Balancing foreign investment with tax sovereignty

Foreign investment plays a significant role in determining a nation's economic health. Bilateral Investment Treaties (BITs) serve as a crucial factor in attracting these investments. These treaties provide investors with a predictable regulatory environment, mitigating the risk of unforeseen costs. However, the very assurances offered by BITs can inadvertently reinforce investor rights, constraining sovereign regulatory powers.

The Cairn and Vodafone cases exemplify how specific transactional elements can grant investor rights that are independent of the investment's underlying objectives. While some may argue that this is about ensuring investor security, the issue becomes more complex when considering the application of standards such as fair and equitable treatment.

Asymmetric application of such standards, where there is no reciprocal protection of the tax base, raises concerns. Historical instances of nationalization, like Mexico in 1938, Cuba in 1959, and post-World War II Europe, underscore the relevance of these concerns. Although fears are not unfounded, their relevance is debatable. Energy supply and extractive industries contribute to a third of investor-state disputes, so the standards appear valid.

Yet, the question remains about the extent to which these standards of protection should apply, particularly given that the remedy for changing asset ownership does not align with policy sovereignty. Ironically, the countries enforcing these standards often lack compliance with the rule of law. The United States accounts for 17.4% of investor-state dispute settlements (ISDS).

Nonetheless, developing countries must extend bilateral investment treaty protections to policy measures like taxation. These treaties not only grant foreign investors rights, such as arbitration in tax matters, but also create discrepancies with India's stance that arbitration in tax matters is not permissible. This exclusion of tax from investment treaties is not unique to India, as many countries grapple with forum shopping.

Over the past decade, 134 tax-related ISDS cases were admitted, and tax treaties were utilized in 53% of these cases. However, claimants, predominantly from Western Europe and North America, opted to invoke BITs. The prevailing practice is changing globally, as the UN model is revised to exclude tax disputes from those covered by investment and trade agreements.

Different mechanisms for dispute resolution are emerging as well. For instance, Brazil's cooperation and investment facilitation agreements exclude ISDS and rely on state-to-state dispute resolution combined with joint committees for implementation. India's mutual agreement procedure (MAP) for tax could further refine these processes.

The explicit exclusion of tax by India in BITs is not uncommon, reflecting a broader trend. India has stipulated a three-year timeline for exhausting local legal remedies in tax matters, which is more efficient than the five-year allowance under the 2015 model. While the specified timeframe may be viewed skeptically, an expeditious process should not interfere with domestic investors' rights or establish a fast-track mechanism based on investor nationality.

Despite empirical evidence not overwhelmingly supporting the significant shift in foreign investors' mood due to BITs, they can still provide reassurance to investors concerned about higher relative returns. As India formalizes its BITs, it must ensure that foreign investors can seek justice without undermining the rights of other taxpayers, particularly domestic institutional investors.