A ruling by Mumbai's high court that has landed UK-based phone operator Vodafone with a huge tax bill could have ramifications for family companies looking to build business interests in India.
The high court ruled on Wednesday that the $11 billion (€8.64 billion) sale of mobile phone business Hutchison Essar, a subsidiary of the Li family's Hong-Kong-based Hutchison Whampoa conglomerate, to Vodafone in 2008, is eligible for capital gains tax in India.
The court ruled on the side of the tax authorities because Hutchison Essar's operating assets were in India, in spite of the fact that the transaction occurred outside its borders.
"India is effectively rewriting international tax law," says Rajesh Sharma, director at Smith & Williamson's international tax practice.
Mukesh Butani, Asia leader at tax advisors network Taxand, says the ruling will embolden the Indian Revenue to investigate further offshore transactions with an Indian connection.
"Parties to transactions will have to weigh their options, tax structuring and mitigate tax risk by providing for capital gains tax. This is bound to enhance the level of transaction cost and consequently the deal may sound less competitive," he said.
Vodafone is expected to appeal the decision as it will now be required to pay tax in two different jurisdictions.
Hutchison Whampoa, controlled by billionaire Li Kashing, received money for the sale via a Caymans Island entity. Another Cayman Islands entity, which actually held the controlling stake in Hutchison Essar, was then handed over to a Dutch company controlled by Vodafone.
Analysts predict that the final bill in India alone could be $2 billion.
Other companies that use offshore structures to do deals could be similarly affected as the Indian government tries to boost its tax take from western companies keen to profit from the country's impressive economic growth rate, which was over 5% last year.
"Normal tax exclusion rules will not apply because domestic tax law now prevails over its international equivalent," says Sharma.
The only exception appears to be Mauritius, which is one jurisdiction Sharma believes could help to circumnavigate the ruling because of the double tax treaties it has with India eliminates any duplication of tax on income or capital gains.
The stakes are high given that cross-border M&A is on the rise again – the first half of 2010 has been the busiest since the same period in 2008.
But analysts are split on whether the ruling will have lasting implications.
"The move is unlikely to discourage fresh investment flows into M&A by foreign multinationals. However, India needs to find the right balance between stopping avoidance and providing certainty in its tax regulations," said Butani.
But Sharma believes the move could backfire. "India is a difficult place to do business even without these tax difficulties and this news will be a further disincentive," he said.
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