By Mukesh Butani and Rahul Yadav
In the Indian Finance Act of 2012, Parliament made several amendments to the income tax laws, with retrospective effect. The express purpose of the legislation was to overrule the January 2012 judgment of the Supreme Court of India in the Vodafone case. This article discusses whether the retrospective aspect of the legislation undermines the doctrine of separation of powers or compromises “judicial independence” to the extent of making the retrospective law unconstitutional.
The Vodafone case involved a sale of shares from Hutchison Telecom International Ltd. (“HTIL”), a Cayman Islands entity owned by the Hutchison group, to Vodafone Interna-tional Holdings BV, a company incorporated in the Netherlands. HTIL owned Hutchison’s operations in India though a series of compa-nies incorporated in Mauritius. The Indian Revenue authorities contended that as the transaction resulted in the sale of business assets located in India from Hutchison to Vodafone, Vodafone was liable to pay tax on the transaction even though the shares were purchased from HTIL and not Hutchinson. Vodafone challenged the decision. The Supreme Court of India ruled that the wording of section 9 of the Income-Tax Act does not permit a “look through”(piercing the corporate veil). Hence, the sale of shares of a foreign company by a foreign company to another foreign company could not be brought within the scope of taxation in India.
The Indian Parliament, to counter the Su-preme Court judgment, introduced retrospective substantive amendments to sections 9 and 2(47)of the Income Tax Act in the form of clarifying explanations to amend the scope of section 9,so as to bring within the ambit of Indian taxation the sale of shares of a foreign company, if such shares have derived substantial value from Indian assets. The legislation had the effect of retroactively making the Vodafone transaction taxable in India. Many have argued that overruling the Supreme Court by retroactively effective legislation undermines the rule of law and the separation of powers.
Parts I, II and III of the Constitution of India provide for separation of powers among the Executive, Parliament and Judiciary. Indian courts have consistently upheld the doctrine of separation of powers, and that each branch of the government must operate within the limits set forth in the Constitution. There must be no transgression or attempt by one branch to supplant, derogate or encroach upon the designated space of the other branches.
THE CONSTITUTIONALITY OF RE-TROACTIVE LEGISLATION
The power to enact laws lies within the exclusive domain of the legislature. The power to legislate includes the power to legislate retrospectively, including within the field of taxation:
“Legislative power conferred on the appro-priate legislature to enact laws in respect of topics covered by several entries in the three lists can be exercised both prospectively and retrospectively. Where the legislature can make a valid law, it may provide not only for the prospective operation of the material provisions of the said law, but it can also provide for the retrospective operation of the said provisions.”Rai Ramkrishna v. State of Bihar (1963) 50 ITR 171 (SC).
While legislative power to introduce amend-ments for the first time or to amend an enacted law with retrospective effect tis rec-ognized, it is nevertheless subject to constitu-tional limitations. Judicial principles require that amendments made retrospectively (a) should use words expressly providing for or clearly implying retrospective operation; (b) must be reasonable and not excessive or harsh, otherwise they run the risk of being struck down as unconstitutional; and (c) where the legislation is introduced to over-come a judicial decision, the power cannot be used to subvert the decision without remov-ing the statutory basis of the decision.
It is also a settled principle that legislative actions are subject to judicial review by the Indian High Courts and Supreme Court. There is no doubt that the legislature is empowered to enact laws retrospectively as well as prospectively. No such enactment, however, should result in an alteration of the basic structure of the Constitution. KesavanandaBharti v. State of Kerala AIR 1973 SC1461). The general rule is that any amendment or enactment which violate fundamental rights may be struck down by the courts as unconstitutional.
Accordingly, pursuant to the writ jurisdiction conferred upon under Articles226and 32of the Constitution, the High Courts and Supreme Court act as a ‘watchdog’ to safeguard fundamental rights. Such powers have been exercised with great caution by Indian courts. On numerous occasions, when the courts have been called upon to consider the validity of legislation, the courts have shown great restraint. Unless the legislation patently violates fundamental rights and there is no recourse to prevent such a violation but to declare the law unconstitutional and strike it down, the courts will find the legislation constitutional.
LIMITS ON RETROSPECTIVE LEG-ISLATION
The power to legislate includes the power to validate a law which has been held invalid by the courts by making retrospective amendments. This can be done by removing the infirmities in the law or by filling the lacuna therein. The obvious question is whether by exercising such power the legislature violates separation of powers by limiting the power of judicial review.
A retrospective amendment to overcome a judgment does not, by itself, render the amendment invalid or unconstitutional, even if it has the effect of neutralizing the judgment of a court, making the judgment virtually ineffective. Such amendments do not amount to the statutory overruling of judicial decisions. I.N Saksena v. State of M.P (1976) IILLJ 154 SC.
“A competent legislature can always validate a law which has been declared by courts to be invalid, provided the infirmities and vitiating factors noticed in the declaratory judgment are removed or cured. Such a validating law can also be made retrospective. If, in the light of such validating and curative exercise made by the legislature granting legislative competence the earlier judgment becomes irrelevant and unenforceable, that cannot be called an impermissible legislative overruling of the judicial decision. All that the legislature does is to usher in a valid law with retrospective effect in the light of which the earlier judg-ment becomes irrelevant.” Ujagar Prints v. Union of India  179 ITR 317 (SC)
Accordingly, the judiciary accepts that the legislature is competent to render a judgment ineffective, provided that the legislature removes the statutory basis of the judgment with retrospective effect. However, such retrospective amendment must satisfy the test of constitutional validity, including inter alia, the test of reasonableness. Taxing statues, like any other statues, are subject to amendment with retrospective effect.
THE DOCTRINE OF “SMALL REPAIRS”
Legislative power to enact retroactive legislation has to adhere to constitutional limitations, of which the most important is the “principle of small repairs,” which is an index of whether the law is harsh and oppressive, or a valid exercise of the power to enact retrospectively. The “principle of small repairs ,”is an expression that originated in an article in the Harvard Law Review where it was observed that “it is necessary that the legislature should be able to cure inadvertent defects in statutes or their administration by making what has been aptly called ‘small repairs.’” This prin-ciple was subsequently adopted by the Indian Supreme Court(Assistant Commissioner of Urban Land Tax v Buckingham and Carnatics Co Ltd 75 ITR 603 (SC); Virender Singh Hooda And Ors v State of Haryana AIR 2005 SC 137), and has been applied by Courts in determining the constitutional validity of retrospective legislation. The doctrine seeks to provide a touchstone by which the limits of legislative power to enact retrospective legislation, including tax legislation, may be tested.
A close analysis of the relevant jurisprudence, specifically in relation to tax legislation, demonstrates that retrospective legislation has been upheld by courts principally in two situations, cumulatively reflecting what amounts to “small repairs:”(a) the imposition of a tax, where the intention to impose the tax was always clear but such imposition failed due to a formal defect; or (b) the imposition of a tax, where the intention to impose the tax was always clear, but the imposition originally failed due to sheer inadvertence.
The doctrine of “small repairs” also assumes importance against the backdrop of the “legi-timate expectations of the taxpayers.” Lord Scarman in R v Inland Revenue Commissioners ex p. Preston (1985) AC 835(House of Lords, England) laid down emphatically that unfair-ness in the purported exercise of power can amount to an abuse or excess of power. Thus the “doctrine of legitimate expectations” is applied in the contexts of reasonableness and natural justice.
The doctrine of small repairs permits retros-pective amendment where the aim of such amendment is to convey the meaning or to clarify the intent of the provision as it always was meant to be; to remove a patent defect which, but for the modification, would result in absurd results; to supply an obvious omis-sion in a former statute; or to explain a formal statute. Therefore, retrospective legislation which does not satisfy the requirement of “small repairs” but in fact leads to substantive amendments which are neither clarificatory nor declaratory in nature, may be struck down by the Courts as ultra-vires and unconstitutional on the grounds that it is unreasonable, harsh or oppressive.
THE QUESTIONABLE CONSTITUTION-ALITY OF THE RETROACTIVE LEGISLA-TIONIN VODAFONE
The amendments made to section 9 of the Income Tax Act by the Finance Act of 2012, which outlines the “deemed source” rule of taxation, cannot be said to have been made to rectify a formal defect or an inadvertent error. Further, the severity and magnitude of these amendments does not appear to be clarificatory even though they have been introduced in the statute under the garb of clarificatory explanations. They clearly seem to fall outside the four corners of the “doctrine of small repairs.”
The constitutional validity of these amend-ments has yet to be tested in a court of law. Nevertheless, we are of the opinion that the amendments cannot rationally be held to be clarifying the intent of the Income Tax Act so as to include the off-shore sale of shares by one foreign company to another foreign company (such as Vodafone) within the ambit of section 9 of that statute. This does not seem to be a valid exercise of legislative power, as it amounts to a substantive amendment levying a fresh charge, which cannot be given retrospective operation as per settled legal principles. Not only are these amendments unreasonable, they fasten substantive liability insofar as their retrospective operation is concerned, and they are also harsh and oppressive. While the amendments may stand the test of constitutional validity insofar as their prospective operation is concerned, whether or not Courts uphold their retrospective operation remains to be seen (writ petitions have been filed challenging the constitutional validity of section 9 by McLeod Russel (India) Limited (an Indian company) in the Calcutta High Court and SABMiller Limited (an Australian Company)before the Bombay High Court).
To conclude, while the legislature has the power to render a court’s verdict ineffective by removing the statutory basis of itsjudg-ment, the exercise of such power has to con-form to constitutional requirements, and the limitations are even more rigorous in the case of a retrospective enactment. A practice whereby the legislature, in an attempt to remove the basis of the judgment, ushers in substantive amendments retrospectively (which do not qualify as “small repairs”) in the garb of clarificatory or declaratory amendments is not a valid exercise of legislative power. Such an attempt by the legislature not only undermines the independence of the judiciary but also disturbs the critical balance between the three branches of government.
Judgments and decisions of the Supreme Court, being the highest court in India, are the “law of the land” as expressly provided for under Article 141 of the Constitution of India. Thus, it remains to be seen whether the retroactivity of section 9 will stand up to judicial scrutiny if and when the McLeod Russell and SABMiller cases wind their way to the Supreme Court.
Every democracy aspires to achieve the goal of good governance in accordance with the “Rule of Law.” For the Rule of Law to prevail it is imperative that there exists a sense of responsibility and mutual respect among the three branches of government. Therefore, no branch should be surprised when its attempt to usurp the power of another in derogation of the constitution is challenged until defeated.
Mukesh Butani is the Managing Partner of BMR Legal and specializes in International Tax and Transfer pricing with over 25 years’ experience in advising Fortune 500 multinationals and Indian business houses on a wide range of matters. He is a member of the Advisory Group on International Tax and Transfer Pricing constituted by the Indian Ministry of Finance. He is also a member of the OECD Business Restructuring Advisory Group, the International Fiscal Association’s Permanent Scientific Committee and the OECD-BIAC committee. Mukesh can be reached at Mukesh.Butani@bmrlegal.in.
Rahul Yadav is an Advocate and interna-tional tax dispute expert at BMR Legal and has worked extensively on several cross border transactions. Rahul can be reached at firstname.lastname@example.org