TITLE: INVESTMENT AGREEMENTS RELATED TO TAX MATTERS IN INDIA:

ISSUES AND CHALLENEGES

In the Partial Fulfillment of Formative Assessment

of SLH 4783 Cross Border and Investment Arbitration

Programme : BA LLB (H)

Semester : VIII
Session : 2023-2024 EVEN
Batch : 2020-2025
Subject Code : SLH 4783
Submitted by : SHRUSTI SALINI SAHOO
Email : [email protected]
Enrolment Number: 200060401021
Admission Number: 20210815
Phone Number: 9870285975

Submitted to. : Mrs. Priti Ramani Nayyar

G.D. Goenka University,

Sohna, Gurugram,
Haryana, India
 ABSTRACT

It is becoming increasingly problematic to pursue tax-related claims through investment

treaty arbitration, an alternative legal process. Since the taxpayer has the ability to make
claims on sovereign, which is a privilege not provided by many developing countries'
domestic or international tax laws. This paper highlights further significant and little-
discussed problems with the application of investment law to tax matters: the former's
criteria are imprecise, out of date, and unfairly apply to the State. This leads to conflict,
particularly when issues pertaining to international tax law are handled using antiquated
norms under customary international law.

This is especially crucial given how quickly the rules governing tax evasion are changing.
The study uses the example of retroactive tax legislation in India to show how foreign
investor rights that outweigh local and international tax guarantees can also have an
impact on tax policy. The paper also considers the possibility that investment agreements'
express exclusion of tax-related disputes may not be sufficient.

KEYWORDS
1. Arbitration
2. Expropriation
3. Bilateral Investment Treaty (BIT)
4. Tax Avoidance
5. Fair and Equitable Treatment

INTRODUCTION
An ad hoc body established to settle investment treaty issues has seen an increase in the
number of tax complaints filed before it in recent years. Thirty-two tax-related cases have
been submitted to international arbitration since 1999. According to Chaisse 1 (2015), this is a
result of the shifting investing environment, where an investor's decision to arbitrate is
influenced by both external and endogenous factors. Endogenous variables pertain to the
diverse character of investments, encompassing infrastructure and sovereign bonds, which
have the potential to intensify conflicts between the host state and investors. Investors would
rather bring the disagreement before an impartial panel of experts because the legal system
may be biassed against foreign interests. Then there are exogenous variables, which play a
big role in tax disputes. The taxpayer is not permitted to file a dispute directly against the
State under the present international tax treaties. Rather, the mutual agreement procedure
(MAP) guarantees that the relevant competent authorities will settle any tax disputes resulting
from a cross-border transaction. Tax arbitration is not an often used kind of arbitration. One
of the minimal standards defined by the OECD's Base Erosion and Profit Shifting programme
(BEPS) is the implementation of improved dispute resolution systems. Mandatory binding
arbitration (MBA) was proposed as a solution for situations in which responsible authorities
cannot come to a consensus. Only thirty countries chose arbitration despite the fact that the
Multilateral Instrument, which became available in 2017, gave nations the option to apply
MBA to all covered agreements. India has made it abundantly evident that it continues to
oppose the arbitration in tax related matters.

Therefore, in nations like India, the increase of tax-related conflicts under the alternative
framework presents a unique scenario. Investors have the option to choose an alternative
dispute resolution process that differs from the stance adopted by the tax administration.

An other concern that has been noted is the frequent invocation of the fair equitable treatment
criteria found in international investment agreements in investor-state disputes. Despite this,
the standard is still ambiguous and flexible. In a same vein, "creeping," "regulatory," or
"indirect" expropriation are all covered by the prohibition against expropriation. "The
umbrella clause, the (indirect) expropriation clause, and the fair and equitable treatment
standard are often used to implicate the State's regulatory authority," it is asserted. Policy
prospects are not good due to the standards' constant expansion and their frequently
contradicting outcomes. Ziff (2011) has highlighted that investor responsibility against the
State was brought about by Argentina's macroeconomic reaction to the crisis of devaluation.
This phenomenon is also evident in non-tax regulatory areas. The State's regulatory
responsibilities and its liabilities underinvestment treaties become tense as a result.

Therefore, it is necessary to maintain a just balance between the claims of investors and the
State's regulatory sovereignty. This is especially significant for the tax policies implemented
after the BEPS programme in 2012, which changed the course of international corporate
taxes. The goal of the plan was to provide governments with the tools they needed to combat
tax evasion by making sure that value is generated and earnings are taxed where economic
activity that generates the profits take place. Investment agreements must implement fair and
1
Julien Chaisse,‘Investor-State Arbitration in International Tax Dispute Resolution: A Cut above Dedicated Tax
Dispute Resolution’(2015) 35Virginia Tax Review149.
equitable treatment (FET) symmetrically in light of the changing standards to ensure that
investors do not receive undue benefit despite the drastically changed economic landscape.

The Cairn and Vodafone2 case shows that although there has been progress against tax
avoidance on a worldwide scale, changes in domestic policy that implemented anti-avoidance
measures were seen as unjust. It is believed that the retroactive alteration to the Income Tax
Act of 1961 violates the idea of legal certainty and was done in bad faith. However, it is
crucial to consider the Cairn and Vodafone cases in light of the previously noted change in
international tax law. Therefore, this article uses the retroactive modification to show how the
uneven and outdated application of standards in the International Investment Agreement
(IIA) can limit policy reforms. Countries ought to have the authority to correct legal
imperfections. It is crucial to establish the boundaries for regulatory modifications in order to
be able to do so. When the treaty allows for it, the necessity defence may be used to define
the parameters of permissible policy change. However, because of the test thresholds, this
defence is frequently difficult to maintain. This essay discusses whether reasonable
expectations and clarity are rules that the state must follow or if investors should follow them
as well.

The norms found in investment agreements were created in rather distinct economic
environments. The political and economic environments in which these accords were formed
were radically different, but the norms still applied unequally to the State and the investors.
This essay first looks at the historical circumstances that influenced the IIA's design before
analysing how ambiguous standards are. The relationship between IIA and the effect of a
nation's sovereign authority to tax is further examined in this study. While it's sometimes
maintained that the sovereign right is not unqualified,11 it is imperative that it take investor
behaviour and norms into account when determining whether an act of expropriation or a
violation of FET has occurred.

The study assesses the standard's application in the context of retroactive tax legislation in
this particular situation to demonstrate that, despite the tax rules being re-examined,
investment laws still take a rather antiquated stance. Moreover, the dispute settlement
procedures made possible by the IIAs are preferred. It is shown through the practice review
that forum shopping may result from the coexistence of IIA with a precisely specified tax
dispute resolution procedure. Finally, the study looks at whether the new model bilateral
investment treaty (BIT), like the one in India's 2016 model, has exclusions and exceptions
that will make things clearer and less likely for people to forum shop, or if the Cairn award's
distinction between investment disputes that are tax-related and those that are not will negate
the impact of the exclusion.

Tax matters and investment arbitration: are retroactive taxes different

The Investment Arbitration Tribunal has already heard challenges to a variety of tax policy
policies. For instance, tax evasion claims (Yukos v. Russia); taxes imposed in free trade
2
Cairn India Ltd v Deputy Commissioner of Income Tax (9 September 2017)
zones; and the refusal of VAT or sales tax refunds (Tza Yap Shum v. Republic of Peru).
Lately, the imposition of disproportionate windfall taxes or capital gains taxes on the
divestment of assets by developing nations has also prompted calls for arbitration
(ConocoPhillips v Vietnam). This debate centres on investor treatment and public
expenditure needs of developing countries. It is seen in these cases that it can often be
difficult for countries to reverse tax policy, even though there are macro eco-nomic
consequences of the status quo.

In Tza Yap Shum v Republic of Peru case, the firm requested sales tax refunds. The SUNAT
(Peruvian Tax authority) conducted an audit and believed that the firm under-declared sales
and ordered a new tax assessment of $4M. All banks were asked to retain any funds related to
the firm and redirect any funds to SUNAT. Enforcement measures were damaging to
company operations. The tribunal found that the BIT was violated and SUNAT measures
amounted to expropriation. Yet this raises the question of whether the tax avoidance and
evasion should be viewed as unfair and inequitable treatment by the investor. A policy
change in this regard must be evaluated on lower thresholds of legitimate expectations.

The Cairn and Vodafone instances share similarities in that they involve an underlying asset
located in India; however, what makes them apart is that the disagreement stemmed from the
capital gains tax legislation that was applied retroactively to an offshore indirect transfer of
Indian-situated assets. Treaties still restrict the implementation of this tax (Article 13(4) of
the UN and OECD model agreement). Although the Platform for Collaboration on Taxation
has made available a toolbox to facilitate its broader implementation, Article 13(4) is present
in only around 35% of Double Tax Treaties (DTTs) and is less common in cases where one
party is a low-income country with abundant natural resources. Thus, for the adjustment to
take effect, domestic tax law is crucial. The intent was clearly to end aggressive tax planning
and with the tax treaty allowing for the application of domestic tax laws, the retroactive
legislation could fix the loophole immediately.

Context and Standard of IIA

The original purpose of the existing IIA standards was to uphold the economic relationships
between trading partners that were wildly disparate. The United States signed friendship,
commerce, and navigation (FCN) agreements prior to World War I, with the primary goal of
facilitating trade and shipping during the period of expanding US international trade, which is
where the IIA got its start. Following World War I, the United States signed the Framework
Convention on Foreign Investment (FCN) which addressed investment abroad more
extensively. It covered issues such as "treatment to be accorded US nationals with respect to
the establishment of businesses, the protection of American-owned property from arbitrary or
discriminatory action, the mechanisms to settle disputes and protection 3 of trademarks and
patents. "Consequently, a clause about property protection was included in many of the
agreements. The IIAs, in contrast to the FCN, were a defensive response to earlier

3
Taxation Laws (Amendment) Act (2021) 148
expropriations of investments without payment of fair market value. The United States placed
a higher priority on fast, appropriate, and effective compensation than it did on the protection
of any one investment asset. In light of this, IIAs emerged as the cornerstone of international
investment relations. Even though the economic environment started to change in the 1990s,
the IIAs found little changed from the post-colonial IIAs. Investment agreements are actually
rarely replaced, and even now, the original text of the agreements is still present. For
instance, a lot of these accords provide comparable levels of security to investments made by
the US in current Friendship, Commerce, and Navigation.

As a result, the fundamental asymmetries stemming from economic relationships continued

in their application. The first asymmetry in these agreements is the underlying expectation of
signatories. Capital exporting countries sought treaties to defend the investment and investor
from exercises of state power by host government with respect to matters such as
expropriation, fair and equitable treatment, transfer of currency abroad and restrictions of
operations. Whereas the capital importing countries signed these agreements in the hope of
higher investment inflows. Therefore, the motto to protect and promote enshrined in the
model IIA applied differently where the former mattered to the source of capital while the
latter was important to the recipient of the capital.

Fair and equitable treatment: asymmetric and vague

Pre-1964, customary international law (CIL) was the primary source of international legal
rules governing foreign investment. However, Anglo-Iranian Oil Co Case 4 proved the
inadequacy of protection offered by CIL.

Investment agreements were thus drafted to compensate for the absence of well-established
customary standards. The conflict between capital exporting (CE) and capital importing (CI)
countries did not go away when CIL was replaced by IIA. Schwebel proposes that this is
reflected in the conflicting legal demands made by CE countries, which state that
expropriation is only legal in situations where it serves a public interest, does not discriminate
against foreign investors, and is accompanied by sufficient and adequate compensation.
However, CI nations do not want to offer foreign investors a rate of return that is greater than
that of the host state. The rights granted under the IIA are frequently greater than domestic
redress, despite this tension. The addition of exhausted local remedies as a requirement
before initiating arbitration under an investment agreement should assist address the
shortcomings of domestic law, but the indeterminacy of these criteria makes implementing
asymmetric norms more difficult.

In the 1980s and 1990s the bilateral investment treaties were signed with the intent of
furthering financial inflows to developing countries and these followed a‘neo-liberal template

4
Anglo-Iranian Oil Co Case (UK v Iran) (Preliminary Objection) [1952] ICJ Rep 93. The case pertained to the
Anglo-Iranian Oil Co Claiming that it continued to enjoy the right to mine oil on payment of royalty. The
concession granted to UK was continued until 1965, however, in 1951 the Iranian government decided to
nationalise oil sector thus stoking the dispute.
that favoured minimalist state’. The global financial crisis reversed such thinking, as the role
of state was enhanced especially with the need for more regulation including that of capital
movement. Then in 2012, the international corporate tax reform was initiated. This in turn
sought to check the abuse of preferential tax treaty provisions and domestic tax incentives.
Yet, the IIAs continue to apply without the revision. But even without the update, the IIAs
are still applicable.

The non-revision of IIAs, the absence of CIL guidance, the implementation of standards-
specifically, the FET- and the protection against expropriation have all presented challenges.
Experts note that the "minimum standard of treatment" that governments accord to foreign
investment is one area of CIL that is evolving similarly to common law domestic courts. On a
case-by-case basis, arbitral tribunals have expanded upon the FET standard's substantive
content; nevertheless, there are no legally enforceable precedents. The minimum standard is
ambiguous, with its content being extremely debatable despite its historical roots in the idea
of denial of justice. Dolzer (2005) contends that it cannot be a valid standard of international
law due to its lack of clarity, particularly given its Defect cannot be fixed by giving new
appellate bodies or ad hoc arbitral tribunals definitional power. However, it is brought up in
almost every case. Indeed, efforts have been made to create an international framework for
investment treaties. OECD5 nations made an effort to establish a multilateral investment
agreement (MAI) in the 1990s. The OECD signed MAI first, followed by other nations.
Developing nations were not represented in the negotiations and the MAI talks were
unsuccessful.

The degree of liberalisation this enforced was then met with opposition. Attempts to negotiate
a multi-lateral investment pact failed due to a lack of convergence in defining
standards. Despite the lack of convergence, investment protection is achieved by using these
criteria. These criteria are also applied to policy actions that are implemented to correct legal
flaws or accomplish macroeconomic goals.

“Broadly, fair and equitable treatment implies–(a) Prohibition of manifest arbitrariness

indecision-making, that is, measures taken purely on the basis of prejudice or bias without a
legitimate purpose or rational explanation; (b) Prohibition of the denial of justice and
disregard of the fundamental principles of due process; (c) Prohibition of targeted
discrimination on manifestly wrongful grounds, such as gender, race or religious belief; (d)
Prohibition of abusive treatment of investors, including coercion, duress and harassment; (e)
Protection of the legitimate expectations of investors arising from a government’s specific
representations or investment-inducing measures, although balanced with the host State’s
right to regulate in the public interest.”

The final one is very significant in terms of tax policy. When the state governs for the benefit
of the public, it must strike a balance with the reasonable expectations of the investor.
However, investigators are not subject to the same standards that are used to assess state
behaviour. The UN has expressed worry over this, saying that fair and equitable treatment
may allow for the concept of legitimate expectations. However, if it is used carelessly and
5
https://www.oecd.org/about/members-and-partners/
considers the problems solely from the investor's point of view, there is a chance that investor
concerns will overshadow the FET provision's original intent under IIAs.

It is a common argument to say that investment arbitration undermines tax sovereignty. The
Cairn Energy Tribunal stated that there are boundaries to the sovereign authority but
accorded India the respect it deserves in determining policy objectives and its power to
regulate. This begs the question of what this right's limitations are. Tax sovereignty limits
must pass the test of not being discriminatory or confiscatory. Using India as an example,
retroactive legislation meant that all investments made before the law's enactment were
covered. Due to the fact that, as of right now, just 17 businesses are liable for the recently
imposed tax, and of those, Vodafone and Cairn, together have paid $2.5 billion in taxes. This
was almost twice as much as the amount obtained from the Securities Transaction Tax in
2019–2020, or the same amount as the income declared by the lowest 7.4% of taxpayers in
2018–2019. Consequently, the absence of law would have resulted in a discriminatory tax
outcome at a disproportionate expense to the exchequer. One may wonder if the necessity to
restore justice for the public interest will take precedence above the requirements of legal
certainty. Citing Alexander Hamilton's arguments in favour of changing laws retroactively to
prevent "sacrifice of substantial interests by strict adherence to ordinary rules," tax officials
also frequently act based on new information and worry that it may not be enough to prevent
"overscrupulous in the times we live in."

Restoring equity may need retroactivity. However, the fundamental tenet for assessing legal
changes is certainty, which is neither an ideal nor an absolute value. Retroactivity can be
explained as an attempt to strike a balance between the goals of the relevant legislation and
the ideal of legal certainty. Therefore, a statement of compatibility with public interest can
help to clarify what types of retrospective legislation are permitted. Therefore, it is essential
to assess the standard from both sides' points of view. Utilising domestic courts to determine
if the legislation is unconstitutional is another option for determining these limitations.

A way forward
Any international agreement has a lengthy lifespan and a difficult modification process.
Considering that unexpected events cannot be planned for and may require adaptation in
response to shifting conditions. Tax treaties are "incomplete contracts" with uncertainty and
may require revisions after the fact. For other aspects of international economic law, the same
holds true. The interpretation of investment treaty law that crosses over into tax law would be
erroneous or incomplete if the normative framework for international taxation altered
following the BEPS programme. The UN saw the fragmentation of international law, which
is the outcome of specialised legislation and the establishment of institutions with a lack of
knowledge about related subjects and general legal concepts and practices. Where there is
time redundancy of legal provisions an update in one without that of the other field would
fragment the legal system. This further results in conflicts between rules or rule-systems,
deviating institutional practices and, possibly, the loss of an overall perspective on the law
which includes forum shopping. Despite this, businesses who invest through conduits and
shell corporations could still profit from the IIAs. This is significant because accounting for
the final investor nation alters international economic ties. Thus, the asymmetric application
is perpetuated by providing the FET and expropriation to investors who might only be using a
jurisdiction for investment. Despite India's stated exception, there are other treaties where this
exclusion is not applicable. Therefore, it's critical that the line drawn between tax disputes
and disputes involving investments related to taxes does not establish a precedent. The Cairn
case's tribunal ruling has been set aside, and although it might not be brought up again in the
future, the tribunal's observations in that particular case may still be problematic if another
panel comes to a similar decision. Therefore, it is essential that tribunals interpret norms like
FET and expropriation protection in light of the updated reality, where active tax evasion and
avoidance must result in the denial of IIA benefits. By determining if it counts as an
investment and submitting FET to the state and investor, this can be accomplished.

CONCLUSION
The conclusion of investment agreements related to tax matters in India requires careful
consideration and negotiation to address the complexities and challenges of the Indian tax
system. Here are some key points to consider in concluding such agreements:

 Clear Tax Provisions: Ensure that the investment agreement clearly outlines the tax
obligations of all parties involved, including any tax liabilities, responsibilities for
compliance, and mechanisms for resolving tax-related disputes.
 Tax Treaties: If the investment involves parties from countries with which India has
tax treaties, incorporate provisions from these treaties into the agreement to mitigate
double taxation and ensure tax efficiency.
 Transfer Pricing Mechanisms: If the investment involves transactions between related
parties, establish robust transfer pricing mechanisms in the agreement to ensure
compliance with Indian transfer pricing regulations and avoid disputes with tax
authorities.
 Permanent Establishment: Define the criteria for determining permanent
establishment in India to mitigate tax risks associated with foreign entities operating
in the country and ensure clarity on tax liabilities.
 GAAR Compliance: Incorporate provisions to ensure compliance with India's General
Anti-Avoidance Rules (GAAR) and other anti-abuse provisions to minimize the risk
of tax disputes and penalties.
By addressing these considerations in the investment agreement, parties can mitigate tax-
related risks, ensure compliance with Indian tax laws, and promote a stable and mutually
beneficial investment environment in India