Retrospective Taxation and Cairn Energy: Why has India been asked to pay $1.2 billion?

The Permanent Court of Arbitration (PCA) at the Hague has ruled in favour of Cairn and asked the Indian Government to pay around $1.2 billion in damages. This is the second arbitration loss India has faced in the last 3 months with regard to the debatable retrospective tax amendments to Section 9 of the Income Tax Act, 1962 brought forward in 2012 by the then Finance Minister Mr. Pranab Mukherjee.

Let’s try to understand what the dispute is really about.

What is Capital Gains Tax?

Any profit or gain that arises from the sale of a ‘capital asset’ is a capital gain. Capital assets include shares of a company, building and jewellery to name a few. On such Capital Gains, the Government collects income tax which is referred to as tax on Capital Gains.

Who is Cairn Energy? What should we know about them to understand this tax dispute?

  • Cairn Energy PLC (CEP) is a company incorporated in Scotland that holds various oil and gas assets in India through its direct/ indirect foreign subsidiaries. It began its investments in India during the 1990s; in 2004, the company made its biggest hydrocarbon discovery of the Mangala oil field in Rajasthan.
  • Cairn UK Holdings Ltd. (CUHL) was incorporated in the United Kingdom as a 100% subsidiary of Cairn Energy PLC (CEP) in June 2006. CEP transferred the entire shareholding of all its subsidiaries which owned Indian assets in the form of Oil and Gas blocks to CUHL in a share for share exchange between the two entities.
  • In August 2006, CUHL incorporated another 100% subsidiary Cairn India Holdings Ltd. (CIHL) which was registered in Jersey, Channel Islands. Thereafter CUHL transferred its entire shareholding of the same subsidiaries which owned Indian assets in the form of Oil and Gas blocks to CIHL in another share for share exchange between these two entities.
  • Between September-October 2006, shares of Cairn India Holdings Limited (CIHL) were then transferred to Cairn India Limited (CIL), a company incorporated in India, for a combination of cash and shares, with CUHL acquiring 100% of the share capital of Cairn India Limited.

What led to the dispute between Cairn Energy and Government of India (GoI)?

The GoI contested that through this internal restructuring mechanism, Cairn Energy PLC avoided paying any tax on the capital gains it enjoyed when shares of CIHL was sold to CIL even though the shares of CIHL derived their value solely from the assets located in India. GoI cited the retrospective amendments to the Income Tax Act, 1961 which gave it the power to retrospectively tax this transaction which was earlier not taxable based on the erstwhile provisions.

Cairn appealed on the following lines:

  • CIHL was incorporated outside India, hence the jurisdiction of taxability on any gain on transfer of shares in CIHL cannot be deemed to accrue or arise in India.
  • The transactions are purely in the nature of internal group restructuring which led to the creation of new subsidiaries in the corporate group but did not generate any real income.
  • The transactions did not lead to any transfer of, or change in control over, any underlying assets in India and the ultimate parent company and control of the group remained with the same entity i.e., Cairn Energy PLC.
  • The retrospective amendments introduced in 2012 to Section 9 of Income Tax Act, 1961 should not be used to penalize Cairn Energy. It appealed that the taxability in this matter should be determined under the provisions of the Act which were applicable when the India – United Kingdom Tax Treaty was entered into force”.

What has the arbitration court said?

Under the bilateral investment treaty between India and the UK, both nations committed to giving each other fair and equitable treatment and in case of dispute it would have to be resolved by arbitration.

Without getting into the retrospective taxation amendment, the Permanent Court of Arbitration (PCA) ruled that these tax demands are a violation of the bilateral treaties and “in breach of the guarantee of fair and equitable treatment”.  Accordingly, the international arbitration court said that Indian government must pay approximately $1.2 billion in damages to Cairn.

What is the way forward?

The Finance Ministry in a statement has said that “the government will be studying the award and all its aspects carefully in consultation with its counsel. After such consultations, the government will consider all options and take a decision on further course of action”.

It is pertinent to note that Cairn had initially lost this case when it had appealed to the Income Tax Appellate Tribunal (ITAT) in 2017 while the case filed in High Court is still pending to be heard. For any further updates in the matter, watch this space!