NO foreign investment is likely to come in a country where the suppliers of capital face the prospect of appropriation of their assets. In the immediate aftermath of the decolonization process, there were indeed instances of nationalization of foreign owned companies/assets in the newly independent countries. However, soon they realized that they needed foreign capital for technology upgradation and for their overall development. Bilateral Investment treaties arose out of this need. Through these treaties, the main assurance that a foreign investor gets is that the State will not confiscate the investment. There are also other purposes of such agreements - like national treatment, most favoured nation treatment and the like. But these are subsidiary purposes.

Foreign investment also implies taxation of the income therefrom by different jurisdictions resulting in double or multiple-taxation. To prevent the same, countries sign double taxation avoidance treaties. Here also there are subsidiary purposes of DTAAs like the non-discrimination provision that prevents the Contracting States from putting more onerous burden of taxation on foreign capital.

In both the agreements, there are methods of dispute resolution prescribed. In the case of BITs, this is the arbitration. Here the party concerned can take on the State itself and demand compensation. In the case of DTAAs, the dispute resolution can be through the Mutual Agreement Procedure (MAP) prescribed in the treaty. Lately, dissatisfied with the pace of dispute resolution through the MAP, foreign investors are clamouring for a compulsory arbitration provision in the DTAAs in the event the competent authorities are unable to reach a consensus within two years.

The experience of developing countries in the area of both the instruments have been mixed. The widespread abuse of tax treaties has resulted in a churning and the BEPS Project is trying to fix the world of bilateral tax treaties.

In the area of BITs also there is rampant treaty shopping and allegation of the abuse of the arbitration process. Particularly galling is the award of hefty compensation in cases where the State might have acted in the larger interest of general public as in the cases of public health asking for increasing the size of warning on cigarettes issued by the governments. In many cases, the arbitral Tribunal where the arbitrators are drawn mostly from developed country experts have sided with the investors perhaps rightly if one goes strictly by the letter of the agreements. The complaints that as a result of the governmental action there was a reduction in the value of the original investment leading to indirect appropriation has been upheld in several cases.

As a result of such cases, there is revulsion in certain quarters against such investment treaties. In an update of World Bank Policy Research, Mary Hallward-Driemers quotes from Bill Moyers in “Trading Democracy”: “A Canadian trade lawyer gave the following assessment regarding NAFTA’s Chapter 11: “They could be putting plutonium in Children’s food. If you ban it and the company making it is an American company, you have to pay compensation"¹ Economists are however divided in their assessment of the efficacy of BITs in promoting foreign investment.

Generally speaking investment treaties and double tax treaties operate in different fields. However after the invocation of the India-Netherlands BIPA by Vodafone to resolve its tax disputes with India, the relationship between the two areas of investment protection and taxation has assumed more importance. Vodafone’s justification for invoking BIPA may be found in the following news release issued by the company:²

“Vodafone Serves Notice Against Indian Government Under International Bilateral Investment Treaty

17 April 2012

Vodafone has today served the Indian government with a Notice of Dispute (“Notice”) regarding proposals in the Indian Finance Bill 2012 that violate the international legal protections granted to Vodafone and other international investors in India. […]

The dispute arises from the retrospective tax legislation proposed by the Indian government which, if enacted, would have serious consequences for a wide range of Indian and international businesses, as well as direct and negative consequences for Vodafone. The proposed legislation would also countermand the verdict of the Indian Supreme Court in January 2012, which ruled that Vodafone had no liability to account for withholding tax on its acquisition of indirect interests in Hutchison Essar Limited in 2007.

Under the BIT, the Indian government is obliged, amongst other things, to:

• accord fair and equitable treatment to investors;

• provide full protection and security;

• not breach the legitimate expectations of investors in making investments;

• not deny justice or breach previously provided assurances; and

• not take steps to indirectly expropriate the investment.

Vodafone believes that the retrospective tax proposals amount to a denial of justice and a breach of the Indian government’s obligations under the BIT to accord fair and equitable treatment to investors. […]”

Similarly, Nokia is also reported to have sent notice under the India-Finland BIPA to settle its tax disputes. More worrying seems to be the case of Cairn Energy PLC where also there was a tax demand of more than Rs 10,000 crores. Cairn apparently is seeking compensation for the diminution of the value of its shares in Cairn India under the India-UK BIPA. However, none of these cases has actually commenced and we do not have any idea as yet of the magnitude of the demands for compensation.

In the area of tax measures and investment protection treaties, we do have the case of Yokos involving companies registered in Cyprus and Isle of Man and the Russian Federation involving the interpretation of a multilateral treaty relating to the oil sector. The judgement of the International Arbitral Tribunal, Netherlands in this case runs into roughly 600 pages and the case is supposed to be the largest award of compensation by an Arbitral Tribunal. Through this order the Arbitral Tribunal has asked the Russian government to pay compensation of roughly 50 billion dollars to the alleged foreign investors. Russia has also been asked to pay roughly 65 million dollars in legal cost. Although the case seems to be extreme from the point of view of the action of the Russian authorities, the Russian government has dubbed the decision of the arbitration court as being influenced by political considerations. It may also be noted that in another case the European Court of Human Rights had held that the case against Yokos was not politically motivated.

The Yokos case represents the history of the haphazard privatization of Russian natural resources at the time of Boris Yeltsin and the emergence of the Russian oligarchs. One of the most important of such oligarchs was Mikhail Khodorkovsky who subsequently became the CEO of Yokos before he fell out with Russian strongman Vladimir Putin.

The conflict with Mr. Putin is well documented in the Tribunal’s order. Khodorkovsky started his career in the 80s under the Komosol with a small computer firm and subsequently founded a bank called Menatap that allowed him to acquire shares in new companies at bargain prices.³

Fearing that the reform process of the 90s might disillusion the population and the communists might return,⁴ the advisers of president Yeltsin decided to sell off state resources and enterprises at throwaway prices. Under a scheme called “Loans for Shares” the oligarch owned banks rigged the auction process to become the successful bidders. Khodorkovsky got a 78 percent share of ownership in Yokos, worth $5 billion, for $310 million. Exploiting their connections with the government officials and the ability to outmaneuver or intimidate rivals, the oligarchs became immensely rich and powerful. It is alleged that the Mayor of Nefteyugansk was murdered after criticizing Yoko’s failure to pay taxes.

Subsequently, Khodorkovsky is supposed to have embraced transparency in the accounting of his companies and reorganized the board of directors bringing well-known Western investors, lawyers and businessmen. He also established charity for supporting educational and cultural projects in Russia.

With the change of guard at Kremlin and Mr. Putin becoming president, the equation changed and the new President apparently made it clear to the oligarchs that he would not interfere in their affairs as long as there was no interference in politics by the oligarchs. However that is precisely what some of these people indulged in.

The rupture with the Mr Putin apparently came about subsequently when Khodorkovsky tried to negotiate with Exxon Mobil and Chevron-Texaco for transfer of some interests in Yokos. The fact that the controlling interests in the strategic and valuable mineral companies might be transferred to Western interests apparently alarmed Kremlin.

Thus started various actions against Khodorkovsky and his Yokos group. Various officials of the company were arrested on various charges. Khodorkovsky himself was arrested in 2003 and subsequently exiled to Siberia. The Russian government brought tax evasion charges and reopened completed assessments for alleged exploitation of special regimes, transfer pricing, misuse of Russia-Cyprus treaty & VAT fraud. As a result of these proceedings, total tax demand of 25 billion dollars was raised. The company was asked to pay up immediately. Thereafter its assets were attached and auctioned off to the state owned Rosneft. On an application by foreign bank creditors bankruptcy proceedings were initiated and it was declared bankrupt in August 2006. Gazprom and Rosneft acquired its remaining assets. Finally in November, 2007 the company was liquidated and struck off the registry of companies. After bankruptcy, the shareholders of Yokos applied to the International Arbitration Court in The Hague asking for compensation.

Three shell companies, Hulley Enterprises Limited incorporated in Cyprus, Yokos Universal Ltd, Isle of Man and Veteran Petroleum Ltd, incorporated in Cyprus together owned 70.5% shareholding of Yokos. These foreign companies alleged that Russia has violated its obligations under the Energy Charter Treaty, concluded by 50 European countries in 1994 that came into force in 1998 and had guarantees against confiscation. In 2005, after the bankruptcy, these companies started arbitration proceedings against the Russian Federation for what they claimed to be indirect appropriation through taxation measures and asking for compensation of more than 100 million dollars.

Russia objected to the jurisdiction of the Tribunal pointing out that it had signed the treaty but never ratified the same. However, Russia formally notified its intention to the depository of not to ratify the treaty during the arbitration proceedings only on 20 August, 2009. Therefore the Tribunal in its interim order held that in terms of article 45(1) of the treaty, the signatories were obligated to provisionally apply the treaty and that investments made in Russia during the provisional application would get the benefit of treaty protection for 20 years i.e. till 19th October, 2029.

The Tribunal also dismissed another preliminary objection raised by Russia that the claimants were shell companies owned by residents of Russia and hence they were not ‘investors’ under the treaty. The Tribunal held that on a plain reading of the treaty all that was required for getting the status of a protected investor was that the investor was organized under the laws of a Contracting State and it has not been denied that the claimants were organized under the laws of Cyprus.

Russia had also argued that the carve out for taxation as provided in article 21 of the treaty should apply; that the claw back provision applied only with respect to expropriatory taxes but not to ‘taxation measures’. The Tribunal however agreed with the contention of the claimants that the Russian measures under the guise of taxation aimed at bankrupting Yokos, appropriating its assets and politically harm its CEO.

The Tribunal also commented on the Russian judicial system and observed that the Russian Courts “ bent to the will of Russian executive authorities to bankrupt Yokos, assign its assets to a State-controlled company, and incarcerate a man who gave signs of becoming a political competitor”.

The Yokos case also demonstrates that there is rampant treaty shopping and round trip financing and that’s how Russian investors could access treaty protection against their own government. In this connection, it is interesting to note that of the many experts that testified before the Tribunal, there were Prof. Phillip Baker, Prof. H. David Rosenbloom, and Prof. Stephen Van Weeghel, all well-known international tax experts. While Prof. Baker testified in favour of the claimants, the other two were witnesses of the Russian Federation. According to Prof. Baker, the benefits received under the Cyprus-Russia DTAA by the claimants were consistent with the purpose of the tax treaty. Prof. Rosenbloom, on the other hand, opined that the facts involve Russian nationals and residents earning Russian source income and claiming a treaty-based reduction of normal Russian tax by reason of a “wafer-thin Cypriot corporate veneer managed from Russian soil;” that Neither the DTAA nor any other income tax treaty would condone such a structure and no rational country would endorse it as sound policy. Professor Rosenbloom also accused Mr. Baker of failing to differentiate between treaty shopping and “round tripping”. He pointed out that Russia’s inaction to insist on strict limitation on benefit or its failure to terminate the Cyprus-Russia DTAA does not establish Russia’s endorsement of round tripping.

Referring to the Yukos holding structure Professor Van Weeghel pointed out that at the bottom of the structure was the successful and profitable Russian oil company developing and exploiting natural energy resources in Russia, while at the top of the structure were a small number of Russian individual shareholders. He concluded that it was “hardly perceivable” that the Russian individual shareholders, in setting up the Yukos holding structure, had any other goal in mind than low taxation and lack of transparency in respect of the ownership of Yukos shares; that such a structure would normally fall within the scope of international efforts to counter the harmful use of tax havens.

There are many more interesting aspects of this case. Those in charge of policy formulation should go through this decision carefully to have an idea of how such treaties will be interpreted by arbitral Tribunals and decide accordingly. The government of India has now come up with the draft of a new model BIPA and asked for comments. There are some welcome changes in the new model from the perspective of taxation. The new model as opposed to the earlier model goes for specific exclusion of taxation. The proposed Article 2.6 states:

This Treaty shall not apply to: […]

(iv) any taxation Measure. Where a Host State asserts as a defence that conduct alleged to be a breach of its obligations under this Treaty is a subject matter of taxation which is excluded by this Article from the scope under this Treaty, any decision of the Host State, whether before or after the commencement of arbitral proceedings, shall be non-justiciable and it shall not be open to any arbitration tribunal to review any such decision.

It seems therefore that taxation measures will be completely out. The model however, prohibits expropriation. Article 5 (relevant portion) states as follows:

5.1 Neither Party may nationalize or expropriate an Investment (hereinafter “expropriate”), or take Measures having an effect equivalent to expropriation, except for reasons of public purpose, in accordance with the procedure established by Law, and on payment of adequate compensation.

5.2 The determination of whether a Measure or a series of Measures have an effect equivalent to expropriation requires a case-by-case, fact-based inquiry, and usually requires evidence that there has been: (i) permanent and complete or near complete deprivation of the value of Investment; and (ii) permanent and complete or near complete deprivation of the Investor’s right of management and control over the Investment (iii) an appropriation of the Investment by the Host State which results in transfer of the complete or near complete value of the Investment to that Party or to an agency or instrumentality of the Party or a third party;

Thus indirect appropriation is covered by article 5 and as we have seen in the Yokos case, indirect appropriation can be through tax. However, in view of the language used in Article 2.6, it does not seem that there can be a plea that the taxation measures have resulted in appropriation of investments unless the same is conceded by the host State. The only flip side of the measure is the fact that the Indian investors abroad will also not argue about appropriation through taxation measures.

The draft model also defines “investor” in section 1.9 as follows:

“Investor” means:

(i) A legal entity constituted, organized and operated in compliance with the Law of the Home State, owned or controlled by a Natural Person or a legal entity of the Home State and conducting real and substantial business operations in the Home State; or

(ii) A Natural Person in the Home State, that/who has made and owns or controls an Investment in the Host State.

While ‘real and substantive business operations’ are not defined, hopefully, this provision will prevent round trip financing by Indian investors masquerading as foreign investors through paper companies.

The Finance Ministry’s revised version has invited some criticism in that the scope of protection has been substantially reduced. But in the light of the experience from the Yokos case, it is obvious that such treaties can be interpreted in a skewed manner and hence the changes suggested in the draft are justified. Moreover, considering the fact that there is no evidence of such treaties actually increasing investment, the government should also consider the broader question as to whether such treaties are actually necessary. Foreign investors can instead be given greater comfort by improving the infrastructure and strengthening the rule of law. As pointed out in an earlier article [Vodafone, BIPA & DTAA] Brazil, one of the largest recipients of foreign investment does not have any such treaties.

__________________________

¹ Paper titled- Do Bilateral Investment Treaties attract FDI? Only a BIT…And They Could Bite.

² Available at: http://www.vodafone.com/content/index/media/vodafone-group-releases/2012/bit.html]

³ Source: Profile of Mikhail Khodorkovsky: The Tale of Modern Russia- available at http://www.ibtimes.co.uk/profile-mikhail-khodorkovsky-tale-modern-russia-1429646