Cairn Energy Tax Arbitration: An analysis

Following the Vodafone arbitration, Cairn UK case is the second tribunal to hold that the retrospective application of capital gains tax was in violation of India’s international treaty obligations.

The Permanent Court of Arbitration in December, decided against the Indian government and in favour of Cairn U.K Holdings in a long contested retrospective tax arbitration matter. This judgment is the second international decision that has held that the retrospective application of tax law introduced in 2012 was in violation of India’s international treaty obligations.

In this article, we examine the history of this case, the judgment from the Permanent Court of Arbitration, and the effect this judgement could have. Although the full judgment is currently unavailable, an excerpt has been released.
 
Facts of the Dispute:
  • Cairn India Holdings Limited is a wholly owned subsidiary of Cairn UK Holdings, a company incorporated in the United Kingdom. Cairn UK transferred shares that were held directly and indirectly by it, to Cairn India Holdings. Cairn India Limited (CIL) was subsequently incorporated in India as a wholly owned subsidiary of Cairn Uk Holdings. Cairn UK holdings sold shares of Cairn India Holdings to CIL as part of an internal group restructuring.
  • The entire issued share capital of Cairn India Holdings was transferred to CIL. CIL then offered 30.5% of its shareholding as an initial public offering in India in 2006. From this divestment, Cairn UK Holdings received INR 6100 crores as proceeds from the IPO.
  • Subsequent to this, a UK based Company Vedanta Resources acquired a majority stake in CIL and CIL then merged with Vedanta Ltd., a subsidiary of the UK company.
  • Around this time, the Supreme Court of India held, in the famous Vodafone Holdings case, that Indian authorities could only charge capital gains tax on the transfer of a capital asset situated in India. In response to the judgment, the Indian government released the controversial amendment to the Indian Income Tax Act in 2012, and applied it retrospectively.
  • Based on the amendment, the Indian authorities then issued notices for reassessment for both the IPO of CIL and the internal restructuring of the Cairn group. An assessment order of nearly 10,247 crores and further penalty was passed by the assessing officers for failure to pay withholding tax on the transfer of capital asset.
  • The order was appealed to the Indian Tax Appellate Tribunal who held in favour of the Indian authorities. Vedanta UK then served a notice to India contesting the matter under the Bilateral Investment Treaty between India and the UK. However, while the proceedings were on going the Indian government continued to enforce the assessment order against Cairn.
 
Holding in 2020:

After various claims for bifurcation of orders and stay on proceedings were rejected by the tribunal, it finally passed a decision on the case in late December 2020. The tribunal held:
  • That this matter could fall under the ambit of the tribunal as it was not only a tax matter, but also dealt with matters regarding violations under the UK-India bilateral treaty.
  • That India had failed to uphold the UK-India Bilateral Investment treaty and had failed to provide fair and equitable treatment to the investments of Cairn.
  • That the Indian authorities had to stop seeking the tax, and to return the shares sold, dividends seized and refunds withheld to recover the claimed demand.
 
Effect of the Holding on Indian International Tax Matters:
  • The arrival of this judgment is at a special time, since it is the second judgement in recent time that has reaffirmed that the collection of tax on capital gains asset under India’s retrospective law is violative of international principles.
  • The retrospective application was introduced in 2012 after the Vodafone Holdings case where the Supreme Court of India had held that the transfer of non-Indian capital assets would not be taxable in India even if it was transferred indirectly through India.
  • The application of this tax has been controversial; however it has not yet been amended or appealed. Cairn is the second case where an international tribunal has held that this retrospective provision is violative of India’s international treaty obligations. Both cases have found that the retrospective application of this law was violative of India’s obligation to provide fair and equitable treatment to its investments as the law was not in place when the investments were made.
  • Indian authorities have challenged the Vodafone Tribunal verdict at Singapore, but are yet to challenge the Cairn judgement.
 
Capital Gains Tax – Retrospective Application

As per explanations to section 9 of the Income Tax Act, income arising to non-residents in respect of the transfer of any interest of a foreign entity, will become taxable in India if such interest substantially derives its value from assets located in India. This provision was introduced by way of an amendment in the Indian Finance Act of 2012, after the Vodafone case where the Supreme Court had held that transfer of assets not held directly in India would not be taxable in India.

The, in 2015, further amendments were brought in to define what ‘substantial assets’ as referred above would mean. Such shares or assets will now be deemed to derive its value from assets in India if:
  • If the value of the assets exceeds INR 100 million,
  • Hey represent at least 50% of the total value of assets owned by the foreign entity.
And in the event of transfer of assets both held in India and otherwise, the income generated from the assets deemed to be held in India would taxable in India.

The 2012 amendment was applied retrospectively (a practice still being carried out) which caused reassessments in several cases but famously in the Vodafone Holding and Cairn UK cases.

According to the rules as it stands, indirect transfer of capital assets will be liable to capital gains tax in India if the assets derive their value from India assets. This is deemed to be income accruing to or arising in India. However, foreign entities may avail advantages under the double taxation agreement, if there are any available to them.
 
What does this mean for India?

As of now, capital gains tax is applicable for transfer of assets indirectly through India if the assets derive value substantially from India. Foreign entities can also avail the benefits under the appropriate double taxation agreements, and pay the lower taxes in the foreign jurisdiction.

Two of the three similar cases of international tax arbitrations have been decided i.e. Vodafone and Cairn. A third arbitration case is pending for Sanofi pharmaceuticals. And the Vodafone case has been appealed to the Tribunal in Singapore. With the decision of Sanofi pharmaceuticals there will be more consistency and the matter may finally put to rest.

India has however shown that they are receptive to the concerns of taxpayers in this regard. It has been announced through the Union Budget 2021-22, that the re-opening or re-assessment of incomes determined as not-assessed has been reduced from 4-6 years to 3 years.

From 2021, only cases where the income has not been assessed up to years 3 years from the specific assessment year can be reopened or reassessed. For cases of serious fraud, up to 10 years from the year of assessment may be re-opened but this can only be done with prior permission from the Commissioner of Tax. This move will reduce tax reassessment cases in the vein of Vodafone and Cairn, and provide some relief to tax payers as a limit has been placed for retrospective assessment of tax matters.