Vodafone, Essar to pay $880 million tax. Tax haven can opens?

Vodafone Group Plc, the world’s largest mobile phone company, and the Essar Group will share the burden of paying withholding tax of $880 million, or Rs4,000 crore, on Essar’s sale of 33% stake in Vodafone Essar.

Essar decided to sell its 33% equity in Vodafone Essar in April for a guaranteed sum of $5 billion under a previous agreement, but the tax liability on the deal was unclear. Including withholding tax, the deal is now valued at $5.46 billion.

But Essar now has a refund claim on the entire $880 million should authorities deem the transaction not taxable as some participants are Mauritius-based, which has a double taxation avoidance treaty with India.

“We are very confident of getting the full refund based on numerous precedents,” said Vikas Saraf, director,  \strategy, M&A, Essar Group.

As per the latest terms, a third of Essar’s equity in Vodafone Essar held through an India-based entity will be valued at $1.26 billion, while the remaining 22% held through Mauritius-based entities will be valued at $3.32 billion after withholding tax of $880 million.

“While Vodafone and Essar continue to believe that no tax is due on this transfer, it was viewed as prudent to pay withholding tax on a without-prejudice basis,” the firms said in separate statements issued late on Friday said.

The $3.32 billion has already been paid and the 22% shares have been transferred to Vodafone as on July 1.

Interestingly, Essar recently reverse-merged a privately held group firm that holds the 11% equity, with India Securities Ltd, which is listed on the Bombay Stock Exchange.

India Securities thus indirectly owns that 11% in Vodafone Essar, and stands to receive $1.26 billion payment for it, expected before February 2012.

Vodafone and Essar have also agreed to “cooperate fully” to seek all regulatory clearance required — a marked change from the belligerence that has marked the last months of their four-year relationship.

The decision to pay tax on this transaction might significantly weaken Vodafone’s case in its other pending tax tussle with Indian authorities, which is seeking $2.5 billion in taxes relating to a 2007 transaction worth $10.9 billion.

Indications of the latest terms of the deal announced late on Friday came earlier in the day, when Vodafone’s counsel Abhishek Manu Singhvi informed the Authority for Advance Ruling(AAR) of the company’s intent to withdraw its application for assessment of this tax liability announced in April.

The Income Tax Department’s counsel G C Srivastava characterised the case as one of ‘dual residency,’ wherein Essar’s Mauritius-based entities were mere investment companies, while effective control and management was in India.
According to Srivastava, Essar’s decision to invest through Mauritius route was taken at the group level and since the group operates out of Mumbai, the investment decisions were made in India.

Such routing of transaction, the tax department argued, was a classic case of ‘tax avoidance’ and hence comes under the provisions of Section 93 of the Indian Income Tax Act which gives authorities the right to tax a transaction whereby a resident transfers stake to a non-resident with the purpose of avoiding tax.

As further indication of tax avoidance intent, Srivastava cited that Essar initially held its stake in erstwhile Hutchison-Essar through an Indian entity and later transferred it to a Mauritius entity to avoid tax.

Reacting to Vodafone’s decision to pay tax, Srivastava said that it was a vindication of state’s position.

Tax expert T P Ostwal feels the application withdrawal will have an impact on the Rs11,000 crore tax case pending before Supreme Court.

“Vodafone will now certainly have difficulties in arguing the other matter before the Supreme Court, if it were to deduct tax on payment to Essar. It means that despite a warning from tax department, it did not purposely deduct tax on payment to Hutchison. This clearly vindicates the Bombay High Court ruling in favour of the revenue department,” said Ostwal.

But the bigger headache could be the precedent this sets for other Mauritius or any other tax-haven-routed transactions involving companies that have a predominantly Indian business.
According to sources in the Central Board of Direct Taxes, the tax department will now aggressively pursue similar transactions where the beneficial or real owner of shares is in India.

Giri is the editor of www.taxsutra.com