Why India Lost To Cairn Energy: BQ Exclusive
In directing the Indian government to pay Cairn Energy Plc over $1.2 billion, the three-member international arbitration tribunal stated that the dispute is a tax-related investment dispute and not a tax dispute. Besides the tax department’s orders in Cairn Energy’s case and legislative debates, it relied on the 2012 Shome Committee report and former late Finance Minister Pranab Mukherjee’s autobiography to conclude that the 2012 retrospective amendment was not merely clarificatory in nature.
As per the award, a copy of which has been reviewed by BloombergQuint, the tribunal concluded that India failed to uphold its obligations under the U.K.-India Bilateral Investment Treaty (BIT) and international law. To arrive at that conclusion it examined -
- Whether Cairn Energy’s investment falls within the scope of BIT protection.
- Whether the nature of dispute is covered under the BIT.
- And finally, if India’s actions were violative of the fair and equitable treatment promised under the BIT.
The dispute relates to the tax demand of Rs 10,247 crore on Cairn UK Holdings Ltd. for alleged capital gains it made in the 2006 business reorganisation of its Indian holdings.
Under this reorganisation, Cairn India Holdings Ltd. was incorporated in Jersey as a wholly-owned subsidiary of Cairn UK Holdings. Under a share exchange agreement, Cairn UK transferred its direct and indirect stake in nine subsidiaries of the Cairn group to Cairn India Holdings. Later, Cairn UK sold its shares of Cairn India Holdings to Cairn India Ltd. As a result of this transaction and Cairn India’s listing, Cairn UK received approximately Rs 6,101 crore. It’s on this sum that the tax demand was raised.
While litigation was underway in Indian courts, in March 2015, Cairn Energy also served a notice of dispute, arguing that India had violated its obligations under the U.K.-India BIT.
Dispute Relates To An Investment And Not Returns, Tribunal Says
India had objected to the jurisdiction of the arbitral tribunal on grounds that the dispute was regarding Cairn UK Holdings ‘returns’ and not ‘investments’. Cairn UK Holdings was established and acquired shares in Cairn India as part of the 2006 transactions, which were structured as an abusive tax-avoidant scheme in violation of applicable laws and regulations, India argued.
Since the language of the BIT made a deliberate distinction between the two, the tribunal could hear ‘returns’-related disputes only under Articles 4(2) and 7 of the BIT.
Article 4(2) guarantees a most-favoured-nation treatment to investors, including in respect of returns on their investments. And Article 7 provides specific guarantees related to the convertibility and transferability of both investments and returns.
“Cairn Energy received capital gains outside India and they have never existed in the form of assets in India. They do not therefore qualify as investments and the dispute concerning the measures applicable to such capital gains is outside the tribunal’s jurisdiction..” - India’s Argument
The tribunal didn’t agree.
It pointed out that the retrospective tax was imposed on the economic consequences of a transaction relating to a part of Cairn Energy’s investment in India, and more specifically on an internal reorganisation of that investment. The BIT, the tribunal said, expressly considers this as an ‘investment’ as per Article 1(b). This provision defines ‘investment’ as every kind of asset established or acquired, including changes in the form of such investment.
The tribunal also relied on the preamble of the BIT - “to create conditions favourable for fostering greater investment by investors of one State in the territory of the Other State”. It would make little sense, the tribunal said, to offer a comprehensive set of protections to investments without extending them to the returns generated by such investments. After all, it noted, investments are made precisely to generate returns.
If the host State were allowed to expropriate or unfairly interfere with an investor’s ability to earn or collect returns from the investment, investors would be hardly induced to make investments in reliance on the BIT.Arbitral Tribunal
Tax-Related Investment Disputes Within BIT’s Scope
India had argued that the matter involves exercise of its sovereign authority in the field of taxation. And that India-U.K. have agreed that such disputes would be settled under the Double Taxation Avoidance Agreement. The fact that in more recent BITs, like the one with the UAE, India may have expressly excluded taxation, does not mean that in older BITs, like the one with the U.K., it did not intend to do so. Taxation is not a form of compensable expropriation, India stated.
“India has never agreed to subject its general fiscal measures to international arbitration and tax disputes are not arbitrable as a matter of public policy. The Tribunal should therefore decline jurisdiction on the Claimant’s [Cairn Energy] wide-ranging challenge to India’s fiscal sovereignty.” - India’s Argument
In dismissing this stance, the tribunal drew a distinction between a tax dispute and a tax-related investment dispute.
The first concerns taxability of a specific transaction i.e. whether and how a particular transaction is taxable under the applicable municipal law or, possibly laws of several countries if the transaction is international.
The second, it explained, pertains to violation of an investment treaty due to certain sovereign measures. "The issue at stake is thus not a matter of domestic tax law. It is whether the fiscal measures taken by the State, valid or not under its own tax laws, violate international law," the tribunal pointed out.
In such cases, the tribunal has to determine whether the State has breached a BIT’s substantive standards by exercising its authority in the field of taxation, and whether a liability arises as a result of this.Arbitral Tribunal
Breach Of Fair And Equitable Treatment Promise
India had denied any breach of the investment treaty. It had argued that as per Indian law, the share transfers that made up the acquisition of Cairn India Holdings were taxable in 2006 irrespective of the 2012 amendment. This since it was a tax avoidance transaction involving transfer of immovable property.
“The 2012 amendment was clarificatory and not retroactive. Even if it was found to be so, retroactive taxation is lawful in India and was thus a part of the legislative framework in which Cairn Energy invested.” - India’s Argument
The tribunal refused to accept India’s stance that the allegations of breach must be seen in light of the position that retroactive taxation is lawful in India. It noted that as per international law, a State cannot justify a breach of international obligations by invoking its own law. And that under the U.K.-India BIT, it’s the tribunal that must determine whether a case for breach has been made.
It found India in breach for the following reasons:
- The income tax assessment orders relied heavily on the 2012 Amendment to impose the tax on Cairn Energy. It is evidenced by the assessing officer’s tax demand order, reports by income tax department’s officers, the finance minister’s budget speech of 2016 which offered a one-time scheme to settle cases arising from the retrospective amendment, and finally the Indian tax tribunal’s 2017 order which recorded that the taxability arises as a result of the 2012 amendment. In essence, the arbitral tribunal concluded that the basis of the demand was the retrospective amendment and not a plain reading of the tax law prior to that.
- The 2012 amendment substantively changed the scope or operation of indirect transfer provisions and was not a true clarification. The tribunal cannot rely solely on the fact that the parliament labelled the amendment as a clarification, or the finance ministry’s explanation of the original legislative intent when the amendment was introduced.
- India’s argument that the 2012 amendment aimed to tackle tax abuse cannot be accepted. The amendment does not target foreign investors who evade or wrongly avoid taxes. It applies to any indirect transfer, whether tax abusive or not. And so, India did not have a specific public purpose that would justify applying the 2012 amendment to past transactions.
By retroactively applying, without a specific justification, a new tax burden on a transaction that was not taxable at the time it was carried out, India deprived Cairn Energy legal certainty which is one of the core elements of the fair and equitable treatment standard under the BIT.Arbitral Tribunal
Basis this, the tribunal found retroactive taxation by India against Cairn Energy “grossly unfair”.