Balancing foreign investment with tax sovereignty

Foreign investment inflows are a barometer to gauge economic success. Bilateral investment treaties (BITs) are among the many factors that lure investors to our shores. BITs assure a steady regulatory framework, allaying concerns of unforeseen costs to investors. However, those very assurances often turn into high standards of protection that investors resort to in order to curtail sovereign regulatory powers. The Cairn and Vodafone cases were examples of how transactional specificities allowed investor rights that are agnostic of the intent of investment.

Some argue that the point is about safety. But what happens when standards such as fair and equitable treatment apply asymmetrically, that is, when there is no reciprocal protection of the tax base?

Another article of relevance in these treaties relates to expropriation. Historical experiences — the nationalisation of the oil industry in Mexico in 1938, the expropriation of foreign owned assets by Cuba in 1959 and the post-World War II nationalisation of industries in Europe — make this relevant.

The fears are not unfounded but are these concerns relevant? Energy supply and extractive industry contribute to a third of investor-state disputes, and so the standards are valid. But how far should these standards of protection apply, especially since the remedy for change in ownership of assets is not interchangeable with policy sovereignty?

Ironically, the countries that enforce these standards are often not in conformity with the rule of law. The US accounts for 17.4 per cent of investor-state disputes settlements (ISDS). Nevertheless, developing countries have to extend bilateral investment treaty protection from policy measures like tax.

Not only do the treaties assign foreign investors rights, such as arbitration in tax matters, beyond those available to domestic investors, but these are incompatible with the position India has held at multiple fora that arbitration in tax matters is not permissible.

This exclusion of tax from investment treaties is not peculiar to India, as many countries grapple with forum shopping. In the last decade, 134 tax-related ISDS cases were admitted, and tax treaties were available for dispute resolution in 53 per cent of these. Yet the claimants, mostly from Western Europe and North America, chose to invoke BITs. The standard practice is evolving across the world as the UN model is being revised to exclude tax from disputes covered by processes stipulated by investment and trade agreements.

There are also different ways to frame the mechanisms of dispute resolution. For example, Brazil’s cooperation and investment facilitation agreements exclude ISDS and rely on state-to-state dispute resolution combined with joint committees for implementation. The state-state dispute resolution pursued by India under the mutual agreement procedure (MAP) for tax could be further bolstered. Thus, the explicit exclusion of tax by India in BIT is not atypical.

The other issue that concerns investors is the exhaustion of domestic remedies prior to proceeding with arbitration. For tax matters, the MAP process would in fact be relatively less time-consuming than alternative judicial processes.

Moreover, for all other covered disputes in its treaty with the United Arab Emirates, India has stipulated a timeline of three years to exhaust local legal remedies, making it more efficient than the 2015 model that allows for five years. The number of years specified is viewed with cynicism. However, a further expedited timeline for foreign investors should not delay justice for domestic investors or set up a fast-track mechanism based on the nationality of investors.

As India moves to formalise its BITs, what can be afforded to foreign investors is the right to find justice without impinging on the rights of other taxpayers, particularly domestic institutional investors. Empirical evidence is not overwhelming to support that BITs can shift the mood of foreign investors substantially. But what it can do is to comfort the investor distracted by higher relative returns.