Tax and investor-state dispute settlement

Introduction

Taxes and tax incentives can either enable international investment or destroy it, and in some cases do both over time. For this reason, structuring of foreign investment is often driven by tax planning. Securing protections to preserve the value of an investment as a part of that planning is critical to the long term success of projects that are exposed to changes in laws and policies around taxation over time, and to the possibility of abusive taxation. In appropriate cases, investor-state dispute settlement (ISDS) can be a helpful tool to allow investors to counter the power wielded by states in the field of taxation.

Taxation: the good, the bad and the ugly

As a general matter, taxation is unobjectionable. An advanced society could not exist without some level of taxation to fund the community’s needs and achieve its objectives. “Taxes are what we pay for civilized society,” wrote US Supreme Court Justice Oliver Wendell Holmes, Jr. However, a rapid and unexpected increase in tax rates, or the imposition of new and surprising tax laws, can be highly disruptive, and in some cases undermine an investor’s reasonable and legitimate expectations.

At the extreme end of the spectrum, the tax power of a state can be wielded abusively to inflict harm on an enemy of the state, or to weaken a target to facilitate a takeover.

Resource nationalism and the obsolescing bargain

Taxation is an increasingly popular form of resource nationalism, in part because it is more subtle than an outright taking, and therefore less likely to attract immediate denunciation. Many countries want to assert greater control over decisions shaping the development of their natural resources and are insisting on a greater share of the benefits flowing from such development. This pressure exists for any capital-intensive investment (notably for large-scale infrastructure or manufacturing projects), and not just for projects in the traditional resource sectors of mining and energy.

The tax measures that a state might use in this context can take a variety of forms, including any one of the following (alone or in combination):

• an increase in taxes or the imposition of new taxes, including windfall profit taxes
• changes to royalty regimes
• legislative reforms to reduce or eliminate incentives that were passed to encourage investment
• the revocation of tax exemptions, or the withdrawal of subsidies
• initiation of tax investigations or tax audit proceedings
• large one-time tax assessments, often including significant penalty components
• aggressive collection of taxes, customs duties or other liabilities allegedly due

These measures will typically be imposed after a significant investment has already been made, and may well ignore the initial terms of the investment. Such cases are a manifestation of the “obsolescing bargain”: once a significant investment has been sunk in the development of a particular project in a country, the relative bargaining power switches in favour of the host government, who can then try to increase its fiscal take by changing the terms of the original deal. In such circumstances, assuming the investment has been properly planned, one tool that could be available to an investor to start to level the playing field is ISDS.

What is ISDS?

ISDS is a mechanism that enables foreign investors to resolve disputes with the government of the host country in a neutral forum through binding international arbitration. ISDS is most commonly offered in international investment agreements (IIAs) but may also be included in domestic legislation and investment contracts. These instruments typically set out certain substantive protections to which foreign investors are entitled, the breach of which gives rise to a right to bring a claim directly against the host state.

What protections and remedies does ISDS offer?

Arguably, the most important procedural protection is the right to have disputes resolved in a neutral forum, before impartial adjudicators and in accordance with transparent rules. Common substantive protections (breach of which may give rise to an ISDS claim) include:

• fair and equitable treatment
• full protection and security
• national treatment
• most favoured nation treatment
• no expropriation without full (and prompt) compensation
• free transfer of capital

Monetary compensation is the most common remedy, however, in certain cases other remedies, including declaratory relief and restitution, may be available.

Tax and ISDS

While certain tax measures might violate the substantive protections usually found in IIAs, a first hurdle to be considered is whether the treaty in question contains a tax carve-out (i.e., a provision that excludes tax measures from the scope of the IIA). Most existing IIAs do not exclude taxation from their scope, which means that investors can be protected from tax-related measures that violate the IIA’s substantive protections.

Recent UN data reveals that some 140 ISDS cases based on IIAs out of a total of more than 1000 have challenged tax-related measures.

Many more recent IIAs do, however, contain tax carve-outs, although they are not all the same. Some IIAs allow a claim to proceed only after certain procedural steps have been satisfied with the governments of both the home country and the host country. Some IIAs also stipulate that only certain substantive protections apply in respect of taxation measures (e.g., the protection against expropriation), thereby significantly narrowing the protection available under the treaty. Ultimately, however, it is up to the arbitral tribunal hearing the case to decide whether the measures in question are taxation measures and, if so, what protections in the IIA apply.

Assuming there is no tax carve-out, or certain protections nevertheless apply in respect of the tax measures, the arbitral tribunal then determines whether the tax measures violate the IIA and have caused compensable loss. At one end of the spectrum, a tax measure may be found to be a legitimate exercise of the state’s regulatory powers, resulting in the dismissal of the claim. At the other end, an investor’s loss may result from an abusive state measure designed to destroy the value of the investment, and result in an award of full compensation. Often, tax measures reflect a desire by the state to rebalance the economics of the investment or advance revenues from the investment in a manner that may or may not be lawful under international law. The outcome of a case will depend on the specific facts at issue and the particular language of the applicable treaty.

The importance of planning and advice

Ideally, every investment should involve not just tax planning, but also planning for the possibility that the tax plan might fall apart. This involves a review of the IIAs to which the host country is a party, and an assessment of the optimal investment structure from both a tax and ISDS perspective. For their part, host countries should consider their responsibility under IIAs for tax measures that violate international law. If unexpected tax measures are imposed, investors should seek advice in order to understand what redress is available before local courts and in ISDS.