When Vodafone Group plc paid $11 billion to acquire a 67% stake in the Indian phone venture now known as Vodafone Essar Ltd., the U.K. company thought it had rung up a tidy presence in one of the world's fastest-growing telecommunications markets. Instead, it connected to the static of an ongoing debate about taxing cross-border deals in India and a partner scrambling to hang up on its joint venture stake at the highest price.
Shortly after completing the acquisition in 2007, Vodafone was slapped with a $2 billion bill for capital gains taxes the Indian tax department said the company should have withheld. It has already paid a 110 billion rupee ($2.4 billion) deposit as it appeals the case.
Meanwhile, partner Essar Group has an option, which expires in May, to sell its remaining 33% interest in the untraded venture to London-based Vodafone. Essar, led by CEO Marten Pieters, can sell the entire holding for $5 billion or a portion of the stake worth between $1 billion to $5 billion "at an independently appraised fair market trading value." Vodafone CEO Vittorio Colao has appointed Goldman, Sachs & Co. to value the stake, and Essar has tapped Standard Chartered plc. UBS will propose a valuation if the two sides can't come to terms.
Essar has moved to fold part of its Vodafone Essar stake into its listed India Securities Ltd. division to see how it affects that company's market value. Vodafone has appealed to an Indian court, the Bombay Stock Exchange and India's securities regulator to prevent what it sees as an artificial valuation.
While analysts say Essar's move could ratchet up the price by just a few hundred million dollars, the outstanding tax bill is more worrisome to foreign investors. It's seen as part of a wider move by Indian authorities to short-circuit the use of offshore entities to buy and sell stakes in Indian companies and circumvent tax and other local regulations.
Vodafone's India deal deployed a common maneuver. Although the acquisition was effectively a case of Vodafone in the U.K. buying control of the Indian telecom venture from Hong Kong's Hutchison Telecommunications International Ltd., technically a Vodafone unit in the Cayman Islands bought a Hutchison unit on the Cayman Islands that held the seller's joint-venture stake.
Vodafone's investment came at a time when Indian tax authorities began considering a levy on any deal that included a transfer of significant stakes in Indian companies. Vodafone wasn't the only one singled out, but Indian attorneys say the Vodafone agreement had two elements that make it especially vulnerable to the tax liability.
First, Vodafone relied on units in the Cayman Islands for the deal rather than on other countries that have double taxation treaties with India -- Cyprus and Mauritius are two of the most popular locations with treaties, followed by Singapore, says one attorney who cautioned that Singapore has higher hurdles for incorporation.
"Most transfers among investors who are familiar with Indian tax regulations prefer to set up an entity in a double-taxation-treaty country," says the attorney.
Indeed, several other companies slapped with similar tax bills alongside Vodafone will likely be able to toss out the invoices by having completed the deals in one of the treaty countries. Among them are private equity firms General Atlantic LLC and Oak Hill Capital Partners, which bought 60% of Genpact Ltd. from General Electric Co. for $500 million in 2004. Conglomerate Tata Group and Aditya Birla Group were also among those hit with a similar bill after buying partner Cingular Wireless LLC's one-third stake in Idea Cellular Ltd. for $300 million in 2005.
Indian authorities point to a second element that makes Vodafone vulnerable to being hit with the tax levy. They say that Vodafone's joint venture itself, as an Indian company, would be responsible for withholding any deal-related capital gains tax, putting both the joint venture and the parent company on the hook for the tax bill. For the moment, that is a policy statement, not a legal statute.
But the Indian tax authorities want to make the policy a law as part of revisions to the country's tax code that are scheduled to take effect in 2012. The reform would give regulators "look-through" provisions that would allow them to see through shell companies and review the true intent of a deal -- and tax any transfer of control.
Talk about taxing cross-border deals does not seem to have yet deterred foreign direct investment, but it has caused investors to re-evaluate their notions about deal strategy and structure.
A recent survey by the United Nations Conference in Trade and Development projected India as the second most important FDI destination, after China, for the 2010-2012 period. But, says Roshan Thomas, a partner at Bangalore, India-based law firm Lexygen, "investors are very keen on revisiting their investment structures. While there definitely hasn't been a waning of interest, a lot of investors are spending a lot more time trying to build more substantial structures."