CANDI 10 AUGUST 2021

EDITORIAL SECTION
The sovereign right to tax is not absolute
GS 3 – Economy
Context:
An important bill introduced in Parliament last week aims to nullify the regressive
2012 amendment in the Income Tax Act.
About the Dispute:
• The arbitration between India and Cairn challenged the India
retrospective taxation policy:
o In 2012, India brought in legislation mandating retrospective tax
demands over deals going back to 1962 in which shares in non-Indian
companies were transferred to an Indian holding company.
o In 2006-07, as a part of the internal rearrangement, Cairn UK
transferred shares of Cairn India Holdings to Cairn India.
▪ Later, when Cairn India divested roughly 30% of its shares
through an Initial Public Offering, mining conglomerate Vedanta
Plc acquired most of Cairn Energy.
▪ But Cairn UK was not allowed to transfer its 9.8% stake in Cairn
India to Vedanta.
o The Income Tax authorities then contended that Cairn UK had made
capital gains and slapped it with a tax demand of Rs 24,500 crore.
• The Supreme Court of India had ruled against the retrospective reading
of the law by tax officials in the case of Vodafone.
• However, Parliament passed a law mandating retrospective taxation
over the transfer of Indian assets.
• This retrospective taxation, Cairn argued, was in breach of the UK-India
Bilateral Investment Treaty.
o This treaty had a standard clause that obligated India to treat
investment from the UK in a fair and equitable manner.
Why is Cairn going after Indian assets?
• In December 2020, a three-member international arbitral tribunal ruled
unanimously that the Indian government was in breach of the guarantee
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of fair and equitable treatment, and against the India-UK Bilateral
Investment Treaty.
o The breach caused a loss to the British energy company and ordered
compensation of $1.2 billion.
• The Indian government is yet to accept the arbitration award. Cairn
Energy is going after Indian assets overseas to recover the
compensation.
• In May 2021, Cairn began the process of extracting the $1.2 billion.
Why has India not accepted the award?
• Since the arbitration award was delivered in Hague, India has moved an
appeal in the Netherlands.
• A similar arbitration verdict was delivered in September 2020 in favour
of Dutch telecom company Vodafone.
• The award requires India to pay $5.47 million to Vodafone as partial
compensation.
The assets Cairn is going after:
• Cairn Energy has so far registered the arbitration award in several
countries, where it has identified Indian assets worth over $70 billion.
o This includes jurisdictions in the US, UK, Canada, Singapore,
Mauritius, France and the Netherlands.
o In the US, Cairn Energy has chosen New York to sue India because it
has located substantial assets it can recover the compensation from in
that jurisdiction.
o Specifically, Air India’s United States operations are headquartered in
this district at 570 Lexington Avenue, New York
Concerns:
• After the World Wars, as more countries gained sovereignty, they tended
to look at foreign investments as a form of neo-colonialism.
• For many years, policies in developing countries turned inwardlooking.
o As a result, developed countries sought to guard their investments
against expropriation.
o Bilateral investment treaties became the primary tool to forge
relationships between developed and developing countries.
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o Some argue that the US, in particular, signed BITs mainly to adopt
standards for prompt, adequate and effective compensation in case of
expropriation.
o With the advent of globalisation, BITs became the means for foreign
investment in developing countries.
o Although the impact of investment agreements on foreign investments
remains highly contextualised and inconclusive, these came to govern
international investment relations.
• Many developing countries view arbitration of tax matters as a breach
of their sovereign right to tax.
o Taxation of cross-border incomes is resolved either through domestic
dispute mechanisms or by competent authorities appointed to agree
on an outcome not binding on the taxpayer.
• The option of arbitration upon an unsuccessful Mutual Agreement
Procedure (MAP) resolution is not available in India.
o In fact, even when the OECD published its multilateral instrument for
tax treaty amendment, India reserved the application of binding
arbitration.
o BITs thus escape such constraints and provide the taxpayer an
opportunity to represent herself and quickly enforce an award.
o For this reason, over the years, there has been a rising trend in tax
disputes involving BITs.
• All investments have tax implications and the acceptance of such a
distinction could create problems even where tax is explicitly carved
out from the bilateral investment treaties.
• A retrospective amendment may be acceptable where it intends to
correct for a legal lacuna provided it is not disproportionate.
o The 2012 explanations to the IT Act of 1961 indeed sought to fix tax
avoidance.
o The loss of tax on account of such legal lacuna is purportedly
equivalent to the securities transaction tax collections in a year, which
raises the question if the legislation has restored equity among
taxpayers.
o The Cairns case retrospective tax has been challenged on grounds of
denial of fair and equitable treatment, akin to expropriation.
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India’s options going forward:
• It is the first one to succeed for Cairn, the French court order boosts its
chances in other jurisdictions.
• The assets will be tangled in a legal dispute and India will join a list of
countries that includes Pakistan, Afghanistan whose assets were seized
abroad.
• Unless it can be proved that the arbitration awards against India are
mala fide in the appeals, the award can be enforced in foreign
jurisdictions.
• However, a settlement between the two parties cannot be ruled out.
• Some suggest that India can invoke state immunity to stop the
appropriation of its assets abroad.
• A better option would be to admit that amending the tax law
retrospectively was a mistake and comply with the international ruling.
o Putting an end to this international embarrassment.
State Immunity:
• State immunity can be invoked to resist the seizure of sovereign assets,
but not commercial properties.
• It is a well-recognised doctrine in international law which safeguards a
state and its property against the jurisdiction of another country’s domestic
courts.
• This covers immunity from both jurisdiction and execution.
• Despite the universal acceptance of this doctrine, there is no international
legal instrument in force administering its implementation in municipal
legal systems of different countries.
• Attempts are underway to create binding international law on the
application of the rules of state immunity such as:
o The United Nations Convention on Jurisdictional Immunities of
States and Their Property (UNSCI).
o However, this convention is yet to be ratified by 30 countries —
the minimum number required to bring it in force, as per Article 30(1)
of UNSCI.
o India has signed the convention, but not ratified it.
• The doctrine of state immunity has progressed from absolute
immunity (immunity from any foreign proceedings unless the state gives its
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consent) to restrictive immunity (immunity only for the sovereign
functions of the state).
• By and large, most prominent jurisdictions follow the concept of restrictive
immunity.
o In the context of the execution of the investment treaty arbitration
awards, it implies that state property that serves sovereign
functions (such as the property of the diplomatic missions, central
bank assets, etc.) cannot be attached.
o However, properties serving commercial functions are available for
seizure.
▪ E.g., The International Court of Justice in the Jurisdictional
Immunities of the State (Germany v. Italy: Greece intervening)
recognised the exception for commercial assets.
o But, in practice, it is not always easy to draw an exact line dividing
the two types of property.
• In the case of India, the most popular commercial property that foreign
investors would target for attachment are the global assets of India’s public
sector undertakings such as Air India.
o To attach the assets of these PSUs, it would have to be shown that
these companies are nothing but the “alter ego” of the Indian state.
Is there any Indian precedent for such seizure of property belonging to foreign
states?
• Seeking courts’ intervention in the enforcement of arbitration awards against
foreign states is fairly common.
• Recently, in a case filed by two Indian private companies for
enforcement of arbitral awards in their favour.
o The Delhi High Court directed the Embassies of Afghanistan and
Ethiopia to file affidavits disclosing the assets owned and held by
them in India.
o The Court held that:
▪ A Foreign State does not have Sovereign Immunity against an
arbitral award arising out of a commercial transaction.
▪ Further entering into an arbitration agreement constitutes a
waiver of Sovereign Immunity.
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▪ The agreement by the respondent to arbitrate the disputes would
operate as a waiver of the said requirement.
▪ When a Foreign State enters into an arbitration agreement with
an Indian entity, there is an implicit waiver of the Sovereign
Immunity, otherwise available to such Foreign State, against the
enforcement of an arbitral award.
▪ The very underlying rationale of international commercial
arbitration is that of facilitating international trade and
investment by providing:
• A stable, predictable, and effective legal framework
within which commercial activities may be conducted
to promote the smooth flow of international
transactions and
• By removing the uncertainties associated with timeconsuming and expensive litigation.
Indian Government Steps to resolve the issue:
• The Union Finance and Corporate Affairs Ministry introduced the Taxation
Laws (Amendment) Bill in the Lok Sabha recently to nullify the relevant
retrospective tax clauses that were introduced in 2012.
• About the Taxation Laws (Amendment) Bill:
o As per the proposed changes:
▪ Any tax demand made on transactions that took place before
May 2012 shall be dropped, and
▪ Any taxes already collected shall be repaid, albeit without
interest.
▪ To be eligible, the concerned taxpayers would have to drop all
pending cases against the government and promise not to make
any demands for damages or costs.
• Impact of the Taxation Laws (Amendment) Bill:
o It will bring past indirect transfer of Indian assets under the ambit of
taxation.
• The rationale behind bringing such law:
o Such retrospective amendments militate against the principle of tax
certainty and damage India’s reputation as an attractive
destination.
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o In the past few years, major reforms have been initiated in the
financial and infrastructure sector which has created a positive
environment for investment in the country.
o However, this retrospective clarificatory amendment and consequent
demand created in a few cases continue to be a sore point with
potential investors.
o This could help restore India’s reputation as a fair and predictable
regime apart from helping put an end to unnecessary, prolonged and
expensive litigation.
Sovereign right to tax:
• Several Investor-State Dispute Settlement (ISDS) tribunals have
recognised the fundamental principle that taxation is an intrinsic element of
the state’s sovereign power.
• For instance, in a case known as Eiser v. Spain, where foreign investors
challenged a tax imposed by Spain on electrical producers under the
Energy Charter Treaty,
o The tribunal held that the power to tax is a core sovereign power of the
state that should not be questioned lightly.
• Likewise, in El Paso v. Argentina, where the investors challenged several
facets of Argentinian tax measures as breaching the United StatesArgentina BIT,
o The tribunal held that the tax policy of a country is a matter relating
to the sovereign power of the state, and
o The State has a sovereign right to enact the tax measures it deems
appropriate at any particular time.
• Not just this, the ISDS tribunals have also held that whenever a foreign
investor challenges states’ taxation measures, there is a presumption that
the taxation measures are valid and legal.
• For instance, an ISDS tribunal in Renta 4 v. Russia said that when it
comes to examining taxation measures for BIT breaches,
o The starting point should be that the taxation measures are a bona
fide exercise of the state’s public powers.
• The tribunal in Cairn Energy v. India said that taxing indirect transfers
is India’s sovereign power and the tribunal would not comment on it.
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o However, such matters are not of absolute, unquestioning deference
and there are limits on it.
o Thus, India’s right to tax in the public interest should be balanced with
the investor’s interest of legal certainty.
o In the context of amending tax laws retroactively, such an action
should be justified by a specific purpose that could not be
accomplished by applying taxes prospectively.
• Limit on the right:
o The two most used BIT provisions to challenge a state’s taxation
measures are expropriation and the fair and equitable treatment
provision.
o In the context of expropriation,
▪ one of the key ISDS cases that explained the limits on the state’s
right to tax is Burlington v. Ecuador.
▪ In this dispute, investors challenged Ecuador’s windfall tax
imposed on excess profits resulting from oil exploration under
the United States-Ecuador BIT.
▪ The tribunal held that under customary international law, there
are two limits on the state’s right to tax.
• First, the tax should not be discriminatory;
• Second, it should not be confiscatory.
▪ In another ISDS case, EnCana v, Ecuador, a Canadian
corporation sued Ecuador for value-added taxes under the
Canada-Ecuador BIT.
• The tribunal held that a state’s tax measures would
amount to an expropriation of foreign investment if the tax
law is extraordinary, punitive in amount, or arbitrary in
incidence.
o In the context of the fair and equitable treatment provision,
▪ Foreign investors have often challenged taxation measures as
breaching legal certainty, which is an element of the fair and
equitable treatment provision.
▪ Although legal certainty does not mean immutability of legal
framework, states are under an obligation to carry out legal
changes such as:
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• Amending their tax laws in a reasonable and
proportionate manner.
Conclusion:
The biggest takeaway from this nine-year-long sordid episode of retrospective
taxation is that India should exercise its right to regulate while being mindful of its
international law obligations, acting in good faith and in a proportionate manner.
ISDS tribunals do not interfere with such regulatory measures. In sum, the debate
never was whether India has a sovereign right to tax, but whether this sovereign
right is subject to certain limitations. The answer is an emphatic ‘yes’ because
under international law the sovereign right to tax is not absolute.