The Sovereign Right To Tax Is Not Absolute

Context: The bill introduced in Parliament to nullify the regressive 2012 amendment in the Income Tax Act is a step in the right direction.

Episode of retrospective taxation in India

• Introduced in 2012: The 2012 amendments overturned the Supreme Court’s decision in Vodafone International Holdings v. Union of India case and made the income tax law retroactively applicable on indirect transfer of Indian assets.
• It was to ensure that foreign corporations who use tax havens for the indirect transfers of underlying Indian assets pay taxes.
• This resulted in Vodafone and Cairn Energy suing India before Investor-State Dispute Settlement (ISDS) tribunals of India-Netherlands and India-U.K. bilateral investment treaties (BITs). 
• Both the tribunals held that India’s retroactive amendment of tax laws breached the fair and equitable treatment provision of the two BITs.
• A course correction on cards: In 2021, an important bill was introduced in Parliament to nullify the regressive 2012 amendment in the Income Tax Act.

Retrospective taxation as sovereign right to tax: That is, the State has a sovereign right to enact the tax measures it deems appropriate at any particular time. Many ISDS tribunals upheld this view-

• Eiser v. Spain case: The tribunal held that the power to tax is a core sovereign power of the State that should not be questioned lightly.
• Renta 4 v. Russia case: The tribunal said that the starting point of examining taxation measures for BIT breaches should be that the taxation measures are a bona fide exercise of the State’s public powers.

Limitations to states’ sovereign right to tax

• Respect fair and equitable treatment provision under BITs

• Burlington v. Ecuador 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.
• EnCana v, Ecuador case: The tribunal held that a state’s tax measures would amount to an expropriation of foreign investment if the tax law is extraordinary, punitive in amount, or arbitrary in incidence.
• Legal certainty: Legal certainty means states are under an obligation (under BITs) to carry out legal changes such as amending their tax laws in a reasonable and proportionate manner.
• Carving out taxation measures under BITs also comes with limitations: India, in its 2016 Model BIT, carved out taxation measures completely from the scope of the investment treaty.
• Yukos Universal v. Russia case: It was held if states act in bad faith towards foreign investors or abuse their right to tax, they won’t be able to take the benefit of the carve-out provision.

Takeaways from ISDS verdicts against India: India’s right to tax in the public interest should be balanced with investor’s interest of legal certainty.

• Need for an additional public purpose: Public purpose that justifies the application of law prospectively will be insufficient to justify retrospective application of the law. There must be an additional public purpose to justify the retroactive application of the law.
• Retroactive application of tax laws in India lacked public policy justification: The objectives of the 2012 amendments could be achieved by amending the income tax law prospectively, not retroactively.

Conclusions: India does have the sovereign right to tax, yet it should exercise its right to regulate while being mindful of its international law obligations, acting in good faith and in a proportionate manner.