The Indian Supreme Court ruling in Vodafone is not only correct but serves another purpose: it ultimately stops the Indian Revenue authorities from hastening the realization and recognition of income in India. I also have encountered the rule that the Indian Supreme court struck down both in India and China. These two countries require that reorganizations or restructurings that do not change the internal composition of the subsidiaries in their country or even effect a disposition of assets  in their country be treated as a form of “indirect” or deemed disposition that entitle them to capital gain.

As an example, assume the shares of a US company X with a subsidiary XY in India or China are acquired by another US company Z via a tender offer in the US. The question is whether there is a realization and therefore recognition event in India or China if there are no shareholders of X in that country?

Under normal circumstance, the acquisition of solely X stock by Z for cash is a sale that occurred in the US of a US asset (the shares of X). The shareholders of X would compute their taxes payable by determining their basis in the shares of X and paying the difference between their basis and the amount paid by Z (FMV). Any capital gain inherent in such a computation would be owed to the country where Z is resident (source of payment) and/or the resident of the shareholder. The reason the shareholders of X would have to compute their taxes payable and pay a capital gains tax (assuming they have held the shares for the requisite period) is because they have exchanged their shares of X for cash. India and the Indian company are affected only to the extent the shareholder of the parent company of XY has changed.

Contrast this with a different scenario: US Company X, sells its shares in XY (an Indian or Chinese Company) to Z, an American company. In this case, X is selling an Indian or Chinese asset. Even though Z is a US company, it is acquiring an asset in India. Under this scenario, India or China has the right to extract tax payment from X.

This is a simplistic example but it illustrates the issue. If India or China is allowed to extract capital gain from the type of transaction Vodafone effected, no one would like to invest in India for fear of being forced to recognize and pay taxes even before you have had a realization event.

I will hasten to add that the Chinese tax authorities did not extract any taxes from our client in a situation similar to the one I described. We were instead required to report the transaction and compute any inherent gain as if we had sold the shares of the Chinese subsidiary. Fortunately, there was no inherent gain because our basis far exceeded any value allocable to the Chinese shares. India, on the other hand, forced us to pay taxes in a situation similar to Vodafone’s.