[Achyutha GM is a 4th year B.Sc. LL.B. (Hons.) student at the Gujarat National Law University, Gandhinagar]
It all began with an acquisition that Vodafone International Holdings B. V. (‘Vodafone’), the Dutch subsidiary of the UK-based Vodafone Group carried out in 2007. CGP Investments Limited (‘CGP’) is a special purpose vehicle based in the Cayman Islands for tax purposes that owns a controlling interest in Hutchison Essar (‘HE’), an Indian joint venture company. Indirectly, Hutchison Telecommunications International Ltd (‘HTIL’) owns HE as it has a controlling interest in CGP Investments. Vodafone entered into an agreement with HTIL to buy out CGP for $11.08 billion which would result in majority ownership of HE.
Classifying this as capital gains, the Indian Revenue Department (‘Indian Revenue’) issued a notice to Vodafone to pay $2.1 billion as capital gains tax. In a suit before the Bombay High Court, Vodafone contended that the demand by the tax authorities was without any taxation nexus. The High Court ruled against Vodafone and this decision was appealed before the Supreme Court (‘SC’). In 2012, the SC noted that the transaction had no nexus to India as the agreements were executed in England and Hong Kong, and monies were paid outside India. Therefore, the SC held, as a share transfer of a non-resident entity, the transaction would not taxable by the Indian Revenue.
While this episode ought to have ended here, the Government introduced the Finance Bill in 2012, which inserted explanation 5 to Section 9(1) of the Income Tax Act, 1961. It allowed retrospective taxation of transactions which received value from substantive assets in India even if the share transfer involved a non-resident company. Subsequently, Indian Revenue renewed their demand for payment of the said taxes.
Following this demand, Vodafone initiated two investment arbitrations against India before the Permanent Court of Arbitration (‘PCA’), citing violation of its fair and equitable treatment (‘FET’), under the India-Netherlands BIT of 2014 and the India-UK BIT of 2016. After an anti-arbitration injunction suit was filed by India before the Delhi High Court, both the proceedings were consolidated to mollify India’s concerns of inconsistency.
Recently, the PCA gave the award in favour of Vodafone, noting that India’s “conduct in respect of the imposition on the Claimant of an asserted liability to tax notwithstanding the Supreme Court Judgement is in breach of the guarantee of fair and equitable treatment laid down in Article 4 (1) of the Agreement, as is the imposition of interest on the sums in question and the imposition of penalties for non-payment of the sums in question.” The PCA has also asked India to pay £4.3 million, which covers 60% of Vodafone’s cost of legal representations. There is a possibility for India to challenge this decision in the Singaporean courts on a jurisdictional basis. However, India will have to potentially shell out Rs 450 million of tax revenue if it fails to exercise this appeal.
Investor’s Legitimate Expectations: A Confusing Standard
A claim for the breach of the FET standard begins with the investor’s legitimate expectations. Legitimate expectations can be sourced in the host State’s regulatory framework at time of making investment. While this does not mean that the host state’s legislation is frozen in time, there are certain standards by which the change has to be undertaken. Thus, it is important to find “the right balance between the stability and legitimate expectations on the one hand, and the host State’s right to amend the regulatory framework on the other.”
One of the early attempts at laying down a link between the FET and regulatory stability was made in Tecmed v. Mexico. The ICSID tribunal noted that one of the basic expectations of an investor is that the host State acts “in a consistent manner, free from ambiguity and totally transparently in its relations with the foreign investor”. This laid the foundation for the standard of an investor’s expectation of a stable legal and business environment. Not only is this a matter of principle, it is also commercially prudent to instil confidence in existing investors and elicit new investors into a State. While the ICSID’s practice seems to favour a stricter approach of restricting a State’s inherent right to perform legislative changes, the practice on this front has been inconsistent and certain.
Saluka v. Czech Republic was one of the first cases which recognised a State’s undeniable right to amend laws and observed that a regulatory stability obligation has to be reasonably construed in light of the prevailing circumstances. The approach afforded more leeway to States to make regulatory changes. The standard for violating a foreign investor’s legitimate expectations was constrained only “in case of drastic or discriminatory change” or “unreasonable modifications” to the regulatory framework. Arguably, among a sea of indecisive awards, the best yardstick to scale this by, is to check “if modifications of laws were made specifically to prejudice its investment”. The PCA’s decision is thus notable, as it points out the targeted response of the Indian Government in trying to retrospectively amend the law laid down by their SC.
India’s Faux Pas: An FET Breach?
To begin with, the SC noted that the amendment to levy such a tax was in the draft taxation codes, which had not yet been legislated. This evinces that an attempt to characterise the 2012 amendment as clarificatory was a mere afterthought. This is further buttressed by the Expert Committee’s (headed by Mr. Parthasarathy Shome) observation that there was no legislative intent to tax capital gains arising out of indirect transfer in the first place. In fact, Australian and Canadian courts took the same stance as the SC which spurred a legislative inclusion of look through provisions in their laws to tax such transactions.
Vodafone and HTIL were advised rightly at the time that Indian taxation law did not cover share transfer of company in the Cayman Islands. When the Indian Revenue raised a demand, it was the task of the SC to determine the legislative intent, which it did and consequently quashed Indian Revenue’s demand. As the final nail to the coffin, the Damodaran Committee which was appointed to address the issue of investor diffidence in India, noted that “while the legal powers of a Government extend to giving retrospective effect to taxation proposals, it might not pass the test of certainty and continuity.”
Thus, based on the prevailing law of the land, Vodafone was justified in expecting that the transaction was commercially efficient and no tax avoidance was underway per Indian tax laws. The Government’s response was a serious alteration of the existing legislation, almost a reversal of the original position on taxing offshore transactions. However, it tried to pass off the alteration as a clarification. Thus, by derailing the legal position in order to bring Vodafone’s transaction into the dragnet of tax laws, the government engaged in a discriminatory move, creating regulatory instability and uncertainty for Vodafone’s investment in India. PCA’s decision reaffirms that a host State’s legislative attempt to nullify a judicial pronouncement with a view to prejudice certain investors violates the expectation of regulatory stability under investment law.
This decision has crucial takeaways for the Indian Government. First, it is important that the Government internalise international investment law in the domestic laws to ensure better co-ordination between the different organs of the State. Second, the decision severely threatens India’s persistent stance that taxation disputes are non-arbitrable before investment tribunals. Third, the State has to rethink its strategy on retrospective taxation. With over 12 investor-state arbitrations pending on related matters, Cairn Energy being the thorniest one as it is a multi-million-dollar claim, the Government might have to fork up huge amounts if the investors are successful.
– Achyutha GM