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Capital gains tax on sale of offshore companies

Capital gains tax on sale of offshore companies

In one of my dreams, I was Bill Gates. I owned cars, diamond mines, plantations in France and dozens of profitable foreign and Philippine companies. Of course, all of my assets were indirectly held through several layers of offshore companies in tax haven countries. As remnants of my consciousness surfaced, I tried to do as much tax planning as I could, even in my dreams. I was content, sipping coconut juice, lounging in my private island, dreaming that should I one day decide to sell one of my offshore companies, I would not be subject to tax in the Philippines.

Such island paradise dreams, however, were disturbed by the decision of the Indian High Court in the Vodafone Case. On September 8, 2010, the High Court in Mumbai affirmed that India's tax department has jurisdiction over offshore transactions, which would make Vodafone liable to pay capital gains tax on its acquisition of shares outside of India. Estimates on the liability pegged it at about USD2.6 billion. I shudder to think of how this could affect us: will it hit the Philippines like a tax tsunami or will it be dispersed and flow discreetly into the Indian Ocean?

Of recent memory, there is probably no other case in tax litigations around the world that is as highly watched and anticipated as the Vodafone one.  International forums on taxation have been abuzz with developments on this case from the moment the Indian tax authority demanded payment of capital gains taxes from seemingly cut and dried transactions originally thought to be beyond Indian tax jurisdiction.

The case started in 2007, when Vodafone entered the Indian telecoms market by paying USD11 billion in exchange for 67% ownership in Hutchison Essar, India’s third biggest telecoms company by subscribers.

Under the Hutchison Essar sale, a Dutch company controlled by Vodafone paid the USD11 billion to a Cayman Island entity owned by Hutchison, for another tax haven company that indirectly held a controlling stake in the India-based mobile operator. Theoretically, the situs of the sale of shares is so far removed from India, that no matter how far the long arm of the Indian law stretches, it will not be able to reach it. 

Vodafone’s acquisition was structured as sale of shares, which took place outside of India between foreign companies. Just like in the Philippines, such a transaction would have been treated as exempt from taxation in India prior to the case. In fact, as an implied acknowledgement that a loophole exists, the Indian government, during the pendency of the case, proposed a new direct tax code and introduced for the first time rules and regulations specifically addressing such transactions. This time, the Indian government proposed to have capital gains tax imposed on acquisitions made overseas if the acquired firm holds 50% assets in an Indian firm.

Despite the lack of existing laws, India’s tax department argued that even though the Hutchison Essar sale was offshore, the deal should be subject to capital gains tax in India because the assets sold are based in India. Thus, an asset whose value is created in India by the existence of Indian customers and operating assets based in India should, when sold, give rise to a capital gain chargeable in India. It insisted that Vodafone should have withheld the capital gains tax on the deal on the government’s behalf. Indian officials argued that Vodafone, as the buyer, was responsible for remitting the money to the government.

Of course, in the face of such a huge tax liability, Vodafone will once more appeal the case to the Indian Supreme Court, as it believes the transaction should not be taxable in India because it took place offshore. The appeal will likely generate another thousand pages of briefs and position papers that this case has already spawned.

Tax experts all over the world tremble at the repercussion of the outcome on tax principles relating to the extraterritorial jurisdiction of a local tax authority. The outcome of the case may allow Indian tax authorities to examine offshore transfers of shares having an impact, no matter how remote, on Indian businesses. The question, of course, is if the tax authorities in other jurisdictions, such as the Philippines, have any inclination to adopt the same rules and interpretations. More importantly, how fast will they react to these new developments?

Some tax pundits are apprehensive that the Indian tax authority’s USD2 billion victory may come at the price of foreign investments shying away from India.  Perhaps this is not cause for alarm for the Indian government since foreign investors have been continually knocking on its doors begging to be let in. Other not so lucky jurisdictions are, however, cautioned against adopting the same hard stance as the one taken by the Indian authorities.

Regardless of the outcome of the case, investors -- whether in India or in the Philippines -- should clearly be careful in structuring future M&A transactions.  If a structure that is assumed to be well thought-out and scrutinized, due to the sheer size, could fall prey to the inquisitive and far reaching efforts of the Indian tax authorities to collect more taxes, it is safe to assume that similar structures inside and outside of India are also at risk.

Surely, there are ways to address the loopholes in the Vodafone case. For example, if the offshore companies had been in treaty countries instead of just tax havens, perhaps the issue on capital gains brought by the tax authorities would never have prospered. In this case, the exemption offered by the treaty may insulate the transaction from the prying hands of the tax authorities. In such a case, will this then result in a round of renegotiations of treaties to address certain cases of capital gains tax exemption? Will this errant court decision one day be the rule in taxation of capital gains?

The issue in this case is one that may be applicable in the Philippines as well. Will this new development prompt the tax authorities to draft new regulations for taxing offshore sales of companies with underlying Philippine assets? Is there even a way for Philippine tax authorities to keep track of offshore sales in the first place? The sheer size of the transaction and the massive amount of media exposure alerted the tax authorities to the Vodafone deal.  Other deals that are not as substantial simply fall below the radar and may not be as publicized. How then will the tax authorities be able to implement the regulations if one is indeed drafted? How long will it take before deal makers and structure designers devise new plans to respond to new regulations?

Admittedly, the recent financial crisis has put pressure not just on businesses but also on governments to increase revenue generation. One should not strive to kill the goose that lays the golden egg.  However, taxes due must always be paid as part of good corporate citizenship. A subtle balance, therefore, on tax planning and tax collection must be reached.

As dawn emerged, accompanied by the shrilling sound of my alarm clock, I woke up from my dream and realized I am not Bill Gates; nor do I own layers of multinational companies.  But perhaps I can buy coconut juice for lunch and make at least one part of my dream come true.