While it is generally accepted that taxation is an exclusive prerogative of every state, this case highlights that bilateral investment treaties (BITs) limit the manner in which states may impose taxes on foreign companies. Indeed, the Vodafone award is another example of an award, which confirms the general opinio juris that the retroactive imposition of taxes is a breach of the obligations generally contained in BITs.
The facts of Vodafone case
The dispute arose in 2007 when Vodafone acquired Hong Kong-based mobile operator Hutchison Whampoa for $10.9 billion. Vodafone International Holdings BV (Dutch tax resident) acquired the entire share capital of CGP Investments (Holdings) Ltd (tax resident of Cayman Islands) (CGP), from Hutchison group, with headquarters in Hong Kong. CGP indirectly owned 67% of Hutchison Essar Limited (HEL), an Indian entity which carried out telecommunication business in India. The sale was made by another Cayman Islands entity of Hutchison group.
Soon after the transaction was completed, the Indian income tax authorities issued a notice demanding payment of $2.2 billion as capital gains tax. However, Vodafone contended it was not liable to pay as the transaction between Vodafone and Hutchison did not involve the transfer of any capital asset situated in India.
The Indian tax authorities sought to tax the capital gains arising from the sale of the share capital of CGP on the basis that CGP, whilst not a tax resident in India, held the underlying Indian assets.
The dispute went first through the domestic Indian court system. In 2012, the Indian Supreme Court as the highest Indian court finally resolved the issue by deciding in Vodafone’s favour, thus discharging the company of its tax liability. Essentially, the Supreme Court found that the Indian Income Tax Act 1961 did not provide a sufficient legal basis for taxing a transaction that took place outside India.
However, very soon afterwards, the Finance Bill 2012 was adopted by parliament, which amended the relevant provisions of the Income Tax Act 1961 in such a way that transactions such as the Vodafone one would retrospectively fall with the Tax Act. In other words, parliament effectively overruled the Supreme Court’s decision.
Following the amended Income Tax Act 1961, the Indian tax authorities renewed the tax demand on Vodafone, at which point Vodafone resorted to arbitration under the India-Netherlands BIT in 2012.
The total amount in dispute, including the principal sum, interest and penalties, was some $5.6 billion at the time the award was issued.
The PCA tribunal dismissed India’s jurisdictional objections and held that the imposition of the tax demand was a violation of the fair and equitable treatment (FET) standard of the Netherlands-India BIT. In its award issued in late September 2020, the tribunal is understood to have found that India had violated the FET standard by imposing the tax liability on Vodafone, even though it had been Hutchinson who made the immediate financial gain.
The arbitral tribunal reportedly also cited the Supreme Court judgment in Vodafone’s favour. Vodafone had also alleged other breaches under the BIT, but the tribunal held that in light of its finding on the FET breach it was not necessary to come to a determination on these.
Finally, India was ordered to cease its conduct in question, that is the attempt to collect the unlawfully imposed taxes from Vodafone. Any failure by India to comply with this order will engage its international responsibility.
The arbitral tribunal ordered India to pay the majority of Vodafone’s costs and for the parties to evenly split the administrative fees of the arbitration.
The decision of the tribunal should not come as a surprise. In fact, retroactively imposing taxes, as Spain did with regard to renewable energy, has been found to violate the Energy Charter Treaty (ECT) in multiple cases.
For example, in the RREEF case, the arbitral tribunal unambiguously concluded that there is, however, one aspect of the case, on which the arbitral tribunal has no hesitation to find that:
“[…] the respondent acted in breach of its obligation to respect the principle of stability which, as recalled above, is a required obligation under the ECT, in that the challenged measures are partly retroactive.”
Accordingly, states should realize by now that retroactive taxes are a no go, which almost inevitably will lead to breaches of their BITs obligations.
Taxation is a favourite tool of states
Taxing (foreign) companies is not only an easy way to generate money but it also answers to the increasing sentiment in the media and parts of the society that multinationals pay too little taxes compared to local companies or the teacher in the school around the corner.
It is therefore not surprising that France and the United Kingdom among others, have adopted legislation for imposing digital services taxes, which would require big tech companies such as Google, Facebook or Amazon to pay taxes over their revenue from digital services.
For example, starting this year, France imposes a 3% tax on revenue from digital services for all companies with global revenue of more than EUR750 million.
Similarly, the UK imposes a 2% digital service tax on businesses that provide a social media service, search engine or an online marketplace to UK users. These businesses will be liable to pay this tax if the group’s worldwide revenues from these digital activities are more than £500 million and more than £25 million of these revenues are derived from UK users.
More recently and of a different nature, the Dutch left wing Green Party introduced a proposal in parliament for a so-called exit tax, for companies that allegedly leave the Netherlands in order to avoid paying taxes on dividends. This exit tax would apply to all companies with a turnover of more than EUR 750 million. Indeed, the Green Party has clarified that it would be in fact the shareholders of such companies who would pay this exit tax.
Interestingly, this proposal is also intended to apply retroactively.
Although it is highly unlikely that this proposal will gather a majority in the Dutch Parliament, it is a telling example of how far politicians are willing to go, despite the fact that the Council of State, which reviews proposed legislation, unequivocally concluded that this proposal would violate not only EU law but also international obligations of the Netherlands.
Using BITs to challenge tax measures
The Vodafone case is an excellent example of how BITs can be successfully used by foreign investors to challenge unreasonable or unfair tax bills , especially if imposed retroactively.
Obviously, the ability to challenge tax measures very much depends on the specific language of the BIT in question. Indeed, new generation BITs often contain carve-out or limitations regarding the admissibility of claims against tax measures.
Despite such carve-outs, the Yukos arbitral tribunal pointedly stated in its award that taxes must be imposed in a bona fide manner:
“Secondly, the tribunal finds that, in any event, the [tax] carve-out of article 21(1) ECT can apply only to bona fide taxation actions, i.e., actions that are motivated by the purpose of raising general revenue for the state.
By contrast, actions that are taken only under the guise of taxation, but in reality aim to achieve an entirely unrelated purpose (such as the destruction of a company or the elimination of a political opponent) cannot qualify for exemption from the protection standards of the ECT under the taxation carve-out in article 21(1). As a consequence, the tribunal finds that it does indeed have “direct” jurisdiction over claims under article 13 (as well as article 10) in the extraordinary circumstances of this case.”
In any event, it goes without saying that it is preferable if states would avoid investment treaty claims from the very beginning by not imposing taxes retroactively or otherwise for manifestly bogus reasons.