Pacific Money | Economy | Risk Intelligence | South Asia

The Unending Saga of India’s Retrospective Tax Debacle

India finally has an investor-friendly image after almost a decade and should strive to maintain that.

By Abhishek Dwivedi for
This article is presented by

Diplomat Risk Intelligence, The Diplomat’s consulting and analysis division. Learn more here

The Unending Saga of India’s Retrospective Tax Debacle
Credit: Flickr/John Rambow

Last week, Cairn Plc (now merged with Vedanta) announced its $1.2 billion win in damages against India in an international arbitration, in a case pertaining to the levy of retrospective tax by the Indian government in 2012. This comes just after the ruling in September 2020 pertaining to retrospective tax, in favor of Vodafone. These awards are a result of India retrospectively amending its taxation laws through the Finance Act of 2012, permitting tax authorities to reopen and/or investigate transactions from 2006 for evasion of capital gains tax. The amendment was made to give a go-by to the Indian Supreme Court’s ruling in favor of Vodafone wherein the tax demand raised by the tax authorities on Vodafone was expressly quashed for “not being backed by law.” The government of India, led by Prime Minister Narendra Modi, despite having multiple opportunities to settle the disputes, chose not to do so. In fact, the current government has decided to challenge the Vodafone award despite explicit assurances to the contrary made by then Finance Minister Arun Jaitley.

The Disputes

The Vodafone dispute traces its origin to the $10.9 billion acquisition of a 67 percent stake in Hutchison Essar by Vodafone in May 2007. The acquisition also included the telecommunication business of Hutchinson in India. Consequent to the acquisition, Vodafone received a demand of 79.9 billion Indian rupees in capital gains and withholding tax from Indian tax authorities. The tax authorities maintained that Vodafone was required, under law, to deduct tax at source prior to affecting the payment of consideration to Hutchinson. Vodafone contested the notice and the matter finally reached the Bombay High Court. The court ruled in favor of the tax authorities and directed Vodafone to clear the demand. Vodafone appealed the decision, and a three-judge bench of the Supreme Court led by the chief justice of India, ruled in Vodafone’s favor and quashed the demand notice.

The judgment specifically noted that the demand of nearly 120 billion Indian rupees by way of capital gains tax would amount to imposing capital punishment for capital investment since it lacks the authority of law. Unimpressed by the ruling, the Indian government amended the Income Tax, 1961, retrospectively, to overturn the judgment of the Supreme Court. The amendment allowed tax authorities to retrospectively tax transactions, including Vodafone’s stake in Hutchison. Consequently, tax authorities demanded that Vodafone pay 200 billion Indian rupees toward back taxes on capital gains, including interest and penalties. Said demand led to Vodafone invoking the Netherlands-India bilateral investment treaty (BIT) in order to bring the dispute to adjudication via an international tribunal.

The Cairn dispute arose in 2006-07 when Cairn UK transferred shares of Cairn India Holdings to Cairn India as part of its restructuring for an initial public offering (IPO). Prior to the IPO, Indian businesses were routed through a Cayman Islands-based subsidiary of Cairn UK. Subsequently, in 2011, the business of Cairn India was sold to the Vedanta group with Cairn India retaining a 9.8 percent share in Vedanta. In 2014, tax authorities alleged that Cairn UK had made capital gains of around 245  billion Indian rupees through the restructuring in 2006-07 and promptly raised a tax demand basis on the retrospective amendment of 2012. The tax authorities barred transfer of 9.8 percent of Vedanta’s shares to Cairn India pending adjudication of the demand, causing severe financial problems for Cairn India that led to 40 percent of its India staff being laid off.

In 2015, Cairn UK gave a notice of dispute under the India-U.K. BIT and requested for arbitration. While the arbitration was pending, in 2017, the tax authorities seized around 20 billion Indian rupees in dividends and tax refunds to the accounts of Cairn India. The tax authorities also attached the Cairn India shares and auctioned them to recover the alleged tax due. The dispute has finally resulted in the award by the international tribunal whereby India has been ordered to pay 80 billion Indian rupees to Cairn for violations of its international commitments under the India-U.K. BIT. Interestingly, it is an unanimous award whereby the arbitrator appointed by India also ruled in Cairn’s favor.

However, Cairn and Vodafone are not the only instances in which such demands, which have been categorically negated by Supreme Court in Vodafone’s case, have been made and continue to be aggressively pursued by the tax authorities. French pharmaceutical major Sanofi received a similar demand in 2010 for a transaction undertaken in 2009. In 2009, Sanofi acquired a majority stake in Shanta Biotechnics Ltd valued at approximately 38 billion Indian rupees. The acquisition was affected through sale of the parent company of Shanta Biotechnics Limited, ShanH SAS France, to Sanofi. Prior to the acquisition, ShanH SAS France was owned by Groupe Industriel Marcel Dassault. In 2013, the Andhra Pradesh High Court decided in favor of Sanofi and specifically rejected the applicability of retrospective amendments to countries where double tax avoidance agreements were applicable. The tax authorities filed an appeal against the judgment, which is pending before the apex court and there appears to be no indication of withdrawal of the appeal. Similar matters pertaining to entities from Belgium and Mauritius are also pending. However, as the BITs with France, Belgium, and Mauritius stand terminated by India, it remains to be seen whether these entities will address notices of arbitration, if any.

Inconsistencies in Policy-making

In 2014, when Modi took office, the hope was that not only would the retrospective amendments be rolled back but also that pending tax demands would be withdrawn. Clearly, the retrospective amendments had backfired: the collection in revenue under the amendments was zero, and losses in terms of foreign direct investment and foreign institutional investors (FII) were substantial. However, the government refused to withdraw the retrospective amendments and merely promised to not raise any further demands under the amendments. The government maintained that all pending demands would be permitted to be resolved through appropriate legal processes and that India would honor the arbitral awards, once delivered. However, not only did the government take a contrary stand before the Supreme Court in the Sanofi matter, arguing that the retrospective tax amendments were valid and applicable; it also initiated coercive action against Cairn while the arbitration proceedings were pending. Further, recent reports suggest that India has challenged the Vodafone award in Singapore in a complete departure from its earlier promise to accept the award. While the chances of India succeeding in this challenge are limited, its effect on foreign investors may be more damaging.

Another important aspect to be highlighted is the sheer lack of consistency in India’s tax policy-making. For instance, in 2015, FIIs, by virtue of having bank accounts in India, received notices for Minimum Alternative Tax (MAT), which led to an exodus of FIIs in August 2015. Constrained by the exodus (which any government should have reasonably predicted), amendments were made to exempt FIIs from MAT prospectively. As the needless confusion regarding applicability of MAT to FIIs prior to 2015-16 persisted, a committee was constituted to look into the issue. The committee reported the obvious that MAT was applicable to companies incorporated in India and thus, FIIs were not covered by it. The government ultimately accepted the report and the recommendations, but it was too late as the whole saga left a bitter aftertaste in the mouths of foreign investors.

Similarly, the policy flip-flops in tax exemptions to Special Economic Zones (SEZs) can also be perceived as a debacle. In 2013, India in an unexpected move, decided to revoke its promise of dividend distribution tax exemption and levied MAT, effective 2012, on SEZs. The government stated that tax benefits would end in 2017 for SEZ developers, and in 2020 for SEZ units. This move was surprising since the entire SEZ system was working well and, in fact, needed a push from the government to achieve better results. Such acts have done little to inspire confidence in India’s already unpredictable political and legal environment.

Further, India’s reaction to international awards has always been reactionary. The White Industries Award led India to revisit its Bilateral Investment Treaties (BITs) that ultimately led to India terminating almost all of its existing BITs. The recent amendments made in November 2020, to the Arbitration and Conciliation Act, 1996, also appear to be a step in the wrong direction. The amendments mandate a court to grant unconditional stay on enforcement of an arbitral award if a prima facie case of fraud or corruption has been made out in either the making of (a) award; or (b) in the underlying agreement that forms basis of the arbitral award. The amendments are retrospective in nature, that is they will apply to pending proceedings. Being retrospective in nature, the amendments do appear reactive to the Devas award against India, in which its allegation of fraud was rejected by the Permanent Court of Arbitration. The hearing on enforcement of the Devas award is likely to begin in Delhi High Court soon and these retrospective amendments appear to be a desperate attempt by the government to undo the award. Such amendments raise fears of legal uncertainty and may not reflect well on India’s attempt to be a stable destination for foreign investors.

The Way Forward

India has a government which has an image of being business-friendly: despite the pandemic, India has been one of the largest recipients of foreign investment. FIIs are continuing to pour money into Indian markets and the economy is doing better than most predictions. This is the right time to put an end to the menace that was unleashed by previous Congress-led United Progress Alliance government through retrospective taxation. The Modi government missed its earlier chances to repeal the amendments and withdraw the demands, but it has another opportunity to put the entire matter to rest. While it has challenged the Vodafone award, it should not litigate the matter further should the challenge fail. Likewise, it should refrain from challenging the Cairn award and withdraw the appeal in the Sanofi case. It is imperative that the government keeps its word on tax incentives promised to SEZs and extend the sunset clause beyond 2020. In this regard, the government should implement the Baba Kalyani Committee report in letter and spirit.

It is also advisable to have the recent amendments to the Arbitration and Conciliation Act, 1996 apply prospectively. There is nothing worse than a government changing laws retrospectively to nullify adverse judgments/awards as it completely defeats the purpose of rule of law. Investors have a legitimate expectation that the legal system will continue to be consistent and predictable. Such expectation is part of the minimum standard of treatment that foreign investments deserve under customary international law. The government must act fairly and, in a manner, to ensure India has a stable and predictable legal environment.

India finally has an investor-friendly image after almost a decade and should strive to maintain that. It must legislate to institutionalize and provide long term commitments of tax benefits and incentives offered to foreign and domestic investors under the Atmanirbhar Bharat Abhiyan. India has a chance to achieve real growth led by manufacturing, inward foreign remittance and technology, and availability of abundant skill. It only has to be backed transparent and consistent policy-making. The COVID-19 pandemic has already given us many uncertainties with multiple variables, and Indian policy-making does not need to be uncertain and unpredictable as well.

Abhishek Dwivedi is an independent advocate and arbitration counsel practicing in Lucknow and Mumbai, India.