India’s sovereign taxation rights on capital gains cannot be held hostage to its bilateral investment treaties with other countries
The Permanent Court of Arbitration (PCA) tribunal in The Hague has rejected the back tax demands of Indian tax authorities in both, the Cairn and Vodafone cases. These back taxes relate to capital gains made on transactions in 2006-2007. According to the PCA, the demands have been rejected on two counts. First, they violate India’s obligations under Bilateral Investment Treaties. Second, they are based on a retrospective amendment to a tax law passed in 2012. Both the arguments are untenable. As regards the first, tax is levied on the earnings of the companies from their operations in India. The Government has done nothing to put their investment at risk. As for the second, the 2012 amendment was only in the nature of a “clarification” to remove ambiguity and bring out the real intent of the law i.e. levy tax on income generated from an underlying asset in India. This is irrespective of how the transaction was given effect. Even when it involves indirect transfer of shares, it can’t be construed as a change in the law itself. The Narendra Modi Government has challenged, rightly so, the tribunal’s order in the Vodafone case and is expected to follow suit in the Cairn case, too.
The capital gains made by the firms on sale of their ownership in Indian companies run into tens of thousands of crores. But on September 25, 2020, the PCA rejected the I-T Department’s demand for Rs 22,100 crore in back taxes (Rs 7,990 crore plus interest and penalty) relating to Vodafone Group Plc (the British telecom giant) $11 billion acquisition of 67 per cent stake in the Hutchison Essar Ltd (HEL) — an Indian company running a mobile phone business — owned by Hutchison Whampoa (HW) in February 2007.
The tribunal held that the Indian Government’s demand from Vodafone using retrospective legislation was in “breach of the guarantee of fair and equitable treatment” assured under the bilateral investment protection pact between India and the Netherlands. It also asked the Centre to reimburse Vodafone 60 per cent of its legal costs (about Rs 85 crore) and half of the Euro 6,000 cost borne by Vodafone for appointing an arbitrator on the panel.
Second, on December 23, 2020, a three-member tribunal at the PCA invalidated India’s March 2015 tax claim of around Rs 24,000 crore (Rs 10,247 crore in tax plus interest and penalty) on the British behemoth Cairn Energy on capital gains made by it on the “internal reorganisation of its India business” run by Cairn India in 2006-07 (then, Cairn UK transferred shares of its subsidiary Cairn India Holdings to Cairn India).
It also ordered the Indian I-T Department to return up to $1.2 billion to Cairn Energy in funds withheld by the former including the (i) value of the latter’s 10 per cent shares in Cairn India attached and sold (during 2011, even as Cairn Energy had sold majority of its holding in Cairn India to Vedanta, the department did not allow it to sell 10 per cent); (ii) seizure of dividends that the company paid to its parent and (iii) tax refunds withheld to recover the tax demand. Add $200 million of interest on these amounts and $20 million of arbitration cost, the total comes to $1.4 billion. Cairn can use the arbitration award to approach courts in countries such as the UK to seize any property owned by India overseas to recover the money, if the award is not honoured.
There is widespread consternation over the decision of the Indian Government to raise the demands in the very first place and thereafter pursue these in the court. Critics argue that raising the demand using a retrospective amendment in tax laws (this was enacted in 2012 to negate a judgment of the Supreme Court in the Vodafone case that had declared untenable a tax demand earlier raised on the February 2007 transaction; armed with this amendment, it resurrected that demand in 2013 besides raising demand on Cairn Energy using the same law) affects long-term stability of the fiscal environment and undermines investor confidence.
Prima facie, retrospective amendment in tax laws may look bad. Investors can argue that they take decisions on the basis of prevailing laws of the land and if laws are changed midstream, this is unfair as it undermines the very basis of the business decision. The million-dollar question is: Did the then Government fundamentally alter the law? To get to the bottom of the truth, we need to closely look at the genesis behind the 2012 amendment.
The cardinal principle of taxation is that tax is levied on income generated from an asset. In the Vodafone case, the underlying asset was the mobile phone business then run by HEL. HW having 67 per cent shareholding in HEL through its fully owned Cayman Island-based subsidiary, viz; CGP Investments sold the entire 67 per cent to Vodafone’s Netherland-based subsidiary Vodafone International Holding. From the sale of these shares, HW made major capital gains. This was made possible due to increase in valuation of the Indian asset, viz; HEL — rechristened Vodafone India Limited (VIL) after acquisition of majority shares by Vodafone. Hence, the Indian Government is fully entitled to collect tax on this income. Yet, the firms exploited an ambiguity in the extant law by citing that the transaction took place between two foreign entities CGP Investments and Vodafone International Holding Ltd (the buyer), thus, camouflaging it as an “indirect transfer” of Indian assets.
To stop abuse and plug the loophole of such indirect transfer of Indian assets, in 2012, the Government amended the law to make such transfers (albeit indirect) taxable in India. As per an amendment to Section 9 of the Income-Tax Act in 2012, if any share or interest in a foreign entity derives its value substantially from the assets located in India, then such share or interest is deemed to be situated in India and any income arising from transfer of such a share or interest is deemed to arise in India.
The amendment was merely in the nature of a “clarification” to the subsisting law aimed at making the intention of the law explicit. Quite clearly, the real intent was to ensure that the income generated from an “underlying asset” in India irrespective of how this transaction was given effect — even when it involves indirect transfer of shares — is taxed by the Indian Government.
Enacted after the aforementioned transactions had happened, while this may give it the color of being retrospective, the fact remains that the amendment was only in the nature of a “clarification.” It can’t be construed as a change in the law itself. Assuming for the sake of argument that the Centre can’t collect tax then, are we to infer that the capital gains made from sale of Indian assets will go untaxed? Does it not violate the basic tenet of taxation?
The demand raised by the I-T Department is pursuant to a law passed by a sovereign Parliament. There is absolutely nothing illegal about it. Had it been so, the top court would have declared it invalid. The ruling of the international arbitration tribunal in the two cases cites the tax demand as being violation of India’s obligation under Bilateral Investment Treaty with the countries concerned. The argument does not hold water as the Indian Government has only levied tax on the earnings of the companies. There is nothing to suggest that it has put at risk the latter’s investment in India. Even so, taxation is not covered under investment protection treaties and the law on taxation is a sovereign right of the country.
In the Cairns Energy case, the tribunal has referred to a statement by the then Finance Minister, Arun Jaitley, on November 7, 2014, that his Government had taken a “policy decision that as far as this Government is concerned, even though there is a sovereign power of retrospective taxation, we are not going to exercise that power.” The demand raised by the I-T Department is in no way incongruous with Jaitley’s assertion as it is merely the result of removing an ambiguity in the extant law and certainly does not fall in the category of retrospective tax.
To conclude, India’s sovereign taxation rights can’t be held hostage to its bilateral investment treaties with other countries. Keeping this overarching consideration in mind and opinion of the Solicitor General that an “arbitral tribunal can’t render a law passed by a sovereign Parliament ineffective,” the Government has decided to challenge the tribunal’s order. In the Vodafone case, on December 24, 2020, it filed a petition in the Singapore court well within the three-month deadline from the date of order. In the Cairn Energy case too, it should challenge the tribunal’s order.
Undoubtedly, India needs foreign investment in its march towards accelerated growth. But this can’t be taken to mean that the Government will forgo its legitimate tax dues on the gains made by foreign investors from their operations here. It should pursue all available legal options to make Vodafone and Cairn pay up.
(The writer is a New Delhi-based policy analyst. The views expressed are personal.)
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