Early 2000 saw a rise in the trend of corporate (direct) taxes being identified as one of the largest sources of revenue in India. FDI regime was simplified, and India opened various sectors to foreign direct investments. Around the same time, India made commitments to the WTO towards rationalisation of indirect taxes. As a result, customs tariffs and excise duties were considerably reduced. Reduced fiscal benefits through indirect taxes led to further acknowledgement of the advantages of corporate direct taxes. Income of non-resident entities entering into contracts in India, drew attention and, corporate taxes came to be identified as a lucrative source of revenue. Soon, disputes started arising around capital gains and taxable income in the context of services originating from cross border transactions. This is when the trend retrospective amendments - either directly, or by way of 'clarifications', saw a rise.
In Ishikawajma-Harima Heavy Industries Ltd. Vs. DIT1, (2007) the Supreme Court of India dealt with the subject of taxation of income from offshore services in the context of S.9(1)(vii) of the Income Tax Act, 1961 (fees from technical services) and provisions of the Double Taxation Avoidance Agreement (DTAA) between India and Japan. Elaborating the principle of "territorial nexus", the Apex Court held that if any operations deriving income are not rendered in India, then the income relating to such operations cannot be taxed in India. Ishikawajma was a non-resident entity providing services to an Indian entity. The court held against giving an extended meaning to the words "income deemed to accrue or arise in India". Thus, where S.9(1)(vii) would cover a resident Indian within its ambit, a non-resident, and services of a non-resident utilised in India, would be outside the purview of this provision.
However, this judgment was diluted when an explanation was inserted to Sec. 9(2) of the Income Tax Act, that too retrospectively from the year 1976. This explanation 'clarified' that income by way of interest, royalty and fees for technical services, are deemed to accrue or arise in India and such income shall be included in the total income of the non-resident Indian, whether, the non-resident Indian has a residence or place of business or business connection in India.
The pattern of amending tax provisions retrospectively, by way of 'clarifications', continued and several judicial pronouncements were reversed or negated through constant amendments. Section 9 of the Income Tax Act itself has been subjected to numerous amendments.
It is widely acknowledged that constant amendments to tax statutes lead to a negative perception amongst investors. Companies require certainty of law while structuring investments, particularly when the investments are in developing countries. Though there is a mechanism of advance rulings where the assessee can seek advance ruling on the proposed transaction, however this provision too, is exercised with caution because such a ruling is binding on the assessee and limits the scope of challenging the same.
In a run up to, what became, a massive legal battle for India with serious financial ramifications, came two crucial cross border transactions. One involving Vodafone International Holding and the other, with Cairn UK Holding Limited. Both transactions involved indirect transfer of Indian assets and got hit by an amendment made to the Finance Act, made retrospectively from 2012. The said amendment had huge financial repercussions on the foreign companies in question and thus resulted in extensive litigation within India as well as before internationals forums.
Vodafone International Holdings
In 2007, Vodafone International Holdings (Vodafone) procured 100% shares in CGP Investments (Holding) Ltd. (CGP), a company situated in Cayman Island, for USD 11.1 billion. CGP was a wholly owned subsidiary of Hutchison Telecommunications International Ltd. (Hutch) which was also based in Cayman Island. Through various entities that CGP owned in countries like Mauritius, it controlled 67% of Hutchison Essar Limited (Hutch Essar), an Indian Company. On account of the share transfer, Vodafone acquired CGP's subsidiaries including Hutch Essar in India. Vodafone also acquired telecom licenses to give mobile communication in India starting from November 1994. In September 2007, a show-cause notice was served on Vodafone by the Indian Tax department to clarify the reason as to why tax was not retained on instalments made to Hutch in connection to the above share transfer as the said transaction, of transfer of shares in CGP, had an impact of indirect transfer of assets in India. The legal issue that arose was whether transfer of shares between two foreign companies, amounted to transfer of capital assets in India and whether such transaction is chargeable to tax in India?
The matter went up to the Supreme Court and in Vodafone International Holdings BV v. Union of India2, the Supreme Court held that it is the duty of the court to find the nature of the transaction and when doing so, it must look at the whole transaction. The Court found that the major purpose in Vodafone share transfer was to transfer the shares of CGP and not transferring the rights in Hutch Essar situated in India.
The Supreme Court interpreted S.9(1)(i) of the Income Tax Act. The said section includes- "All income accruing or arising, whether directly or indirectly, through or from any business connection in India, or through or from any property in India, or through or from any asset or source of income in India, or through the transfer of a capital asset situate in India". The Court found that the words "directly or indirectly" in section 9(1)(i) of the Act refer to the income and not the transfer of a capital assets. It held that to apply the words "directly or indirectly" to the transfer of a capital asset (Hutch Essar being a capital asset) "would amount to changing the content and ambit of section 9(1)(i). The court found the intention of the legislature to be clear in as much as that it included only direct transfer of income within its purview and not indirect transfers. What was considered was the sale of shares and not sale of assets. Also, Hutch Essar had a presence in India since 1994 and had been paying income tax throughout.
It was held that the tax is levied based on the source and the source is the location where the sale takes place and not where the product is derived or purchased from. Hutch and Vodafone are foreign companies, and the sale took place outside India, so the source of revenue is outside India. The transaction was carried out between two non-resident entities in a contract conducted outside India where the consideration was also rendered outside India. It was held that the selling of Hutch's CGP shares to Vodafone is transfer of capital assets under the scope of Section 2(14) of the Income Tax Act and therefore not chargeable under capital gains. Thus, the demand raised by the Income Tax department was quashed.
Finance Act 2012 - Amendment to Section 9(1)(i) of the Income Tax Act, 1961
In 2012, in what was an obvious move to circumvent the Supreme Court decision in Vodafone, a retrospective amendment was made to Section 9(1)(i) of the Income Tax Act to make it applicable to transfer of share by a non-resident in a company incorporated abroad if the share derived (directly or indirectly) its value substantially from assets located in India.
This struck at the root of the entire case on which Vodafone's claims were based before the proceedings in the Supreme Court. Considering the law of the land itself had been changed, Vodafone initiated arbitration before the Permanent Court of Arbitration, Hague, on the ground that the retrospective amendment was in violation of the fair and equitable treatment promised under two separate Bilateral Investment Treaties (BIT)— The India-Netherlands BIT and the India-UK BIT.
Recently, the Indian government has challenged the arbitration award in Singapore Court on the ground that taxation is not covered under the treaty and is a sovereign right of the country.
Cairn UK Holdings Limited
The Vodafone judgment and the subsequent amendment to Section 9(1)(i) of the Income Tax Act had an impact on several existing cross border transactions. Thus, after Vodafone, in 2015, the Indian government imposed on Cairn UK Holdings Limited (Cairn UK), a draft tax assessment of ?10,247 crores for an alleged capital gain by way of an internal corporate restructuring that took place in 2006.
Cairn UK, a company incorporated in the U.K., had a wholly- owned subsidiary namely Cairn India Holdings Limited (Cairn India), a company incorporated in Jersey - (Cairn Jersey). Cairn Jersey owned subsidiaries in India. In the year 2006, Cairn UK transferred its entire shareholding of Cairn Jersey to Cairn India. Subsequently, Cairn India, divested about 30% of its shares through an Initial Public Offering.
In 2014, in view of the 2012 amendment, the income tax department in India found that the transfer of shareholding in Cairn Jersey, in 2006, had the effect of transferring the business in India and therefore, in view of the retrospective amended income-tax laws, Cairn UK was liable to pay capital gain tax in India. The income tax department raised a demand of Rs. 22,100/- crore on Cairn.
Cairn initiated arbitration against India before the investor state dispute settlement arbitral tribunal at Hague. Interestingly, it was argued by India that the impugned amendment of 2012 was merely a clarification on "indirect transfers" and that there was no actual retrospective amendment to the statute. Cairn argued that the retrospective amendment breached the UK-India Bilateral Investment Treaty which had a standard clause that obligated India to treat investment coming from UK in a fair and equitable manner. This argument was dismissed by the tribunal, and it was held that Section 9(1)(i) of the Income Tax Act was substantially altered by the 2012 amendment. It was also held that India was bound by its treaty obligations, that India's liability arose on account of violation of international law and the same was independent of constitutionality of the impugned provision within India.
In December 2020, the three-member arbitral tribunal held in favour of Cairn and held that India was in breach of the fair and equitable treatment provision of the India-UK BIT. The tribunal held India liable to pay more than $1.2 billion to Cairn UK towards restitution of Cairn's losses resulting from the expropriation of its investments in India in 2014, continued attempts to enforce retrospective tax measures, and the failure to treat the company and its investments fairly and equitably. 3
In the months after the passing of the Award, it was reported that talks were on for a possible settlement between parties and that India had offered to forgo 50 % of the alleged tax liability imputed to Cairn under the Indian law. However, all speculations around possible settlement between the parties were put to rest when in May 2021 Cairn Energy Plc. filed a lawsuit in the USA in order to enforce the Award.
What is interesting is that Cairn filed the suit against Air India. Cairn sought to implead Air India and for it to be declared as the 'alter ego of Indian government' by virtue of it being wholly owned and extensively controlled by the government of India. It is being argued that Air India is "legally indistinct from the state itself" and that it should be held jointly and severally responsible for the amounts owed to Cairn by the government of India.
Cairn seeks to rely on the judgment of the US Supreme Court titled First National City Bank NA versus Banco Para El Comercio Exterior de Cuba4 - better known as Bancec, where the court held that federal common law should determine the separate juridical status of an entity wholly owned by a foreign state. Thus, once the court finds that it is a case of piercing the corporate veil while holding the Indian government liable, Cairn would become legally entitled to seek attachment of Indian assets (like airplanes, bank accounts etc.) in the US.
Cairn has also initiated proceedings against India in other jurisdictions around the world seeking recognition and enforcement of the Award. India has appealed against the Award in the Netherlands.
Role of BIT and Fair and Equitable Treatment clauses in such disputes
The complete text of the two arbitral awards, in Cairn and Vodafone, is not available to the author herein. However, from information available, it can be gathered that violation of the fair and equitable treatment clause (hereinafter referred to as FET) in the respective BIT, has been an important factor for holding in favour of the investors. The dispute originates from retrospective amendments carried out in India and concludes (so far) with the arbitral tribunal holding the retrospective amendment and the subsequent impact on the investor, to be violative of BIT - FET. Thus, a brief understanding of interpretation of FET clauses becomes relevant.
Bilateral investment treaties (BITs) impose obligations on the contracting country to treat the investing- country in a "fair and equitable" manner. FET clause, which is otherwise an innocuous, usually a vaguely worded provision in the contract, has found significance in many recent cross border disputes. This provision is now frequently invoked in arbitrations pursuant to BITs. It is noteworthy that this clause has a 62% success rate in international dispute resolution.5 Both, Cairn and Vodafone, are instances of the arbitral tribunal holding in favour of the investor on the grounds of violation of FET clause.
Concept of fair and equitable treatment, in reference to BIT, is nuanced. FET clause is usually a broadly worded provision in BITs. The extent of obligations being imposed on the host country is also not well defined. While 'national treatment' and 'most-favoured-nation treatment' obligations, take into consideration the circumstances of the host country, FET clause is independent of the local circumstances of the host country and, also independent from how it is treated in relation to other investing countries. One school of thought lays down that FET clauses obligates the host government to treat the investing country with "minimum standard" as required under customary international law. However, actual practice seems to indicate that it demands, from the host government, something beyond the required minimum standards of international law. Unlike the 'minimum standards' obligations, FET as a concept does not originate from customary international law. Yet, increasingly, it is becoming a standard clause incorporated in international investments agreements. It is widely believed that FET clause is incorporated with the aim of providing protection to investing countries entering contracts with developing countries.
FET is not a specifically defined concept. It has been evolving over a period alongwith international arbitral jurisprudence. While there may be variations in the way FET clauses are drafted, some common factors, in those concerning developing countries as host nations, include: -
transparency and respect for legitimate expectation, stability and consistency of law and administrative decisions, following due process of law and, protection from arbitrary and discriminatory treatment. At the first blush these seem to be straightforward and reasonable factors to be considered while interpreting the FET circumstances. However, their interpretation by the arbitral tribunals can still be tilted in favour of the developed investing country. There is increasing pressure from the developing nations, seeking equal weightage to their respective sovereign rights to regulate and legislate their laws. From the point of view of the developing countries, FET clause is merely one aspect of what is only a business investment deal. Thus, while being interpreted by arbitral tribunals, outside the hosting nation, they ought not to be used as business or profit guarantee to business investments. Further, they must certainly not be used as instruments to intrude within the regulatory framework of the host country. The host country ought to be free to bring about changes in its regulatory framework in consonance with its law and socio-economic-circumstances, without being deterred by threats of narrow interpretation of such (FET) clauses. Further, even the interpretation of FET by arbitral tribunals is not consistent. In some instances, tribunals have sought to apply the ELSI standard6 which implicates a particularly high threshold; that is, the conduct of the host state must 'shock or surprise the tribunal's sense of judicial propriety'. Conversely however, other tribunals have opted for a relatively low threshold by resorting exclusively to dictionary definitions, while other tribunals have set forth a rather subjective and ambiguous threshold requiring 'treatment in such an unjust or arbitrary manner that the treatment rises to the level that is unacceptable from the international perspective. From a developing country's perspective, the latter two thresholds represent not only the increasingly pervasive nature of the FET obligation, but more so, arbitral tribunals treading on dangerous grounds by introducing subjectively vague formulations which can potentially expose serious gaps in the regulatory prospectuses of developing countries. Evidence of this unwarranted development could be gleaned from a commentator's empirical assessment which found that violations of the ELSI standard was established in only 22 per cent of the cases in which arbitrariness was alleged, whereas 75 per cent violations were established where tribunals applied a lower threshold.7 These findings appear to affirm the fear held by many developing countries that as tribunals endeavour to lower the threshold for a finding of arbitrariness, there will be more violations, and hence, greater potential for intrusion in the host nations' regulatory framework.
In the S.D. Myers, Inc. v. Canada, (November 13, 2000) arbitration, amongst others, the Tribunal also gave a finding that "..determination (of whether or not there is a breach of a FET like clause) must be made in light of the high measure of deference that international law generally extends to the right of domestic authorities to regulate matters within their own borders. The determination must also take into account any specific rules of international law that are applicable to the case..."
What the author herein finds interesting is that, viewed from the developing / host country's perspective, the arguments, (of unpredictability, arbitrariness, inconsistency, discrimination etc.), which are raised by the investing countries against the host countries when arguing their case before arbitral tribunals, can also be raised by the host countries against the arbitral tribunals while they interpret the FET clauses in favour of the investors. Just as the investor has legitimate expectations with respect to the legal framework within the host country, the host country also has a right to be assured of a fair, equitable, consistent, and non-discriminatory standard of adjudication when its domestic legal framework is subjected to scrutiny before international forums.
Conclusion
Conflicting interests of both the investor and the host country must be considered while determining tax disputes. To assess if it is a case of tax avoidance or, of justifiable tax planning. To balance, the reasonable expectation of the government to retain its sovereignty over fiscal matters, with the investor's expectation of a stable tax policy. The answer may be found in exercising sovereign rights in consonance with international law & practice and, at the same time, for transnational tribunals to apply international law concepts in a fair, equitable and consistent manner while adjudicating disputes when the parties are not placed on equal footing.
Vodafone, to begin with, duly submitted itself to the jurisdiction of the Indian courts and, as part of its legal recourse, litigated all the way till the Supreme Court. The Supreme Court held in its favour. However, it was subsequent to this decision that the government of India made retrospective amendments and used the legislature to get what the judiciary would not allow. Even without the benefit of the detailed submissions made on behalf of India before the tribunal, it is clear that till such time the retrospective amendment was made, the law of the land favoured Vodafone. Further, when Vodafone reached out to the international tribunal, it challenged, inter alia, the very act of the Indian government to bring about a substantive change in law retrospectively, and then call it a mere clarification. In other words, Vodafone did not challenge an existing law or regulation, but challenged the act of changing the prevailing law to its detriment. Considering that the apex court of the India itself held in favour of the investor company, it would be difficult to apply even the high ELSI standard to hold in favour of India before an international forum. In case of Cairn too, the repercussion was similar because its investments in India precede the date of retrospective amendment. It is not unreasonable for an investor to assume that regulation of laws in the host country would be within the four corners of its legal framework, which itself would be protected by the courts therein. When the law itself is amended, that too retrospectively, it offsets and disbalances all bonafide computations made by the investor.
Tax regime of any nation must be certain as well as predictable. Absence of any of these two conditions results in discouraging investors, affecting the overall economic growth of the host country.
In the present context, while the legal dispute started with tax demands raised by India against foreign investors, it has ended up dragging India in protracted litigation before international forums. When a sovereign country enters into transactions with foreign investors, there are expectations of mutual benefits, but the host country's sovereign rights must be respected. However, this must also be balanced with legitimate expectations of the investors who decide to invest only after assessing the feasibility of their investments based on prevailing laws of the host country.
Footnotes
1. (2007) 3 SCC 481,
2. (2012) 6 SCC 613
3. Due to its 2012 blunder, India's Cairn challenge at The Hague is likely to fail, Hindustan Times, 30th March 2021
4. 462 US 611 (1983)
5.https://www.researchgate.net/publication/270370959_The_Evolving_Nature_of_the_Fair_and_
Equitable_Treatment_FET_Standard_Challenging_Its_Increasing_
Pervasiveness_in_Light_of_Developing_Countries%27_Concerns_-_The_Case_for_Regulatory_Rebalancing
6. Elettronica Sicula SpA (ELSI) (United States of America v. Italy), ICJ Reports. 1989. The Chamber of the International Court of Justice (I.C.J.), in its Judgement of 20 July 1989, held that the requirement for constant protection and security, as expressed in the FCN treaty between Italy and the United States, was not a warranty to a U.S. investor that no disturbance in any circumstances would occur, and that the requisition by an Italian government entity of an insolvent Italian company partially owned by the U.S. investor did not violate the requirement. Also, its formulation of arbitrariness at international law declined to equate mere unlawfulness at domestic law, without more, with arbitrariness.
7.https://www.researchgate.net/publication/270370959_The_Evolving_Nature_of_the_Fair_and_
Equitable_Treatment_FET_Standard_Challenging_Its_Increasing_Pervasiveness_in
_Light_of_Developing_Countries%27_Concerns_-_The_Case_for_Regulatory_Rebalancing
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