After selling its Indian business to Vodafone in 2007, HTIL shrank itself by distributing proceeds, as well as its HK business, to shareholders, leaving far less in net tangible assets than the US$2bn+ Indian capital gains tax claim now levied against Vodafone. HTIL was privatised last month. If the tax is upheld, Vodafone may claim it back under an HTIL indemnity. How much is that worth now, and will HWL shareholders carry the can?

Vodafone's potential US$2bn+ claim against Hutch
23 June 2010


On 12-Feb-2007, Hutchison Telecommunications International Ltd (HTIL) announced the sale of CGP Investments (Holdings) Ltd (CGP, Cayman) to Vodafone International Holdings B.V. (Netherlands), a wholly-owned subsidiary of Vodafone Group Plc (Vodafone) for US$11.08bn (HK$86.57bn). CGP held a 66.9848% interest in Hutchison Essar Ltd (HEL, India), a mobile telecoms operator. A circular to HTIL shareholders was dated 21-Feb-2007. The next day, HTIL announced an intended special dividend of HK$6.75 per share.

On 15-Mar-2007, HTIL announced that it would pay US$415m (HK$3.24bn) to Essar Communications (India) Ltd (ECIL), which owned a 21.9% interest in HEL, to settle various claims of rights in relation to the sale, reportedly including pre-emption rights. The sale completed on 8-May-2007, when Vodafone and HTIL also agreed that Vodafone would retain US$352m in lieu of "certain potential claims" against HTIL. HITL booked a gain of HK$69.34bn (US$8.89bn) on the sale.

The HK$6.75 special dividend was formally declared on 22-May-2007, distributing HK$32.23bn. 18 months later, on 12-Nov-2008, HTIL announced another special dividend of HK$7, distributing HK$33.68bn. On 4-Mar-2009, HTIL announced the proposed distribution of the entire share capital of Hutchison Telecommunications Hong Kong Holdings Ltd (HTHK, 0215) as a dividend. HTHK operates a mobile telecoms business in HK and Macau, and a fixed-line business in HK. It was listed on 8-May-2009. The distribution further shrank the shareholders' equity of HTIL from HK$19.11bn to HK$9.05bn, down from a pro forma $92.33bn immediately after the sale of CGP.

The final published balance sheet of HTIL at 31-Dec-2009 put its net assets at HK$11.97bn, but that included goodwill and other intangible assets of HK$2.63bn, leaving net tangible assets of HK$9.34bn.

On 8-Jan-2010, HTIL announced its proposed privatisation by a scheme of arrangement in which it cancelled the 39.65% of the issued shares not owned by Hutchison Whampoa Ltd (HWL, 0013) for HK$2.20 per share, payable by a wholly-owned subsidiary of HWL, valuing HTIL at HK$10.59bn. The privatisation completed on 24-May-2010.

Potential US$2bn+ tax liability

As you may have observed, the disposal by HTIL of CGP did not involve any transfer of assets in India. CGP was incorporated in the Cayman Islands, so the sale of CGP was entirely offshore. However, the Indian tax authorities don't see it that way, and have launched a claim estimated at some US$2bn (HK$15.6bn) plus interest, for capital gains tax on the transaction. They say that it is the underlying assets which matter. If the claim is upheld, then it has wide-reaching implications for foreign investment in India.

Since HTIL has no assets in India, they are going after Vodafone for not withholding and paying the tax on the transaction. Vodafone, of course, does have assets in India which could be pursued in settlement of a claim. It is contesting the claim in the Indian courts.

The India Economic Times reported on 28-Mar-2007, before the deal completed, that the tax authorities were asserting a claim. The Indian Income Tax Department (IT Department, as it is known) issued a "show cause" letter in 2007 asking Vodafone to explain why it should not be taxed for failure to deduct tax from the purchase payment. Vodafone filed a writ petition against the notice, challenging its validity and legality in the Bombay High Court, which dismissed the petition on 3-Dec-2008. See the press release of the Central Board of Direct Taxes here. Vodafone appealed to India's Supreme Court, which in Jan-2009 sent the case back to IT Department with an instruction to first decide whether or not it had jurisdiction. On 31-May-2010, the IT Department issued a reported 761-page ruling saying that it did. On 7-Jun-2010, Vodafone filed an appeal with the Bombay High Court, which has deferred the case to 8-Jul-2010.

HTIL's indemnity to Vodafone

Now, why does all this matter to HTIL? Well, it turns out that in the original sale, HTIL indemnified Vodafone against a tax claim. This was not mentioned at the time in the announcement or circular regarding the transaction. It might have appeared in the agreement which was "available for inspection" in an office in Tsing Yi, New Territories, HK, for 14 days in Feb-2007, but we bet that nobody went to see it.

Regulatory note: again, we urge that the Listing Rules be amended to require "documents available for inspection", including material contracts, to be uploaded to the central web site at HKEx and left there permanently. Making them available only for physical visits is a joke.

HTIL was also listed on NYSE (ticker HTX), so it had to file a "Risk Factors" statement not required under HK Listing Rules. In its 2007 Form 20-F, filed on 9-May-2008, it said:

"We may be subject to claims or have to make payments as a result of warranty or indemnity obligations assumed in connection with the sale of interests relating to [CGP] to Vodafone. Furthermore, the Indian tax authorities may consider the gain arising from this sale to be taxable in India.

The Indian tax authorities have initiated an attempt to investigate certain aspects of such sale, focusing on whether Vodafone should have withheld tax from the acquisition proceeds. Vodafone has taken court action in India to quash such attempt.

We believe that the sale is not taxable in India and therefore neither is any Indian tax payable by us nor was Vodafone required to withhold any Indian tax. Accordingly, we have not provided for any claims or Indian tax liabilities in connection with the sale. However, we cannot assure you what the final outcome will be. If we eventually make any such payments or suffer any Indian tax on this sale, it may have a material adverse effect on our financial position."

The 2008 20-F, filed on 27-May-2009, said:

"In addition, the Indian tax authorities may consider the gain arising from this sale to be taxable in India. The Indian tax authorities have initiated an investigation into Vodafone's obligations to withhold tax from the acquisition proceeds. Vodafone disputed the jurisdiction of the Indian tax authorities in this matter. The Indian Supreme Court ruled, in proceedings initiated by Vodafone, that the question of jurisdiction should be determined by the Indian tax authorities in the first instance, and in the event the authorities make a determination against Vodafone, it may appeal to the Indian High Court.

We have received legal advice and believe that the sale is not taxable in India, and therefore, no Indian tax is payable by us. Accordingly, we have not provided for any claims or Indian tax liabilities in connection with the sale. However, there can be no assurance what the final outcome will be. If we eventually make any such payments or suffer any Indian tax on this sale, it may have a material adverse effect on our financial position and results of operations."

Following the privatisation on 24-May-2010, HTIL, if it still exists, is a wholly-owned subsidiary of HWL. HTIL, which was incorporated in the Cayman Islands, ceased to have a place of business in HK on 5-Jun-2010, according to the HK Companies Registry. As noted above, even before the privatisation, its net tangible assets had been reduced by the dividends to HK$9.3bn, far less than the potential tax claim from Vodafone. Most of those dividends went to HWL as controlling shareholder of HTIL. Now that HTIL is a 100% HWL subsidiary, it is possible that further distributions of its assets to HWL have been, or may be, made - there is no requirement for public disclosure of any intra-group reshuffling.

Vodafone shareholders should be concerned about this. In the event that India is successful in its tax claim, Vodafone may have a struggle to recover the tax from HTIL under the indemnity. It may even have to sue HWL and/or the directors and officers of HTIL for distribution of the assets of HTIL when they knew that there was a potential claim for tax, as shown by the Risk Factors statements in their own filings. The Indian tax case, and any litigation from Vodafone that follows it, is likely to drag on for years. We don't know whether Vodafone is using part of its US$352m retention monies to fight the case.

True it may be that HTIL took a view, and received legal advice, that the sale is not taxable in India, so we can understand why the directors did not record it as a contingent liability in the balance sheet. However, it is another thing not to make any mention of it in the notes of the audited financial statements, and then to pay out so much by way of dividends as to leave HTIL unable to satisfy the amount of tax claimed by India which might be recovered under the indemnity. It is equally odd that HWL has not seen fit to mention this risk either in its own financial statements. Former HTIL investors may be glad to have escaped this liability through the dividends and privatisation, but HWL may not be so lucky.

©, 2010

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