Cairn Energy v India: Retroactive Taxation, Fair and Equitable Treatment and the General Principles Method

This post addresses an Award of 21 December 2020 in Cairn Energy v India, a case under the UK–India BIT. The headline outcome of the Award is that India’s retroactive application of taxation legislation, that subsequently imposed taxes on the transactions of the claimants that were not taxable at the time the transactions occurred, constituted a violation of the fair and equitable treatment (FET) standard in the BIT. India has been ordered to pay the claimants over $US 1.2 billion and withdraw the underlying tax demand.

This post focuses on two key aspects of the Award. First, how the Tribunal understood its role, in assessing whether India’s taxation measures complied with the BIT, vis-à-vis the role of the Indian courts, given that questions of Indian taxation and constitutional law lay at the heart of the dispute. In this regard, proceedings challenging India’s tax assessment of the relevant transactions remain pending before the Delhi High Court (para 1820(b)), and India also emphasised the claimants’ failure to bring a constitutional challenge against the relevant legislative amendments (paras 982-3, 989). Second, this post will consider the Tribunal’s use of various ‘general principles of law’ to establish the content of the FET standard.

Essential Facts

In 2012, India passed an amendment to its taxation legislation that enabled it to tax income arising from the transfer of shares in a company incorporated outside of India, by a non-resident of India, if the shares derived their value substantially from assets located in India (paras 123-4). The 2012 amendment was adopted in response to a decision of the Supreme Court of India in another dispute, the Vodafone case, in which the Supreme Court had rejected India’s attempt to tax such a transaction (paras 102-112, 120-122). Importantly, the 2012 amendment was applied retroactively, so that it applied from the date India’s tax legislation entered into force in 1962, although due to a statute of limitations in the legislation, tax could only be levied back to 2006 (paras 124, 1256-9).

India is currently involved in two other investment treaty arbitrations concerning the same retroactive taxation measures. In September 2020, a tribunal in Vodafone v India, under the Netherlands–India BIT, found that India’s retroactive taxation, notwithstanding the Supreme Court of India’s judgment, violated the FET standard and ordered India to cease demanding payment. An award is also reportedly pending in Vedanta Resources v India, another case under the UK–India BIT that concerns India’s taxation of the same transaction as Cairn Energy.

The case at hand concerns India’s application of the 2012 amendment to tax a series of transactions that occurred in 2006, by Cairn Energy PLC, the first claimant, and Cairn UK Holdings Limited, the second claimant and Cairn Energy’s wholly owned subsidiary.

Cairn Energy had between 1996-2006 acquired numerous interests in India’s oil and gas industry, which were held through 27 subsidiaries, all incorporated outside of India. In 2006, Cairn Energy decided to consolidate these subsidiaries under a new publicly listed entity in India, Cairn India Limited, in which it sold 31% of shares to the public. After the public offering, Cairn UK Holdings Limited, the second claimant, held 69% of Cairn India Limited’s shares. The corporate reorganisation was carried out in a series of steps, whereby the 27 subsidiaries holding Cairn Energy’s Indian assets were initially transferred to Cairn UK Holdings Limited, and then transferred to a wholly owned subsidiary incorporated in Jersey, Cairn India Holdings Limited (CIHL). Finally, CIHL, the Jersey subsidiary, was acquired by Cairn India Limited, from Cairn UK Holdings Limited.

It was Cairn India Limited’s acquisition of CIHL, the Jersey subsidiary, and the capital gains realised by Cairn UK Holdings Limited, which was the focus of India’s taxation measures. In early 2014, as the claimants were looking to sell their remaining shares in Cairn India Limited, the Indian tax authorities began investigating the 2006 restructuring transactions and prevented Cairn UK Holdings Limited from selling its shares in Cairn India Limited. In 2016, India issued Cairn UK Holdings Limited a notice of demand for tax payable on the 2006 transactions of some $US 4.4 billion, which included interest that had accrued at 2% per month on a principal of US$ 1.6 billion. In 2017, India’s Income Tax Appellate Tribunal upheld the tax demand, although not the imposition of interest, due to the retrospective nature of the 2012 amendment (para 197). Subsequently, after Cairn UK Holdings Limited did not pay the tax owing, India engaged in a forced sale of its remaining shares in Cairn India Limited.

Role of the Tribunal vis-à-vis Indian Courts

Throughout the Award, the Tribunal grappled with its role, compared to that of the Indian courts, given that the application of the standards in the BIT depended, in part, on whether India’s conduct was well founded in terms of Indian tax and constitutional law. India essentially argued that the claimants’ claim was premature and thus inadmissible, as it raised untested issues of Indian law, which had not been tried at the domestic level, such as on the constitutionality of the 2012 amendment (paras 838-46). The Tribunal held that this was not an issue of admissibility but one that went to the merits (paras 866-73).

The UK–India BIT does not contain any requirement to utilize or exhaust local remedies prior to international arbitration (art 9). The BIT instructed the Tribunal to make its award ‘in accordance with the provisions of this Agreement’, and also provided that ‘[s]ubject to the provisions of this Agreement, all investment[s] shall be governed by the laws in force in the territory of the Contracting Party in which such investments are made’ (UK-India BIT, arts 9(3)(c)(iii), 11(1)).

The Tribunal held that while determining whether India had breached its obligations under the BIT was primarily to be answered by applying international law, it ‘may [also] need to determine incidental issues of Indian law’ (paras 651-2, 863). The Tribunal reasoned that is mandate under the BIT, to determine ‘[a]ny dispute … in relation to an investment’, included ‘the authority to ascertain independently the content of the domestic law, where this is necessary’ (para 865). The Tribunal was to make assessments of Indian law ‘independently from, although not in ignorance of, any relevant determinations of India’s organs’ (para 863).

At several key points, the Tribunal engaged in detailed analysis of issues of Indian law, as an intermediate step to facilitate the application of the FET standard in the BIT. For example, the Tribunal engaged in a lengthy analysis to determine that the 2012 amendment had expanded the scope of the relevant taxation provision, rather than merely clarifying it, and had done so with retroactive effect (paras 1060-1259). Likewise, the Tribunal engaged in a 100-page analysis to determine that India had failed to establish that the 2006 transactions constituted abusive tax avoidance, and thus would have been taxable under Indian law irrespective of the 2012 amendment (paras 1260-1591).

In determining whether the 2012 amendment violated the FET standard, the question of the weight to be given to Indian law arose again. As noted above, India emphasised that the claimants had not challenged the constitutionality of the 2012 amendment before the Indian courts. The Tribunal held that while the constitutionality of the 2012 amendment could be relevant to applying the FET standard, it would not be dispositive of whether India’s measures complied with the FET provision, as this was an independent, international standard of protection (paras 1688-92). Accordingly, the Tribunal did not need to analyse the constitutionality of the 2012 amendment (paras 1693-4).

Use of General Principles to Interpret FET standard

To establish the content of the FET standard, the Tribunal adopted a methodology of referring to various ‘general principles of law’ (paras 1715-7). Interestingly, India had submitted that the Tribunal should not resolve the question of whether retroactive taxation violated the FET standard by referring to the approaches ‘of different municipal jurisdictions or other international adjudicative bodies in respect of retroactive taxation, as this would amount to deciding ex aequo et bono’ (para 1738). The Tribunal rejected this argument, noting that ‘[i]t is not improper for a treaty tribunal to seek guidance from the practice and jurisprudence of municipal legal systems in order to identify the general principles that are relevant for the interpretation of treaty terms in a specific context’ (para 1738).

In analysing the consistency of retroactive taxation with the FET standard, the Tribunal considered legal certainty an aspect of the rule of law, referring to various definitions of the rule of law (eg from the European Commission for Democracy through Law or ‘Venice Commission’, UN bodies, and writings of Lord Bingham) (paras 1741-1747). Ultimately, the Tribunal found that legal certainty qualified as a general principle of law that could inform the content of the FET standard ‘irrespective of the background or political stance of the Contracting States’ (para 1749).

The Tribunal recognised that the principle of legal certainty is not absolute, and some retroactive regulations could be justified by a public purpose. The Tribunal endorsed the principle of proportionality, as an element of FET standard, to balance the state’s public purpose, in enacting retroactive legislation, against the claimants’ interest in legal certainty (paras 1788-9).

The test ultimately applied by the Tribunal, in determining whether the retroactive application of the 2012 amendment violated the FET standard, was whether there was ‘a specific and compelling public policy objective that warrants not only the regulatory change in general, but also the retroactive application of that change’ (para 1790). This meant that a public purpose justifying the prospective application of fiscal measures, such as increasing the tax base or revenue, could not justify the retroactive application of such measures (para 1791). Rather, there had to be some additional public purpose that could justify the retroactive application (paras 1794, 1801).

Applying this test, the Tribunal rejected various justifications that were advanced for the retroactive application of the 2012 amendment. For example, India’s aim of adapting its laws to the reality of the use of tax havens by foreign investors and ‘indirect transfers’ of underlying Indian assets, was found to only justify increasing revenue by making such transfers taxable; it did not justify retroactively applying the 2012 amendment (paras 1809-10). Likewise, the interest of combatting systemic tax abuse by foreign investors was not seen as a sufficient purpose to justify the retroactive application of the 2012 amendment, as India had not proved such systemic abuse existed – indirect transfers remained rare – and India had other legal tools that addressed tax evasion through abusive transactions (paras 1813-5).

Ultimately, India was found to not have had ‘a specific public purpose that would justify applying the 2012 amendment to past transactions’, meaning it failed to balance adequately the claimants’ interest in legal certainty with its own regulatory interests. India’s retroactive taxation of the 2006 transactions was thus ‘“grossly unfair”’ and violated the FET standard (para 1816, quoting Waste Management v Mexico II).

Evaluation

The Tribunal’s use of a ‘general principles of law’ methodology to inform the content of the FET standard, with repeated references to Stephan Schill’s work on this issue, is one of the most extended uses of this approach in existing case law (compare Total v Argentina, para 111; Toto v Lebanon, para 166). In my view, the Award exhibits several of the potential shortcomings of a general principles approach that have been debated in existing literature, including that the survey of domestic jurisdictions is often selective, Western-centric, and expressed at a high level of generality (see Alvarez, p. 565, 568; Paparinskis, p. 173-4; Peat; Schneiderman; Paine p. 338-342). For example, the discussion of definitions of the rule of law, drawing on a checklist developed by the Venice Commission, seems very far from what the treaty Parties may have had in mind when including an FET provision in the treaty.

Similarly, in the crucial part of the Award concerning the test for when retroactive taxation will violate the FET standard, the Tribunal relied upon a few academic writings, and a handful of examples from the European Convention on Human Rights, certain European jurisdictions and the United States (see paras 1790-1801). Strikingly, in this part of the Award there is only a brief mention of Indian law, to confirm the general principle that legislation generally operates prospectively, although at an earlier point the Tribunal had considered the approach of Indian law to retroactivity in somewhat more detail (paras 1758, 1680-1686). Essentially, this reflects the Tribunal’s approach that FET was an autonomous international standard, and its application did not depend on whether the 2012 amendment was constitutional under Indian law (paras 1692-4, 1822).

This aspect of the Award is a good example of how investment treaties transform domestic constitutional balances, by providing a parallel, non-identical set of additional protections for foreign investors, combined with direct access to international arbitration, typically without a requirement to exhaust local remedies. I have considered this issue in detail in a forthcoming chapter, analysing the investment treaty regime through the prism of Dunoff and Trachtman’s idea of ‘supplementary constitutionalization’.

What about Investment Treaty Reform?

Finally, it is interesting to consider whether certain changes that have occurred in the investment treaty regime in recent years would have made any difference to a case such as Cairn Energy. India has since 2015 terminated almost all its existing investment treaties and has been negotiating new treaties, or agreeing to joint interpretations, based on its 2015 Model BIT (see generally Ranjan (2019) ch 7). While India’s 2015 Model includes a self-judging tax carve-out that would exclude jurisdiction over the measures at issue in Cairn Energy (art 2.4(ii)), I will put that point to one side for the purposes the following discussion, which illuminates broader issues, not specific to taxation measures. India’s 2015 Model does not include the FET standard, but includes a general treatment provision, tied to customary international law, that protects investors against inter alia ‘fundamental breach of due process’ (art 3.1). The Model also provides that it ‘shall be interpreted in the context of the high level of deference that international law accords to States with regard to their development and implementation of domestic policies’ (art 23.1).

Additionally, recent investment treaties increasingly contain provisions aimed at regulating how tribunals approach issues of domestic law. For example, EU investment treaties provide that tribunals may consider the domestic law of the disputing Party as a matter of fact and that they ‘shall be bound by the interpretation given to the domestic law by the courts or authorities which are competent to interpret the relevant domestic law’ (eg EU – Vietnam IPA, art 3.42(2)-(3)). Jarrod Hepburn analysed such provisions in a prior post on this blog.

To my mind, some of the above reforms may make a significance difference in a case such as Cairn Energy. For example, without an FET provision, an investor would be forced to establish that a retroactive law constitutes a ‘fundamental breach of due process’ that violates customary international law (India Model BIT art 3.1(ii)). This would be significantly more difficult than establishing that a retroactive law violates the legal certainty aspect of a free-standing FET provision. In Cairn Energy one of India’s arguments was that there is no customary rule prohibiting retroactive taxation and thus it was for each state to balance the relevant principles under its own law (paras 1006, 1753). The Tribunal was able to dismiss this point quickly, as it was faced with deciding whether the 2012 amendment violated an FET provision not tied to customary international law (para 1731). Similarly, an instruction to interpret an investment treaty in accordance with ‘the high level of deference’ afforded to states’ implementation of their domestic policies (language taken from SD Myers, para 263) might have a significant influence on a tribunal’s approach.

In contrast, I am not convinced that a clarification that an international tribunal can only consider domestic law as an issue of fact, and shall be bound by prevailing domestic interpretations, would have made any difference in Cairn Energy. To the extent the Tribunal entered into questions of Indian law, (eg to determine whether the 2006 transactions were taxable on some other basis), it sought to follow the relevant principles as interpreted by Indian courts (eg paras 1298-1424). The Tribunal’s consideration of Indian law, while extensive, did not go beyond considering such issues as incidental matters, in order to fulfil its task of applying the FET standard.