Mumbai, Sept. 10: Vodafone Plc had withheld a sum of $352 million from the $11.08-billion buyout deal it struck with Cayman Island-based Hutchison Telecom International Ltd (HTIL) in May 2007 to acquire a 67 per cent controlling interest in telecom service provider Hutchison Essar as a way to indemnify itself against future tax claims.

The $352-million tax shield was built into the deal, indicating that Vodafone was aware that it could take no chances with the Indian tax authorities and needed to protect itself even as it aggressively argued in courts that it wasn’t liable to pay the tax since the share transfer deal had been struck outside India.

Last Wednesday, a division bench of Bombay High Court threw out Vodafone’s petition against a Rs 12,000-crore ($2.6 billion) tax claim slapped by the income tax authorities.

Vodafone and Hutchison Telecom had closed the deal on May 8, 2007 for $11.08 billion — a day after the Foreign Investment Promotion Board (FIPB) approved the transaction, subject to compliance with applicable laws and regulations in India.

Out of the $11.08-billion deal amount, Hutchison Telecom was forced to agree to make two payments: the first was a sum of $415 million to the Ruias of the Essar group who had threatened to scupper the deal by taking the matter to the courts on the ground that Vodafone already held a 10 per cent stake in rival Bharti Airtel and could jeopardise Hutchison Essar’s future prospects. The Ruias took the money and quietly backed the deal.

The second was a sum of $352 million that Vodafone deducted from the payout — termed as a “retention fee” — which was apparently meant to be used to make any tax obligations that might arise.

One could well argue that the “retention fee” is really a withholding tax under another guise, which the income tax authorities are trying to get their hands on even though the sum is less than a seventh of the $2.6-billion tax tab served on Vodafone.

Tax covenant

In their summation of the facts relating to the Vodafone tax case, Justices D.Y. Chandrachud and J.P. Devadhar refer to a “tax deed of covenant” signed between Vodafone and HTIL along with the sale and purchase agreement with the intention of “indemnifying the petitioner (Vodafone) in respect of taxation or transfer pricing liabilities payable or suffered by the wider group of companies … including any reasonable costs associated with any tax demand”.

There’s very little detail available on this tax deed of covenant as it has never been made public. This aspect was raised very briefly in Bombay High Court with the counsel for Vodafone saying that no formal notice of a claim had been served upon HTIL under this agreement.

However, there are some sketchy details available in a filing dated May 10, 2007, that HTIL made with the Securities and Exchange Commission of the US. “In consideration of Vodafone’s agreement to waive certain potential claims against the company (HTIL)...it agreed to a retention from the consideration of an amount of $352 million,” the filing said.

It added that the deed signed on May 8, 2007, laid down the terms under which Vodafone could use the retention amount to “meet certain specified liabilities which Vodafone (or its nominated person) may incur in connection with the interests acquired with the transaction”.

But there is a rider in the agreement. Vodafone can use the proceeds from the retention amount to defray costs or pay taxes only over a period of 10 years from the date of completion of the deal. This means that Vodafone has the sum of $352 million at its disposal till May 7, 2017.

If the amount isn’t used by then or only partly utilised, Vodafone is obliged to return either the entire sum or the unutilised portion along with the relevant interest— the rate isn’t known — to HTIL.

“The (HTIL) board considers it prudent to make a full provision against recovery of any part of the retention amount,” the filing added. It is not clear how the two sides agreed on the sum of $352 million. The filing only mentions that it was agreed after “arms’ length negotiations”.

HTIL said that after agreeing to the two payouts — $415 million to the Ruias and a retention amount of $352 million that Vodafone withheld — it was still left with an estimated pre-tax gain of $9 billion.

It is this capital gain that the Indian tax authorities are seeking to tax. The taxman is going after Vodafone for its failure to withhold tax from the sum it paid HTIL.

But the truth is that Vodafone has already “withheld” a sum against potential tax claims even as it argues that the deal was struck outside India’s tax jurisdiction. It is believed that the taxman had come up with the $2.6-billion tax tab by calculating the withholding tax at 20 per cent of the deal size.

Options available

Vodafone has already said it planned to contest the Mumbai high court order before the Supreme Court. It has eight weeks to decide on such a challenge.

It now has a choice: it can continue to strenuously argue that it isn’t liable to pay tax on an overseas transaction.

Or, it could try and draw some comfort from certain elements of Wednesday’s judgment. The court order gave Vodafone some leeway when it noted that the shares that were transferred abroad — between a Dutch subsidiary of Vodafone and Hutchison subsidiary based in the British Virgin Islands — carried a panoply of entitlements, including a control premium, use and rights to the Hutch brand in India, a non-compete agreement with the Hutchison group, various loan obligations, and call options to acquire another 15 per cent stake in Hutchison Essar from former Vodafone India CEO Asim Ghosh, Max group chairman Analjit Singh — an entity in which the Hindujas once held a small stake.

The judgment said there was a need to draw a distinction between how much of the payout could be apportioned to overseas income and how much to the underlying rights and obligations that had a clear nexus “within the Indian taxing jurisdiction”.

“The manner in which the consideration should be apportioned is not something which can be determined at this stage,” the judges said, adding that the exercise ought to be done by the tax assessing officer. Legal eagles believe that this has given Vodafone the opportunity to push for a far lower tax tab which the $352 million retention amount may be able to fully cover.