By Sumeet Khurana
Brief background
The case of Vodafone involved capital gains tax implication on transfer of shares of a Cayman Island entity CGP Investments (CGP) by another Cayman Island entity Hutchison Telecommunications International Limited (HTIL) to a Netherlands resident entity Vodafone International Holdings (VIH). HTIL had direct and indirect control to the extent of 52% of an Indian entity Hutchison Essar Limited (HEL). That apart, HTIL also had managerial and controlling rights along with a further 15% equity interest in HEL by virtue of certain agreements it had with other shareholders of HEL. The Indian Revenue Authorities had initiated action upon the transfer of shares by HTIL in CGP alleging capital gains taxable in India on the premise that transfer of CGP resulted in transfer of a capital asset situated in India, being the shares / controlling interest in HEL.
Tax demand was raised on VIH on the ground that it was liable to deduct tax at source or alternatively it is the representative assessee of HTIL for its tax liability. Rejecting the contentions of the Revenue Authorities, the Supreme Court has made various observations which have arguably set the tone for discussion on a number of allied issues. One such observation of the Court was that contractual rights do not constitute a capital asset. This article dwells upon this key characterization of capital asset.
The facts and findings in Vodafone’s case
In the facts of the case, the seller i.e. HTIL also had some managerial and controlling rights in the form of (i) right to direct a downstream subsidiary as to the manner in which it should vote (ii) call options to buy further shares (iii) Tag Along rights (iv) right to nominate directors etc. which were also transferred to VIH. The issue arose as to whether these constitute a property right and hence a capital asset. In this regard, the majority order of Hon’ble Chief Justice and Hon’ble Justice Swatanter Kumar observes “In this case, we are concerned with the expression ‘capital asset’ in the income tax law”......“did HTIL possess a legal right to appoint directors onto the board of HEL and as such had some “property right” in HEL?.....“A legal right is an enforceable right i.e. enforceable by a legal process.”.......“...enforceability is an important aspect of a legal right.”.....“Applying these tests, on the facts of this case and that too in the light of the ownership structure of Hutchison, we hold that HTIL, as a group holding company, had no legal right to direct its downstream companies in the matter of voting, nomination of directors and management rights.” Hon’ble Justice S. Radhakrishnan in his separate judgment has more explicitly stated that these are contractual rights and do not sound in ‘property’, hence cannot be, in the absence of a statutory stipulation, considered as capital assets.
These observations have the potential of leading to a conclusion that no contractual right can be a capital asset; a result of this would be that income from transfer of such rights could be capital receipt not chargeable to tax. However the key question is whether such a wide proposition, potentially limiting the scope of capital gains tax, really flows from the decision in Vodafone case.
The legal position prior to Vodafone’s decision
The expression ‘capital asset’ has been defined under Section 2(14) of Income Tax Act, 1961 to mean ‘property of any kind’ held by assessee subject to certain exclusions. The expression ‘property’, as appearing in the erstwhile Article 19(1)(f) of the Constitution was considered by a Seven Judge Constitutional Bench of Supreme Court in Commissioner, Hindu Religious Endowments, Madras v. Sri. Lakshmindra Thirtha Swamiar of Sri. Shirur Mutt. [(1954) SCR 1005]. It held therein that there is no reason as to why the word ’property’ as used in that article should not be given a liberal and wide connotation and should not be extended to those well recognised types of interest which have the insignia or characteristics of proprietary right.
This decision was subsequently followed in Ahmed G. H. Ariff [76 ITR 471] wherein a three Judge Bench of Supreme Court held in the context of wealth tax that ‘property’ is a term of widest import and subject to any limitations that the context may require, it signifies every possible interest which a person can clearly hold or enjoy. On similar lines a three Judge Bench of the Supreme Court in A. Gasper [192 ITR 382] held that tenancy rights constituted capital asset. Subsequently in Ganapathi Raju Jogi [200 ITR 612] Supreme Court held route permits as also being capital assets.
In various rulings the High Courts have consistently held contractual rights as being capital assets. For illustration, the following have been held to be capital assets by the respective High Courts:
Conclusion
The earlier rulings wherein a ‘capital asset’ was understood in a wider sense did not have an occasion to deliberate specifically on the issue of whether ‘contractual rights’ can be capital asset, whereas the decision in Vodafone has examined this aspect in detail. Thus the decision in Vodafone can be considered as the new law and the principles enunciated therein be applied henceforth, displacing the hitherto understood meaning. A rider to this unqualified enunciation of law is that it must not be held subsequently that the observations of the Court are only in the nature of obiter made by the Court as a passing observation and thus not the ratio decidendi of the Vodafone decision. In such event the observations in Vodafone on such count will lose their binding sheen. Further, given the facts in this decision, it may also be argued that Vodafone is confined to declaring that only where the rights are conferred and governed by a specific statute (here Companies Act, 1956) a modification of such rights through contracts may not result in genesis of a capital asset. However a definitive certainty which prevailed on this issue has certainly been stirred and the ripples of the decision in Vodafone will be felt in subsequent decisions.
[The author is Joint Partner, Direct Tax Team, Lakshmikumaran & Sridharan, New Delhi]
Brief background
The case of Vodafone involved capital gains tax implication on transfer of shares of a Cayman Island entity CGP Investments (CGP) by another Cayman Island entity Hutchison Telecommunications International Limited (HTIL) to a Netherlands resident entity Vodafone International Holdings (VIH). HTIL had direct and indirect control to the extent of 52% of an Indian entity Hutchison Essar Limited (HEL). That apart, HTIL also had managerial and controlling rights along with a further 15% equity interest in HEL by virtue of certain agreements it had with other shareholders of HEL. The Indian Revenue Authorities had initiated action upon the transfer of shares by HTIL in CGP alleging capital gains taxable in India on the premise that transfer of CGP resulted in transfer of a capital asset situated in India, being the shares / controlling interest in HEL.
Tax demand was raised on VIH on the ground that it was liable to deduct tax at source or alternatively it is the representative assessee of HTIL for its tax liability. Rejecting the contentions of the Revenue Authorities, the Supreme Court has made various observations which have arguably set the tone for discussion on a number of allied issues. One such observation of the Court was that contractual rights do not constitute a capital asset. This article dwells upon this key characterization of capital asset.
The facts and findings in Vodafone’s case
In the facts of the case, the seller i.e. HTIL also had some managerial and controlling rights in the form of (i) right to direct a downstream subsidiary as to the manner in which it should vote (ii) call options to buy further shares (iii) Tag Along rights (iv) right to nominate directors etc. which were also transferred to VIH. The issue arose as to whether these constitute a property right and hence a capital asset. In this regard, the majority order of Hon’ble Chief Justice and Hon’ble Justice Swatanter Kumar observes “In this case, we are concerned with the expression ‘capital asset’ in the income tax law”......“did HTIL possess a legal right to appoint directors onto the board of HEL and as such had some “property right” in HEL?.....“A legal right is an enforceable right i.e. enforceable by a legal process.”.......“...enforceability is an important aspect of a legal right.”.....“Applying these tests, on the facts of this case and that too in the light of the ownership structure of Hutchison, we hold that HTIL, as a group holding company, had no legal right to direct its downstream companies in the matter of voting, nomination of directors and management rights.” Hon’ble Justice S. Radhakrishnan in his separate judgment has more explicitly stated that these are contractual rights and do not sound in ‘property’, hence cannot be, in the absence of a statutory stipulation, considered as capital assets.
These observations have the potential of leading to a conclusion that no contractual right can be a capital asset; a result of this would be that income from transfer of such rights could be capital receipt not chargeable to tax. However the key question is whether such a wide proposition, potentially limiting the scope of capital gains tax, really flows from the decision in Vodafone case.
The legal position prior to Vodafone’s decision
The expression ‘capital asset’ has been defined under Section 2(14) of Income Tax Act, 1961 to mean ‘property of any kind’ held by assessee subject to certain exclusions. The expression ‘property’, as appearing in the erstwhile Article 19(1)(f) of the Constitution was considered by a Seven Judge Constitutional Bench of Supreme Court in Commissioner, Hindu Religious Endowments, Madras v. Sri. Lakshmindra Thirtha Swamiar of Sri. Shirur Mutt. [(1954) SCR 1005]. It held therein that there is no reason as to why the word ’property’ as used in that article should not be given a liberal and wide connotation and should not be extended to those well recognised types of interest which have the insignia or characteristics of proprietary right.
This decision was subsequently followed in Ahmed G. H. Ariff [76 ITR 471] wherein a three Judge Bench of Supreme Court held in the context of wealth tax that ‘property’ is a term of widest import and subject to any limitations that the context may require, it signifies every possible interest which a person can clearly hold or enjoy. On similar lines a three Judge Bench of the Supreme Court in A. Gasper [192 ITR 382] held that tenancy rights constituted capital asset. Subsequently in Ganapathi Raju Jogi [200 ITR 612] Supreme Court held route permits as also being capital assets.
In various rulings the High Courts have consistently held contractual rights as being capital assets. For illustration, the following have been held to be capital assets by the respective High Courts:
- Leasehold right – Andhra Pradesh High Court in Rajendra Mining Syndicate v. CIT - [1961] 43 ITR 460)
- Right to subscribe for shares in a company – Punjab & Haryana High Court in [1964] 52 ITR 399
- Contractual right to obtain title over immovable property – Bombay High Court in Sterling Investment - [1981] 123 ITR 44
- Leasehold right – Calcutta High Court in Pramia Engineering - [1992] 202 ITR 298
- Right to obtain sale deed – Bombay High Court in Tata Services Limited - [1979] 122 ITR 594.
Conclusion
The earlier rulings wherein a ‘capital asset’ was understood in a wider sense did not have an occasion to deliberate specifically on the issue of whether ‘contractual rights’ can be capital asset, whereas the decision in Vodafone has examined this aspect in detail. Thus the decision in Vodafone can be considered as the new law and the principles enunciated therein be applied henceforth, displacing the hitherto understood meaning. A rider to this unqualified enunciation of law is that it must not be held subsequently that the observations of the Court are only in the nature of obiter made by the Court as a passing observation and thus not the ratio decidendi of the Vodafone decision. In such event the observations in Vodafone on such count will lose their binding sheen. Further, given the facts in this decision, it may also be argued that Vodafone is confined to declaring that only where the rights are conferred and governed by a specific statute (here Companies Act, 1956) a modification of such rights through contracts may not result in genesis of a capital asset. However a definitive certainty which prevailed on this issue has certainly been stirred and the ripples of the decision in Vodafone will be felt in subsequent decisions.
[The author is Joint Partner, Direct Tax Team, Lakshmikumaran & Sridharan, New Delhi]