#73 Thinking About Retrospective Taxation - Will India Appeal? 🎧

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- RSJ

The Permanent Court of Arbitration at The Hague last week ruled against India’s retrospective tax demand of Rs. 22,100 crores on the Vodafone Group. India has the option to appeal the decision at the appellate court in Singapore. Vodafone International Holdings, a Dutch entity, that had bought the Indian business operations of Hutchison Telecom International had invoked Clause 9 of the Bilateral Investment Treaty (BIT) signed between India and Netherlands in 1995 to contest the retrospective amendment of taxation law by India.

A quick background of the case will help set the context here. In 2007, Vodafone Plc bought a 67 per cent stake in Hutchison Whampao that included the rising star of the group – its India business assets. The tax department raised a demand for about Rs. 8000 crores that year in capital gains and withholding tax from Vodafone. Their argument was simple – the underlying place of business was India and the value that was being paid for by Vodafone was created in India. It should therefore withhold the taxable amount from what it pays to Hutchison. It didn’t matter if the transaction was done by two overseas entities and executed in the tax haven of Cayman Islands.

Vodafone contested this in the Bombay High Court which ruled in favour of the Tax Department. It then challenged this judgment in the Supreme Court which ruled in its favour in 2012. The UPA-2 government and the FM then didn’t take this lying down. Later that year the government passed an amendment to the 1961 Income Tax act that allowed tax authorities to retrospectively tax such transactions. In 2014, Vodafone went to the Parliament Court of Arbitration against this legislative change. Last week it won at The Hague.

Move On, India?

The reactions to the verdict from The Hague last week have been on expected lines. Most have suggested the Indian government to take the verdict in its stride and get on with life. Andy Mukherjee writing for the Business Standard echoed the prevailing views across media outlets:

“This ends a decade-old saga that tarnished India’s reputation among foreign investors. Rather than appealing the decision, Prime Minister Narendra Modi’s administration should accept defeat, honor the award, and move on. While much of the blame for this mess belongs to the previous Congress Party-led coalition, Team Modi had six years to end the dispute. Ending “tax terror” was also his party’s promise in the 2014 election that brought Modi to power.

If anything, reckless expansion of the state’s power — both in the economy and broader society — has become the norm since then. 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.”

We have three questions we will discuss in this edition:

* Is retrospective taxation always a bad idea?

* What’s a fair way to do retrospective taxation (if there’s one)?

* What will India do now (as opposed to what should India do which seems to be the focus of most op-eds)?

The Problem With Retrospective Taxation

You might argue taxation itself is a form of violence of the state on its subjects. Legitimate, yes. But violence, nonetheless. Doing it retrospectively makes it worse because you weren’t even aware you were doing something that will invite this violence.

Adam Smith set out four canons of taxation in The Wealth of Nations:

* The subjects of every state ought to contribute towards the support of the government, as nearly as possible, in proportion to their respective abilities (Canon of Equity).

* The tax which the individual is bound to pay ought to be certain and not arbitrary (Canon of Certainty).

* Every tax ought to be levied at the time, or in the manner, in which it is most likely to be convenient for the contributor to pay it (Canon of Convenience).

* Every tax ought to be so contrived as to take out of the pockets as little as possible, over and above that which it brings into the public treasury of the state (Canon of Economy).

The Canon of Certainty further states:

“The time of payment, the manner of payment, the quantity to be paid, ought all to be clear and plain to the contributor and to every other person.”

Retrospective taxation goes against this principle of fairness. It taxes a transaction that’s happened prior to law being framed. In the bigger picture, it is a human right violation since the state cannot remove a right without a transitional period.

However, there is a reason almost every developed country in the world has retrospectively taxed transactions. This is to avoid what is often termed ‘forestalling’ – the practice of taxpayers acting to avoid the impact of a change in tax laws before it can take effect. Now, it is possible to nip this practice by making the tax changes applicable almost immediately upon their announcement. But this isn’t practical all the time. There are laws that need Parliamentary approval or change in systems and processes that could take time. Therefore, in most cases there is always a lag between a tax change announcement and its effective date of implementation. This is what gives rise to forestalling. And that’s the reason lawmakers opt for retrospective tax laws.

In the Vodafone case, the Indian state has a valid moral argument like mentioned before. The underlying asset is the Indian operations which has been valued at a much higher consideration than its book value. The deal between Vodafone and Hutchison was designed in a manner to avoid this tax incident. This was unfair to the ordinary taxpayers in India who pay taxes for such transactions. The state plugged the loophole through a change in the law, but it also wanted to win the moral argument. So, it decided to apply the change in law retrospectively to 1961. Vodafone’s argument was it broke no extant tax laws when it structured the deal. So it should be protected under the canon of certainty.  

A Fair Way To Tax Retrospectively

If one were to accept for a moment that retrospective taxation can’t be avoided in certain cases, what’s a fair way to do it then? In the UK this question was raised in 1978 when the then Chancellor Healey announced two measures in his budget speech to curb tax avoidance through artificial schemes:

“[Tax avoidance] has emerged recently in a new form which involves marketing a succession of highly artificial schemes – when one is detected, the next is immediately sold – and is accompanied by a level of secrecy which amounts almost to conspiracy to mislead. The time has come not only to stop the particular schemes we know about but also to ensure that no schemes of a similar nature can be marketed in future.

So the provisions I shall be introducing this year to deal with artificial avoidance by certain partnerships dealing in commodity futures will go back to 6 April 1976, that is, before the date when the intention to legislate was announced in a parliamentary answer.”   

The debates that followed this retrospective legislation in the Standing Committee led to the framing of what’s called the ‘Rees Rules’ named after MP Peter Rees. He put down four conditions that must be satisfied for any retrospective tax legislation to be considered fair. These include:

* “A warning in the House of Commons by some recognised method – either by an answer to a Parliamentary Question or by some statement with plans to legislate in the subsequent Finance Bill back to the date of that warning. The warning must be precise in form. A mere suggestion that there are vague schemes of tax avoidance that must be counted should not suffice.”

* Secondly, the problem at which the warning has been directed should immediately be referred to a committee to devise the precise legislative measures which should then be introduced in the parliament.

* Thirdly, if the committee can hit on appropriate legislative provision, the draft clause ... should immediately be published in advance of the Finance Bill so that those who are likely to be in the field of fire will have a second clear intimation of what to expect.

* Fourthly, such a clause must, without fail, be introduced in the following Finance Bill to formalise it into law

In the Vodafone case, it is clear there wasn’t a semblance of Rees Rules that was followed. This is what made it perverse. That the law had a loophole that allowed Vodafone and Hutchison to avoid taxes wasn’t their fault. They can’t be blamed for it. Had they known of the tax, the contours of the deal or the deal itself could come into question?

What Will India Do Now?

Most of the arguments made (including that of Andy Mukherjee) suggest India shouldn’t appeal against the ruling for 2 reasons:

* It will send a signal to the investor community around the world that India has accepted it erred in this case. It will improve investor sentiment around India

* The current government will set a good precedent for future regimes to not lapse into arbitrary use of its coercive power

In our view, this isn’t likely how India will act. First, how much of investors’ view of India is hinging on this case really? The original retrospective law was passed in 2012 and much water has flown under the bridge. Newer investors have come across sectors in India (including over Rs. 150,000 crores invested in Jio platforms, another telecom player) even as Indian tax authorities have made newer demands on Vodafone for AGR dues in excess of Rs. 55,000 crores. The government believes a large, accessible market with a rule of law that’s better than most developing nations are good (enough) propositions to attract foreign capital. It isn’t going to lose sleep over investor sentiments.

Second, accepting this verdict will embolden a lot of other companies to appeal against the Indian state. Further, it is possible not appealing against the verdict may be used by the opposition to target the government for not standing up for India’s interests. This will be unacceptable to a government earning its equity on the back of robust nationalism.

Third, it is the right of the sovereign to amend its laws to protect its interests and not have the burden of taxes fall on its citizens who can’t use the resources like Vodafone to avoid taxes. The scope and intent of the BIT signed between India and the Netherlands doesn’t cover specific instances of tax avoidance. Its broad provisions drafted to signal intent of co-operation between the two countries can’t be used to override the sovereign will of the Indian people expressed through an act passed in its parliament.

This Isn’t The End

It will surprise us if the government decides to back off and accept the verdict. It has nothing to lose going to the appellate court. In fact, there’s a potential upside of Rs. 22,000 crores and further burnishing of its nationalist credentials if it appeals and wins. Its best option is to go the distance in this fight.     

HomeWork

Reading and listening recommendations on public policy matters

* [Article] A 2013 article by T.K. Arun in The Economic Times that stayed with me for its arguments against the Supreme Court verdict then.

* [Note] A note titled Retrospective Taxation - Indian Experience by Harish Salve who represented Vodafone Plc in the Supreme Court. The Vodafone case appears at page 14.

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