorities and Vodafone has prompted predictions of a fall in foreign direct investment in Asia’s third-largest economy. Such fears are exaggerated. But there is a danger that the Indian move could complicate FDI across Asia as other governments follow its example by trying to tax hitherto exempt offshore corporate activity.

Vodafone’s problems in India stem from the $11bn acquisition in 2007 of Hutchison Essar, an Indian subsidiary of Hong Kong’s Hutchison Whampoa conglomerate.

The deal was nearly derailed by a row over permissible foreign shareholdings. Then the government handed out a parcel of fresh mobile operating licences, deepening competition and prompting Vodafone to write down the value of its 67 per cent holding by £2.3bn ($3.7bn).

In September, Mumbai’s high court ruled that Vodafone must pay capital gains tax on the acquisition of the Hutchison company, renamed Vodafone Essar, even though the deal was conducted between offshore subsidiaries of the two principals, and was thought to be exempt from taxation. The bill comes to Rs112.18bn ($2.47bn).

Vittorio Colao, Vodafone chief executive, inherited the mess from his predecessor, Arun Sarin, who saw India’s telecoms market as a pot of gold waiting to be opened. Not surprisingly, Mr Colao takes a different view, suggesting that future investment in India will depend, at least in part, on a positive outcome in the tax case.

His annoyance is understandable. No previous offshore transfer of Indian assets has been taxed in this way, and in any case Vodafone was the acquirer, not the seller. That ought to mean that if any capital gains tax is payable, it should come from Hutchison.

To add insult to injury, Vodafone was on Monday ordered by the supreme court to lodge a $553m deposit against the eventual tax bill, pending a final judgment expected in February.

Vodafone continues to insist that the deal is not liable for tax, and it may yet emerge victorious.

The issue for the high court was whether the structure of the deal – technically a transfer of shares between two Cayman Islands entities – involved a real connection with the Essar operating assets. The court decided it did, but the supreme court may disagree.

Even if it decides that the connection was real, the supreme court may judge that the tax authority was wrong to pursue Vodafone instead of Hutchison, since the UK company acted in good faith. The taxman argues that Vodafone should have withheld the tax payable from its payment to Hutchison.

The case could be settled out of court in administrative negotiations based on a tax treaty between India and the Netherlands, the location of one of a chain of companies involved in the offshore transaction.

The outcome matters, and not just to Vodafone. SABMiller, Mitsui and General Electric have similar arguments pending with the taxman over the sale or acquisition of Indian subsidiaries of foreign companies that could be affected by the Vodafone case.

Some of the more dramatic predictions seem fanciful. India is not imposing tax retrospectively: the tax authority is testing the application of existing law to the growing number of offshore deals.

Widening the tax net would probably make some deals undoable. But claims that overall FDI may be damaged ignore the lure of the Indian economy, growing at 8 per cent a year. Companies need clarity about potential liabilities, but that should be provided by the supreme court’s final ruling.

The bigger issue is that India has potentially paved the way for a similar attack on offshore deals by tax authorities all over Asia. China has tightened its rules, including forcing in the region are about to become more aggressive in chasing a share of the income from offshore assets, especially if Vodafone loses in New Delhi.

“Every tax authority in all the major countries in Asia will want to look at this if the court rules in the government’s favour,” says Veerinderjeet Singh, a lawyer at Taxand, the tax advice network.

That could cause complications in FDI flows, especially where they involve countries that do not have an independent judicial system, unlike India.

The outcome would be messy, since tax rules vary greatly between countries, and it might be painful for many companies.

But the case against Vodafone is no reason to dial down interest in India.

kevin.brown@ft.com

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