Image credit: Scroll.in, September 26, 2017
This is the fourth blog piece in our series entitled “Those Were the Days”, which is published monthly. We hope you enjoy reading this as much as we have enjoyed putting this together.
The world is becoming corporatised, and the time of the business owner living over his little shop are well-nigh over. The world is also becoming smaller and, as it does, a business’s reach spreads across multiple jurisdictions and through multiple subsidiary or group companies.
In this age of corporatisation, most jurisdictions recognise the concept of a company as a separate juristic person, with an identity distinct and independent of its shareholders, members or directors. This corporate existence separates a company’s identity from that of its promoters or shareholders. It enables the company to contract in its own name, with its shareholders and third parties, to acquire and hold property in its own name, and to sue and be sued in its own name. A company has perpetual succession; its life is not co-dependent with that of its shareholders and it remains in existence irrespective of any change in its members, until it is dissolved by liquidation. The shareholders of a company are not identified with the company and cannot be held personally liable for acts undertaken by, or liabilities of, the company.
This independence or distinction is not a new concept. In the late 19th Century, the judgment in the classic case of Salomon v. Salomon[1] was passed, ruling that a company is a separate legal entity distinct from its members and so insulating Mr. Salomon, the founder of A. Salomon and Company, Ltd., from personal liability to the creditors of the company he founded.
This is a fiction created by law and enables an organisation of multiple owners to function as a single identity. It also enables company longevity – by having its own distinct personality, it can far outlive its body of owners. This legal fiction is integral to the functioning of companies and is the fundamental basis or rationale for incorporation. Such is the line, or the veil in place, between the corporate legal personality of a company and its shareholders, that it cannot be crossed or lifted except in exigent circumstances. Decisions of courts of several jurisdictions have followed and quoted the ruling in Salomon, fine-tuning the principle of the corporate veil and circumstances under which it may be lifted.
In certain situations, a court may lift or look beyond the façade of this fictional identity to penetrate the inner-workings of the company or the shareholders behind the entity. An offshoot of this is that these exceptions also allow a group of companies consisting of otherwise independent and distinct companies, to be either treated as a single economic unit, or to treat holding-subsidiary companies as one. By so doing, a court pierces or lifts, the corporate veil.
The corporate identity of the company can be pierced in situations where this separate identity is used as a shield masking wrongful or illegal ends, or used to conceal or defend the persons in actual control of the company. Some of these exceptions have been explicitly identified in statutes. Some others have been developed through judicial precedents, which have developed the law and the principles for piercing the corporate veil of companies, over time.
Beginning with LIC v. Escorts
One of the first Indian cases that dealt with the issue of a company as an independent juristic personality and the lifting of the veil, known almost as well as Salomon, is the ruling of the Supreme Court in the case of Life Insurance Corporation of India v. Escorts Ltd. & Ors.[2]
This case dealt with a non-resident portfolio investment scheme, which existed under the erstwhile Foreign Exchange Regulation Act, 1973 (FERA). The scheme allowed non-resident companies, which were owned by or in which the beneficial interest vested in non-resident individuals of Indian nationality / origin was at least 60%, to invest in the shares of Indian companies. Investment was allowed to the extent of 1% of the paid-up equity capital of such Indian companies, and could not exceed a ceiling of 5%. Under the scheme, 13 companies, all owned by Caparo Group Limited, invested in Escorts Limited – an Indian company. Importantly, 60% of the shares of Caparo Group Limited were held by a trust, whose beneficiaries were Swraj Paul and members of his family (all non-resident individuals of Indian origin).
The investment by the 13 Caparo Group companies was challenged on the ground that it was an attempt at circumventing the prescribed ceiling of investment of 1% under the Scheme, and that, “One had only to pierce the corporate veil to discover Mr. Swraj Paul lurking behind.”
The Supreme Court firstly noted the judgment in Salomon, and that it was firmly established that a company once incorporated, has an independent and legal personality distinct from the individuals who are its members. It also noted that only in certain exceptional circumstances may the corporate veil be lifted, the corporate personality ignored and the individual members recognised for who they are.
Eventually, however, the Supreme Court ruled that in the facts of this case, and only for the purposes of ascertaining the ownership in the investment, lifting of the veil would be necessary to a limited extent, i.e. to ascertain the nationality or origin of the shareholders. It was not necessary to ascertain the individual identity of each of them. Merely because more than 60% of the shares of the foreign investor companies were held by a trust of which Mr. Swraj Paul and the members of his family were beneficiaries, could not deny the companies the facility of the scheme on the basis that the permission granted was illegal. As such, the Court ignored that the identity of the shareholders may be common, thus recognising that each company was an independent juristic entity, looking only at nationality for compliance with the requirements of the scheme.
The Supreme Court also took the opportunity to set out the basic conditions and principles to be applied and the various circumstances under which the corporate veil of a company could be pierced, i.e. to cast responsibility or liability for an act carried out by the company. Such acts would include fraud or improper conduct, the evasion of a taxing or a beneficent statute or where associated companies are inextricably connected as to be, in reality, part of one concern and should therefore, be treated as such.
Development of the Law
Over the next several years, courts in India curtailed, amplified (where required), and clarified the circumstances in which an independent corporate personality may be ignored, and the veil lifted, to look at, and hold responsible or liable, the entities in actual control. Often a litigant demanded that the veil be lifted in respect of parent / subsidiary companies or associated / affiliated companies. Each company upon incorporation, is treated as a separate legal entity, unless two or more companies function as a single economic entity, in which case the corporate veil may be lifted. So, for instance, where the subsidiary does not in fact act autonomously and essentially only carries out instructions given to it by its parent, it is possible to say that the subsidiary and the parent are really one and the same, thus ignoring their separate legal status and lifting the veil. Among the factors a court would consider in this regard, are whether the companies were “guided by the same head and brain” and whether the parent controlled the actions of its subsidiary.[3] Courts have also lifted the corporate veil if it is found that a subsidiary company has been constituted with the sole intention of concealing the true facts, to act as a façade and thereby perpetrate a fraud,[4] or to “look at the realities of the situation and to know the real state of affairs“.[5]
It is not always a bad thing that the veil be lifted, and this worked to the advantage of Hindalco Industries Limited. In the case of State of U.P v. Renusagar Power Co.,[6] Hindalco used the electricity produced by its wholly-owned subsidiary Renusagar Power Company Limited, and was able to avail of the benefit granted under the Uttar Pradesh Electricity (Duty) Act, 1952, which provided for a reduced rate of duty on electricity generated from a company’s own source of energy. The Supreme Court found the two companies – Hindalco and Renusagar, to be inextricably linked such that the electricity generated by Renusagar was considered to be generated by Hindalco from its own sources. By lifting the veil and ignoring the separate identity of the two companies Hindalco was granted the benefit of the reduced rate of duty.
In another landmark decision of the Supreme Court in New Horizons Ltd. v. Union of India,[7] the court observed that the corporate veil may be lifted and the independence of the corporate entity disregarded, in cases where the principle of corporate personality is flagrantly opposed to justice, convenience, or in the interest of revenue.
This exception to what is a fundamental premise of corporate law, has enabled the courts to come down on individuals/entities who have tried circumventing laws or perpetrating fraud by hiding behind the veil. An example of this is the case of State of Rajasthan v. Gotan Lime Stone Khanji Udhyog,[8] where a partnership firm attempted to transfer a mining lease allotted to it, by first converting the firm into a private company. The shareholders of the company so formed, subsequently sold their shareholding to a subsidiary of Ultra Tech Cement Company Limited, effectively giving rise to a sale of the mining lease. The relevant governmental authorities were neither informed of this transfer nor was their permission taken. Under the law the lessees were not permitted to profit from the sale of the mining rights. The court held that this transaction was an attempt by the respondents at doing something through the medium of companies, which they were not otherwise allowed to do. The court further recognised that mining rights are vested in the State and are held in public trust. It stated that even ‘public interest’ is a consideration in piercing the corporate veil of an entity. The court noted that in isolation both these transactions were within the bounds of law, but seen together in view of other facts and circumstances were patently illegal and ought to be set aside.
The Vodafone Debacle and Cure
One of the most recent and also a landmark case of the Supreme Court, is its decision in the case of Vodafone International Holdings B.V. v. Union of India & Another.[9] In judgment, the Supreme Court set aside the Bombay High Court’s judgment directing Vodafone International Holdings BV (“Vodafone”), to pay INR 110 billion, as withholding tax in a transaction that took place off-shore.
The facts, as briefly put, are that in May 2007, Vodafone, incorporated in the Netherlands, acquired from Hong Kong based Hutchison Group, the entire share capital of CGP Investments (Holdings) Limited (“CGP“), a company incorporated in the Cayman Islands, which in turn controlled a 67% interest in Hutchison-Essar Limited (“HEL“), Hutchison’s Indian mobile business. The Indian income tax authorities contended that capital gains were made by Hutchison in India and that Vodafone was therefore liable to pay withholding tax thereon, amounting to approximately INR 110 billion (the sale price being USD 11.2 billion).
Vodafone challenged the tax demand in the Bombay High Court, which ruled in favour of the income tax authorities, holding that the essence of the transaction was a change in the controlling interest in HEL, which constituted a source of income in India. Vodafone appealed to the Supreme Court, which overruled the High Court and held that the transaction fell outside India’s territorial tax jurisdiction and was hence not taxable.
The judgment is not only important in the context of taxation, but also covers other issues of law. One of these is in the context of the principle of the corporate veil, and the circumstances under which it may be lifted, particularly in the context of commercial cross-border transactions and tax avoidance.
The Court recognised the fundamental principle of the corporate veil by noting that, “The approach of both the corporate and tax laws, particularly in the matter of corporate taxation, generally is founded on the abovementioned separate entity principle, i.e., treat a company as a separate person. The Indian Income Tax Act, 1961, in the matter of corporate taxation, is founded on the principle of the independence of companies and other entities subject to income-tax.”. It observed in the context of parent / subsidiary relationships, that it is generally accepted that the group parent company would give guidance to group subsidiaries, but that by itself would not justify piercing the veil or imply that the subsidiaries are to be deemed residents of the State in which the parent company resides, and that “a subsidiary and its parent are totally distinct tax payers”.
The Court clarified that it was only in a situation where the subsidiary was fully controlled by or subordinate to the parent company, and / or the actual controlling parent company made an indirect transfer through “abuse of organisation form/legal form and without reasonable business purpose” which resulted in tax avoidance, that the independence and distinctness of the separate legal entities may be ignored. In such a case, the subsidiary’s place of residence may be linked with that of its parent, and tax imposed on the parent company, so that where “… a transaction is used principally as a colorable device for the distribution of earnings, profits and gains … the principle of lifting the corporate veil or the doctrine of substance over form or the concept of beneficial ownership or the concept of alter ego arises.”
While dealing with tax liability in India and indirect transfers / holding companies and subsidiary company relationships, the Court noted that it was common for foreign investors to invest in Indian companies indirectly, through an interposed foreign holding or operating company, such as a Cayman Islands or Mauritius based company, for both tax and business purposes. India’s judicial anti-avoidance rules, permit the Revenue to “invoke the ‘substance over form’ principle or ‘piercing the corporate veil”, if it is able to establish that the transaction is a “sham or tax avoidant”. For example, if the Revenue finds that in an investment transaction / acquisition, “an entity which has no commercial/business substance has been interposed only to avoid tax”, then in such cases the Revenue would be entitled to ignore the separate legal identity or interposition of that entity, to look at the holding company as having directly made the investment / acquisition.
Six factors that may be considered to determine whether the transaction is a sham and whether in a specific case, the corporate veil may be lifted, are: “(i) the concept of participation in investment, (ii) the duration of time during which the Holding Structure exists; (iii) the period of business operations in India; (iv) the generation of taxable revenues in India; (v) the timing of the exit; and (vi) the continuity of business on such exit.”
In the final analysis, the Supreme Court decided against lifting the corporate veil in Vodafone, as the tax authorities failed to establish that the transaction was a sham or tax avoidance scheme. The Court noted, “There is a conceptual difference between a preordained transaction which is created for tax avoidance purposes, on the one hand, and a transaction which evidences investment to participate in India” – and that to ascertain which bracket the transaction fell into, the six factors mentioned above should be taken into account. Notice was taken of the fact that the Hutchison structure (i.e. the parent company in Hong Kong, the intermediate subsidiary in the Cayman Islands, and the final subsidiary in India etc.), had existed for a considerable length of time (from 1994), generating taxable revenues, the transaction envisaged “continuity” of the telecom business, and that accordingly the Hutchison structure was not a sham or tax avoidance scheme.
The Supreme Court further observed, that where the court was convinced that the transaction satisfies all the parameters of “participation in investment” the Court need not go into the questions such as de facto control vs. legal control, legal rights vs. practical rights, etc., and accordingly, there was no need to lift the corporate veil of the Hutchison or Vodafone entities.
In arriving at this conclusion, the Supreme Court upheld the letter of the law on the premise that fiscal statutes have to be strictly interpreted. Accordingly, since the Income Tax Act clearly envisaged a different regime for tax withholding at source on a transaction between two non-resident entities, there was no occasion to read the law differently so as to require tax withholding on the premise that the non-resident transferor controlled a substantial undertaking in India, i.e. no case was made for piercing the corporate veil.
Conclusion
The principle of the juristic and legal independence of companies and the corporate veil, that is drawn between a company and its shareholders, is a fundamental but not sacrosanct principle of modern corporate law. As explained in LIC v. Escorts and beyond, this veil can, in exceptional circumstance, be lifted or pierced, to look at and take into account, the shareholders or entities in actual control of the company concerned. Considerations such as the economic reality, substance of the transaction, and viewing the transaction as a whole, are critically evaluated, but unless there are compelling circumstances, Indian law demands that courts respect the sanctity of the corporate veil and the independent corporate personality that comes into existence immediately upon incorporation of a company.
* The author was assisted by Pranjal Mehta, Associate.
[1] (1897) AC 22
[2] (1986) 1 SCC 264
[3] Hackbridge-Hewittic & Easun Ltd. v. G.E.C. Distribution Transformers Ltd. – [1992] 74 Comp Cas 543 (Mad)
[4] Delhi Development Authority v. Skipper Constructions Co. (P) Ltd. – (1996 ) 4 SCC 622
[5] Subhra Mukherjee v. Bharat Coking Coal – (2000) 3 SCC 312
[6] 1988 AIR 1737
[7] (1995) 1 SCC 478
[8] 2016 SCC Online SC 62
[9] S.L.P. (C) No. 26529 of 2010