Ajay Lulla [i]
Not long after India was criticized for its conduct in the Vodafone case, it has yet again been adjudged to have violated the UK-India Bilateral Investment Treaty (BIT) in an arbitral proceeding at the Permanent Court of Arbitration. The claimant, Cairn Energy, a UK-based company has been awarded $1.4 billion in compensation for damages as a result of the retrospective tax amendment by the Government of India. Due to its longevity, the case is highly reminiscent of the White Industries case. Even though the award has been passed, India has decided to challenge the arbitral award claiming that taxes are a sovereign right, and BITs do not and shall not apply to the same. India has currently filed an application for stay in a lower court in the Netherlands and further plans to challenge the award in several jurisdictions. At the same time, Cairn Energy plans to file applications in multiple jurisdictions as well, looking to seize Indian assets to acquire the damages as per the award.
a) Transactions involved:
Cairn Energy ran its Indian operations through nine subsidiaries. It incorporated two Wholly Owned Subsidiaries (WHS) to consolidate operations, which were Cairn UK Holdings Limited (CUHL) and Cairn India Holdings Limited (CIHL). Shares of the nine subsidiaries mentioned above were transferred to CUHL, and then to CIHL. Later, another WHS named Cairn India Limited (CIL) was incorporated. CUHL then sold all shares of CIHL to CIL. CIL divested 30% of these in an IPO and raised $931 million in December 2006. A company named Vedanta UK purchased 59% of the remaining 70% shares in December 2011 and transferred it to their Indian WHS called Vedanta Limited (VL). CIL merged with VL in 2017. As a result, Cairn Energy received 5% shareholding in VL valued at $1.1 billion.
b) Vodafone case and the retrospective amendment:
In January 2012, the Income Tax Department (ITD) was accused of charging unfair capital gains tax in the Vodafone case. The Supreme Court decided in favour of Vodafone, and held that the taxed capital assets did not fall under Section 2(14) of the Income Tax Act (ITA). Consequently, it quashed the demand of INR 120 billion in the form of capital gain tax and directed a refund of INR 25 billion to Vodafone that had been deposited as a result of an interim order passed in November 2010.
The relevance of the Vodafone case lies in the fact that the Finance Act, 2012 was passed by the Parliament in the aftermath of this case. The Finance Act, 2012 added Explanation 5 to Section 9(1)(i) of the ITA, which contains that capital assets located outside India shall be deemed to be and shall always be deemed to have been situated in India if they derive value substantially from the assets located in India. This retrospective amendment brought within its ambit the transactions of Vodafone International as well as Cairn Energy.
c) Effect on Cairn Energy:
Reassessment proceedings were initiated against CUHL by an Assessing Officer in January 2014 under Section 147 and Section 148 of the ITA. The ITD sent a notice to Cairn Energy, requesting them to produce documents related to the restructuring of assets that took place in 2006, including the ones related to transfer of shares and the IPO. The purpose of requesting these documents was to bring them on record so that they fall within the ambit of the 2012 amendment to the ITA. This barred CUHL from selling its 10% stake in CIL worth $1 billion. The draft assessment order passed in March 2015 (Draft Assessment Order) after the production of the aforesaid documents stated that CUHL was liable to pay 1.6 billion USD along with any additional interest and penalties. Upon appeal by CUHL, the Income Tax Appellate Tribunal struck off the demand for interest but upheld the capital gains tax demand. Subsequently, CUHL appealed before Delhi High Court challenging the capital gains tax demand while the ITD filed a cross appeal challenging the order that struck off the interest demand.
In March 2015, Cairn Energy initiated Investor-State Dispute Settlement (ISDS) arbitration as per Article 9(3) of the UK-India BIT seeking to not only restrict the ITD from seizing assets but also restoring the assets that had already been seized. Assets seized by the ITD included $155 million dividend from shareholding in VL, $234 million tax rebate due for overpaid capital gains tax in a separate matter, and $216 million in proceeds of sale of Cairn Energy’s shareholding in VL by the ITD during the arbitration leaving their stake at 3% from 5% previously. Cairn Energy contended that the ITD had breached the fair and equitable treatment clause of the BIT by applying the retrospective amendment to transactions that had been approved by the government previously. Meanwhile, the Draft Assessment Order was passed by the ITD that rendered CUHL liable to pay 1.6 billion USD owing to the transactions that took place in 2006 along with additional interests, amounting to a total of $3.293 billion. VL challenged this demand by serving a notice of claim under the BIT in a separate case. Meanwhile, arbitration proceedings in the Cairn case began in January 2016 and a statement of claim was filed in June 2016. India appealed for a stay on proceedings in the same month contending it was unfair that they had to deal with two cases at once. A statement of defence was filed in February of 2017.
Cairn Energy pleaded for nullification of tax assessment and refund of withheld tax returns, dividend and sale of VL shares amounting to $1.4 billion. It further demanded its restoration to the position enjoyed prior to the actions of the ITD that breached the treaty.
India contended that the transactions in question were taxable regardless of the amendment, hence denying treaty breach. They further contended that the whole process of restructuring was a guise to avoid paying taxes. Therefore, they demanded $1.6 billion including taxes and interest. They also justified seizure and sale of assets to reluctance on part of CUHL to abide by the law.
The tribunal at Permanent Court of Arbitration concluded that the government of India breached its treaty obligations and must compensate CUHL. In the final award, the government was ordered to refrain from seeking taxes and to compensate CUHL for $1.4 billion including interests.
Analysis: Breach more far reaching than expressed
Cairn Energy has claimed that India breached the fair and equitable clause under Article 3(2) of the BIT, but it appears that Article 4(1) and Article 4(3) of the BIT have also been breached.
As regards the breach of Article 4(1) of the BIT, the National Treatment Principle (NTP), enshrined under this provision, states that investments by a foreign investor covered under this treaty shall not be accorded a less favorable treatment in any manner than that is enjoyed by the native investors of the state. In the present case, NTP has been breached by India as a result of the retrospective tax amendment that specifically targets foreign investments while not affecting investments by Indian nationals at all. Additionally, it cannot be denied that the amendment was an indirect consequence of the Vodafone case, which concerned breach of the same BIT and the same provisions that impact the present case.
In addition to this, the Full Protection and Security principle (FPS) places an obligation upon the states to protect investments under a BIT against direct harm by acts of state and private individuals of the host state. With regard to the extent of the application of this principle, there have been debates as to whether it is limited to physical safety of investments or extends to legal safety as well. It was held in CME v. Czech Republic that neither by amendment of its laws nor actions of its administrative bodies can an investment by a foreign investor be allowed to devaluate.
Even though FPS is not contained in the BIT, its non-application causes a breach under Article 4(3), which contains the Most Favored Nation principle (MFN). As per MFN, investors belonging to two different countries cannot be treated differently by the host state. To understand it better, one can refer to the White Industries case wherein the arbitral award was passed in favour of the investor in ISDS arbitration. However, it could not be executed for a long time as the Australia-India BIT had no execution clause, and the delays caused by Indian judiciary lasted for years. However, an execution clause was provided under Article 4(5) of the Kuwait-India BIT. It was thus contended by White Industries that the existence of this execution clause in the Kuwait-India BIT and the absence of the same from the Australia-India BIT resulted in investors from Kuwait being favoured over investors from Australia, which constituted a breach of MFN. The court accepted this contention and White Industries were allowed to apply the clause from a different BIT, which did not concern their own case. Similarly, in the present case, while the UK-India BIT does not contain FPS, it can be found under Article 3(4)(b) of the Colombia-India BIT and Article 4(1) of the UAE-India BIT. Hence, it can be exercised in the present case using MFN.
This case not only demonstrates the breaches made by India but also highlights the inefficiencies of the whole system of ISDS by making its complexities widely visible. There is an exigent need for change in the manner of dealing with disputes related to BITs which are referred to ISDS.
For the past few years, India has been making rules and regulations to promote the ease of doing business to capture the attention of investors globally. However, decisions such as the one at hand create an effect contrary to its endeavors in the minds of the investors. The present case was one of the three cases that were filed against India for the breach of the same BIT and for losses caused by the same amendment within a short span of three months. The present case also seems to be going down a similar path as India is seeking to challenge the arbitral award against it in many jurisdictions. What happens ahead is yet to be seen, but India must rethink its stand when it comes to ISDS by noting that regardless of the supportive rules that it makes, what would ultimately matter to the investor is how they are executed, and if it is indeed practically easy to do business in India. There is also a dire need to improve the award enforcement mechanism, since it is often lengthier than the arbitration process itself.
Ajay Lulla is a penultimate year law student at Institute of Law, Nirma University. His interests lie in the fields of Arbitration, Insolvency and Bankruptcy and Real Estate law. For any discussion related to the article, he can be contacted via email at firstname.lastname@example.org.