India: Vodafone International Holdings BV v Union of India
On 25 September, it was reported by Reuters that the Permanent Court of Arbitration at the Hague (via its seat in Singapore) has ruled in favour of Vodafone in its dispute against India, initiated under the India-Netherlands Bilateral Investment Treaty (BIT). Has this case, which we have been following since the get-go, finally run its course? It would appear so, but with so much at stake and Modi’s BJP Party having such a huge majority in the Indian parliament, it would be brave to bet against there being one last-ditch roll of the dice.
A (much simplified) look at the facts:
- in 2007, Vodafone International Holdings BV acquired 100% of the shares in a Cayman target company for $11.2bn from Hutchison Telecommunications International Ltd (also a Cayman company);
- the Cayman target indirectly controlled 67% of Hutchison Essar Ltd, an Indian joint venture company that owned various Indian telecom licences;
- the Indian tax authorities challenged Vodafone claiming that Indian capital gains tax of $2.5bn should have been withheld by Vodafone; and
- the Indian tax authorities based their claim on the fact that the acquisition of the Cayman target was in fact an indirect transfer of an Indian situs capital asset.
Many countries impose capital gains tax on the sale of shares that derive their value from real estate (France, Spain, the US, Australia, the UK and so on), but generally the sale of ‘regular’ shares (i.e. those that do not derive their value from real estate) can be made without deduction of tax at source. An unusual feature of the Indian tax system is that it is the purchaser, in this case Vodafone, that is obliged to withhold the seller’s capital gain. A non-resident entity obliged to withhold tax on behalf of another non-resident entity raises a number of sticky cross-border enforcement issues, particularly where the asset being bought/sold has no Indian nexus!
In the first instance, the Bombay High Court held that the transaction was a transfer of a capital asset situated in India and that the tax authorities had jurisdiction. The matter was then referred to the Supreme Court which duly reversed the decision holding that Vodafone was not liable to pay any tax.
Following the decision of the Supreme Court, the then government introduced retrospective legislation in Finance Bill 2012 that allowed it to continue to pursue Vodafone for the tax, penalties and interest.
In 2012, Vodafone initiated proceedings under the India-Netherlands BIT arguing that the use of retrospective legislation was in breach of the principles of equitable and fair treatment per Article 4.1, which includes an obligation to ensure a stable and predictable regulatory environment. Vodafone argued that by failing to abide by the most senior Court’s ruling and introducing legislation specifically designed to thwart a decision of that court, the Government created an unstable and unpredictable business environment.
In 2014, Vodafone initiated further proceedings, this time under the India-UK BIT. The Government sought an anti-arbitration injunction which was initially granted by the High Court in Delhi, but was subsequently dismissed as being an abuse of process in May 2018. What’s the point in signing up to BITs if you intend to railroad them when used against you? The answer to this question is that you terminate those BITs you don’t like and start negotiating BITs that contain very restrictive arbitration provisions (the recent Brazil-India BIT expressly provides that a tribunal cannot award compensation, it can only interpret the BIT or order conformity of any non-complying measure).
The Court of Arbitration found the Indian government in violation of the fair and equitable treatment standard under Article 4(1) of the India-Netherlands BIT and directed India to pay $5.5mn to Vodafone as compensation for its legal costs.
Interestingly, the Indian government can still approach the High Court of Singapore (where the arbitration was held) requesting it to set aside the award and in this vein the Indian Ministry of Finance has said “the government will consider all options and take a decision on further course of action including legal remedies” suggesting it might just appeal.
The Supreme Court, when deciding the case in favour of Vodafone, commented as follows:
‘Foreign Direct Investment flows towards the location with a strong governance infrastructure which includes enactment of laws and how well the legal system works. Certainty is integral to rule of law. Certainty and stability form the basic foundation of any fiscal system.’
Since the days of Adam Smith, it has generally been accepted that for an economy to grow there needs to be strong protection of property rights. If you cannot be certain you own something, you will not spend money improving it in case it is taken away and someone else benefits from your expenditure. Nor can you use it as collateral for a loan to improve something else. A bank will not lend against an asset you may not own.
This makes you wonder why India undermined property rights by enacting and enforcing retrospective legislation, particularly because of the damage it would do to foreign direct investment and investor confidence. Vodafone isn’t alone, however. As often happens, once legislation is on the books the tax authority will try to use it which is what they did when Cairn Energy undertook an internal reorganisation in 2006 to allow it to make an initial public offering of its Indian subsidiary. It even received the Indian Tax Authority’s blessing that no Indian tax was due. That, as they say, wasn’t worth the paper it was printed on, as the Indian Tax Authority used its new power to raise a $1.5bn, plus interest, assessment on Cairn in respect of the transactions within the reorganisation.
The Cairn arbitration decision is still pending but expected before Christmas.