Retrospective Taxation in India – Meaning, Issues, Way Ahead

retrospective taxation in india upsc essay notes mindmap

In 2020, India lost arbitration cases to Vodafone and Cairn. These cases were against India’s retrospective taxation regime that came into effect on 2012. On December 21, the Indian government challenged the Vodafone case verdict before the Singapore Court. Given the retrospective taxes’ reputation of being unattractive for investors, the government could do well in removing such taxations – especially at the time when India is considering increasing investments to ensure Atmanirbhar Bharat. Alterations in this regard should be ensured to enable India to become a lucrative investment destination.

retrospective taxation in India

What is Retrospective Taxation?

  • Retrospective taxation is a combination of two terms – “retrospective” and “tax”.
  • Retrospective means taking effect from a date in the past and tax involves a new or additional levy of tax on a specific transaction.
  • Thus, retrospective tax law takes effect from a date before it is implemented.
  • It is often not welcomed by taxpayers as it creates an additional levy on the transaction that is already concluded when the law’s provisions were different.
  • It is unjust as it goes against individuals’ finance and taxation plans.
  • Thus, the validity of retrospective taxation is analysed on the merits of amendment in lights of facts and circumstances under such amendment is made.
  • If the retrospective amendment benefits the taxpayers or is for clarificatory purpose, it is valid.
  • If the retrospective amendment is irrational and unexpected, it would be deemed invalid.
  • Apart from India, many countries like the US, the UK, the Netherlands, Canada, Belgium, Australia and Italy have retrospectively taxed companies.

What is the purpose of retrospective taxation?

  • Countries often levy retrospective tax to remove any loopholes in their taxation policies that have led to companies benefit in the past.
  • It is also used to clarify existing laws that, due to their ambiguity, is interpreted differently by companies.
  • This tool is also used to undo outcomes of the judiciary’s decisions that went against the legislative intent.
  • Its purpose may be also to benefit taxpayers and remove undue hardship or difficulties faced by them.

Most probable and repeated topics of upsc prelims

What are the two cases in which India recently lost on retrospective taxation?

Vodafone case:

Why was retrospective taxation imposed?

  • In 2007, Vodafone bought a 67% stake in Hutchison Whampoa for $11 billion, which included Hutchison’s assets in India.
  • During the same year, India’s IT Department demanded Rs.7,990 crore in capital gains and withheld tax from Vodafone by stating that the company should have deducted the tax at source before making the payment to Hutchison.
  • This demand was challenged by Vodafone in the Bombay High Court, which ruled in favour of the IT Department.
  • Vodafone then challenged the HC ruling at the Supreme Court, which in 2012 held that the interpretation of IT Act, 1961 by Vodafone was correct and that the company need not pay any taxes for the stake purchase.
  • The dispute focused on whether an indirect transfer of property located in India is taxable under the IT Act’s Section 9(1)(i), which calls for the imposition of capital gains tax when capital assets are transferred directly from one country to another.
  • The indirect transfer involves underlying assets being transferred while a company’s share is transferred.
  • This SC ruled in favour of Vodafone because Section 9 (1)(i) does not instruct levying of tax when capital assets (machinery, buildings etc.) lying in India is transferred indirectly by transferring shares by foreign companies abroad.
  • The Indian government responded to this ruling by amending the Finance Act to clarify that when a share transaction takes place between two non-resident entities that result in indirect transfer of assets lying in India, such income will be taxed in India.
  • This amendment, made in 2012, took effect from 1962, leading to retrospective taxation on Vodafone.
  • This was to allay the concerns with regards to the impact of the apex court’s ruling on other Vodafone-type deals. It is estimated that the government would lose some Rs.40,0000 crore in revenues because of that decision.
  • Thus, the decision of the highest court of the land was overturned and the onus of paying tax fell back on Vodafone and other such entities.

 

What is the ruling by the Permanent Court of Arbitration?

  • In 2014, the Vodafone Group initiated arbitration against India at the Permanent Court of Arbitration under Article 9 of the India-Netherlands Bilateral Investment Treaty, which was signed in 1995 and has expired in 2016.
  • The Court of Arbitration ruled in favour of Vodafone because India violated the BIT and the UN Commission on International Trade Law (UNCITRAL).
  • Article 9 of the BIT states that any dispute between an investor of one contracting party and the other contracting party in connection with an investment in the territory of the other contracting party shall as far as possible be settled amicably through negotiations.
  • Article 3 of the arbitration rules of UNCITRAL states that the constitution of the arbitral tribunal must not be hindered due to controversy with regards to the sufficiency of the notice of arbitration.
  • The arbitration tribunal held that since it had been established that India had breached the terms of BIT, it must now stop efforts to recover the said taxes from Vodafone.

Cairn Energy case:

  • Cairn initiated international arbitration proceedings against the Indian government under the UK-India Bilateral Investment Treaty in March 2015.
  • It challenged the Indian government seeking taxes over an internal business reorganisation undertaken in 2006 using the 2012 retrospective tax law.
  • The government took action against this company to recover the retrospective tax.
  • During the pendency of the arbitration, the government sold Cairn’s 5% holding of Vedanta Ltd, seized dividends worth Rs.1,140 crore and set off Rs.1,590 crore tax refund against the demand.
  • In its judgement, the tribunal ruled in favour of Cairn by stating that the 2006 reorganisation of Cairn Energy’s India business prior to listing on local bourses was not “unlawful tax avoidance” and ordered the IT department to drop the tax demand.
  • It ordered the return of the value of shares that the IT Department sold, the dividend it seized and tax refunds it withheld to recover tax demand that was levied following the 2012 amendment of the IT Act.
  • It also asked to reimburse the cost of arbitration.
  • These together were worth $1.25 billion in addition to the interest.

How do these verdicts impact India?

  • The two consecutive defeats faced by India following the unfavourable verdicts by the international arbitration tribunals in Vodafone and Cairn cases have a significant impact on the already suffering government exchequer.
  • Arbitrary and regressive retrospective taxation by the Indian government can erode investor confidence and sully the country’s image.
  • These verdicts also damage India’s record of contract enforcement.
  • This makes India unattractive at the global market and for potential investors.
  • This will have a significant adverse impact on India’s Atmanirbhar Bharat Initiative that seeks to boost domestic manufacturing in a bid to substitute imports.

How did the Indian government respond to these outcomes?

  • After it lost the Cairn Energy arbitration case, the Indian government challenged the international arbitration court’s verdict on the Vodafone case.
  • This comes as the government felt the need to challenge the award because it questioned the right of a sovereign country to levy tax and not on the tax demand per se.
  • It is likely that the government would argue before the Singapore arbitral tribunal that BITs cannot overrule the sovereign rights to levy tax.
  • Besides, the BITs in question have expired and have not been renewed.
  • There is a possibility that the Vodafone might face difficulty in getting the tribunal’s award implemented even if the challenge is dismissed by the Singapore Court.
  • This is because India is not a signatory to the International Centre for Settlement of Investment Dispute (ICSID) Convention.
  • Therefore, India is not obligated to honour the award.

Way forward:

  • The decision to challenge the arbitration award in the Vodafone case is bound to spook foreign investors who have been looking to expand their businesses in India.
  • One may argue that that retrospective taxation is vital for mobilising funds and improving tax collections to address the revenue shortfall caused by COVID-19.
  • However, such policies only look at the present issue and fail at viewing the long-term impact.
  • They do not consider the long-term interests of the businesses, leading to investors being wary of investing within Indian borders.
  • Therefore, India must comply with recent verdicts instead of looking for ways to bypass them.
  • This is to fix India’s tarnished reputation as a bad investment destination.
  • India can take this as an opportunity to do away with the retrospective element of taxation in the next budget.
  • With the investors’ attention on these aspects, there will be a clear increase in investment inflows into the country.
  • This is especially vital given the importance of investment in kickstarting economic growth.
  • For India to become an attractive investment destination, there is a need for a relook into the legislature prospects hurting investors and the tax community.
  • Alterations must be ensured to enable the tax system to be predictable, certain and stable.
  • The government can also consider adopting the Shome Committee’s recommendations:
  1. Levying taxes on indirect transfer of assets located within India should be prospective and not retrospective.
  2. Retrospective application of tax law should occur only after exhaustive and transparent consultations with concerned stakeholders.

  • In addition, the government can consider tackling domestic direct tax disputes, which is estimated to be worth 9.32 lakh crore.
  • To free up tribunals and end prolonged litigation, the government launched the Vivad se Vishwas scheme.
  • However, only Rs.72,460 crore was collected – much less than the estimated Rs.2 lakh crore.
  • To address this issue, the government can adopt a modern direct tax code that ensures transparency and limits systemic issues.

Conclusion:

The retrospective taxation law has ill-effects on the investors’ interests as well as on India’s reputation as an investment destination, especially at a time when efforts are being undertaken to woo investments for economic revival. It is high time for India to make a clean break from retrospective tax law and ensure policy stability and robust regulatory framework.

Practice question for mains:

Two consecutive adverse verdicts by international arbitration tribunals have given India the opportunity to do away with retrospective taxation regime. Comment. (250 words)

Subscribe
Notify of
guest
0 Comments
Inline Feedbacks
View all comments
0
Would love your thoughts, please comment.x