Burying the ghost of retrospective taxation
Amid the disruption in the Parliament, the Narendra Modi government introduced a bill, on Thursday, aimed at correcting a momentous blunder in the contemporary history of taxation laws.
This blunder pertains to the Manmohan Singh government’s notorious retrospective amendment in the Income Tax Act in 2012. After losing a tax dispute to Vodafone on the issue of taxation on indirect transfer of Indian assets, the government nullified the judgement by altering Section 9(1)(i) of the Income Tax Act retroactively. Taxing indirect transfer of Indian assets implies taxing the gains arising out of the transfer of shares by a non-resident in a company incorporated abroad, if the share derived its value, directly or indirectly, substantially from assets located in India.
This regressive legislative development, later extended to Cairn Energy’s internal restructuring, triggered a spate of legal disputes. Vodafone and Cairn Energy sued India before investor-state dispute settlement (ISDS) tribunals constituted under the Indianetherlands and the India-united Kingdom bilateral investment treaty (BIT).
The Bharatiya Janata Party (BJP) valiantly resisted the retroactive amendment while in Opposition. Thus, many assumed that the Modi government would correct this gaffe on coming to power. But the new government pursued these claims robustly. Both the ISDS tribunals indicted India for violating the fair and equitable treatment (FET) obligation under the two BITS. India didn’t comply with the awards, which compelled Cairn Energy to start enforcement proceedings aiming at attach Indian assets in several countries.
Finally, it seems, good sense has prevailed. The tax bill states that the amendment to Section 9(1)(i) will not apply to indirect transfers of Indian assets made on or before May 28, 2012. In simpler terms, the law on taxing the gains arising out of indirect transfer of Indian assets shall be prospective.
Exorcising the retrospective aspect of Section 9(1)(i) implies that the tax department can no longer pursue taxation claims against Vodafone and Cairn Energy for its pre-2012 transactions that involved indirect transfers of Indian assets. The taxes collected would be returned without interest. This bill removes the legal measure that formed the basis of ISDS claims against India by Vodafone and Cairn Energy, thus, hopefully bringing the curtain down on the arduous international legal battles.
However, this law is subject to certain riders. Both Vodafone and Cairn Energy will have to withdraw their legal claims against India including under international law. Also, the investors will have to waive their right to pursue legal claims for retrospective taxes. This implies that Section 9(1)(i) and the attendant tax provisions would continue to apply retrospectively if investors do not meet these conditions.
While it is quite evident that the adverse ISDS awards triggered this amendment, it seems India is still not accepting the decision of the two tribunals. The fact that India will return only the principal amount, not the interest is a clear pointer to this. For instance, the ISDS tribunal ordered India to pay $1.2 billion (the tax collected) plus interest and other costs, totalling about $1.7 billion to Cairn Energy. As per the bill, India will only return $1.2 billion (the principal amount) to Cairn Energy. Thus, Cairn Energy will still lose about $0.5 billion. It remains to be seen whether Cairn Energy and Vodafone will accept this as an honourable settlement. It is also not clear whether India would stop pursuing challenging the Vodafone and Cairn awards in Singapore and The Hague, the respective seats of arbitration.
While this amendment will shore up the confidence of foreign investors, and give a leg-up to the overall economic sentiment, one needs to ask a larger question. What did India gain out of this misadventure that lasted for more than nine years? It will not get the much-needed revenue that it kept hoping for. On top of it, taxpayer money and other scarce resources were spent in fighting expensive cases in international tribunals. Plus, India’s reputation in the eyes of the world as a prime destination for foreign investment was tarred, upsetting India’s growth story.
The key takeaways from this nine-yearlong sordid episode are as follows.
First, before introducing such drastic legal and policy changes, those in power should weigh and balance the benefits and costs prudently in a transparent fashion. Legal certainty is an aspect that foreign investors value enormously. A penny-wise pound-foolish kind of approach often proves detrimental.
Second, there must be a better internalisation of India’s BIT obligations by the government. Third, while the right to tax is indeed a sovereign right, a fact attested by numerous ISDS tribunals, this right has its limits. Abusing the right to tax vis-à-vis foreign investors will spark claims under international law. Changes in the legal regime through taxation should be reasonable and proportional to the public welfare sought to be achieved.
Fourth, amending tax laws retroactively is a bad idea. The Shome committee — a special committee appointed by Manmohan Singh to examine the implications of the 2012 amendment — categorically said that retrospective application of tax law should occur in exceptional cases such as to counter highly abusive tax planning, rather than expand the tax base. One hopes that our policymakers and legislators have learnt their lessons now.