Tax Reforms

The sovereign right to tax is not absolute

Note4Students

From UPSC perspective, the following things are important :

Prelims level : ISDS

Mains level : Paper 3- Issue of retrospective taxation

Context

A bill introduced in Parliament last week aims to nullify the 2012 amendment in the Income Tax Act which made the income tax law retroactively applicable on indirect transfer of Indian assets.

Issue of taxation as a sovereign right of the state

  • Several  Investor-State Dispute Settlement (ISDS) tribunals have recognised the fundamental principle that taxation is an intrinsic element of the state’s sovereign power. 
  • The ISDS tribunals have also held that whenever a foreign investor challenges states’ taxation measures, there is a presumption that the taxation measures are valid and legal.
  • For instance, an ISDS tribunal in Renta 4 v. Russia said that when it comes to examining taxation measures for BIT breaches, the starting point should be that the taxation measures are a bona fide exercise of the state’s public powers.

What are the limits on the taxation rights of a Country under BITs

  • The two most used BIT provisions to challenge a state’s taxation measures are expropriation and the fair and equitable treatment provision.
  • 1) Expropriation: In the context of expropriation, one of the key ISDS cases that explained the limits on the state’s right to tax is Burlington v. Ecuador.
  • In this case, the tribunal held that under customary international law, there are two limits on the state’s right to tax.
  • First, the tax should not be discriminatory.
  • Second, it should not be confiscatory.
  • 2) Fair and equitable treatment: In the context of the fair and equitable treatment provision, foreign investors have often challenged taxation measures as breaching legal certainty, which is an element of the fair and equitable treatment provision.
  • Although legal certainty does not mean immutability of legal framework, states are under an obligation to carry out legal changes such as amending their tax laws in a reasonable and proportionate manner.

So, what happened in Cairn Energy v. India case?

  • The tribunal in Cairn Energy v. India said that taxing indirect transfers is India’s sovereign power and the tribunal would not comment on it.
  • Legal certainty: The tribunal said that India’s right to tax in the public interest should be balanced with the investor’s interest of legal certainty.
  • The tribunal held that the public purpose that justifies the application of law prospectively will usually be insufficient to justify the retroactive application of the law.
  • India argued that the 2012 amendment was to ensure that foreign corporations who use tax havens for the indirect transfers of underlying Indian assets pay taxes.
  • However, the tribunal held that this objective could be achieved by amending the income tax law prospectively, not retroactively.
  • The tribunal did not rule against retroactivity of tax laws per se but against the retroactive application that lacked public policy justification.

Way forward

  • Carving out taxation from BITs: India in its 2016 Model BIT carved out taxation measures completely from the scope of the investment treaty.
  • Nonetheless, carving out taxation measures from the scope of the BIT does not mean that states are free to do as they please.
  • India should exercise its right to regulate while being mindful of its international law obligations, acting in good faith and in a proportionate manner.
  • ISDS tribunals do not interfere with such regulatory measures.

Conclusion

In sum, the debate never was whether India has a sovereign right to tax, but whether this sovereign right is subject to certain limitations. The answer is an emphatic ‘yes’ because under international law the sovereign right to tax is not absolute.


Back2Basics:  Investor-State Dispute Settlement (ISDS) tribunal

  • ISDS is a mechanism included in many trade and investment agreements to settle disputes.
  • Settling these investor disputes relies on arbitration rather than public courts.
  • Under agreements which include ISDS mechanisms, a company from one signatory state investing in another signatory state can argue that new laws or regulations could negatively affect its expected profits or investment potential, and seek compensation in a binding arbitration tribunal.
  • The system only provides for foreign companies to sue states, not the other way around.
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