India’s International ‘Retrospective Taxation’ Regime Vis-a-Vis PCA Rulings in Vodafone and Cairn in 2020

The imposition of retrospective taxation of foreign companies doing business in India has been at the helm of controversy since the passage of the law in 2012. Several companies have approached domestic courts as well as the Permanent Court of Arbitration (“PCA”) for relief from such claims as well as claimed damages from India. Notably, in the recent Vodafone International Holdings BV v. Government of India [I], PCA Case No. 2016-35 (Dutch BIT Claim) and the Cairn UK Holdings Limited v. The Republic of India (PCA Case No. 2016-7), the PCA ruled against India in both the Investor-State disputes. Along with granting relief from such claims, enormous sums were imposed as damages to be paid to the companies in September and December 2020, respectively.

Background

In May 2007, Vodafone acquired a 67% stake in the Hutchinson-Essay Ltd. based in the Netherlands and Cayman Islands. The Income Tax Department (“IT Department”) in India taxed this by maintaining that since capital gains were made in India, Vodafone was liable to pay the taxes in India. A show-cause notice in this regard was issued but it was subsequently challenged before the Bombay High Court on the argument that the share transfer occurred outside India. This argument was rejected by the court and Vodafone subsequently approached the Apex Court. The Court directed the IT Department to determine if it had the jurisdiction to tax the transaction. In 2010, the IT Department ruled that it had competent jurisdiction and it has the power to treat Vodafone as an “assessee in default” for failure to deduct the tax at source. The Apex Court ruled against the IT Department’s decision and held that the IT Department had no jurisdiction to levy taxes on overseas transactions between companies incorporated outside India.

In 2012, while the review petition was pending before the Supreme Court, the Indian government introduced a retrospective clarification to the Income-Tax (I-T) Act, 1961, and thereby amended the law to ensure that cross-border transactions are taxable in India;

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“For the removal of doubts, it is hereby clarified that an asset or a capital asset being any share or interest in a company or entity registered or incorporated outside India shall be deemed to be …… situated in India, if the share or interest derives….. its value substantially from the assets located within India.”

During the 2012 Budget briefing, it was envisioned that the clarification could earn the exchequer Rs 35,000 to 40,000 crores in back-dated revenues. The amendment would apply from the assessment year 1962 – 1963, meaning several foreign investments would now be liable for taxation, including the Vodafone deal.

Investor-State Arbitration Proceedings Before the PCA

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Vodafone commenced international arbitration in 2014 under the India-Netherlands Bilateral Investment Treaty (“BIT”), by claiming that the conduct of the Government breached the protections promised to foreign investors under the BIT. In 2020, the Tribunal with its seat in Singapore, under the auspices of the PCA has held that India was in breach of the BIT.

In Cairn India’s case, the IT Department on similar grounds sold most of its 4.9% stake in the company to recover a retrospective tax demand. In addition to realising about Rs 5,000 crores from selling the shares together with redemption proceeds on Vedanta Limited. preference shares, the IT Department has also seized Rs 1,140 crores of dividend due to the British company as well as Rs 1,590 crores of tax refund in an unrelated case. In March 2015, Cairn approached the PCA challenging the tax claim as well as demanding damages amounting to $1.4 billion. Based on the actions of the Indian tax authorities in 2014 to enforce the tax demand by seizing and then selling shares held by Cairn Energy in the Indian company, Vedanta Limited. Cairn Energy claims that the sale occurred at a low point in the value of the shares, which caused it substantial financial harm.

Foreign Investors in India and Bilateral Investment Treaties

An international investment usually involves a commercial agreement between the foreign investor company and the host State, in the form of an Investment Contract. Investment contracts provide for dispute resolution either before domestic courts or administrative tribunals or through international arbitration.

In addition, any foreign investor can examine if the Home Country has entered into an International Investment Agreement (“IIA”) with the State within whose territory investment is made – Host State. IIAs can be in the form of either a-

(i) Bilateral Investment Treaty,

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(ii) Free Trade Agreement with an investment chapter (FTA),

(iii) Regional cooperation and economic partnership agreement with a guarantee for investment protection.

In the event of a dispute, therefore, investors may find that the relevant facts fit both under an investment contract or an IIA. The Vodafone and Cairn case did not arise out of an investment contract between the investing country and the Government of India (“GOI”). The dispute having roots in retrospective tax legislation by India, it was brought under an IIA. While Vodafone and Cairn could have exercised a right to challenge the constitutionality of the amendment before the Supreme Court of India, it chose to initiate arbitration under the India-Netherlands BIT and the India-UK BIT respectively. This reflects the benefits that an investor can derive out of investing in a host country with which already exists a valid BIT.

The arbitral awards were based on the clear principle that India’s actions were manifestly in breach of “fair and equitable treatment” to be meted out to foreign investors.

However, such investor beneficial provisions are being done away with gradually. India faced flak for replacement of the ‘Fair and Equitable Treatment‘ clause with ‘Treatment of Investments’ clause that states “neither party shall subject investments to measures that are manifestly abusive, against norms of customary international law and to an un-remedied and egregious violation of due process” in its 2016 Model BIT. This may hinder foreign investment due to the lack of protection that such a clause entails and thereby thwarting the ease of doing business in India. India has also been terminating BITs rapidly which is evident as per the Indian Department of Economic Affairs website, wherein 69 out of 84 BITs are terminated on various dates since 2016. This may affect the investors’ image of India being an investor as well as an arbitration-friendly.

Whether To Appeal or Not? The Way Ahead

The mischievous 2012 tax amendment have been repealed through the 2013 – 2014 Budget announcement but the claims still have after-effects in the form of posing questions about India’s economic independence as well as ease of doing business. Now, India will have to decide whether to challenge the current arbitral awards or not. While the chances of success on an appeal are bleak, India should rather focus on bringing in more clarity for foreign investors in areas of business. Universally, what foreign investors require is certainty in tax laws and not a tax-free environment, which no emerging economy, like India can afford.

Apart from tax clarity, India should also embark upon expeditiously passing the proposed foreign investment legislation which would ensure speedy dispute resolution through setting up fast-track courts for investor-state disputes. This would ensure the certainty of enforcement for their investor-state contracts. The government envisions that the government could avoid entering into BITs after a localised dispute resolution system, as proposed. While it is argued that such a system would not be substitutable for a BIT, it is nevertheless envisioned to improve investor confidence in India. Therefore, determinate tax clarity, as well as other business environment factors, would ensure India’s place among the list of business-friendly havens across the world.


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