I must start with a disclaimer: I’m one of the lawyers representing Cairn Energy. But this is not about the proceedings initiated by India to set aside the US$ 1.25 billion arbitral award or even about the proceedings initiated against Air India in the US to seek to recover this amount. This article is about the curious adventures of Cairn Energy in India and why they highlight the best and worst that India has to offer.

Cairn’s Expansion in India

Cairn began oil and gas exploration and development activities in India in 1996. A series of acquisitions enabled Cairn to make huge discoveries, including of oil fields in Rajasthan which currently account for roughly a quarter of India’s entire domestic oil production.

By 2006, the Cairn Energy group’s remarkable success in India raised the possibility of gathering all Indian operations and assets under a single Indian entity, Cairn India, and offering shares to the public. The resulting capital increase would allow further investment in Rajasthan and other locations in India.

What followed was the largest IPO in India; it raised nearly US$ 1.98 billion in January 2007. Cairn’s India subsidiary, Cairn India, became one of India’s top 25 listed companies by market capitalisation.
So far, so good.

Vodafone and the Tax Dispute

In January 2012, the UK-based Vodafone Group won a seminal case in the Supreme Court against the Income Tax Department which had asked the telecom to pay over Rs 19,000 crore as capital gains tax (and penalty) for a transaction that had been completed five years earlier. In 2007, Vodafone had acquired a Cayman company from Hutchison. This Cayman company, together with certain Indian entities, ultimately held a 67 per cent stake in Hutchison Essar Limited, the Indian telecom company. The shares acquired by Vodafone were those of a foreign company, but this was the first time the Income Tax Department sought to tax transfers of shares of a foreign company on the basis that this Cayman company derived its value from Indian assets. An indirect transfer of Indian assets had occurred, the Income Tax Department claimed. Until then, only transfers of shares of an Indian company were subject to capital gains tax in India. Vodafone alleged that high-ranking tax officials publicly acknowledged that the Income Tax Department’s tax of capital gains arising from the Hutchison-Vodafone transaction was a “test case”.

The Vodafone case attracted considerable international attention. On February 5, 2010, Prime Minister Manhoman Singh wrote to his UK counterpart, Gordon Brown, assuring him that Vodafone would “have the full protection of the law” and indicating his understanding that “there is no retrospective application of taxation and a recent court judgment has affirmed this position”.

On January 20, 2012, the Supreme Court issued a decision in Vodafone’s favour and had re-established order; justice had prevailed – or so we thought. But just two months later, the Finance Ministry amended the Income Tax Act, 1961 to provide that transfers of shares of foreign companies that substantially derived their value from assets situated in India were subject to tax in India. They did this with retrospective effect.

In 2014, the BJP assumed power in India. Its election manifesto criticised the preceding government for having unleashed “tax terrorism” and “uncertainty”, which “negatively impact[ed] the investment climate”. In his first budget speech, the new Finance Minister, Arun Jaitley, stated that “[t]his Government will not ordinarily bring about any change retrospectively which creates a fresh liability”. A new committee was formed which would decide whether action could be taken in new cases identified for retrospective taxes.

In a television interview a few months later (which also featured the former Finance Minister, P. Chidambaram), the Finance Minister admitted that it was not on his immediate agenda to repeal the controversial amendment; however, he insisted that “even though there is a sovereign power of retrospective taxation, we are not going to exercise that power.”

This view was confirmed by Prime Minister Narendra Modi on February 14, 2016. The Prime Minister was quoted in February 2016 by the Financial Times as saying that the government “will not resort to retrospective taxation; we are making our tax regime transparent, stable and predictable”.

Back to Cairn Energy

Between 2009 and 2010, Cairn Energy sold much of its shareholding in its Indian business to third parties. The most significant transaction was the sale of a controlling stake in Cairn India to Vedanta. This was completed in December 2011. Cairn Energy ultimately sold 40 per cent of Cairn India’s issued share capital. The off-market portion of the sale was subject to capital gains tax in India because it involved the private sale of shares in an Indian company.

Between June 2012 and January 2014, Cairn Energy sold additional shares in Cairn India on the stock exchanges. At that time, Cairn Energy held approximately 10 per cent of the shares of Cairn India and was looking to divest additional shares in Cairn India held by it. When Cairn India formally announced a buy-back programme of its shares in January 2014, Cairn Energy intended to participate, and sell at least some of its shares back to Cairn India. 

That was not to be. A few days after this announcement by Cairn India in January 2014, income tax officials showed up at Cairn’s Gurgaon offices to review files on the 2006 restructuring and IPO of Cairn India. Cairn maintains that the visit was triggered by its announcement of the buy-back, and “was plainly an excuse to initiate tax proceedings against Cairn based on the Retroactive Amendment more than seven years after the 2006 restructuring and to block Cairn from selling its investment.”

In what must be record time, only a day later, tax officials submitted a 125-page interim report based on the ‘survey’ at Cairn’s Gurgaon office. The report held Cairn liable for taxes even though the shares involved in its restructuring ahead of its public offering all belonged to foreign entities. A tax order followed, freezing Cairn’s remaining 10 per cent equity in its India business.

On January 25, 2016, the Income Tax Department issued a Final Assessment Order that provided for Cairn to pay approximately US$ 4.4 billion at that time. This included interest that had allegedly accrued at a rate of two per cent per month. That was not all. On September 29, 2017, India issued a lump sum penalty order against Cairn for approximately US$ 1.6 billion.

In the months that followed, the Income Tax Department engaged in the forced sale of Cairn’s shares in Cairn India. By November 2018, 98.72% of Cairn’s shareholding in its India business had been sold by the Income Tax Department. These sale proceeds, together with tax refunds due to Cairn Energy, and dividends declared by Cairn India in respect of Cairn Energy’s shareholding, have all been retained by the Income Tax Department.

Bilateral Investment Treaties

In March 2015, Cairn Energy and a subsidiary served a notice of dispute to India arguing that India had violated its obligations under the Bilateral Investment Treaty between the United Kingdom and India entered into in 1995 (the UK-India BIT).

In October 2020, a different arbitral tribunal, constituted in relation to Vodafone’s claims under a similar investment treaty between the Netherlands and India, unanimously held that India has violated its obligations under this Treaty. We understand India has filed an application to set aside this award in Singapore (the seat of that arbitration).

A couple of months later, at the end of lengthy proceedings under the UK-India treaty, the arbitral tribunal at The Hague issued a unanimous award in December 2020 in favour of Cairn Energy. The arbitral tribunal (i) declared that India had failed to comply with its obligations under this Treaty; and in particular, that it has failed to accord Cairn’s investments fair and equitable treatment; (ii) ordered India to compensate Cairn for the total harm suffered for an aggregate amount of approximately US$ 1 billion and pay approximately US$ 248 million for tax refunds that had been due to Cairn plus interest; (iii) ordered India to withdraw the tax demand; and (iv) ordered India to pay Cairn’s costs of arbitration and legal fees.

The amount payable by India is not a penalty. It represents what has been appropriated by the Income Tax Department. As mentioned above, the sale proceeds of 98.72% of Cairn Energy’s shareholding in Cairn India, together with tax refunds due to Cairn Energy, and dividends declared by Cairn India in respect of Cairn Energy’s shareholding, have all been retained by the Income Tax Department.

India is yet to comply with the award – it is seeking to set aside the award in the Netherlands. The Finance Minister has stated it is her “duty” to “appeal” in such cases. There is also a duty under the Constitution to foster respect for international law and treaty obligations.

The burning question is this: how do we attract foreign investment with a record like this?

(Uday Walia is a partner at Touchstone Partners, a law firm.)​

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