Mumbai, Dec. 3: Vodafone — the London-based telecom giant — suffered a serious setback today when Bombay High Court threw out its petition challenging a tax demand of around $2 billion arising from its acquisition of a controlling interest in Vodafone Essar last year.

The court dismissed a writ petition filed by Vodafone International Holdings BV — a group company — that challenged the showcause notice issued by the income tax department asking it to pay the withholding tax it had failed to deduct from $11.2 billion it paid while acquiring Hong Kong-based Hutchison Whampoa’s stake in the telecom giant. This is the largest-ever tax demand in India and the first relating to the acquisition of a company.

Bombay High Court has stayed the operation of the order for eight weeks. Lawyers for Vodafone said they would file a special leave petition before the Supreme Court after receiving a copy of the written order.

The controversy erupted last year when income tax authorities issued a show-cause notice saying that Vodafone should have deducted tax at source from the payment to an overseas entity which held shares in the Indian company.

According to Shantanu Surpure, managing attorney at law firm Sand Hill Counsel, who has tracked the case, the department claimed capital gains under section 9(1)(i) of the income tax act.

It was of the view that the transaction involved transfer of an Indian asset and profit made by the seller was generated in India. The tax authorities, therefore, contended that Vodafone had an obligation to pay withholding tax in India before paying the requisite price to the seller (Hutchison).

When any amount is to be paid to a non-resident, the person responsible to pay is obliged to deduct tax at source. This is called withholding tax.

Vodafone contended that it was not required to pay withhold tax on the acquisition as the deal was struck between two entities based overseas. It also argued that the capital gains tax was usually paid by the seller, not the buyer.