The sovereign tax law will not be absolute

BIT provisions for challenging taxation measures include expropriation and fair and equitable treatment

A major bill tabled in parliament last week aims to undo the regressive amendment to the 2012 Income Tax Act. The 2012 amendment reversed the Supreme Court ruling in the Vodafone International Holdings v Union of India case and made the Income Tax Act retrospectively applicable to indirect transfers of Indian assets. The retrospective change resulted in Vodafone and Cairn Energy suing India in the Investor-State Dispute Settlement Courts (ISDS) of the India-Netherlands and India-United Kingdom bilateral investment agreements. Both tribunals found that India’s retrospective amendment to tax laws violated the provision of fair and equitable treatment of the two BITs.

The proposed change, long overdue, is a welcome development. However, it is presented as a domestic legal reform that reverses a past mistake. It appears that this change was not proposed to comply with the two negative ISDS decisions against India or India’s international obligations contained in BITs. This is due to the erroneous belief in bureaucratic and political circles that tax matters, as they are part of sovereign measures, cannot be challenged in ISDS courts.

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Sovereign tax law

Several ISDS courts have recognized the basic principle that taxation is an essential element of state sovereignty. In a case known as Eiser v Spain, in which foreign investors challenged a tax Spain imposed on electricity producers under the Energy Charter Treaty, the court found that the power to tax is a core power of the state that is not easily questioned. Also in the El Paso v Argentina case, in which investors questioned several facets of Argentina’s tax measures in violation of the US-Argentina BIT, the tribunal found that a country’s tax policy is a matter of state sovereignty, and so is it “The state has a sovereign right to take the tax measures it deems appropriate at a particular point in time”. In addition, the ISDS courts have found that whenever a foreign investor contests tax measures by a state, the tax measures are assumed to be valid and lawful. For example, an ISDS tribunal in Renta 4 v Russia said that when considering taxation measures for BIT violations, the starting point should be that the taxation measures represent an honest exercise of the state’s public powers.

Boundaries right

Regardless of the state’s sovereign right to tax and the presumption of the validity of taxation measures, the exercise of this public authority is subject to certain limits. The two most common BIT provisions used to challenge a state’s taxation measures are expropriation and the provision of fair and equitable treatment. In connection with the expropriation, Burlington v Ecuador is one of the most important ISDS cases, which explains the limits of state tax law. In this dispute, investors challenged Ecuador’s windfall tax, which is levied on excess profits from oil exploration under the US-Ecuador BIT. The tribunal found that state tax law has two limits under customary international law. First, the tax should not be discriminatory; second, it shouldn’t be confiscatory. In another ISDS case, EnCana v Ecuador, a Canadian company sued Ecuador for VAT under the Canada-Ecuador BIT. The tribunal found that a state’s tax measures amounted to expropriation of foreign investment when the tax law is exceptional, criminal or arbitrary.

In the context of the fair and equal treatment provision, foreign investors have often challenged taxation measures as a violation of the legal certainty that is an element of the fair and equal treatment provision. Although legal certainty does not mean the immutability of the legal framework, states are obliged to make legal changes such as B. change their tax laws in an appropriate and proportionate manner.

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The tribunal in Cairn Energy v. India said the indirect transfer taxation was India’s sovereign power and the tribunal would not comment on it. However, such matters are not of “absolute, unconditional reverence and there are limits to it”. Therefore, India’s right to tax in the public interest should be weighed against the investor’s interest in legal certainty. In the context of a retrospective change in tax laws, such an approach should be justified by a specific purpose that could not be achieved through prospective taxation. The court found that the public purpose justifying prospective application of the law is usually insufficient to justify retrospective application of the law. There must be an additional public purpose that justifies the retrospective application of the law. India argued, for example, that the 2012 amendment is designed to ensure that foreign companies using tax havens for indirect transfers of underlying Indian assets pay taxes. However, this goal can be achieved through a prospective and non-retroactive amendment to the Income Tax Act. It is important to remember that the court did not rule against the retroactive effect of tax laws per se, but against the retrospective application that is justified without public policy.

Elaboration of tax measures

India has completely removed taxation measures from the scope of the investment agreement in its 2016 model BIT. However, outsourcing taxation measures from the scope of the BIT does not mean that states are free to do what they want. As found in the Yukos Universal v. Russia case, states cannot benefit from the outsourcing regime if they act in bad faith or abuse their right to tax or mala-fide taxation measures against foreign investors.

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The biggest lesson from this dirty nine year episode of retrospective taxation is that India should exercise its right to regulate, while being aware of its international legal obligations, acting in good faith and proportionate. ISDS courts do not intervene in such regulatory measures. In summary, the question was never whether India has a sovereign tax law, but rather whether this sovereign right is subject to certain restrictions. The answer is an emphatic “yes”, because sovereign tax law is not absolute under international law.

Prabhash Ranjan will soon join OP Jindal Global University as Professor and Vice Dean of Jindal Global Law School. Views are personal