The Vodafone judgement is out (2012-TII-01-SC-INTL). The Revenue has lost its case. Vodafone has won. There is already a lot of ‘shabashi’: the rule of law has been vindicated; it has been shown to the world how independent our judiciary is. Interested parties have already labeled it as a ‘landmark’ judgement. In such circumstances, it is difficult to be a party pooper.

That Vodafone has won the case or that the tax department has been asked to refund Rs 2500 crores with added interest is not very material. What is problematic about the judgement is the fact that there are observations by the court which will be quoted for years to come to justify aggressive tax planning, use of artificial structures, use of tax havens. Ironically, there is ‘international’ consensus [including on the part of the OECD] now precisely to move against these very ills whereas the Supreme Court judgement comes as a shot in the arm for tax planners creating artificial structures and paper companies located in Lawyer’s offices in Cayman Islands and other tax havens and the rampant misuse of the Mauritius route for money laundering and round tripping.

There are two judgements, one given by Chief Justice Kapadia along with justice Swatanter Kumar, while there is a separate concurring judgement of justice Radhakrishnan which takes the cake in coming out with an observation that raising tax demand on Vodafone was like inflicting capital punishment for capital investment. But, more on that judgement later.

What I find most interesting is the following observations in the conclusion part of the main judgement: “FDI flows towards location with a strong governance infrastructure which includes enactment of laws and how well the legal system works. Certainty is integral to the rule of law….” The logic is that by challenging the artificial structure built in by Hutchison/Vodafone, the tax department is generating uncertainty, which is inimical to the flow of FDI into India, and hence the Court cannot approve the same. I am frankly amused. It is not long time back that the Supreme Court has thundered in the Ram Jethmalani case (2011-TII-05-SC-INTL): “From the status reports, it is clear that the problem is extremely complex, and many agencies and departments spread across the country have not responded with alacrity, and urgency, that one would desire. Moreover, the Union of India has been unable to answer any of the questions regarding its past actions, and their implications, such as the slowness of the investigations, or about the grant of license to conduct retail banking by UBS, by reversing the decision taken earlier to withhold such a license on the grounds that the said bank’s credentials were suspect. To this later query, the stance of the Union of India has been that the entry if UBS would facilitate the flow of foreign investments in India. The question that arises is whether the task of bringing foreign funds into India override all other constitutional concerns and obligations.” [Para 39] The Bench of the Supreme Court might as well have addressed the homily to the Bench that gave the Vodafone verdict or indeed the one that came up with the gem of the quote for all tax literature: “There are many principles in fiscal economy which, though at first blush might appear to be evil, are tolerated in a developing economy, in the interest of long term development. Deficit financing for example, is one treaty shopping in our view, is another……” Yes, I am talking of the Azadi Bachao case.

The problem with such observations by the Court, particularly of the Supreme Court is that they are not based on any arguments made at the bar. Thus, the Supreme Court was not dealing with the desirability of foreign investments in India and obviously no arguments were advanced in this regard. The Court also did not do any thorough research on the subject. In such circumstances, such observations only reflect the personal predilections of the judges. Even in the Azadi Bachao case (2003-TII-02-SC-INTL), the observation that is associated with the Supreme Court is in fact taken from the book of Roy Rohatgi. Clearly, Mr Rohatgi is not an authority on treaty shopping and the Court does not indicate why it chose to quote from that particular portion. The two judgements of Vodafone and Azadi are, in a way, interlinked and unfortunately both are flawed.

Coming back to the Vodafone case, there are various elements of the judgement. The first one as dealt with by the Court relates to the reconciliation between McDowell case (2002-TII-59-SC-CB-MISC) and the Azadi case. It is a fact that world over, there are still problems relating to the dividing line between tax planning and tax evasion. India has been a happy hunting ground for tax planners, helped in their effort by the absence of any written anti avoidance rule and the general attitude of the judiciary dependent upon precedents that came in the times of confiscatory tax regime. But, things have changed. Should we nevertheless cling on to those precedents that have no relevance to the reality of the present day world?

The McDowell case was the first articulation by the Supreme Court of the changed circumstances. It was a 5 judges Larger Bench judgement. A still Larger Bench has not overruled it as yet. Therefore, under Article 141 of the Constitution, whether the Honourable judges like it or not, it should be binding on all Courts and Tribunals. Since there are extensive references to the McDowell case, both in the Vodafone case, as also in the Azadi case, it is necessary to consider the facts of that case a little.

The McDowell case essentially involved determination of the question as to whether for the purpose of the levy of sales tax; the turnover should include excise duty paid. Justice Ranganath Mishra on behalf of himself and four other judges wrote the main judgement. (RM judgement). There was a separate concurring judgement by Justice Chinappa Reddy on the issue of tax avoidance, tax planning etc. It was the effort all along whether in Azadi case or now in the Vodafone case to isolate the observations of Justice Chinappa Reddy and say that the majority of the judges did not share his view. However, this is not true. Even if we restrict ourselves to the judgement as given by justice Mishra, we come to the same conclusion.

The essential argument of the taxpayer in the McDowell case was that when under an arrangement, the buyers pay the excise duty, the same does not become part of the turnover of the manufacturer seller and consequently no sales tax is payable on the same. In this connection, the RM judgement mentions as follows: ( in Para 40):

“…. If we accept the observations of Hidyataullah,J. as laying down the test for general application, it would be very prejudicial to the Revenue as between the seller and the buyer, by special arrangement, a part of what ordinarily would constitute consideration proper could even be kept out and the turnover could be reduced and tax liability avoided……” In the RM judgement, the Court could have simply looked at the arrangement while refusing to look through the same and could have said that there is an agreement between the buyer and the seller and the judges had to respect the same and such planning was legitimate. Indeed, if we apply the ratio of the Vodafone judgement to the McDowell case that is precisely the conclusion that one would arrive at.

In fact the argument of legitimate tax planning was advanced by Mr. Sorabjee based on the so called Westminster principle that it is open to everyone to so arrange his affairs as to reduce the brunt of taxation to the minimum and such a process did not constitute tax evasion; nor did it carry ignominy. In this connection, the RM judgement in para 44, mentions: “We may recall the observations of Viscount Simon in Latilla V. I.R.C (1943) 25 Tax Case 107:

Of recent years much ingenuity has been expended in certain quarters in attempting to devise methods of disposition of income by which those who were prepared to adopt them might enjoy the benefits of residence in this country while receiving the equivalent of such income, without sharing in the appropriate burden of British Taxation. Judicial dicta may be cited which point out that, however elaborate and artificial such methods may be, those who adopt them are “entitled” to do so. There is, of course, no doubt that they are within their legal rights, but that is no reason why their efforts, or those of the professional gentlemen who assist them in the matter, should be regards as a commendable exercise of ingenuity or as a discharge of the duties of good citizenship. On the contrary one result of such methods, if they succeed, is of course to increase pro tanto the load of tax on the shoulders of the great body of good citizens who do not desire, or do not know how, to adopt these maneuvres. Another consequence is that the Legislature has to make amendments to our Income Tax Code which aim at nullifying the effectiveness of such schemes.”(Emphasis supplied)

The RM judgement quoted the above obviously being in agreement with the same as they had not mentioned that they did not agree with particular portions of the aforesaid judgement. It is only thereafter, that the RM judgement mentions in Para 45, which has now become famous:

“45. Tax planning may be legitimate provided it is within the framework of law. Colourable deices cannot be part of tax planning and it is wrong to encourage or entertain the belief that it is honourable to avoid the payment of tax by resorting to dubious methods. ….”

And then in Para 46, it says: “On this aspect one of us, Chinappa Reddy, J., has proposed a separate and detailed opinion with which we agree.”

Even if the entire observations of Justice Reddy are ignored, what emerges from the RM judgement is what has been quoted above upholding the principle that tax avoidance through tax planning would be impermissible. The Supreme Court has not tried to define ‘Colourable device’. They were dealing with the larger aspect of tax avoidance and when they said that they agreed with the observations of Justice Reddy, it means that they agreed with him entirely and not with x or y Para of his judgement. Therefore, to read ‘on this aspect’, as referring to only to Para 45 is indeed artificial.

The Supreme Court in the Azadi case attacked justice Reddy’s observation that ghost of Westminster has been exorcised in its country of birth asserting that the same was the view of a particular judge with which the majority did not agree. Therefore, in Vodafone case, the Revenue tried to argue that Para 46 of McDowell judgement clearly points out that the other judges agreed with justice Reddy. The Supreme Court therefore was hard put to reconcile the two. It did so by quoting mainly from other UK court cases, which would show that Westminster principle was still being applied. However, all these references become unnecessary in the face of the authoritative judgement in McDowell case whereby the Court need not approve all commendable cases of ingenuity.

Justice Reddy, in his separate judgement, while recounting the evil consequences of tax avoidance in Para 17 says: “… In our view, the proper way to construe a taxing statute, while considering a device to avoid tax, is not to ask whether the provisions should be construed literally or liberally, nor whether the transaction is not unreal and not prohibited by the statute, but whether the transaction is a device to avoid tax, and whether the transaction is such that the judicial process may accord approval to it…..”

And, what is more important and is seldom articulated: “It is neither fair nor desirable to expect the legislature to intervene and take care of every device and scheme to avoid taxation. It is up to the Court to take stock to determine the nature of the new and sophisticated legal devices to avoid tax and consider whether the situation created by the devices could be related to the existing legislation with the aid of ‘emerging’ techniques of interpretation (as) was done in Ramsay, Burma or and Dawson, to expose the devices for what they really are and to refuse to give judicial benediction.'’ (Para18). The other Supreme Court judges, having agreed with justice Reddy, the said interpretation must be adopted till such time as it is not expressly overruled by the Supreme Court. It seems that at one point in the course of the arguments Chief Justice Kapadia considered reference to a Larger Bench the issue relating to reconciling the difference between McDowell and Azadi. But, this was finally not done. Therefore, the mistake done in Azadi by ignoring the decision of a Larger Bench continues in the decision rendered in the Vodafone case.

For Related Facts of Case: Pl see earlier Edits:

Vodafone Saga Part I: The Story of Project Comet

Vodafone Saga Part II: What happens When Venus takes over Moon

(To be continued)