Vodafone Redux? India's Retrospective Taxation Woes Resurface In Online Gaming Sector

In a startling turn of events, it appears that India Inc is staring at yet another “Vodafone moment,” as the government's implementation of the 28 per cent Goods and Services Tax (GST) on the online gaming industry takes a decidedly retrospective turn.

Over two weeks ago, the Directorate General of GST Intelligence issued pre-show cause notices demanding approximately Rs 150,000 crore in past taxes from online gaming companies.

According to the Central Board of Indirect Taxes and Customs, the latest amendment to the GST Act brought in by the Finance Ministry was “clarificatory” in nature and the tax rate has always been 28 per cent on the face value of the amounts involved — and not on the value of “services” provided by online gaming platforms.

This is a classic case study for policy enthusiasts and one of the most unfortunate actions by policy makers — where they have used the legislation method to achieve goals beyond the realm of justice, equity, and good conscience.

This move has threatened and unsettled a thriving sector that has been a significant contributor to India's digital economy. It also raises concerns that echo the tumultuous repercussions of past retrospective taxation policies.

As demand notices running into thousands of crores cast a long shadow over the industry, it is imperative to closely examine how this retrospective tax imposition is indeed a harbinger of uncertainty, akin to the infamous Vodafone case.

Department's Ability To Recover Tax Demands

Delta Corp Limited, which is listed on both the National Stock Exchange and Bombay Stock Exchange, had a market capitalisation of about Rs 4,500 crore at one point.

This was before the fall in their share price, after the receipt of a whopping Rs 16,822 crore GST demand from the department for the period between July 2017 to March 2022.

Between April 2017 to March 2023, the cumulative turnover of the company stood at Rs 4,690 crore, and the net profit after taxes stood at Rs 911 crore.

Do you think its possible for any company to manage such large payout with these numbers?

A $2 billion tax demand, which is not provisioned for and is retrospective in nature, is bound to affect even well-established large conglomerates, let alone a nascent industry.

The ability to recover alleged tax dues in terms of cash availability with the tax payers is still a secondary issue, which will arise when it's duly established that the demands are legitimate.

The primary issue the department has to face is the scrutiny by the courts that the latest amendments are clarificatory in nature and they will have to defend their moves in the court.

Retrospective taxation is a basic violation of the principle of legal certainty; it's going to be difficult for the department to justify it in the courts.

Businesses need to be able to rely on the legal framework in place at the time of a transaction to make informed decisions.

Investors In Gaming Invest Elsewhere Too

The ripple effect of India's retrospective taxation on the online gaming industry extends far beyond its immediate boundaries — many investors in this sector also hold interests in a diverse range of other industries within the country.

These investors, who have displayed faith in the Indian economy's potential, are surely watching closely as the government's decisions unfold.

For instance, Sequoia Capital is the largest institutional investor in Mobile Premier League (MPL); Dream11 has Tiger Global, D1 Capital, Falcon Edge, DST Global, and Redbird Capital as investors; and Games24x7 has Raine Group, Tiger Global, and Malabar Investments as investors.

Many of these investor entities have backed other e-commerce, fintech (financial technology), and technology companies in various other sectors.

In fact, many gaming sector investors have written directly to the Prime Minister's Office asking to intervene and have sought a personal meeting with the Prime Minister himself.

The imposition of retrospective taxes, a move seemingly at odds with predictability and stability in policymaking, may cast a shadow of doubt over the trust these investors place in India's overall policy framework.

Such uncertainty can have a chilling effect on investment enthusiasm, potentially prompting investors to re-evaluate their allocations in India across various sectors, thereby hindering the country's broader economic growth and development.

Was this implication even considered before making such a disastrous move? Only the policymakers, perhaps, will be able to answer this question.

The Problem Of Political Risk Premium During Valuations

The risk discount applied due to government policies during the valuation of a company is often referred to as "political risk premium," or simply "political risk."

This premium reflects the additional level of risk associated with a company's operations and investments in a particular country or region, due to uncertainties related to government policies, regulations, political stability, and other political factors.

To simplify: higher the risk premium, lower will be the valuation.

Investors and analysts may incorporate a political risk premium into their valuation models to account for the potential negative impacts — that changes in government policies or political instability can have on a company's future cash flows and overall business prospects.

The size of the political risk premium can vary significantly depending on specific circumstances and the perceived level of political risk in a given jurisdiction.

This aspect, however, is applicable to unlisted companies and they are clearly going to face an uphill task in a fresh fund raise. For publicly traded companies, this risk is at display on the bourses already.

India Inc is already witnessing a funding winter due to global financial uncertainty, and if we go by reports, MPL has laid off 350 employees and has clearly said it is due to the "increased tax burden."

Legal Position Vs Myths Held By The Department

Nearly every company that has received these absurd demand showcause notices have petitioned to the courts.

There are multiple case laws from the past which have both persuasive and precedent value that work against the stance taken by the department and are in favour of the arguments made by online gaming companies.

Take, for instance, how the department is going to establish the deposit towards prize pool contribution by the players being a consideration for supply made by the online gaming operators to the players — and hence there being a nexus with the taxable event.

They will not be able to do so. The fact of the matter is that there is no supplier-recipient relationship between any parties qua the prize pool contribution, that is, actionable claims.

As per Schedule III, Entry 6 of the Central Goods and Service Tax Act, 2017, actionable claims are only taxable with respect to lottery, betting, and gambling, which are res extra commercium activities, distinct from online gaming, which is held to be legitimate business activities protected under Article 19(1)(g) of the Constitution of India.

Before and after the introduction of the GST in India, there has been a clear distinction in indirect tax laws between betting, gambling, and online gaming, when it comes to determining tax rates and the value of supply.

In the pre-GST era, Section 66D of the Finance Act, 1994, established a negative list of services that explicitly included betting, gambling, or lottery (focused on games of chance).

Online gaming, on the other hand, fell under the definition of "online information data access or retrieval services" (OIDAR) according to Rule 2(1)(ccd) of the Service Tax Rules, 1994. Consequently, gaming companies paid taxes to the Central Government under the OIDAR category.

Even under the GST regime, the distinction remains. Online gaming continues to be categorised as OIDAR, as outlined in Section 2(17) of the Integrated Goods and Services Tax (IGST) Act.

In contrast, betting, gambling, and lottery activities are addressed under Schedule III, Entry 6 of the Central Goods and Services Tax (CGST) Act. This distinction in taxation treatment persists in the GST framework.

Modi Government's 'Vodafone Moment'

The retrospective taxation issue, exemplified by the Vodafone case, had a significant impact on the UPA (United Progressive Alliance) government, led by Manmohan Singh.

The controversial move to impose backdated taxes on Vodafone's acquisition of Hutchison Essar in 2007, sparked a massive outcry in both domestic and international business circles.

This retrospective taxation move not only strained India's reputation as an investment-friendly destination but also led to prolonged legal battles and diplomatic tensions.

In September 2020, the Permanent Court of Arbitration at The Hague, held that the Indian government's attempt to retrospectively tax Vodafone's acquisition of Hutchison Essar in 2007, was in violation of the bilateral investment treaty between India and the Netherlands — where Vodafone had established a subsidiary.

Ultimately, the department could not recover a single penny but the damage done due to ego and strict stance, based on myths and pre-conceived notions, caused a lot of damage to India Inc.

The recent developments have created a bewildering scenario, where one arm of the government appears to be at odds with another.

On one hand, we have the Ministry of Information Technology actively working on new rules to regulate the industry, including addressing the crucial distinction between games of skill and games of chance.

These efforts aimed at bringing about a fair and transparent environment for players and operators.

However, on the other hand, the imposition of a hefty 28 per cent GST on full value, accompanied by substantial tax demands retrospectively, threatens to stifle and kill the very industry that the IT ministry is striving to regulate sensibly.

This raises concerns about the government's internal coordination, as it seems that one department may not fully comprehend the impact of its actions on an industry that is vital to India's digital economy.

If the online gaming industry, along with others, struggles to survive under the weight of such retrospective taxation, it begs the question of what exactly the IT ministry will regulate when there's nothing left to regulate.

The first sector to take a hit is obviously the online gaming industry and the next and immediate sector to get affected by this move will be: the fintech and the regulatory technology or regtech sector.

These gaming companies use fintech firms to process payments. They use regtech firms to undertake KYC (know your customers) of gamers and bank account verifications.

As per data, around 10 million KYC transactions are done for the gaming industry alone and in fact 5 per cent of the regtech industry’s volume comes from gaming companies and it is estimated that fintech’s will see 25 per cent erosion of transaction volume from this sector.

This will hit topline and bottom line of fintech sector and the amount of GST they pay to government which comes from the online gaming industry.

The contradiction between the government's efforts to nurture innovation and entrepreneurship in the digital sphere and its punitive taxation measures underscores the need for better alignment and collaboration between different government bodies.

In the end, striking a balance between regulation, taxation, and industry growth is essential for India's economic well-being and its aspirations to become a global player in the digital arena.

Such moves should be completely avoided, especially when the chance of recovering even a single rupee from these entities is next to impossible.