On September 25, an investment tribunal constituted under the India-Netherlands bilateral investment treaty (BIT) handed down its award in the long-running tax dispute between Vodafone and India. It held India liable for breach of its BIT obligations and directed it to reimburse a substantial portion of Vodafone’s costs for legal representation.
The Vodafone award is a major setback for India, and comes after a welcome trend of recent victories for India in BIT arbitrations.
The Vodafone award, and its possible ramifications, are significant for India for a number of reasons. Most importantly, the award could operate as a persuasive precedent for other pending claims against India relating to taxation measures. Whilst the concept of ‘binding’ precedent does not exist in the realm of BIT arbitrations, it is not uncommon for tribunals to afford weight to earlier decisions on comparable issues by other BIT tribunals.
Indeed, in some cases, tribunals have felt duty bound to adopt the approach established in earlier cases subject to ‘compelling contrary grounds’ – the rationale for this being that tribunals have a duty to contribute to the harmonious development of investment law so as to foster predictability. Although not all BIT tribunals may share this view, and some arbitrators may well consider it their duty to decide each case on its merits independent of any apparent jurisprudential trends, it is quite likely that the Vodafone award will (despite significant factual differences in respect of the other cases) at least carry some persuasive value in other investment arbitrations pending against India.
This factor alone should be sufficient for India to give serious thought to challenging the award.
In 2007, Vodafone International Holdings BV (a Dutch entity) acquired rights in a mobile telecommunications business in India by purchase of a single share in a Cayman Islands-based shell company from Hutchinson Telecommunications International Limited (also a Cayman Islands entity). According to the income tax department, Vodafone International Holdings BV was liable to pay withholding tax on this transaction. The Supreme Court of India ultimately held that under the tax regime, as it existed at the time of the share purchase transaction, the transaction between Vodafone and Hutchinson was not subject to taxation in India.
Subsequently, by means of an amendment to the statute, it was clarified that capital gains tax would be payable on a share purchase transaction between foreign entities if the shares or interests sold derived their value substantially from assets in India. This clarificatory amendment was given retrospective effect. Pursuant to the amendment, Vodafone International Holdings BV became liable to pay withholding tax to the Indian tax authorities. Vodafone challenged the tax amendment as being in breach of India’s BIT obligations, including the obligation to accord fair and equitable treatment (FET) to investments covered under the BIT.
Amendments to the Income Tax Act consistent with global initiatives to tax indirect transfer of assets
The amendment was introduced by the Indian legislature to plug a gap that existed in the Indian income tax regime. Whilst capital gains tax was payable on transfer of assets located in India, there was ambiguity in respect of whether capital gains tax was payable even in cases where a share purchase transaction between foreign entities did not result in a direct transfer of the assets located in India.
In the Vodafone case, for example, the assets in India were held by a shell company in the Cayman Islands and the share purchase transaction between Vodafone and Hutchinson related to purchase of the single share of this shell company. The transfer of assets in India took place indirectly. Although the Supreme Court of India eventually held that capital gains tax could not be levied on such an indirect transfer of assets, the opposite view – that capital gains tax could be levied on share purchase transactions that indirectly and effectively resulted in a transfer of assets in India – was also plausible on an interpretation of the relevant provisions of the Income Tax Act.
In fact, the Bombay High Court had adopted this opposite view and held that there was a sound basis under Indian law to subject the transaction to capital gains tax in India. Particularly in the light of divergent judicial decisions, the amendment was introduced to clarify the issue.
Why the criticism of ‘tax terrorism’ is unfair and unfounded
Whilst much criticism has been levelled against the amendment, particularly its operation with retrospective effect, it should equally be recognised that the purpose of introducing the clarificatory amendment was to prevent multinational companies from escaping capital gains tax through indirect transfer of shares carried out in tax havens. Such deals were structured to take advantage of an ambiguity in the text of the Indian statute, and effectively transfer assets located in India on a tax-free basis. Moreover, the amendment was consistent with global trends in taxation of indirect transfer of assets.
There have been several instances where multinational companies have indirectly carried out asset transfers without paying capital gains taxes in the States where the underlying assets were located. For example, in 2009, Ecopetrol Colombia (a Colombian entity) and Korea National Oil Corporation (a South Korean entity) jointly purchased Offshore International Group Inc (a US entity) from Petrotech International (another US entity). Offshore International Group Inc’s main asset was a Peruvian company which was one of the largest oil producers in Peru. There was an indirect transfer of Peruvian assets, but the Peruvian laws at the time of the transaction did not provide for taxation of an indirect transfer of Peruvian assets. Peru’s domestic legislation was subsequently amended to provide for taxation of such indirect transfer of assets.
Apart from measures taken by States at a domestic level to address the mischief of avoidance of capital gains tax in the State where the underlying assets are located, there have also been international initiatives in this field. For example, the Platform for Collaboration on Tax (a joint initiative of the IMF, OECD, UN and World Bank Group) released a ‘toolkit’ in June 2020 on taxation of offshore indirect transfers. This ‘toolkit’ provides guidance on taxation of indirect transfer of assets. The Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (MLI), an OECD-G20 led initiative which has the effect of modifying existing tax treaties of signatory States, also contemplates taxation of indirect transfers in the State from which the transferred shares or rights derive more than a certain part of their value.
The tax amendment introduced by India, when considered in light of these global developments, serves the important public policy objective of preventing tax leakage through clever structuring of transactions. It would therefore be unfair, and quite simplistic, to label the tax amendment as being an instance of “tax terrorism”.
As to the retrospective operation of the amendment, the amendment was, at least on the face of it, clarificatory in nature. It clarified that capital gains tax could be imposed on an indirect transfer of assets in India and sought to dispel the ambiguity that was created by the language of the unamended provision. It is a well-settled principle of Indian law that if an amendment is clarificatory or declaratory, it is presumed to have retrospective effect.
India’s jurisdictional objection
In the BIT arbitration, as a preliminary matter, India challenged the jurisdiction of the investment tribunal primarily on the ground that the BIT expressly excluded domestic tax legislation from the ambit of the FET protection. Article 4 of the BIT, which bears the heading ‘National Treatment and Most Favoured Nation Treatment’, sets out the substantive protections provided to investments under the BIT and is extracted below.
The language of Article 4(4) is ambiguous. It states that the provisions of paragraphs 1 and 2 “in respect of the grant of national treatment and most favoured nation treatment” would not apply in relation to domestic tax legislation. However, only the provisions of paragraph 2 are in respect of the grant of national treatment and most favoured nation (MFN) treatment – the provisions of paragraph 1 are in respect of the FET and full protection and security (FPS) standards.
If the domestic tax legislation is only excluded from the scope of review on the basis of the principles of national treatment and MFN treatment in paragraph 2, the reference to paragraph 1 in Article 4(4) would essentially be redundant. Such an interpretation would not be consistent with the intention of the contracting States.
Article 31(1) of the Vienna Convention of the Law of Treaties requires that a treaty be interpreted "in good faith in accordance with the ordinary meaning to be given to the terms of the treaty in their context and in the light of its object and purpose". The ‘good faith’ interpretation of a treaty requires that each provision of the treaty be given a meaning and effect – this is the principle of effectiveness or ‘effet utile’. Application of the ‘effet utile’ principle would require that the words ‘paragraph 1’ also be given real meaning and effect. Not excluding domestic taxation legislation from the scope of the FET and FPS standards in paragraph 1 would arguably be contrary to the principle of ‘effet utile’.
Although the full award is not available in the public domain, the operative part of the award indicates that the tribunal ruled that it had jurisdiction to consider Vodafone’s claims for breach of the BIT on merits, and that fastening tax liability on Vodafone (especially in light of the earlier decision of the Supreme Court of India) constituted a breach of the FET guarantee.
This suggests that the tribunal failed to give any meaning to the words ‘paragraph 1’ in Article 4(4) of the BIT, else it could not have assumed jurisdiction over Vodafone’s claim that India’s taxation measure breached the FET standard under the BIT. Any such disregard for the specific reference to ‘paragraph 1’ in Article 4(4) of the BIT would likely be considered contrary to well-established principles of treaty interpretation.
Moreover, if it was plausible to interpret Article 4(4) of the BIT as excluding domestic taxation measures from the scope of the FET protection contained in Article 4(1) of the BIT, the tribunal should have favoured that interpretation, unless there was clear evidence of a contrary intention. This is because taxation, much like dispensation of criminal justice, is an essential sovereign function. An intention to relinquish sovereignty over this function should not readily be inferred. This is especially the case when considered in the light of the well-recognised principle that each State has full autonomy in the matter of enacting and enforcing domestic taxation measures within its territory.
Retrospective operation of legislation is not uncommon in India
The reasons that the investment tribunal may have provided for its finding of breach of the FET guarantee by India are not public, but the operative part of the award shows that much weightage was given to the fact that the tax amendment challenged by Vodafone had been introduced after the Supreme Court had ruled in favour of Vodafone. The tax amendment did in fact have the effect of reversing the Supreme Court’s ruling – but could implementation of such a taxation measure with retrospective effect have been considered a breach of the FET standard?
The fact that the Supreme Court’s decision was consistent with Vodafone’s understanding of its tax liability at the time of the share purchase transaction could not have given rise to any legitimate expectation that Parliament could not step in to clarify how it had intended the statute to be interpreted.
Further, enactment of legislation with retrospective effect is not uncommon in India. At the time of making an investment in India, an investor could therefore not have harboured any ‘legitimate expectation’ that Indian laws (and the interpretation of such laws) would remain unchanged - especially when no assurance was provided by the State to this effect.
It is also well settled under Indian law that equitable considerations have no place in the interpretation and application of taxation measures. This too should have been known to Vodafone. Vodafone was not singled out for the levy of this retrospective tax and the tax amendment was not introduced for improper motives. On the other hand, there is ample evidence to the contrary.
The Vodafone tribunal may not have fully appreciated the purport of the express language excluding taxation measures from the scope of the FET protection under the BIT, or the fact that the tax amendment enacted after the Supreme Court’s decision was enacted in compliance with the legal mechanisms and procedures that had existed at the time of the investment, and which formed part of the legal regime to which the investor voluntarily subjected itself. India should therefore have a reasonable basis for challenging the Vodafone award on the grounds that the investment tribunal exceeded its jurisdiction and did not properly apply the FET standard.
The seat of challenge and the possibility of de novo review
The seat of the Vodafone arbitration was Singapore and any challenge to the award will have to be brought before the courts of Singapore. Unlike other jurisdictions (such as Switzerland which accord a wide margin of deference to the decisions of investment tribunals), the courts of Singapore have not hesitated to set aside BIT awards in cases where an investment tribunal has exceeded its jurisdiction.
In Lesotho v. Swissbourgh Diamond Mines, for example, the Singapore High Court set aside a treaty award on the ground that there had been no ‘investment’ within the meaning of the term in the investment agreement. The decision of the High Court was confirmed by the Singapore Court of Appeal.
The Lesotho award was set aside by the courts of Singapore in exercise of their powers under Article 34(2)(a)(iii) of the UNCITRAL Model Law on International Commercial Arbitration, which is incorporated by reference in the Singapore International Arbitration Act. This provision empowers the courts in Singapore to set aside an award if it deals with a dispute not contemplated by or not falling within the terms of the submission to arbitration. It is also significant that the courts of Singapore typically adopt a de novo standard of review in considering challenges on the basis of jurisdictional issues uninfluenced by the arbitral tribunal’s treatment of such issues.
Possible next steps for India
India has an opportunity to challenge the Vodafone award in Singapore, which it should avail of. The time period for challenging an award is 90 days from the date of receipt of the award. The scope of consent to arbitration (including whether India has ceded jurisdiction to an ISDS tribunal to decide tax disputes arising out of the exercise of sovereign legislative power) is an important issue that needs to be finally settled - not least because it could have multi-billion dollar implications for India in respect of other cases involving challenges to India’s taxation measures by foreign investors.
At least two other investment arbitrations – commenced by Cairn and Vedanta respectively – where final awards are presently awaited, arise out of the same taxation measure that was held to be in breach of India’s obligation to accord FET protection under the India-Netherlands BIT in the Vodafone arbitration.
A favourable decision from the courts of Singapore in the Vodafone case could serve as a useful persuasive precedent for such other cases, and also uphold the government’s position that it has not ceded jurisdiction to ISDS tribunals to decide issues that go to the very core of legitimate exercise of legislative power by a sovereign State.
The authors are advocates at Arista Chambers and have previously represented the Republic of India in BIT arbitrations.