Foreign investors in India – and people considering such investments – should be keeping an eye on the Vodafone case, which broadens India’s tax net.

The Government of India is about to ask Vodafone PLC why it shouldn’t pay up nearly $2 billion in taxes on its 2007 purchase of an Indian cellphone company. It’s the tax case that every anxious foreign investor and multinational tax attorney has been watching.

It all started in 2006, when Hutchison, a Hong Kong-based company, wanted out of its majority stake in the Indian cellphone company Hutchison Essar. It sold its share to Vodafone, which wanted in. That part was simple enough. The way the transaction was set up wasn’t. Hutchison sold a Cayman Islands company, which had a majority stake in the Indian company, to Vodafone International Holdings BV, registered in the Netherlands.

The question is, does Vodafone owe the Indian government around $2 billion in taxes, or doesn’t it? (Or in fact, possibly around $4 billion, if India levies penalties.)

If a sale is a purely foreign one — one foreign company selling assets to another foreign company — it is not taxable under Indian law. But if an Indian company sells assets, the seller pays capital gains taxes. That part is also quite straightforward.

However, a gray area exists: the “Business Connection.” If a company has a business connection to India, then the profits it makes in India do become taxable in India. (India Business Checklists goes into more detail.) Indian tax authorities argued that since Hutchison Essar’s business was in India, it made for an Indian connection. Hutchison Essar should have withheld and paid taxes on the transaction.

No, claimed Vodafone. The thing was a totally foreign transaction between Cayman Island companies, and transacted in the tax haven of Mauritius. It just happened to be India-based assets. Anyway, if anyone was liable for taxes, it would be Hutchison, which had left the country.

When India Business Checklists went to press, Vodafone had taken the case to court. Here’s the update: It lost in the Bombay High Court in December 2008; and in February 2009, the Supreme Court declined to hear the case. Meanwhile, India retroactively changed its laws to make buyer responsible for taxes if the seller did not pay (so Vodafone can no longer argue that it’s Hutchison’s problem, not theirs). Now the I-tax department is about to send a notice to Vodafone – and also to the local company, saying they should have withheld the tax in the first place.

———-

So what does this mean for foreign companies investing in India, particularly if they want to buy an existing company? I’d recommend they factor in taxes. If it turns out that they don’t have to pay them, it’s found money. But don’t count on it. The government could come back years later, asking for taxes they believe they’re owed.

And the Supreme Court has ruled that retroactive changes to the law are legal in India, so long as they aren’t discriminatory.