India’s retrospective taxation blunder is still extracting heavy costs
A retroactive law is truly a monstrosity. Law has to do with the governance of human conduct by rules. To speak of governing...today by rules that will be enacted tomorrow is to talk in blank prose”. This quote by Lon L Fuller, an American legal philosopher, aptly summarises India’s retroactive tax misadventure.
In 2012, India amended the Income Tax Act retroactively to overturn the Supreme Court’s decision favouring Vodafone in a tax battle with the government. The 2012 amendment spooked foreign investors. It amended Section 9(1)(i) of the Income Tax Act, retroactively making it applicable to “indirect transfers”, ie. to the transfer by a non-resident of a share in a company incorporated abroad, if the share derived, directly or indirectly, its value substantially from assets located in India. One such “indirect transfer” was the 2006 internal corporate restructuring carried out by Cairn Energy. Armed with the 2012 amendment, the Indian government in 2015 imposed on Cairn a draft tax assessment of ₹10,247 crores for the corporate restructuring that took place in 2006.
Consequently, Cairn sued India before an investor-State dispute settlement (ISDS) tribunal alleging that imposition of taxes retroactively violates the India-United Kingdom bilateral investment treaty (BIT). The ISDS tribunal, in late December, ruled in favour of Cairn, holding India guilty of violating the fair and equitable treatment (FET) obligation of the India-UK BIT. The tribunal dismissed India’s argument that the 2012 amendment clarified the intent of Parliament regarding “indirect transfers” and that it was not retroactive.
The tribunal held that the 2012 amendment substantively changed the scope or operation of Section 9(1)(i) of the Income Tax Act. The tribunal also ruled that whether the 2012 amendment was constitutional or not has no bearing on India violating its treaty obligations because India’s liability has to be ascertained under international law. This is important because it ruptures the myth perpetuated by the defenders of the retroactive amendment that a law passed by Parliament that has not been declared unconstitutional does not violate India’s BIT obligations. The sovereign right to tax should be exercised in a manner consistent with international law.
The tribunal reasoned that India’s decision to retroactively apply the law, without a specific justification, created a new tax burden on a transaction that was not taxable at the time it was carried out, ie. in 2006. India robbed Cairn of its ability to plan its activities keeping in mind the legal consequences of its conduct. It disproportionately undermined the principle of legal certainty, which is one of the core elements of the FET standard specifically and of the rule of law generally. Hence, the tribunal ordered India to return over $1.2 billion to Cairn Energy Plc. This is the second instance of an ISDS tribunal admonishing India’s 2012 retroactive amendment of the Income Tax Act. A few months ago, another ISDS tribunal in Vodafone International Holdings v India found India guilty of breaching the India-Netherlands BIT for imposing taxes on Vodafone retroactively.
The 2012 amendment was a momentous error committed by the United Progressive Alliance (UPA) government. The National Democratic Alliance (NDA) government, on assuming office in 2014, had a great opportunity to correct this blunder by amending the law and making it prospective in application. This was expected because the Bharatiya Janata Party’s manifesto, cited by the Cairn tribunal, correctly criticised the UPA government for unleashing tax terrorism and uncertainty that deleteriously impacted the investment climate. However, the NDA government, instead of amending the law, relentlessly pursued the tax claims against Vodafone and Cairn Energy.
India has already challenged the Vodafone award. Presumably, it will do the same with the Cairn Energy award. In endeavouring to extract revenue through retroactive taxation that damages investor sentiment in the long run, India is being penny-wise and pound-foolish. The government should remember that promoting rule of law and safeguarding legal certainty are important drivers of foreign investment inflows.
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