The sovereign right to tax is not absolute

Relevance: This article explains India’s sovereign right to tax and its limitations

Synopsis:

India has a sovereign right to tax, but that right is subject to certain limitations.

Introduction:

The government has recently introduced the Taxation Laws (Amendment) Bill, 2021, in Parliament. The bill seeks to nullify the contentious retrospective tax law by amending the Income Tax (IT) Act of 1961 and the Finance Act of 2012. 

About the backdrop of the bill:

Earlier, the Supreme Court had ruled against the retrospective reading of the law by tax officials in the case of Vodafone. Despite that, In 2012, the Indian government then retrospectively amended the tax code, giving itself the power to go after mergers and acquisitions(M&A) deals all the way back to 1962 if the underlying asset was in India.

The retroactive amendment resulted in Vodafone and Cairn Energy suing India before Investor-State Dispute Settlement (ISDS) tribunals of India-Netherlands and India-U.K. bilateral investment treaties (BITs) respectively.

Both the tribunals held that India’s retroactive amendment of tax laws breached the fair and equitable treatment provision of the two BITs.

The proposed amendment, long overdue, is a welcome development. But this amendment hasn’t been proposed to comply with the two adverse ISDS decisions. This is because of the government’s belief that taxation matters are part of sovereign measures, they cannot be challenged before ISDS tribunals.

Does the state have a sovereign right to tax?

Several ISDS tribunals have recognised the fundamental principle that taxation is an intrinsic element of the state’s sovereign power.

For instance, in a case known as Eiser v. Spain case, the tribunal held that the power to tax is a core sovereign power of the state that should not be questioned lightly. A similar opinion is held in other cases as well.

Then how a state’s taxation can be questioned?

The two most used BIT provisions to challenge a state’s taxation measures are expropriation and the fair and equitable treatment provision.

1. Expropriation: The State’s taxation measures can be questioned on the following conditions.
   1. The tax should not be discriminatory
   2. It should not be confiscatory
   3. The tax law should not be extraordinary, punitive in amount, or arbitrary in incidence
2. Fair and equitable treatment provision: In this type, a state’s taxation can be questioned if,
   1. It breaches legal certainty
   2. Amending tax laws in an unreasonable and disproportionate manner.

Thus, India’s right to tax in the public interest should be balanced with the investor’s interest of legal certainty. So, the retrospective laws with public purpose have to justify the retroactive application of the law.