India Proposes New Tax on Foreign Mergers (WSJ)

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The Indian government proposed legislation Friday that would allow it to retroactively tax overseas mergers in which an underlying Indian asset is transferred, a move that would override the effect of a recent Supreme Court decision in favor of British telecommunications giant Vodafone Group PLC and is likely to sit very badly with foreign companies.

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A general view of the launch of Vodafone London Fashion Weekend at Somerset house on February 23, 2012 in London.

The government's proposal to amend its tax law retroactively to all relevant deals since 1962 is part of the finance bill that accompanies the annual budget, which Finance Minister Pranab Mukherjee unveiled on Friday. If the legislation is enacted – the budget will be debated beginning next week – it would deal a major blow to foreign investor sentiment in India, which was buoyed by the Court's earlier verdict, and create new uncertainty for companies seeking to trade Indian assets.

In January, the Supreme Court ruled that Vodafone did not have to pay taxes of over $2 billion on the deal it struck to enter India in 2007, when it acquired a controlling stake in an Indian cellphone company from Hong Kong's Hutchison Whampoa Ltd.

The deal was structured as a transaction between Vodafone's Dutch subsidiary and a Cayman Islands-based company that held Hutchison Whampoa's India assets. The Court agreed with Vodafone that the deal wasn't subject to capital gains tax—and Vodafone therefore had no obligation to withhold tax.

The Court based its decision on its interpretation of Indian tax law, leaving an opening for the Indian government to revise the law and achieve a different outcome.

The new proposed tax law amendment does just that. Besides potentially reopening Vodafone to liability, tax experts say, the move could embolden the government in its tax cases against companies including Genpact, AT&T Inc., and SABMiller Plc. Those cases are at various stages in the Indian courts and the companies' positions could be adversely impacted.

In a statement, Vodafone said: "We are examining this proposed decision with our lawyers, but we do not believe this retrospective change in tax law should have any impact on the final judgment handed down by the Supreme Court in our tax case. We continue to have faith in the Indian judicial system."

SABMiller declined to comment. A Genpact spokeswoman couldn't immediately comment.

India's finance secretary said the change could yield as much as $8 billion in tax revenue for the government, according to Dow Jones Newswires.

"They've overridden the Supreme Court's decision, and now they can go re-open every deal under the sun," said Mahesh Kumar, a lawyer at Nishith Desai Associates who is an expert on international mergers and acquisitions.

The move to collect more taxes comes as India is trying to narrow a fiscal deficit that's expected to touch 5.9% for the fiscal year ending March 31.

But Mr. Mukherjee didn't mention the major corporate tax change in his budget speech, even as he announced increases to a range of other taxes. He said the government will raise the service tax rate by two percentage points to 12%, increase import duties on items such as gold and bicycles, and increase excise duties on aircraft parts and health equipment.

The budget was widely panned by Indian industrialists as devoid of the reforms India needs to galvanize private investment and accelerate economic growth. The government has predicted that GDP growth will increase to 7.6% in the next fiscal year and 8.6% the following year, up from an estimated 6.9% in the year ending March 31.

But many analysts and economists say those projections are overly rosy, partly because they assume a big turnaround in business investment, which has contracted for the last two quarters.

The Congress party-led government of Prime Minister Manmohan Singh, which is suffering from infighting in its ruling coalition and the fallout of corruption scandals, will have difficulty pushing painful reforms, political analysts say, such as increases in fuel prices to offset the nation's rising oil import bill. Mr. Mukherjee promised to lower spending on fuel and fertilizer subsidies from about 3% of GDP now to 1.7% in a few years.

As for allowing foreign investment by multinational retailers such as Wal-Mart Stores Inc. – a reform the government has been struggling to enact but promising for years -- Mr. Mukherjee said, "efforts are on to arrive at a broad based consensus in consultation with the state governments." Several states' chief ministers have said they are opposed to liberalizing FDI in retail.

Mr. Kumar said the proposed law change on acquisitions wouldn't impact transactions in countries where India has a special tax treaty, such as Mauritius. He said he expected heavy lobbying by some Indian businesses against the tax change.

The amendment in the finance bill says a foreign entity – whether a registered company or shares in a company – would be deemed to be situated in India and therefore be taxable if it derives "its value substantially from the assets located in India." The legislation states that the amendment would be applicable from April 1, 1962 onward.

This is "very bad news for foreign investors," says Dinesh Kanabar, chairman of the tax practice at KPMG in India. "The question that we need to answer is are we respecting the judicial system or not. The Government may or may not agree with the Supreme Court but it needs to respect it."

Several tax lawyers and consultants said they expected the proposed legal change would be challenged in court. Previous court decisions have held that tax authorities cannot amend laws to collect a new income tax retroactively, they say. The Indian government is likely to argue that the change is merely a clarification of its longstanding powers.

"It is utter nonsense, in my view," said Mukesh Butani, chairman of consulting firm BMR Advisors. He said the move "doesn't augur well for foreign direct investment. It's hard to explain to an American or European lawyer that India can amend a law 50 years later." Vodafone is a BMR client but BMR didn't advise the telecom firm on the Supreme Court tax case.