Tuesday, January 31, 2012

Part II - An Analysis of the Supreme Court’s judgment in Vodafone

In our first post on the Vodafone judgment, we set out the issues of law arising from the Court’s findings, and discussed two of those – the approach to tax avoidance and the meaning of controlling interest.  This post considers two other important issues – India’s approach to the corporate veil, and the scope the “extinguishment” provision under section 2(47) of the Income Tax Act, 1961 [“the 1961 Act”].
1.      Corporate Veil
It is as easy to state that the origin of the separate entity principle is often traced to Salomon v Salomon as it is difficult to outline when a court will lift the veil. One of the best attempts in the literature to extract coherent principles in this branch of the law is Professor Ottolenghi’s essay published in the Modern Law Review in 1990, and perhaps the best judicial analysis is Slade LJ’s masterly treatment of the subject in Adams v Cape Industries. In Vodafone, there are important differences in the approach of the Chief Justice and K.S. Radhakrishnan J., and the Chief Justice’s judgment suggests that the court may more readily lift the veil than is commonly supposed. The Chief Justice begins by affirming that “a subsidiary and its parent are totally distinct taxpayers” (¶66), and that the fact that a parent exercises substantial control over the affairs of its subsidiary is not in itself a reason to depart from this principle. The Chief Justice then outlines important exceptions to this principle – in particular, that it is permissible to ignore the separate legal status of the subsidiary if its decision-making is “fully subordinate” to the holding company or if the parent company makes an “indirect transfer through abuse of legal form and without reasonable business purpose”, and clarifies that these are by no means exhaustive. At first sight, the “fully subordinate” language the Chief Justice uses may suggest that a court will readily lift the veil, but it is submitted that the better view is that the Chief Justice is simply referring to the well-known exception (accepted in Adams) in which the business of the subsidiary is in fact the business of the holding company.
The Chief Justice then holds that India has a “judicial anti-avoidance rule” (¶68) which allows the Revenue to invoke “substance over form” or “pierce the corporate veil” if it discharges its burden of establishing that the transaction in which the corporate entity is used is a “sham or tax avoidant”. While the word “tax avoidant” may give rise to the impression that every case in which the use of a corporate entity leads to a reduction in the tax liability of the assessee is covered, it is submitted that the better view, and one which is consistent with the rest of the Chief Justice’s analysis in ¶¶67 and 68, is that no substantial departure is intended from the limited grounds on which the veil may presently be lifted. That view is reinforced by the fact that “sham” is used in conjunction with “tax avoidant”, and by the examples given by the Chief Justice in the sentence that immediately follows – round tripping and payment of bribes. The example of lack of business purpose is also given, but the Chief Justice clarifies that this lack of business purpose must not be a result of “dissecting” the legal form of a transaction as the Revenue sought to do in Vodafone’s case. The most important part of the Chief Justice’s analysis is the list of six factors set out to assist the Court in determining on which side of this test a particular transaction falls: “participation in investment”, duration of existence of holding structure (prior to acquisition), period of business operations in India, generation of taxable revenues in India, timing of exit and continuity of business on exit. This analysis suggests that it may be a mistake to read this judgment as a complete victory for tax planning, because the “dominant purpose” of a transaction may easily be found, on the application of these factors, to lack commercial substance, even though it may not satisfy the traditional tests of lifting the corporate veil. It also suggests, so far as tax avoidance is concerned, that the test in India, unlike in English law after MacNiven and BMBF, is not simply statutory construction, which is difficult to reconcile with the Court’s subsequent finding that it is.
It is also interesting to contrast this with the analysis in Adams v Cape Industries. In that case, Slade LJ clearly stated that the fact that “justice so requires” is never a reason to treat a subsidiary as anything other than a separate legal entity; that certain observations of §Lord Denning MR in DHN Food Distributors may have gone too far; that it is settled in English law that a subsidiary can be ignored only if it is the alter ego or agent or part of a single economic entity with, the parent; and that it is such only if the business of the holding company is the business of the subsidiary. This test may be considerably narrower than the factors outlined in the Chief Justice’s judgment (duration of existence of holding structure etc.). Indeed, the application of the Adams test to the facts of that case so suggest – in that case, although the Court concluded that AMC (the Liechtenstein corporation) was a façade, it held that CPC (the American marketing company set up after NAAC was liquidated) was not the alter ego of Cape and Capasco even though Cape exercised substantial control over it, because CPC had control over its day to day activities, paid rent for its premises, paid income tax separately etc.
K.S. Radhakrishnan J.’s judgment appears to endorse Adams (but see below), and recognises that members of a company have no interest in its assets. More significantly, the judgment appears to implicitly hold that the separate entity will prevail except in very limited circumstances, for it repeatedly observes that the veil can be lifted only if the Revenue establishes that the corporation has been used for a fraudulent or dishonest purpose (as opposed, for example, to a benign purpose through an entity that is part of a single economic unit). It begins (¶44) by holding that many factors may guide the choice of a vehicle for doing business through a corporation, of which one can legitimately be a desire to minimise tax liabilities. K.S. Radhakrishnan J. then holds that the burden is on the Revenue (¶46) to show that the corporation was used for “a fraudulent, dishonest purpose, so as to defeat the law”. In ¶¶ 58 and 59, it is held that the fact that a parent and a subsidiary may have economic union of interest and a consolidated balance sheet does not mean that they are not “distinct legal entities” and that the veil can be lifted only if the Revenue shows that the company has been used to perpetrate “fraud or wrongdoing” (¶59). Even in approving Adams (¶60), K.S. Radhakrishnan J. specifically observes that the Court of Appeal emphasised in that case that a subsidiary can be ignored “where special circumstances exist indicating that it is a mere façade concealing true facts.” This theme is repeated subsequently, when K.S. Radhakrishnan states that the court will not permit a corporate entity to be used as “a means to carry out fraud or evade tax” (¶61). All of this indicates that K.S. Radhakrishnan J. has virtually rejected the single economic entity or alter ego grounds for lifting the veil (or confined its application to rare instances), although there is one reference to “sham” and “agent” (¶61).
It is submitted that K.S. Radhakrishnan J.’s approach, even if it perhaps goes too far, is, with respect, preferable to the approach of the Chief Justice, for the latter analysis would permit the veil to be lifted on a number of grounds that may not be entirely consistent with the sanctity of the separate entity principle. Indeed, the Chief Justice’s analysis leaves one with the impression that Vodafone prevailed not on the ground that the veil cannot be lifted except on Adams grounds, but on the ground that the veil should not be lifted for it had demonstrated business purpose and commercial substance.
2.      Extinguishment under section 2(47)
The Revenue’s primary case in the Supreme Court was that there was a capital asset situate in India in the form of various rights that HTIL had which were “extinguished” when the SPA was entered into on 11.02.2007. For example, HTIL by virtue of its shareholding had the “right” to appoint directors, the right to use certain licences, redeem certain shares etc. The Chief Justice rejected this argument inter alia on the ground that the Court was concerned with the sale of shares, not the sale of assets, and that a sale of shares cannot be dissected as the sale of assets unless the six factors set out in para 68 (discussed above) are satisfied. It is implicit in this analysis that there cannot be, at the same time, a sale of property and the extinguishment of rights comprised in the bundle of rights that is sold. It is submitted that this conclusion is entirely correct – indeed, “extinguishment” did not exist in the 1922 Act, and was inserted by Parliament to widen the scope of section 2(47) in order to cover transactions in which there is no sale in the ordinary sense. Although section 2(47) does not so provide, it is submitted that it is not open to the Revenue to invoke “extinguishment” in a transaction in which there is admittedly a sale, simply because that sale is not taxable. The Chief Justice’s implicit approval of this proposition is, it is submitted, to be welcomed.
To put it differently, the Revenue was attempting to convert the sale of a “non-taxable whole” (situate outside India) into the sale of its “taxable component parts” (situate in India). There is an interesting parallel to be drawn with the analysis of the Court of Appeal in IRC v Rysaffe Trustee Co [2003] EWCA Civ 356, in which Mummery LJ held that it is not open to the Revenue to invoke a legal fiction when there is a “disposition of property in its ordinary and natural sense”. In this case, the transaction was a “disposition in its ordinary and natural sense” of an asset situate outside India – the Revenue could not invoke a legal fiction to overcome this fact.
We will continue to discuss other this judgment in subsequent posts, and in particular the analysis of section 9.

Venture Capital Funds: Minimum Investment Norms

(The following post is contributed by Ravi Shankar Jha, a final year student at the Dr. RML National Law University, Lucknow. It points to a lacuna in SEBI’s Venture Capital Funds Regulations)
Venture capital funds (VCFs) have been envisaged to provide easy capital to start-up firms. In India, VCFs are regulated by SEBI (Venture Capital Funds) Regulations, 1996. Through these regulations, SEBI has sought to lay down conditions within which a VCF must restrict its investments.

The regulations provide for setting up of a venture capital fund by a company, trust or a body corporate. The regulation further provides different eligibility criteria for these forms of vehicles for the purpose of grant of certificate under clause 4 of these regulations. It is further to be pointed that the expression “body corporate” was inserted by an amendment in the year 2000 in clause 3(1) of these regulations.

Clause 11 of these regulations lays down minimum investment in a venture capital fund. To that effect, clause 11(2) provides that no venture capital fund set up either as a company or any scheme of a venture capital fund set up as a trust shall accept any investment from any investor which is less than five lakh rupees (Rs. 500,000). This is where the regulators seem to have left a lacuna in the law. Gathering from the intention of the regulators, it seems that they want to ensure financial soundness of a VCF by providing for such minimum investment norms. But these regulations have failed to cover venture capital funds set up as a body corporate. A bare reading of the provision suggests that this norm of minimum investment of 5 lakh rupees applies only to funds set up either as a trust or a company. There is also no definition of the term given in this regulation. Clause 2(c) defines company as a company incorporated under the Companies Act, 1956 which obviously does not include a body corporate as body corporate under the Companies Act is a much wider concept which subsumes within it companies as well. Also, since the word, “body corporate” was introduced in clause 3 by an amendment in the year 2000, it can be argued that SEBI could have amended clause 11(2) accordingly and provided for such minimum investment norms for venture capital funds set up as body corporate as well. But such prominent absence only strengthens the argument that funds set up as body corporate (not being companies or trusts) are not subject to this minimum investment condition which at best is counter intuitive as there seems to be no logic or rationale in exempting such funds from this minimum investment norms.

This lacuna in the law must be filled as it could potentially be called in question in case a VCF were to be set up in the form of a body corporate that is neither a company nor trust (which is permissible under the Regulations), particularly if the intention is to circumvent the minimum investment norms by contending that clause 11(2) does not apply to investment funds set up as a body corporate under the Venture Capital Regulations.

- Ravi Shankar Jha

Monday, January 30, 2012

Preferential Allotments Liberalized for Certain Institutional Investors

Over the years, SEBI has gradually tightened the regime relating to preferential allotment of shares in order to prevent possible abuse of the process and to thereby protect the interests of minority shareholders in listed companies. One of the requirements pertains to lock-in on shares of allottees. There are currently three types of lock-in applicable to persons who are allotted shares on a preferential basis (although the requirements are more onerous for promoters):
1. At the outset, persons who have sold shares in a company in the previous 6 months are ineligible to be allotted shares on a preferential basis;

2. Allottees’ pre-existing shares in the company held prior to the allotment will be locked in for a period of 6 months;

3. The shares issued as part of the preferential allotment will be locked in for a period of 1 year.
By way of a press release issued last week, SEBI has made conditions 1 and 2 inapplicable to preferential allotments made to insurance companies and mutual funds “which are broad based investment vehicles representing the interests of the public at large”. This is likely to provide additional avenues to such institutional investors to obtain shares in companies through preferential allotments rather than through the secondary markets. The policy rationale is understandable because these institutions generally represent broader investors and not just the proprietary interests of a limited group of investors.

Friday, January 27, 2012

Third Week of Arguments: Constitution Bench on Bhatia International

Arguments continued this week before the Constitution Bench comprising the Chief Justice, and Justices Jain, Nijjar, Khehar and Desai. Unlike counsel before him, Dr Singhvi concentrated principally on the applicability of section 9 of the 1996 Act to arbitrations in which the seat is abroad, and it was his case that section 9 ought to apply no matter what view the court takes of the applicability of other provisions of Part I. Counsel reiterated that section 2(2) of the Act is an “affirmative” provision and not one that excludes the jurisdiction of the Indian court, and emphasised that section 2(5), which provides that the 1996 Act applies to “all arbitrations”, has been made subject to section 2(4) but not to section 2(2). The Chief Justice pointed out that there are provisions that although worded positively have a “negative effect” and vice versa, and asked why this is not true of section 9 as well. Counsel’s answer was that the “nature” of section 9 is “seat-neutral”, “Part-neutral” and “asset-based”, intended to ensure that arbitral proceedings are not frustrated by the alienation of assets. Counsel submitted that a petition under section 9 is never maintainable for frustrating arbitral proceedings (for example by seeking an anti-arbitration injunction).
Arguments, especially on Wednesday, also focussed on whether a civil suit is maintainable seeking interim relief in the event a petition under section 9 is not. The Chief Justice put to counsel the possibility that the underlying assumption in Bhatia International that a party is “remediless” unless Part I applies to an arbitration with a foreign seat may not have taken into account the fact that it is open to the claimant to institute a civil suit and seek interim relief to ensure that property is not dissipated. Counsel’s submission was that section 9 is a clearer path to the same result, but that if that is held to be inapplicable, a clear and unequivocal finding that a civil suit is maintainable is necessary, along with guidelines on the circumstances in which it may be instituted. This arose particularly because of the possibility that it is not open to a court to grant interim relief once an application under section 8 or section 45 is allowed. It was suggested that this may not necessarily be the case, despite the observations in Anand Gajapathi Raju and other cases that “nothing remains” to be decided one such an application is allowed, because sections 8 and 45 do not provide in terms that the suit shall be stayed. The thrust of counsel’s submission was, however, that a remedy under section 9 is more appropriate because holding that a civil suit is maintainable may not be entirely consistent with principles of arbitration law. Counsel also referred to the rules of various arbitral institutions and the experience of other jurisdictions to demonstrate that obtaining interim relief from a national court in which assets are located is by no means incompatible or inconsistent with the arbitration agreement. The arbitration legislation of many jurisdictions, including England and Wales, and the rules of arbitration of a number of arbitral institutions, expressly so provide.
The Respondents opened their case towards the end of the week and Mr Salve’s submissions emphasised that the seat of arbitration is a fundamental premise of jurisdiction in international arbitration, and that the existence of “concurrent jurisdiction” is entirely alien to arbitration law.
Arguments continue on Tuesday.

Sunday, January 22, 2012

An Analysis of the Supreme Court’s judgment in Vodafone – Part I

In our post on the judgment of the Bombay High Court, we expressed the hope that the Supreme Court would take a different view. That the Court has now done so has been welcomed as much needed respite in bad times. Even more importantly, it is heartening that the Court has taken what it is submitted is the correct view especially on the facts of Vodafone’s case. But from that qualification it follows that the prevailing assumption that this judgment is a complete victory for tax planning over a more robust approach may not be entirely accurate. As we discuss below, much of the Court’s reasoning, particularly in the judgment of the Chief Justice, is premised on a factual finding that the Vodafone-Hutch deal did not lack commercial substance or business purpose, and its analysis of the legal principles suggests that a finding for the assessee is not a foregone conclusion in “similar” cases.     
It is easiest to analyse the two judgments by identifying seven issues of law that emerge from it. This post deals with the two of these issues. The seven issues are: (i) the law on lifting the corporate veil; (ii) the law on tax avoidance; (iii) the meaning of “extinguishment” under section 2(14) of the Income Tax Act, 1961 [“ITA 1961”]; (iv) section 9 of the ITA 1961; (v) section 195 of the ITA 1961; (vi) controlling interest and the situs of shares; and (vii) important factual points in the Vodafone case that illustrate the application of some of these principles. In addition, there are the observations of K.S. Radhakrishnan J. on VB Rangaraj v VB Gopalakrishnan.
Before we turn to these issues, it should be noted that two crucial findings on fact are at the heart of the conclusion of the Chief Justice and K.S. Radhakrishnan J. that the IT Department lacked jurisdiction – first, the rejection of the Revenue’s argument that CGP was “fished out” at the last minute from the HTIL structure solely to avoid tax and secondly, the explanation given in respect of an application made by VIH to the FIPB. As far as CGP is concerned, the Revenue relied on a Due Diligence report submitted by Ernst & Young in which it was stated that the parties had originally envisaged transferring Array Holdings Ltd. [“Array”], a company incorporated in Mauritius, and later decided to instead transfer CGP. The Chief Justice (¶81) and K.S. Radhakrishnan J. (¶124) explain that this change was for an important commercial reason and not simply a device to avoid tax – Global Services Pvt Ltd. [“GSPL”], one of the entities which held call options in respect of HEL shares held by companies controlled by Mr Asim Ghosh and Mr Analjit Singh, was a wholly owned subsidiary of Hutchison Teleservices Holdings Ltd. [“HTIHL”], which was in turn a wholly owned subsidiary of CGP, but not a wholly owned subsidiary of Array. Therefore, as both judgments note, transferring CGP instead of Array had distinct commercial advantages.  As for FIPB, the Revenue relied on a letter dated 19.03.2007 addressed by it to VIH asking why VIH proposed to pay $11.08 billion for acquiring approximately 67 % of the equity of HEL when in fact its equity acquisition was only 51.96 %. To this VIH replied that the $11.08 billion was paid not only for the 51.96 % equity but also for control premium, the entitlement to acquire an indirect 15 % interest (through the GSPL call options) and stated that it in sum represented payment for 67 % of the economic value of HEL. The Chief Justice rightly notes that some of these differences arose out of the different accounting standards prevalent in the USA and India, and that in any event, “valuation cannot be the basis of taxation” (¶85).
There are many other important questions of fact which illustrate the scope of the legal principles set out by the Court, and we will discuss some of these in Part II of this post. It is worth bearing in mind, however, that the assessee appears to have prevailed largely because it was able to persuade the Court that there was commercial substance and business purpose, and not on the ground that business purpose is irrelevant. That is especially apparent from ¶68 of the judgment of the Chief Justice, which we will discuss in Part II of this post in the context of the corporate veil.
1.      Approach to Tax Avoidance
The correct approach to cases involving tax avoidance has historically been a contentious issue. In India, this has come to consist of two distinct questions: first, whether the approach of the Court in Azadi Bachao Andolan is contrary to the Constitution Bench’s judgment in McDowell’s case; and secondly, independent of this question, the proper approach to tax avoidance. On the first question, doubts had arisen because of the exiguous observation in paragraph 46 of the majority judgment in McDowell endorsing “on this aspect” the concurring judgment of Chinnappa Reddy J., in which the ghost of the Duke of Westminster had been duly exorcised.
While the Chief Justice and K.S. Radhakrishnan J. reach the same conclusion that Azadi Bachao remains good law, there are some differences in the reasoning. The Chief Justice holds (46) that the words “this aspect” indicate that the majority’s agreement with Reddy J. was confined to the use of “tax evasion through the use of colourable devices”. The final sentence in that paragraph reiterates that “in cases of treaty shopping and/or tax avoidance” there is no conflict at all. While it may be suggested that this means that the Chief Justice has equated treaty shopping and tax avoidance with “colourable devices”, it is submitted that the better view is that the Chief Justice has distinguished between tax avoidance/treaty shopping on the one hand and the use of “colourable devices” on the other, especially since the expression tax evasion has been used with reference to the former in the same paragraph. K.S. Radhakrishnan J. has gone considerably further, and has clearly stated that: (i) the judgment of Ranganath Misra J. constitutes the ratio of McDowell; and (ii) Reddy J.’s remark that the Duke of Westminster is not good law is incorrect even as a matter of English law.  
Having clarified that it was therefore unnecessary to overrule Azadi or refer McDowell to a larger Bench, the Court considered the question of tax avoidance independently. This involved an analysis of the English case law, which has had considerable influence on this subject in India (as elsewhere). In English law, despite many caustic remarks about the Duke of Westminster’s case (perhaps none better than Templeman L.J.’s famous description of it in the Court of Appeal in Ramsay), the recent cases suggest that Ramsay and perhaps even Furniss v Dawson is not an overarching principle of construction, but simply a result of the usual process of interpreting legislation. The Chief Justice accepts this. K.S. Radhakrishnan J. examines it in more detail and interestingly appears to suggest that the distinction between Ramsay and IRC v Plummer lies in the fact that Ramsay was a “readymade” scheme (see ¶ 78). While this is not implausible, the force of the suggestion is diminished by the fact that Plummer was a readymade scheme too, as the judgment of Walton J. at first instance suggests, and also by a subsequent decision of the House of Lords (Moodie v IRC 65 TC 610), in which Lord Templeman expressed the view that Plummer would have been decided differently had “the Ramsay principle” been applied.    
One more point must be made about K.S. Radhakrishnan J.’s approach to this issue. His judgment appears to endorse (¶ 87) Lord Hoffmann’s celebrated analysis of the law on tax avoidance in his speech in MacNiven v Westmoreland Investments, in which it was suggested that the apparent difficulty in reconciling the cases on tax avoidance was a failure to appreciate that the legislature sometimes defines a term in a “legal” sense and sometimes in a “commercial” sense. That formulation has subsequently been criticised, and the UK Supreme Court has virtually rejected it in a recent case– Tower MCashback v Revenue and Customs Commissioners (not cited in Vodafone). It is submitted, however, that Lord Hoffmann’s approach is in fact a most useful way of analysing this issue, and some of the criticism is perhaps a result of the belief that Lord Hoffmann intended a formulaic classification of definitions as “legal” or “commercial”. While it is not possible to develop this point in more detail here, it suffices to state that what Lord Hoffmann really appears to have intended is a test to distinguish cases in which legislative intent is consistent with a degree of artificiality (for instance Lord Hoffmann’s own example of conveyancing) from those in which it is not. It is therefore submitted that K.S. Radhakrishnan J.’s remarks on this test are to be welcomed, notwithstanding, with respect, the comments of Lord Walker in Tower MCashback.
2.      Controlling Interest and Situs of Shares
The judgment of the Bombay High Court had accepted that in principle “controlling interest” is not an independent capital asset, although it had eventually found that there was “something other than” the transfer of a single share of CGP. On this issue, the Chief Justice’s judgment is especially interesting. It begins by observing that controlling interest is a “mixed question of fact and law” (¶83), and rejects the Revenue’s case not only on the ground that controlling interest is not a distinct capital asset, but also on the ground that Vodafone did not acquire 67 % controlling interest. The Chief Justice reaches the latter conclusion by holding that GSPL’s right under the Call Options with the Asim Ghosh and Analjit Singh companies is “at the highest” analogous to a “potential share” because “till exercised it cannot provide right to vote or management or control”. Similarly, the practice before the SPA was that HTIL would appoint six directors, Essar (which held 33 %) would appoint four, and TII (which indirectly held 19.54 % in HEL) would appoint two directors, who “in practice” were Mr Ghosh and Mr Singh. In a “Term Sheet” Agreement entered into between VIH and Essar on 15.03.2007, it was agreed that this “practice” would continue (ie VIH would appoint 8, and Essar 4). The Chief Justice holds that an agreement to “continue  the “practice” concerning nomination of directors on the Board of Directors of HEL which in law is different from a right or power to control and manage…” did not give VIH “controlling interest”. In ¶88, the Chief Justice holds that in any event a sale of shares cannot “as a general rule” be “broken up into separate individual components” and that such components are not distinct capital assets (approving in this respect the well-known judgments in Maharani Ushadevi and Venkatesh (Minorv CIT). It is submitted that this conclusion is entirely correct – as a matter of law, if it were possible in every circumstance to vivisect the sale of the whole into the sale of its component parts, it would have been entirely unnecessary for Parliament to expressly provide that the sale of the whole is taxable if certain conditions are satisfied.
In subsequent posts, we will consider the other important issues set out above.

Friday, January 20, 2012

Vodafone: Key Points

The Supreme Court’s judgment today in Vodafone is of enormous importance to a number of branches of Indian law. The majority judgment has been delivered by the Chief Justice and Swatanter Kumar J. A concurring judgment delivered by K.S. Radhakrishnan J. in some respects goes even further. A copy of the judgment is available on the Supreme Court’s website. A detailed analysis of the judgment will follow. This post reproduces key extracts from the two judgments with brief comments, on some of the issues before the Court.
1.      Azadi Bachao Andolan and McDowell
Both judgments hold that Azadi Bachao Andolan is good law. The Chief Justice holds that there is no conflict between Azadi and McDowell because the observations of Reddy J. are confined to cases in which a colourable device is used. Radhakrishnan J. appears to have gone even further and has expressly said that the “ghost” of the Duke of Westminster has not been exorcised. We will analyse this in detail in the coming days.
[para 64] The  words  “this  aspect” [ed: referring to the majority’s observation that they “on this aspect” agree with Reddy J.’s judgment] express  the  majority’s  agreement  with  the  judgment  of Reddy, J. only in relation to tax evasion through the use of colourable devices and by resorting to dubious methods and subterfuges. Thus, it cannot be said that all tax planning is illegal/illegitimate/impermissible.  Moreover,  Reddy,  J. himself  says  that  he  agrees  with  the  majority.  In  the judgment  of  Reddy,  J.  there  are  repeated  references  to schemes  and  devices  in  contradistinction  to  “legitimate avoidance  of  tax  liability”  (paras  7-10,  17  &  18).    In  our view,  although  Chinnappa  Reddy,  J.  makes  a  number  of observations  regarding  the  need  to  depart  from  the “Westminster” and tax avoidance – these are clearly only in the  context  of  artificial  and  colourable  devices.  Reading McDowell, in the manner indicated hereinabove, in cases of treaty  shopping  and/or  tax  avoidance,  there  is  no  conflict between  McDowell  and    Azadi  Bachao  or    between  McDowell and Mathuram Agrawal.
[paras 110, 112] Justice Reddy has, the above quoted portion shows, entirely agreed  with  Justice  Mishra  and  has  stated  that  he  is  only supplementing  what  Justice  Mishra  has  spoken  on  tax avoidance. Justice Reddy has also opined that the ghost of Westminster (in the words  of  Lord  Roskill)  has  been  exorcised  in  England.    In our  view,  what  transpired  in  England  is  not  the  ratio  of McDowell and cannot be and remains merely an opinion or view. 112.   Justice Reddy, we have already indicated, himself has stated  that  he  is  entirely  agreeing  with  Justice  Mishra  and has  only  supplemented  what  Justice  Mishra  has  stated  on Tax  Avoidance,  therefore,  we  have  go  by  what  Justice Mishra has spoken on tax avoidance
2.      Corporate Veil
Both the Chief Justice and Radhakrishnan J. hold that the existence of a holding-subsidiary relationship is no reason to suppose that the two entities are not separate in law. The Chief Justice sets out circumstances in which the Revenue may appeal to India’s “judicial anti-avoidance rule”. Justice Radhakrishnan cites with approval Adams v Cape Industries.
[paras 67, 68] However,  the  fact  that  a  parent  company  exercises shareholder’s  influence  on  its  subsidiaries  does  not generally  imply  that  the  subsidiaries  are  to  be  deemed residents of the State in which the parent company resides
In the application of  a  judicial  anti-avoidance  rule,  the  Revenue  may  invoke the  “substance  over  form”  principle  or  “piercing  the corporate  veil”  test  only  after  it  is  able  to  establish  on  the basis  of  the  facts  and  circumstances  surrounding  the transaction that the impugned transaction is a sham or tax avoidant…the  concept  of  participation  in  investment,  the  duration  of time  during  which  the  Holding  Structure  exists;  the  period of  business  operations  in  India;  the  generation  of  taxable revenues  in  India;  the  timing  of  the  exit;  the  continuity  of business  on  such  exit.    In  short,  the  onus  will  be  on  the Revenue  to  identify  the  scheme  and  its  dominant  purpose. The corporate business purpose of a transaction is evidence of the fact that the impugned transaction is not undertaken as a colourable or  artificial  device.    The  stronger  the evidence  of  a  device,  the  stronger  the  corporate  business purpose must exist to overcome the evidence of a device

[paras 58, 61] Legal relationship between a holding company and WOS is  that  they  are  two  distinct  legal  persons  and  the  holding company  does  not  own  the  assets  of  the  subsidiary  and,  in law,  the  management  of  the  business  of  the  subsidiary  also vests in its Board of Directors
3.      Shareholders’ Agreements and Rangaraj
Justice Radhakrishnan has expressed the view that Rangaraj v Gopalakrishnan, which we have discussed on several occasions, may have been wrongly decided because shareholders have the freedom to contract unless there are specific restrictions in legislation.

[paras 63, 64]  The  nature  of  SHA  was  considered  by  a  two  Judges Bench  of  this  Court  in  V.  B.  Rangaraj  v.  V.  B. Gopalakrishnan and Ors. (1992)  1  SCC  160 …    This  Court  has  taken  the  view  that provisions  of  the  Shareholders’  Agreement  imposing restrictions  even  when  consistent  with  Company  legislation, are  to  be  authorized  only  when  they  are  incorporated  in  the Articles  of  Association,  a  view  we  do  not  subscribe
64.  Shareholders  can  enter  into  any  agreement  in  the  best interest  of  the  company,  but  the  only  thing  is  that  the provisions in the SHA shall not go contrary to the Articles of Association.    The  essential  purpose  of  the  SHA  is  to  make provisions  for  proper  and  effective  internal  management  of the  company
4.      Controlling Interest and Extinguishment
Both the Chief Justice and Justice KS Radhakrishnan have held (on this aspect affirming the legal conclusion of the Bombay High Court in the impugned judgment) that “controlling interest” is not a distinct capital asset.
[para 88]  As  a  general  rule,  in  a  case  where  a transaction  involves  transfer  of  shares  lock,  stock  and barrel,  such  a  transaction  cannot  be  broken  up  into separate  individual  components,  assets  or  rights  such  as right  to  vote,  right  to  participate  in  company  meetings, management  rights,  controlling  rights,  control  premium, brand  licences  and  so  on  as  shares  constitute  a  bundle  of rights
[para 144] Further, the High Court failed to note  on  transfer  of  CGP  share,  there  was  only  transfer  of certain  off-shore  loan  transactions  which  is  unconnected with underlying controlling interest in the Indian Operating Companies. The  other  rights,  interests  and  entitlements continue  to  remain  with  Indian  Operating  Companies  and there is nothing to show they stood transferred in law
5.      Section 9
[para 71] Hence, it is not necessary that  income  falling  in  one  category  under  any  one  of  the sub-clauses  [ed: of section 9] should  also  satisfy  the  requirements  of  the other sub-clauses to bring it within the expression “income deemed to accrue or arise in India” in Section 9(1)(i)… The  said  sub-clause  consists  of three  elements,  namely,  transfer,  existence  of  a  capital asset,  and  situation  of  such  asset  in  India.  All three elements should exist in order to make the last sub-clause applicable [emphasis added].
[paras 171-174] Section  9, therefore,  covers  only  income  arising  from  a  transfer  of  a capital  asset  situated  in  India  and  it  does  not  purport  to cover  income  arising  from  the  indirect  transfer  of  capital asset in India. Section 9 has no “look through provision” and such a provision cannot be brought through construction or interpretation of a word ‘through’ in Section 9.  In any view, “look  through  provision”  will  not  shift  the  situs  of  an  asset from  one  country  to  another.    Shifting of situs can be done only by express legislation
6.      Situs of the CGP Share
Although both the Chief Justice and Justice K.S. Radhakrishnan hold that the situs of the CGP share is the place of incorporation/register of shares, they appear to have adopted different approaches: the Chief Justice applies the Indian Companies Act, while Justice KS Radhakrishnan applies the well-known conflict of laws rules on situs of shares. This will be discussed in more detail in a subsequent post.
[para 82] Be  that  as  it  may,  under  the  Indian Companies  Act,  1956,  the  situs  of  the  shares  would  be where  the  company  is  incorporated  and  where  its  shares can  be  transferred.    In  the  present  case,  it  has  been asserted  by  VIH  that  the  transfer  of  the  CGP  share  was recorded  in  the  Cayman  Islands,  where  the  register  of members  of  the  CGP  is  maintained.
[para 127] Situs of shares situates at the  place  where  the  company  is  incorporated  and/  or  the place  where  the  share  can  be  dealt  with  by  way  of  transfer.  CGP  share  is  registered  in  Cayman  Island  and  materials placed  before  us  would  indicate  that  Cayman  Island  law, unlike  other  laws  does  not  recognise  the  multiplicity  of registers

Vodafone's appeal allowed

It has been reported that Vodafone’s appeal has been allowed, the Supreme Court inter alia rejecting the Revenue’s “extinguishment” argument and holding that section 9 is not a “look-through” provision.
We will have an opportunity to discuss this judgment in detail over the coming days once a copy is available.

Second Week of Arguments: Constitution Bench on Bhatia International

Arguments continued this week before the Constitution Bench comprising the Chief Justice, and Justices Jain, Nijjar, Khehar and Desai. As we noted, counsel for the appellants in the first week concentrated principally on whether the courts of the seat of arbitration have exclusive jurisdiction to test the validity of an arbitral award even when the proper law of the contract is the law of another country.
This week, Mr Gopal Subramanium developed the submissions he had outlined last week. It is easiest to describe counsel’s contentions by dividing his case into two parts: a negative case, which sought to establish that the “seat of arbitration” is not the basis on which the jurisdiction of the courts has been defined under the Indian Arbitration Act; and a “positive” case, which consisted of certain propositions on the correct approach to jurisdiction under the Indian Act, drawing from the principle of party autonomy, the significance of choice of law, English law and from the travaux préparatoires to the UNCITRAL Model Law on International Commercial Arbitration. In his negative case, counsel submitted that the primacy accorded to the “seat of arbitration” in England is in fact judge-made law; that the drafters of the Model Law in 1985 were fully aware of the contesting views, and yet defined “international commercial arbitration” in article 1(3) not only with reference to the seat of arbitration but also the places of business of the parties;  and that the Indian legislature went even further because it omitted all references to the seat in section 2(1)(f) of the 1996 Act. Counsel further submitted that it is possible that parties to an arbitration with a foreign seat expressly designate the 1996 Act as applicable, in which event the 1996 Act must ex hypothesi apply even though the seat of arbitration is outside India. Counsel also relied extensively on the judgment of the UK Supreme Court (particularly Lords Mance and Collins) in Dallah Real Estate v Government of Pakistan, which we have discussed here, to suggest that a court must always have jurisdiction to examine matters which are “fundamental” to an arbitration, such as arbitrability of the dispute, whether there was a valid arbitration agreement etc. Counsel then relied on section 48(1)(e) of the Act, which corresponds to art. 5(2)(e) of the New York Convention, to suggest that Parliament clearly contemplates that not only the court of the seat of the arbitration (captured by the words “country in which the award was made”) but also the court of the country whose law governs the arbitration agreement has jurisdiction to set aside the award.
Counsel then argued that the test of jurisdiction under the 1996 Act is therefore not seat, but “subject matter”, for section 2(1)(f) defines an “international commercial arbitration” without reference to its seat, and section 2(1)(e) the jurisdiction of a “court” by reference to the subject matter of the arbitration.  Counsel reiterated that section 2(2) only indicates when the Indian court has jurisdiction, and not when it does not, and submitted as a consequence that a Convention award under Part II may be enforced either under Part II or under Part I because the provisions of Part II are “additional” to those in Part I. As an example, counsel pointed out that although sections 8 and 45 deal with similar issues, the right of the defendant to have the parties referred to arbitration is lost under section 8 if he takes the objection after the written statement is filed, but is never lost under section 45. There are of course other differences. The Chief Justice put to counsel that this results in duplication and that it may not have been necessary for Parliament to enact Parts I and II separately, to which counsel said that these provisions are additional for those awards that fall within Part II. Counsel therefore submitted that it is open to an Indian court to exercise the power to appoint an arbitrator under section 11 in respect of a Convention arbitration agreement. Justices Nijjar and Khehar put to counsel the possibility that this is wholly unnecessary since the court under section 45 also has the power to appoint an arbitrator, to which counsel said that this would have the effect of rendering section 11 otiose, for such a power must ipso facto also exist under section 8 as well.
On Thursday, Dr Abhishek Singhvi briefly outlined his submissions, which will be developed next week. In contrast to the submissions of counsel before him, he stated that his case is confined to section 9, and argued that the court is entitled to take an independent view of section 9 – that is, it is possible that section 9 may be invoked in respect of a foreign arbitration even if section 34 or any other provision of Part I cannot be. He started by suggesting that a party may be left entirely remediless if a section 9 power is not available, and gave the example of an arbitration with its seat in Brussels involving a party whose major asset is a castle in the State of Rajasthan. Counsel submitted that the claimant in the Brussels arbitration has only three remedies: (i) obtaining interim relief from a court in Brussels (under its arbitration legislation); (ii) obtaining interim relief from the Tribunal and (iii) obtaining interim relief in respect of property situated elsewhere (for example in America). Counsel submitted that as far as the castle in Rajasthan is concerned, none of these remedies is “worth the paper” it is written on. The Bench put to counsel the possibility that a party may not be entirely remediless, for a civil suit may be maintainable, to which counsel said that it may not be correct to hold that a suit is maintainable despite the existence of an arbitration agreement. In short, counsel’s submission was that “the core of Bhatia” is correct, and the fact that it has engendered other decisions on other sections of Part I should not lead one to conclude that Bhatia is itself incorrect as far as section 9 is concerned.
Arguments continue on Tuesday.

Thursday, January 19, 2012

Regulating the Pay of Bankers in the Private Sector

Last week, the Reserve Bank of India (RBI) issued compensation guidelines for implementation by private sector and foreign banks that become operational from the financial year 2012-2013. This approach is consistent with the trend that corporate governance norms in the banking sector tend to be more controlled than in other industry sectors. Apart from the fact that the pay of CEOs and wholetime directors requires the prior regulatory approval, the compensation guidelines set out detailed principles to be deployed in order for these banks to determine senior bankers’ pay.

The guidelines place emphasis on board’s oversight regarding compensation design and operation. For example, banks must constitute a remuneration committee consisting of independent directors that frames, reviews and implements the compensation policy. The guidelines also stipulate operational matters in sufficient detail, including the distribution between fixed component and variable component of the compensation. It encourages deferral arrangements in compensations so as to eliminate short-termism in the senior management’s approach. Other mechanisms, which received significant attention following the onset of the financial crisis, such as clawback arrangements are also required to be implemented. Reliance is also placed on greater disclosure of compensation arrangements, both at a quantitative level as well as qualitative level. While the guidelines stop short of imposing quantitative limits on pay, they set out stringent requirements that banks will have to comply with starting the next financial year.

On a related note, the Economist has a different take on the politics and economics of executive compensation generally, and bankers more specifically.

Saturday, January 14, 2012

QFI Route Operational

Following the decision of the Government of India to permit qualified foreign investors (QFIs) to invest in the Indian stock markets, SEBI and RBI yesterday issued detailed guidelines (here and here) to operationalise the investment mechanism.
SEBI has introduced a number of checks and balances to prevent misuse of this route. For example, significant KYC obligations have been imposed on the depository participants. Moreover, the QFIs are required to provide details regarding their beneficial ownership to prevent anonymity in trading. In the context of foreign institutional investors (FIIs), SEBI has in the past sought to ascertain details of beneficial ownership of shares, but not always with success. It remains to be seen whether SEBI will be faced with a similar situation with respect to QFIs. Further, QFIs cannot issue offshore derivative instruments such as participatory notes. All these are intended to ensure close scrutiny of investments such that significant inflows or outflows do not cause undue volatility in the Indian stock markets thereby affecting investors in general.

Friday, January 13, 2012

Constitution Bench on Bhatia International: First Week of Arguments

A Constitution Bench comprising the Chief Justice and Justices Jain, Nijjar, Khehar and Desai heard arguments this week in Bharat Aluminium v Kaiser Aluminium Technical Services, in which the principal issue is whether Part I of the Arbitration and Conciliation Act, 1996 applies to arbitrations where the seat of arbitration is outside India. As is well known, and as we have discussed on several occasions, a three-judge Bench of the Court answered this question in the affirmative in Bhatia International in the context of section 9 (interim measures), and subsequent decisions have applied other provisions of Part I (section 11, section 34 etc.) to such arbitrations.  Also before the Court are important questions of the conflict of laws arising from these decisions, principally the juridical significance of the “seat of arbitration” and whether questions of validity of an award are governed by the lex arbitri or the law governing the contract (“the proper law”).
Before giving an account of the first week of arguments in the Supreme Court, it is perhaps useful to describe the manner in which these issues are before the Constitution Bench. This batch of appeals arises from a number of judgments of High Courts across the country, some of which have held that an application under section 34 is not maintainable to challenge a foreign arbitral award in cases in which the parties have provided that the lex arbitri is English (or other foreign) law, even though the proper law is Indian law. Other High Courts have considered whether a petition under section 9 is maintainable, and there are therefore two issues before the Court: (i) the scope of section 2(2) of the 1996 Act and whether Bhatia International was correctly decided; (ii) whether, if the designation of a foreign lex arbitri has the effect of excluding Part I, there is any distinction between provisions that apply during the conduct of arbitral proceedings (such as section 9) and those which apply after the award is made (such as section 34), particularly when Indian law is the proper law.
Although Mr Sundaram, senior counsel for the appellants, opened the appeal by submitting that Bhatia International was correctly decided in its entirety, the thrust of his submissions was that even if the designation of a foreign lex arbitri makes section 9 inapplicable on the ground that the parties themselves have contracted out of it, the right to challenge an award is governed not by the lex arbitri but by the proper law. If this submission is accepted by the Constitution Bench, it would mean that it is open to a party to invoke the jurisdiction of the Indian court under section 34 to challenge a foreign award made pursuant to a contract governed by Indian law, even though it is not open to him to invoke the jurisdiction of the court under section 9 or section 11 during the conduct of arbitral proceedings. Developing this submission, counsel pointed out that denying a section 34 challenge to a judgment debtor in a foreign award could make him “remediless” if the judgment creditor chooses not to enforce the award in India (for section 48 is a shield, not a sword), which may be especially anomalous if the foreign award in question is contrary to Indian public policy, but not contrary to the public policy of the country in which the judgment creditor seeks enforcement. Counsel relied for this submission inter alia on certain observations made by Bharucha J. in Sumitomo Heavy Industries v ONGC, on the expression “under the law of which” in section 48(1)(e), and argued therefore that the recent judgment of the Court in Videocon Industries, on which we have commented here, is wrongly decided.
The Chief Justice put to counsel the possibility that the judgment debtor in the hypothetical described above can challenge the foreign award in the country of the seat: for example, if an award is made pursuant to a contract governed by Indian law but which designates London as the seat of arbitration or English law as the lex arbitri, the judgment debtor can challenge the award under the equivalent of section 34 in the foreign jurisdiction, although he cannot challenge it in India or set up Indian public policy as a ground unless the judgment creditor chooses to enforce it in India (and even if he does, the award is merely not “enforced”, not “set aside”). To this counsel’s answer was inter alia that section 69 of the English Arbitration Act, 1996 does not permit an appeal on a question of law in a contract governed by foreign law (since section 82(1)(a) defines a question of law as a “a question of the law of England and Wales”) and that in any event that it may not be possible to set up Indian public policy in the court of the seat.
Mr Sorabjee, also for the appellants, developed these points by concentrating on the applicable principles of conflict of laws and relied heavily on the judgment of Bharucha J. in Sumitomo for the proposition that while interim measures may be governed by the lex arbitri, the right to challenge an award is governed by the proper law. The Bench put to counsel questions relating to the difference between the tests applicable under section 2(1)(f) and section 2(7), and also about how the extent to which Parliament intended to depart from the New York Convention/Geneva Protocol, and the UNCITRAL Model Law on International Commercial Arbitration. On the third day, Mr Gopal Subramanium submitted that it is wrong to start with the assumption that any interference by a court in the arbitral process is “antithetical” to arbitration because arbitration, to be effective, requires the assistance of the national court. Counsel also emphasised that Parliament, in defining “international commercial arbitration” in section 2(1)(f) based on article 1(3) of the Model Law, chose not to use the “seat of arbitration” (which features in article 1(3)), and suggested therefore that the “seat” may not be decisive in determining whether section 34 applies to a foreign award. Counsel will continue his arguments on Tuesday.
The Constitution Bench’s judgment is likely to be the last word on what has proven to be a hotly contested issue in Indian arbitration law and is also likely to clarify certain unresolved questions on the conflict of laws rules applicable to arbitration in India. Arguments continue next week.