The Cairn Arbitration Ruling Against India — Is It Time to Rethink Retrospective Taxation

The Government has reserved the right to tax corporations for their wealth, capital gains, property, net worth etc. However, digging too deep into corporate coffers can sometimes backfire in a spectacular fashion, as was evidenced in the cases of Vodafone and Cairn Energy, two retrospective tax disputes that the Indian Government probably wishes it could shrug from its record.

Let’s take a closer look at this intricate tax dispute which has caught the Government twice short now.

Recap of Recent Events

Yesterday, the Permanent Court of Arbitration (PCA) at the International Court of Justice (ICJ) in The Hague ruled in a 582-page order that the Indian Government was at fault for applying retrospective tax obligations on Cairn. It also mandated payment of damages worth ₹8,000cr ($1.2bn) to the latter.

This is the second such instance in less than three months involving international arbitration proceedings on the controversial tax issue. In October 2020, Vodafone received an award from the same court which held the Government in reproach for upholding similar retrospective tax liability against the company.

What is the Retrospective Tax Issue?

The word ‘retrospective’ means ‘looking over the past’ or ‘pertaining to the past’. So, retrospective tax essentially refers to a form of levy that is calculated from a certain time in the past, before the law that gives effect to it, is enforced.

Now, this wouldn’t seem unorthodox in light of backdated dues or arrears that are very common. But, the problem is that those are all in the nature of entitlements and not obligations (unlike tax). On top of it, one of the cardinal rules of jurisprudence (les prospicit non respicit) dictates that the law always looks forward and not backward.

The Twin Retribution of Retrospective Taxation

It all began when the Supreme Court, in Vodafone’s case, invalidated the Government’s attempt to tax capital gains on Vodafone for its acquisition of Hutchinson. Ired by this outcome, the Government slipped in an amendment in the Union Budget Bill of 2012 to enable levying taxes on capital gains from foreign companies which “derive substantial value from their assets located in India”, all the way back from 1962.

Moving on to the Cairn case. In 2005–06, Cairn Energy transferred its India assets to a subsidiary Cairn India and subsequently took it public in one of the biggest IPOs ever (raising over ₹8,616cr ($1.1bn)).

The IT department viewed this as a material change in the company’s internal structure. It also alleged that Cairn made a capital gain of ₹24,503cr ($3.3bn) in the shares-transfer process which the company undertook by setting up a subsidiary in the tax haven country of Jersey (in the British-held Channel Islands).

Thereafter, in 2011, Cairn sold almost the entirety of its stake in Cairn India to Vedanta Group for $8.67bn. Incidentally, the remaining 9.8% which Cairn Energy still held in Cairn India was held hostage by the Indian authorities who barred the former from selling it.

After the arbitration proceedings were launched, the government sold 5% out of the 9.8% stake Cairn still held in Vedanta (erstwhile Cairn India). It also appropriated dividends in the value of ₹1,140cr ($154.4m) due from those shares and set off a ₹1,590cr ($215.3m) tax refund against the demand, all in the pursuit to recover the capital gains tax that the company owed since 2006.

The Government’s case may not be iron-clad, but one has to admit that from a moral and sceptical point of upholding enforcement goals, efforts to prevent tax avoidance is justifiable. Besides, even though long-term tax stability is a preferred expectation for corporates wishing to set up shop in the country, it is not prudent to think that the sovereign can make an open-ended promise not to raise taxes for all time to come.

The ICJ Ruling

The premise of the ruling is based upon the distinction between ‘tax’ and ‘investment’. The Indian Government had argued that taxation is a sovereign right and is hence, out of the purview of international law.

The court, however, said that because the operating law (2012 Budget amendment) which determined the retrospective tax claim in question arose as a “fiscal measure”, therefore, it cannot be clubbed exclusively as a tax dispute proper and should be construed as a violation of the treaty law (India-UK Bilateral Investment Treaty).

It further goes on to say that by retroactively applying the tax burden onto the company, the Government incapacitated them from planning their business ventures ahead because they weren’t aware of the financial consequences of their ventures at the time. This is in line with Cairn’s grievance that it would have listed its Indian subsidiary on the UK Stock Exchange instead of India, had it been aware of the succeeding legal implications at the time of its IPO.

The Road Ahead

While it is undeniable that this is a significant setback for Indian interests, in addition to the ongoing erosion of faith in India as an investment destination by foreigners, the implications of these judgments are far-reaching.

What sets the Cairn ruling apart from Vodafone is both the quantum and nature of compensation obligated upon India. While in the latter, judgment was largely clarificatory and the amount owed was meant for the reimbursement of the plaintiff’s legal costs, the latter imposes damages on Indian authorities, indicating its punitive nature.

Nevertheless, following the Cairn ruling, the Indian Government has approached the Singapore seat of the PCA challenging the judgment given earlier in the Vodafone case. This has spelled a new twist in the issue and it remains to be seen who is left standing in the ring at the end of this elaborate tax bout.

(Originally published December 26th 2020 in transfin.in)