THE new Indian Government's Jekyll and Hyde approach towards retrospective taxation unleashed by its predecessor might prove costly in the case of Cairn Energy Plc.

The Government, led by National Democratic Alliance (NDA), has dubbed Cairn case as a legacy issue of United Progressive Alliance (UPA) regime. It wants such cases to run through the legal process. At the same time, it has reiterated its commitment to not resort to retro-taxation except in rare situations. It has repeatedly vowed to end tax terrorism.

The new Government has, however, refrained from repealing retro-tax law, which it can do easily with absolute majority in Lower House as pointed by ex-Finance Minister P. Chidambaram. The existence of retro-tax provision in the Statue would thus always remain a business risk factor for the corporate sector.

The NDA Government is thus speaking in two voices that smacks of Jekyll and Hyde syndrome or split governance to be precise.

Cairn Energy has, however, subtly referred to NDA's credibility deficit on retro-taxation. To a recent query from an analyst as to "how does this (tax notice) square with the Indian Finance Minister's comment that he is never going to use a retrospective capital gains tax again."

Cairn Energy Chief Executive Simon Thomson quipped: "It doesn't square."

The Company says it is "very disappointed" on $ 1.6bn capital gains tax demand served on its wholly owned subsidiary, Cairn UK Holdings Limited (CUHL). In 2006, Parent company had consolidated shares of different subsidiaries of Indian operations into CHUL, which served as intermediate holding company for Cairn India Limited (CIL), which incorporated as a prelude to its initial public offer in 2007.

As put by Thomson at a conference held shortly after receipt of retro-tax notice on 10th March 2015, "we tried very hard to seek a resolution with the Indian authorities. We were encouraged by statements made both in public and private by ministers in respect to seeking a resolution and avoiding the use of retrospective tax provisions. Unfortunately, it looks like the uncertainty in the budget itself has prompted the tax office to move forward with this draft assessment."

It remains to be seen whether Cairn Energy sues the Government for damages resulting from attachment of its residual 9.8% stake in CIL, diminution in the value of shares and ban on repatriation of dividend. If it does, then the compensation would easily run into several hundred million dollars. And the compensation verdict might thus serve as egg on NDA's face and thus force its review its dual stand on retro-taxation.

Cairn Energy has not yet disclosed whether it would sue the Government in India or abroad. It has, however, stated that this compensation case would run parallel to the one relating to tax dispute that it has initiated under the Indo-UK Bilateral Investment Protection Treaty (BIPA) following receipt of 100-pages notice to pay $1.6bn under the retro-tax law enacted by predecessor UPA Government. The compensation case might well be initiated separately under BIPA.

Mr. Thomson stated: "I don't think we would want to quantify at this stage the potential extent of a full damages claim. You'll be able to see how much the value of our stake in Cairn India has diminished since it was frozen over 12 months ago and clearly there is a case around that and the impact it has on our business."

Cairn Energy has articulated this matter in its annual report for 2014 released on 27th March 2015. It says: "The continued freeze of the Group's CIL shares could restrict the Group's funding capacity. The Group will take whatever steps are necessary to protect its interests. The Group has the option to take legal action to recover the value of the CIL shareholding but this has not been initiated."

Under BIPA, Cairn Energy has already filed a notice of dispute. This should set into motion discussions between the Company and the Government for resolving the dispute within three and six months. If the discussions turn out to be futile, then the Company can file a notice of arbitration.

BIPA provides for international conciliation under the Conciliation Rules of the United Nations Commission on International Trade Law.

According Cairn Energy's Chief Financial Officer James Smith, "We are not seeking a resolution in the Indian courts for this matter. The protections under the treaty are very clear against appropriations of assets in favor of the equitable treatment of investors against the principles of retrospective taxation."

BIPA, which came into effect in January 1995, says that investments of investors of either Contracting Party (India or the UK) shall not be nationalized, expropriated or subjected to measures having effect equivalent to nationalization or expropriation in the territory of the other Contracting Party except for a public purpose related to the internal requirements for regulating economic activity on a non-discriminatory basis and against fair and equitable compensation.

BIPA adds: "Each Contracting Party shall In respect of Investments grant to Investors of the other Contracting Party the unrestricted transfer of their investments and returns. Transfers shall be effected without delay in the convertible currency in which the capital was originally Invested or in any other convertible currency agreed by the investor and the Contracting Party concerned."

Mr. Thomson had obviously the details of BIPA at the back of his mind, when he averred: "So, those are the protections we're seeking to invoke. In terms of the process, the first step is a three month, or three to six month negotiation period to the extent that's helpful and constructive. Both parties of the Indian government and ourselves are required to commit to that negotiation in good faith and constructively."

If the negotiations turn out to be fruitless, Cairn Energy can seek appointment of a tribunal in an international court for resolution of the tax dispute.

The case originated on 22nd January 2014 when ITD requested Cairn Energy to provide information in relation to the accounts and transactions for the year ended 31 March 2007.

According to Cairn Energy, the correspondence with ITD indicates that the request for information is in respect of amendments introduced in the 2012 Indian Finance Act which seek to tax prior year transactions under legislation applied retrospectively. By the end of fiscal 2013-14, ITD ordered to not divest its stake in CIL. It also restrained it from repatriating out of India the dividend that it received from CIL on its shares.

The value of the 9.8% stake has declined from $1.1 billion in June 2014 to $700 million in March 2015.

Like Cairn Energy, CIL's parent company with 59.9% ownership, Vedanta Resources Plc has also invoked BIPA. This follows ITD serving a mammoth tax demand on CIL for the same Cairn Energy's transaction in CIL in 2007. In 2010-11, Cairn Energy sold controlling stake in CIL to Vedanta group.

The tax demand is for an alleged failure to deduct withholding tax on alleged capital gains arising during 2006-07 in the hands of CUHL, which is erstwhile parent company of CIL. CUHL continues to be fully owned subsidiary of Cairn Energy. The tax demand, raised in rupees, on CIL aggregates to equivalent of $ 3.29 billion.

As put by Vedanta in its release issued on 27th March, "If enforced, such tax demand would have serious consequences for Cairn India and therefore Vedanta's investment in Cairn India. Vedanta understands that a parallel tax demand has also been made by the Indian Income Tax Department on Cairn UK Holdings Limited."

Such cases are bound to put all private investors on guard, notwithstanding Finance Minister Arun Jaitley's claim that this legacy issue has not dampened foreign investors' enthusiasm.