Cairn tax blow: India must walk the talk on ease of doing business  

The retrospective tax law enacted in 2012 is coming back to haunt India. On Wednesday, an international arbitration tribunal ruled that India’s tax demand from Cairn Energy Plc is in breach of ‘fair and equitable treatment’ guaranteed under the bilateral investment treaty. The court also ordered New Delhi to compensate Cairn for the "total harm suffered" and pay $1.2 billion, that is roughly Rs 8,800 crore, in damages.

Here’s some background. In 2015, Cairn had invoked arbitration proceedings under the India-UK BIPA (Bilateral Investment Promotion and Protection Agreement) challenging India’s action to recover tax on a cross border deal involving an indirect transfer of shares, which was necessitated by an internal restructuring prior to Cairn India’s (CIL) IPO in 2006.

The transaction saw CIL acquiring 100 percent in Cairn India Holding (CIHL), a company incorporated in Jersey, from Cairn UK Holdings. The Income Tax department made a tax demand of nearly Rs 10,247 crore from Cairn in connection with the gains from the said internal restructuring.

Cairn had challenged the tax claim before the Mumbai bench of the Income-tax Appellate Tribunal (ITAT) saying the retrospective amendment to Section 9 of the ITA (Income Tax Act) is “bad in law and ultra vires”. The ITAT then said it was not the right forum to challenge the validity of the provisions of the Act and thus rejected the contention.

Let’s understand this indirect transfer in more detail. In 2012, the Supreme Court delivered a landmark judgment in the Vodafone case. The apex court held that the transfer of shares of a foreign company from one non-resident to another non-resident would not attract tax in India, even if such transfer indirectly resulted in transfer of control in underlying Indian subsidiaries. After this ruling, the government, through the Finance Act 2012, amended Section 9 of the Income-Tax Act, 1961, to “clarify” that gains arising from such cross-border transactions in which the underlying assets are located in India will be taxable in India. This amendment effectively and controversially overruled the apex court’s decision in the Vodafone ruling.

However, the larger controversy was that the changes were made with retrospective effect from April 1, 1962. On the question whether India can pass retrospective legislations, the Supreme Court in the Vatika Township case said the presumption against retrospective operation was not applicable to clarificatory statutes. This means retrospective operation is generally intended for clarificatory statutes. So, the jury is out on whether the tax amendment triggered by the Vodafone ruling on indirect transfers is simply clarificatory in nature, considering that a whole host of further amendments were introduced to determine what qualifies as “indirect transfer”, appropriate computation mechanism, exemptions and reporting obligations.

The Cairn arbitral award is the second setback for India as it lost an arbitration case against Vodafone under the India-Netherlands BIPA on the same issue of retrospective tax on indirect transfers only a few weeks ago. The Vodafone arbitration award had also held that the tax demand based on a retrospective legislation related to indirect transfer was in the "breach of the guarantee of fair and equitable treatment" guaranteed under India-Netherlands BIPA.

India will have the opportunity to file an appeal challenging the Cairn award. Considering that the government has filed an appeal in the Vodafone matter before a Singapore Court, it is likely that this time too, it will follow the same route.

This is an unfortunate development. If the government goes for an appeal, this may not just significantly harm investment sentiment, particularly in these difficult times, but also fly against Prime Minister Narendra Modi’s assertions that his government stands for stable governance and a predictable taxation system and that the government is taking steps to ensure this stability.

While one may argue that this action is necessary to protect the sovereign’s right to pass a retrospective law, I would argue that the entitlement to make retrospective law is not perfected, especially when a question subsists on whether such law on indirect transfer is “clarificatory” at all.

It is also pertinent to note that India has unilaterally terminated almost all of the BIPAs it signed with various countries.

For a country committed to making it easier to do business, India must necessarily consider a policy change that aligns with the promises made by this government and repeal the retroactivity in the application of the indirect transfer provisions.