UPDATE: Vodafone Wins India Tax Case; Doesn't Have To Pay Tax On 2007 Hutchison Essar Buy

NEW DELHI (Dow Jones)--India's Supreme Court Friday backed mobile giant Vodafone Group PLC (VOD.LN)'s appeal against a INR112.18 billion ($2.2 billion) tax bill on its 2007 purchase of a majority stake in India's Hutchison Essar Ltd., saying that local authorities can't tax the deal, in a landmark ruling which is expected to boost foreign investor confidence.

The decision could result in Vodafone being able to avoid handing over around $2.2 billion in taxes, which it says it shouldn't have to pay because the deal was conducted overseas.

The offshore transaction is a "bonafide" structure and isn't taxable, Chief Justice S.H. Kapadia, head of a three-judge bench, said while passing the verdict.

The bench directed the tax department to refund the INR25 billion ($496.5 million) which Vodafone--the world's biggest mobile network operator by sales--had deposited in the case, with 4% interest.

India's tax authorities can file an appeal against the ruling, but they haven't decided yet, said Mohan Parasaran, counsel for the local tax department.

In a statement responding to the Supreme Court judgment, Vodafone said: "We are a committed long-term investor in India and will continue to grow our Indian business..."

Vodafone lawyer Harish Salve said the Supreme Court has reacted positively to a foreign investor which came in and set up one of India's most successful telecommunication networks.

The case is being closely watched by foreign companies with investments in India for clarity on the country's tax regime.

The uncertainty created by the case is already viewed as one reason why foreign direct investment has declined in India.

The country received $30.38 billion of FDI in the fiscal year through March 2011, about 20% lower than in the previous fiscal year. India has received about $27.88 billion of foreign direct investments in 2011's April-October period.

The case concerns Vodafone's $11.2 billion purchase of a 67% stake in Hutchison Essar, India's second-largest mobile operator by revenue, from Hong Kong's Hutchison Whampoa Ltd. (0013.HK).

This was Vodafone's first move into the Indian market, where it now has nearly half of its worldwide total number of customers.

When asked to pay tax in India, the U.K.-based company argued that--since the purchase was made by a Vodafone holding company in the Netherlands, and Hutchison Essar was registered in the Cayman Islands--no capital gains tax is due in India since neither company involved in the purchase is Indian.

Even if tax were due in India, it is the seller, Hutchison, and not the buyer which should pay it, Vodafone said.

Friday, Judge Kapadia ruled that it can't be said that Hutchison's Cayman Islands unit was created only for the purpose of the deal, given the duration of the holding structure, the business operation and the timing of the exit.

Following the ruling, Vodafone shares were up 3 pence, or 1.8%, at 178 pence on the London bourse. It is the top riser on the FTSE 100 index, which is down 0.2% at 0843 GMT.

Vodafone had challenged a lower court ruling which allowed Indian local authorities to charge INR112.18 billion ($2.2 billion) in capital gains tax and interest on the transaction. The company also appealed against a penalty for non-payment of the tax that it said could amount to 100% of the taxable amount, taking the total sum to nearly $4.5 billion.

"So this is a great sign that Vodafone is managing local relationships better and that, at least on this occasion, the Indian authorities have behaved rationally," said Sanford C Bernstein analyst Robin Bienenstock.

Following orders from the Supreme Court, Vodafone deposited INR25 billion with the court, and provided a bank guarantee worth INR85 billion ($1.69 billion) with a state-run bank.

Vodafone has had a rough time in India. Apart from the court case, the company was forced to book a GBP2.3 billion impairment charge on its Indian operations--now renamed Vodafone Essar--in May 2010 due to tough competition from more than a dozen mobile players as well as a fierce price war.

It has also had to pay $2.6 billion for third-generation licenses and faces further spending for additional spectrum and license renewals.

It is also embroiled in a widening investigation by Indian police into alleged irregularities in the awarding of 2G mobile spectrum between 2001 and 2003.

Indian police raided the offices of Vodafone Essar and Bharti Airtel--the country's biggest telecom company by subscribers--in mid-November, accusing two former telecom officials of colluding with the two companies and causing the government a loss of INR5.08 billion ($99 million) through faulty allocation of additional bandwidth between 2001 and 2007.

Both companies said they were in compliance with existing rules.

Still, fast-growing India contributed GBP2.18 billion, or around 9%, of Vodafone's total revenue of GBP23.52 billion for the six months to Sept. 30. Of the group's 391 million mobile customers, more than 145 million are in India.

In November, Vodafone posted an 11% drop in first-half net profit due to costs for the company's Greek operations, but it raised its full-year outlook because of a better-than-expected performance in Europe and strength in emerging markets.

The group's Indian business posted a 13% rise in first-half revenue from a year earlier, underpinned by consumer demand and new short message service termination charges in the country.

--By R. Jai Krishna, Lilly Vitorovich, Romit Guha and Prasanta Sahu, Dow Jones Newswires; [phone]; [e-mail]