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Epps, Tracey --- "Taxation and expropriation" [2013] OtaLawRw 6; (2013) 12 Otago LR 145

Last Updated: 23 April 2015

Taxation and Expropriation

Tracey Epps* I Introduction

Taxation law and policy lies at the very heart of a government’s core regulatory functions, with taxation providing the means by which a government obtains revenue in order to fund spending that is vital to the running of the country, including on various social programmes and infrastructure. Yet as critical a function as taxation is, governments cannot simply impose measures with absolute impunity. To the contrary, international law acts to constrain the actions of governments so as to ensure a certain level of treatment to aliens. This article addresses a key one of those situations, namely, the situation where a taxation measure is found to constitute an expropriation of a foreign investment that is compensable by the state under international investment law. This is an area of law that has been developing rapidly in recent years, and in respect of which there remains significant uncertainty.

Two factors make the question of when taxation constitutes expropriation under international investment law a particularly salient one. First, many countries (including New Zealand) have entered into multiple bilateral and regional investment and free trade agreements that contain an obligation for governments to compensate foreign investors in the event of expropriation of their investment. The term expropriation as used in such agreements includes not only direct expropriation (transfer of title or physical seizure) but also indirect expropriation that occurs when a government’s actions result in near total deprivation of an investment. As this article discusses, in certain cases, indirect expropriation of an investment may occur through taxation measures.

Second, given the importance to governments of maintaining an appropriate level of control over their regulatory powers in this area, they have a particularly strong interest in ensuring that obligations they owe to foreign investors do not impinge on their ability to set and implement taxation policy. The combination of these two factors – the existence of obligations not to expropriate without compensation, combined with the importance of retaining regulatory freedom in this sensitive area to set and implement taxation policy in the interests of the country – raises the question as to whether international investment law has struck an appropriate balance between investment protection and the right to regulate. This is the question addressed in this article. In the following section, I outline the main contours of the expropriation obligation in international investment law. In section III, I consider the key cases where an investor has claimed that there has been an expropriation by taxation. In section IV I then describe some of the special procedural safeguards

* Senior Trade Law Adviser, New Zealand Ministry of Foreign Affairs and

Trade; Faculty of Law, University of Otago (part-time).

that governments have inserted into their investment agreements to assist in ensuring that they are afforded appropriate regulatory space by tribunals asked to adjudicate an expropriation claim involving a taxation measure.

II The obligation to compensate for expropriation

Customary international law recognises the sovereign right of states to nationalise or otherwise expropriate property held by aliens, provided that certain conditions are met:

1. Property must be taken for a public purpose;

2. On a non-discriminatory basis;

3. In accordance with due process of law; and

4. Accompanied by payment of compensation.

This right has been crystallized and elaborated upon by many countries in their bilateral investment treaties (BITs), or free trade agreements (FTAs) that include investment chapters. These agreements – whether BITs or FTAs – typically provide a right for foreign investors to bring arbitration claims against the host state in the event of a violation of the obligations contained in the agreement, including the obligation not to expropriate without compensation.

The US 2012 Model BIT (used by the US as a negotiating template)

uses the following formulation:

Neither Party may expropriate or nationalize a covered investment either directly or indirectly through measures equivalent to expropriation or nationalization (“expropriation”), except:

(a) For a public purpose;

(b) In a non-discriminatory manner;

(c) On payment of prompt, adequate, and effective compensation; and

(d) In accordance with due process of law and Article 5 [Minimum Standard of Treatment](1) through (3).

The New Zealand China FTA1 uses a different formulation in Article 145.

1. Neither Party shall expropriate, nationalize or take other equivalent measures (“expropriation”) against investments of investors of the other Party in its territory, unless the expropriation is:

(a) For a public purpose;

(b) In accordance with applicable domestic law;

(c) Carried out in a non-discriminatory manner;

(d) Not contrary to any undertaking which the Party may have given; and

1 Free Trade Agreement Between The Government of New Zealand and

The Government of The People’s Republic of China, signed on 7 April

2008. Text available online at:

(e) On payment of compensation in accordance with paragraphs 2 and 3.

The New Zealand China formulation is different to the US model in that it uses the term “in accordance with applicable domestic law” instead of “in accordance with due process of law”, thus replacing an international legal concept of due process with one grounded in domestic law; and introduces the concept that the expropriation must not be contrary to any undertaking which the Party may have given. The compensation requirement is also different, not using the formulation of “prompt, adequate and effective” which is seen in the US model as well as numerous other agreements.2

New Zealand has used a formulation akin to the US model in other agreements, for example in the CER Investment Protocol, and the Australia New Zealand ASEAN FTA (AANZFTA) which both list the classic four requirements that the expropriation be for a public purpose; in a non-discriminatory manner; in accordance with due process of law; and on payment of prompt, adequate, and effective compensation.3

A critical, and often controversial, issue arising in many investment arbitrations involving claims of expropriation is whether or not there is in fact a compensable expropriation. As noted in the Introduction, expropriation may be either direct or indirect. Direct expropriation has been defined as meaning a “mandatory legal transfer of the title to the State itself or a State-mandated third party. In cases of direct expropriation, there is an open, deliberate and unequivocal intent, as reflected in a formal law or decree or physical act, to deprive the owner

2 Paragraph 2 provides that compensation shall be:

equivalent to the fair market value of the expropriated investment immediately before the expropriation measures were taken. The fair market value shall not reflect any change in value due to the expropriation becoming publicly known earlier. The compensation shall include interest at the prevailing commercial rate from the date the expropriation was done until the date of payment. It shall be paid without delay and shall be effectively realizable and freely transferable. It shall be paid in the currency of the country of the affected investor, or in any freely convertible currency accepted by the affected investor.

Paragraph 3 goes on to provide that:

if the fair market value is denominated in a freely usable currency, the compensation paid shall be no less than the fair market value on the date of expropriation, plus interest at a commercially reasonable rate for that currency, accrued from the date of expropriation until the date of payment.

3 New Zealand Australia Closer Economic Relations Investment Protocol, Article signed 16 February 2011, Article 14, available online at: Relationships-and-Agreements/Australia/index.php; and Agreement Establishing the ASEAN – Australia – New Zealand Free Trade Area, signed 27 February 2009, Chapter 11, Article 9, available online at: http://

of his or her property through the transfer of title or outright seizure.4

The more controversial type of expropriation, and that which will be at

issue in the case of claims involving taxation measures, is that which is

indirect. Indirect expropriation involves total or near-total deprivation

of investment, but without a formal transfer of title, or outright seizure.5

A variation on indirect expropriation is what is known as “creeping”

expropriation. This involves a series of measures which have the effect

of substantially depriving an investor of the benefit of their investment,

but where no one measure by itself would amount to an expropriation.6

The possibility of indirect expropriation was recognised in a number

of early international cases before it was given a place in international

investment agreements. In the Starrett Housing case, for example, the

Iran-United States Claims Tribunal said that:7 is recognized under international law that measures taken by a State can interfere with property rights to such an extent that these rights are rendered so useless that they must be deemed to have been expropriated, even though the State does not purport to have expropriated them and the legal title to the property formally remains with the original owner. (Emphasis added)

Arbitration tribunals have typically looked at three key aspects to determine whether or not there is an indirect expropriation:

1. The economic impact of the measure;

2. The extent to which the measure interferes with reasonable, investor-

backed expectations; and

3. The nature, purpose, and character of the measure

I briefly examine these three aspects below.

A Economic Impact

The economic impact of the measure complained of is critical to determining whether there is in fact a measure rising to the level of an expropriation, but it has not always been clear as to whether economic impact alone is sufficient to ground a finding of indirect expropriation (the so-called “sole effects doctrine”). Countries are increasingly including language in their investment agreements to make it clear that economic impact alone is not sufficient to show expropriation.8 Nevertheless, it can

4 United Nations Centre for Trade and Development (UNCTAD), “UNCTAD Series on International Investment Agreements II” (New York and Geneva, 2012) at 6.

5 Ibid, at 7.

6 United Nations Centre for Trade and Development (UNCTAD),

“UNCTAD Series on International Investment Policies for Development,

Investor-State Disputes Arising from Investment Treaties: A Review”

(New York and Geneva, 2005) at 42.

7 Starrett Housing v Iran, Interlocutory Award No ITL 32-24-1, 19 December

1983, 4 Iran-United States Claims Tribunal Reports 122 at 154.

8 UNCTAD, Expropriation Series II, above n 4, at 63. For example, the

United States 2012 Model BIT states that: “... the fact that an action or

series of actions by a Party has an adverse effect on the economic value

be expected that tribunals will pay close attention to the economic impact of the measure or action complained of. The degree of economic impact is important, with a large majority of tribunals holding that a finding of expropriation requires that the measure or degree of interference be such as to render the investor ’s property rights useless. They have used various formulations, such as interference that “has the effect of depriving the owner, in whole or significant part, of the use or reasonably-to-be- expected economic benefit of property”;9 that the economic value of the use, enjoyment or disposition of the assets or rights have been neutralised or destroyed;10 “interference is substantial and deprives the investor of all or most of the benefits of the investment”;11 and “have the effect of destroying the business in question”.12

The analysis of economic impact involves consideration of a number of factors: whether the measure has resulted in a total or near-total destruction of the investment’s economic value,13 whether the investor has been deprived of control over the investment;14 and whether the effects of the measure are permanent. The weight to be afforded to each of these factors will in turn depend on the facts and circumstances in question. The exercise of determining whether a measure has resulted in the required degree of deprivation is a fact-based one, as the Tribunal said in Chemtura v Canada:15

the determination of whether there has been substantial deprivation is a fact-specific exercise to be conducted in the light of the circumstances of each case ... it would make little sense to state a percentage or threshold

of an investment, standing alone, does not establish that an expropriation has occurred”. Available online at US Department of State <http://www.> .

9 Metalclad Corporation v The United Mexican States, ICSID Case No

ARB(AF)/97/1, Award (30 August 2000) at para 103.

10 Tecnicas Medioambientales Tecmed S A v The United Mexican States, ICSID

Case No ARB(AF)/00/2, Award (29 May 2003) at para 116.

11 Archer Daniels Midland Company (ADM) and Tate & Lyle Ingredients Americas,

Inc v The United Mexican States, ICSID Case No ARB(AF)/04/05, Award

(21 November 2007) at para 240.

12 Corn Products International v the United Mexican States, ICSID Case No

ARB(AF)/04/01, Decision on Responsibility (15 January 2008) at para 93.

13 Eg In Compañía de Aguas del Aconquija S A and Vivendi Universal S A v

Argentine Republic, ICSID Case No ARB/97/3, Award (20 August 2007) the

Tribunal said that “the weight of authority ... appears to draw a distinction

between only a partial deprivation of value (not an expropriation) and a

complete or near complete deprivation of value (expropriation)”.

14 Eg In Sempra Energy International v Argentine Republic, ICSID Case No

ARB/02/16, Award (28 September 2007) the Tribunal said that “a finding

of indirect expropriation would require ... that the investor no longer be

in control of its business operation, or that the value of the business has

been virtually annihilated”.

15 Chemtura Corporation v Government of Canada, Ad Hoc NAFTA Arbitration

Under UNCITRAL Rules, Award (2 August 2010) at para 249.

that would have to be met for a deprivation to be substantial as such modus operandi may not always be appropriate.

B Legitimate investment-backed expectations

Tribunals have taken varying approaches to this factor, which recognises that in some cases, an investor may have certain expectations that his or her rights will not be regulated or restricted in a certain way. Some Tribunals have required specific commitments by governments to investors, and others have taken a looser approach that allows claims based on implicit assurances, coupled with the investor ’s assumptions.16

However, in a recent summary of the law on expropriation, UNCTAD concludes that tribunals have generally adopted a high threshold concerning legitimate expectations, finding that a legitimate expectation will only arise where a State has made specific representations or commitments to the investor on which the investor has relied.17

C Nature, purpose, and character of the measure

UNCTAD notes that the nature, purpose, and character of a measure are particularly important in distinguishing between an indirect expropriation and a valid regulatory act which is not compensable. It considers that the nature of the measure relates to whether it is a bona fide regulatory act; purpose relates to whether the measure genuinely pursues a legitimate public policy objective; and character relates to factors such as whether the measure is non-discriminatory, proportionate to its objective, and was enacted in accordance with due process.

D Police Powers

Even where an examination of the above factors points to a conclusion that the measure or action in question constitutes an indirect expropriation, if the measure is a regulation that is directed towards legitimate public welfare purposes, then the international law notion of “police powers” will come into play, pointing towards a conclusion that it does not constitute a compensable expropriation. Referring to the “police powers” doctrine, tribunals have recognised that at customary international law there is a category of measures that do not rise to the level of constituting an expropriation, and that therefore are non- compensable. In general terms, the police powers doctrine covers State acts to advance legitimate public welfare objectives. UNCTAD refers in this regard to States’ intervention in the economy through regulation in a variety of ways:18

16 UNCTAD, above n 4, at 75.

17 Ibid.

18 See Ian Brownlie, “Principles of Public International Law” (7th ed, Oxford

University Press, Oxford, 2008) at 532; Andrew Newcombe, “The

boundaries of Regulatory Expropriation in International Law” (2005) 20

ICSID Review: Foreign Investment Law Journal 1 at 23; and M Sornarajah

“The International Law on Foreign Investment” 2nd ed, Cambridge

University Press, Cambridge, 2004).

preventing and prosecuting monopolistic and anticompetitive practices; protecting the rights of consumers; implementing control regimes through licences, concessions, registers, permits and authorizations; protecting the environment and public health; regulating the conduct of corporations; and others.

The power to tax may be seen as falling squarely within this concept of core regulatory activity.

In Saluka Investments v Czech Republic, the tribunal recognised the police powers doctrine in its statement that “[i]t is now established in international law that States are not liable to pay compensation to a foreign investor when, in the normal exercise of their regulatory powers, they adopt in a non-discriminatory manner bona fide regulations that are aimed at the general welfare”.19 Similarly, in Methanex v United States, the tribunal (discussing a California ban on a gasoline additive) said that:20

as a matter of general international law a non-discriminatory regulation for a public purpose, which is enacted in accordance with due process and, which affects, inter alios [sic], a foreign investor or investment is not deemed expropriatory and compensable unless specific commitments had been given by the regulating government to the then putative foreign investor contemplating investment that the government would refrain from such regulation.

The concept was also discussed in Feldman v Mexico where the tribunal noted that “governments must be free to act in the broader public interest through protection of the environment, new or modified tax regimes, the granting or withdrawal of government subsidies, reductions or increases in tariff levels, imposition of zoning restrictions and the like”, adding that “reasonable governmental regulation of this type cannot be achieved if any business that is adversely affected may seek compensation, and it is safe to say that customary international law recognizes this”.21

E Elaboration of indirect expropriation in investment agreements

Given the importance of ensuring regulatory space for governments to act in the public interest, governments have increasingly – rather than relying on tribunals to properly interpret and apply the customary international law concept of police powers and the general development in the case law on expropriation – sought to include language in their trade and investment treaties that provides clarification and guidance to tribunals as to when a measure might be found to constitute an indirect expropriation. In the US 2012 Model BIT, for example, such language is found in the Expropriation Annex. This Annex requires tribunals to consider the question of whether there has been an indirect

  1. Saluka Investments BV (The Netherlands) v The Czech Republic, UNICTRAL Arbitration, Partial Award (17 March 2006) at para 255.
  2. Methanex Corporation v United States of America, UNCITRAL Arbitration, Final Award (3 August 2005) at Part IV, Chapter D, para 7.
  3. Marvin Feldman v The United Mexican States, ICSID Case No ARB(AF)/99/1, Award (16 December 2002) at para 103.

expropriation on a case-by-case basis. It sets out an inclusive list of factors that tribunals must consider in making its determination, namely: (i) the economic impact of the government action; (ii) the extent to which the government action interferes with distinct, reasonable investment- backed expectations; and (iii) the character of the government action. It also provides that “except in rare circumstances, non-discriminatory regulatory actions by a Party that are designed and applied to protect legitimate public welfare objectives, such as public health, safety, and the environment, do not constitute indirect expropriation”.

A differently worded approach is found in the Expropriation Annex of the New Zealand China FTA. Rather than listing factors which have to be taken into account, it states that in order to constitute indirect expropriation, the State’s deprivation of the investor’s property must be:22

(a) Either severe or for an indefinite period; and

(b) Disproportionate to the public purpose.

The Annex goes on to state in paragraph 4 that deprivation of property “shall be particularly likely to constitute indirect expropriation where it is either: (a) discriminatory in its effect, either as against the particular investor or against a class of which the investor forms part; or (b) in breach of the State’s prior binding written commitment to the investor, whether by contract, licence, or other legal document.” Finally, the Annex specifies that “except in rare circumstances to which paragraph

4 applies, such measures taken in the exercise of a State’s regulatory powers as may be reasonably justified in the protection of the public welfare, including public health, safety and the environment, shall not constitute an indirect expropriation.”

Other investment agreements also contain annexes fulfilling the function of providing guidance to tribunals on how to determine whether or not there has been an indirect expropriation. There is potential for much ink to be spilled in dissecting the words of these and other approaches to providing such guidance, and I will not attempt such an exercise here. The key aspect to note here is that the very presence of these types of provisions show clearly that governments take seriously the goal of ensuring that investment agreements provide sufficient regulatory space to allow them to regulate in the government interest. In negotiating these types of annexes, they are affirming the general direction taken by tribunals that have sought to strike an appropriate balance between upholding the rights of investors while recognising the legitimate regulatory space of governments.

Given the indisputable importance of taxation policy as a core government function, it is almost impossible to conceive of a tribunal taking a position that did not recognise taxation measures as falling within the sphere of public welfare measures. That said, the case law to date shows that there are rare circumstances where the factual situation

22 Annex 13, paragraph 3.

is such that taxation measures do constitute compensable expropriation. The next section describes these cases, but concludes that the tests applied by tribunals to date set an appropriately high threshold that should provide comfort to governments that, regardless of whether the investment treaty in question includes guidance to tribunals on determination of indirect expropriation, their taxation authorities would have to significantly overstep the usual bounds of taxation administration before a finding of expropriation will be made.

III Treatment by tribunals of expropriation claims relating to taxation

In this section, I set out the essential facts and findings from the key cases to date that have questioned whether or not a taxation measure constitutes an expropriation.

A Revere Copper & Brass v OPIC23

This early case involved a 1967 agreement between a Jamaican subsidiary of Revere and the Jamaican government regarding the construction and operation of a mining plant in Jamaica. The agreement contained a clause that provided for tax stability (in other words, a written commitment on the part of Jamaica that it would not change its tax laws). Seven years after the agreement had been signed, a newly elected government announced that it would not be bound by its existing aluminium contracts and it issued a series of measures that removed some of the investment guarantees its predecessor had given to Revere. These measures included an increase in taxes and royalties. In making these increases, the government ignored the tax stability agreement but justified its actions by citing changes in the economic environment. A year after implementation of the measures, Revere – having unsuccessfully filed a claim for its losses with the Overseas Private Investment Corporation (OPIC)24 – brought an investment claim for, inter alia, expropriation of its investment. It claimed that its revenues had dropped substantially since implementation of the tax measures, forcing it to shut down its plant.

The tribunal established to hear the case recognised that a mere breach of contract does not constitute expropriation, but concluded that in this case the government’s repudiation of the tax stability agreement directly prevented Revere from exercising effective control over the use or disposition of its property. It therefore concluded that there had been an expropriation under the terms of the policy. A key factor in this decision was the existence of the stability clause in the investment agreement, which created a very fact-specific situation that will not be typical of many other situations.

23 Revere Copper and Brass, Inc v OPIC, AAA Award of August 24, 1978, 17

ILM 1321 (1978).

24 OPIC is the United States Government’s development finance institution.

It offers political risk insurance to cover investment-related losses that

result from political perils. See online at:

B Reynolds-Guyana Mines25

Another early case, Reynolds-Guyana Mines, involved a claim against the Guyana government by an investor who owned a bauxite mining facility in Guayana. In 1970, the Guyanan government announced its intent to acquire a meaningful participation in Reynolds’s investment. When Reynolds refused to accede to the government’s plan, Guyana found a US $2.7 million tax deficiency, and implemented bauxite severance and production taxes that required a US $7 million minimum payment: this was tantamount to a 1,630 per cent tax increase. Reynolds refused to pay the amount demanded by the government. In response, the government placed a ban on shipments of chemical and calcined bauxite, which forced Reynolds to withdraw its personnel, shut down the plant and lay off the local workers. In this case, Reynolds agreed with OPIC for compensation of US $10 million. Later, the government of Guyana, OPIC and Reynolds signed an agreement in which the government agreed to pay US $14.5 million for the nationalised assets and US $10 million to offset the tax refund and levy claims between Reynolds and the government. While this case was not subject to an investment tribunal decision as such, it usefully illustrates the type of extreme factual situation that may justify a finding of expropriation.

C Occidental v Ecuador26

Occidental was an American company that, in 1999, entered into a participation contract with Petroecuador, a State-owned corporation of Ecuador, under which it undertook, as a service provider, to undertake exploration for and production of oil in Ecuador. 27 Under the contract, Occidental applied regularly to the Servicio de Rentas Internas (SRI) for, and received, reimbursements of Value-Added Tax (“VAT”) paid by it on local purchases that it required for its exploration and exploitation activities under the contract and the ultimate exportation of the oil produced. However, beginning in 2001, SRI issued various resolutions in which they denied all further reimbursement applications by Occidental and other companies in the oil sector and required the return of amounts previously reimbursed (saying that they had been based on a mistaken interpretation of Ecuador ’s tax laws). This was based on the opinion that VAT reimbursement was already accounted for in the participation formula under the contract whereby Occidental received a percentage of the oil production.

Occidental filed a number of legal actions in Ecuador ’s tax courts

25 “Reynolds Metals Company, Narrative Summary – Contract No 5877 (Guyana)”, in Mark Kantor, Michael D Nolan and Karl P Sauvant (eds), Reports of Overseas Private Investment Corporation Determinations, (Oxford University Press, Oxford, 2011) vol 1 at 555.

26 Occidental Exploration and Production Company v the Republic of Ecuador, London Court of International Arbitration Administered Case No UN3467, Final Award (1 July 2004).

27 This contract followed earlier agreements that had been in force between

Occidental and Petroecuador since 1995.

objecting to SRI’s resolutions. The claim was based on the grounds that the resolutions were inconsistent with Ecuador ’s legislation. It also brought a claim under the Treaty Between the United States of America and the Republic of Ecuador Concerning the Encouragement and Reciprocal Protection of Investment (the “Investment Treaty”). Occidental argued, inter alia, that its investment had been expropriated indirectly through measures tantamount to expropriation by Ecuador ’s refusal to refund the VAT to which it was entitled under Ecuadorian laws. It argued that these laws entitled it to a credit where it exported oil and paid VAT as a result of the importation or local acquisition of goods and services used for such oil. It claimed that Ecuador had “unlawfully, arbitrarily, discriminatorily, and retroactively” taken its right to VAT refunds, and that in doing so, it had expropriated all or part of its investment.28 Ecuador argued, inter alia, that taxation could not be considered as a kind of property subject to expropriation. It also argued that the participation formula included a reimbursement of VAT which meant that Occidental’s argument that it was entitled to refunds under Ecuador ’s tax laws could not be sustained.

The Tribunal held that as a general matter, taxes can result in expropriation, in the same way as can other types of regulatory measures.29 However, in this case, it did not find an indirect expropriation on the facts. It cited the definition of expropriation given by the Tribunal in Metalclad v United States, a definition which it noted that it considered to be a rather broad one, namely, that expropriation includes:30

[C]overt or incidental interference with the use of property which has the effect of depriving the owner, in whole or in significant part, of the use or reasonably-to-be-expected economic benefit of property even if not necessarily to the obvious benefit of the host State.

The Tribunal noted that even in the context of this broad definition, the Tribunal in Metalclad had said that there must be a deprivation, that this deprivation must affect at least a significant part of the investment and that all of it relates to the use of the property or a reasonably expected economic benefit.31 But here, the Tribunal found that there had been no deprivation of the use or reasonably expected economic benefit of the investment, let alone measures affecting a significant part of the investment. It further found that “substantial deprivation” in international law (as identified in Pope & Talbot) was not present, and that if narrower definitions of expropriation under international law were examined, a finding of expropriation would lie still farther away.32

28 At para 81.

29 At para 85.

30 At para 87. Citing Metalclad Corporation v The United Mexican States, ICSID

Case No ARB(AF)97/1, Award (30 August 2000).

31 At para 88.

32 At para 90.

D EnCana v Ecuador33

In EnCana v Ecuador, the claimant was a Canadian oil and gas company whose Ecuadorian subsidiaries entered into contracts for the exploration and exploitation of oil and gas reserves with Petroecuador. Similarly to the facts in Occidental v Ecuador, at issue were VAT refunds to which the claimant claimed to be entitled under Ecuadorian laws and regulations. The claimant argued that even if its subsidiaries were not entitled to a tax refund under Ecuadorian law, their deprivation of this refund had an impact so substantial as to be equivalent to expropriation of EnCana’s investment. The tribunal rejected the claim, laying out the following principle with respect to taxation and expropriation:34

it is well settled that taxation is a “specific category of measures for the purposes of expropriation. This is because it relates to a universal State prerogative to create a new legal liability on a class of persons to pay money to the government in respect of some defined class of transactions. By definition, taxation is not accompanied by the payment of any compensation—and, therefore, under traditional legal principles would ipso facto be illegal. Therefore, international law sets forth a specific test for the assessment whether tax measures are expropriatory: a tax is an unlawful deprivation if it is “extraordinary, punitive in amount or arbitrary in its incidence.

Further, the tribunal stated that in the absence of a specific commitment from the host State, the foreign investor has neither the right nor any legitimate expectation that the tax regime will not change, perhaps to its disadvantage, during the period of the investment. Indeed, it said that “it will only be in an extreme case that a tax which is general in its incidence could be judged as equivalent in its effect to an expropriation of the enterprise which is taxed”.35

On the facts of the case, the tribunal found that the effect of the legislative change on EnCana’s subsidiaries was not substantial, since they continued “to function profitably and to engage in the normal range of activities”.36 It found that “only if a tax law is extraordinary, punitive in amount or arbitrary in its incidence would issues of indirect expropriation be raised.37 In the case at hand, it found that there was no commitment from Ecuador in relation to future VAT credits, and that the denial of VAT refunds in the amount of 10 per cent of transactions associated with oil production and export did not deny EnCana “in whole or significant part” the reasonably-to-be expected benefits of its investment.38

33 EnCana Corporation v Republic of Ecuador, Arbitration Pursuant to the Canada-Ecuador Bilateral Investment Treaty and the UNCITRAL Rules, London Court of International Arbitration, Case No UN3481, Award (3 February 2006).

34 At para 177.

35 At para 173.

36 At para 174.

37 At para 177.

38 At para 177.

E Quasar de Valors v Russian Federation39

In Quasar de Valors v Russian Federation Spanish investors in the Russian oil company Yukos brought a claim against the Russian Federation for, inter alia, indirect expropriation under the Spain – Russia Investment Treaty. In December 2003, after a September ruling that Yukos had no unsettled tax liabilities and no violations of the tax legislation, Russian tax authorities announced their plans to re-audit Yukos for the tax year 2000. Three weeks later, the authorities announced that they had uncovered underpayment of $2.27 billion in taxes. This was followed four months later by imposition of a total assessment of $3.4 billion for which the authorities sought enforcement through domestic courts, resulting in a freeze order forbidding the company from alienating or encumbering its property. Following the freeze order, court bailiffs seized Yukos’ share in its oil-producing subsidiary YNG, and subsequently auctioned off YNG. Although YNG was reported to be worth between $15 and $20 billion, it was sold for just $9.35 billion to Baikal Finance Group, a shell company created two weeks before the auction. Rosneft, a state-owned energy company, subsequently acquired YNG from the shell company with financing provided by the China National Petroleum Corporation. Prior to the auction, the government made new assessments for the 2001 through 2003 tax years. In the end, the total assessments amounted to more than $24 billion.

Like other companies in the energy sector, in its operations, Yukos had followed a practice of limiting the profits-tax exposure of its production companies by running sales through trading companies located in domestic tax havens.40 In its re-audit of Yukos, the Russian government essentially imputed the trading company transactions to Yukos, and used an interpretation and application of the tax laws that resulted in its being held liable for VAT on goods that had been exported and thus ought to have qualified for a zero rate. Stephan describes the approach taken by the tax authorities as using a “dubious legal theory”, and overall, “a spectacular perversion of the tax system”.41 It was not just the legal interpretation, but also the tactics used by the taxation authorities. As Stephan neatly summarises:42

One judge who tried to overturn the asset freeze was removed from the case, and then fired; another judge who fully backed the government’s case won an award, and then promotion. The company’s legal department,

39 SCC Case No 24/2007, Award, 20 July 2012.

40 Russia had created domestic “tax havens” which were essentially cities

or regions where local entities had authority to take actions such as

rebating taxes to firms that located in them. Paul B Stephan III “Taxation

and Expropriation – The Destruction of the Yukos Empire” (2012) 35

Houston Journal of International Law 1, Forthcoming; Virginia Public

Law and Legal Theory Research Paper No 2012-48, available at SSRN: at 22.

41 Ibid, at 22 and 29.

42 Ibid, at 29.

in turmoil due to the arrests of Yukos personnel, was given exceptionally short deadlines to respond to the government’s case and no effective opportunity to review the government’s evidence. Most extraordinarily, the government relied on the asset freeze to bar any payment of the assessment ... the government insisted on payment only in case, not in property, and used the freeze to bar Yukos from converting its liquid assets into cash.

Stephan writes that after 2004, “all of Yukos within Russia was either seized or crippled”.43 As a result of the events that had taken place, a number of Yukos investors brought arbitration claims against Russia. Three international claims were brought other than the one by the Spanish investors (Quasar de Valors).44 Before the various tribunals, Russia argued that the power to characterise Yukos as the actual taxpayer came from a constitutional doctrine that distinguished between good-faith and bad- faith taxpayers. It argued that the Constitution allowed the government to disregard transactional forms used by taxpayers who purposively sought excessive tax benefits. Stephan notes that the doctrinal support for Russia’s constitutional argument was thin at best, and the principle as stated had no logical limits.45

In the Quasar de Valors claim, the tribunal was called upon to decide whether the measures taken by the Russian Federation were bona fide, as part of the ordinary process of assessing and collecting taxes, or were part of an expropriatory pattern. The tribunal looked at three aspects of Russia’s actions against Yukos – the tax claims, enforcement of those claims, and the overall purpose of the action – in order to assess whether their purpose was the genuine collection of taxes or concealed expropriation of the investment. In looking at these three aspects of Russia’s actions, the tribunal made a number of factual findings that were key to its decision:

1. The Russian Federation should have been aware of the manner in which Yukos was organised and its use of internal tax havens to reduce its tax liabilities. It then observed that the structure used by Yukos should have been challenged by the authorities on the basis of transfer pricing regulations rather than mere characterisation as an “abuse”. The arbitrators found no fault in a tax payer using loopholes in the tax legislation to obtain an advantage, noting that the tax authorities’ claim that it was done in bad faith and disproportionately could not make it illegal, especially when the concepts of bad faith and disproportionality

43 Ibid, at 32.

44 RosInvest Co UK Ltd v Russian Federation, Final Award, SCC Case No

075/2008, IIC 471 (2010) (a claim by British shareholders of Yukos

under the Russia United Kingdom BIT); Hulley Enterprises Ltd v Russian

Federation, Interim Award on Jurisdiction and Admissibility, PCA Case

No AA 226; IIC 415 (2009) (a claim under the Energy Charter Treaty);

and OAO Neftyanaya Kompaniya Yukos v Russia [2011] ECHR. 14902/04,

54 EHRR 19 599 (2012) (provisional judgment on the merits) (claims

under the European Court of Human Rights).

45 Stephan, above n 40, at 43.

were not found in the tax legislation.

2. Yukos had already paid its taxes for the relevant year. While noting that expropriation is an objective standard, the tribunal considered that there were signs that the government had deliberately targeted Yukos; no other large company was subjected to a similar test of disproportionality.

3. The decision of the Russian tax authorities’ to treat the intermediary companies as “shams” and Yukos as the real owners of the oil (and therefore the payer of profit tax) had no support in Russian law. The tribunal also criticised the authorities’ refusal to grant Yukos a VAT refund for the oil exported by the intermediary companies which the authorities themselves claimed was effectively owned and exported by Yukos.

4. Regarding the enforcement of the tax claims against Yukos, the tribunal took issue with the authorities’ refusal to consider Yukos’ requests for deferral of payment or settlement of claims as well as the auction of shares in its principal oil-producing subsidiary.

Based on these findings, the Tribunal concluded that the claimants’ investment had been expropriated and that they were therefore entitled to adequate compensation. In reaching this decision, the tribunal made it clear that bona fide taxation does not constitute expropriation, and that the good faith of states in such case should be presumed. However, it did say that taxation might constitute expropriation “if the ostensible collection of taxes is determined to be part of a set of measures designed to effect a dispossession outside the normative constraints and practices of the taxing authorities”.46 It said that the mere label of “taxation” cannot be sufficient to remove a taking from the scrutiny of international tribunals under relevant investment treaties.

The extreme facts in this case were central to the tribunal’s finding. The tribunal concluded that “Yukos’ tax delinquency was indeed a pretext for seizing Yukos assets and transferring them to Rosneft. . . . [T]his finding supports the Claimants’ contention that the Russian Federation’s real goal was to expropriate Yukos, and not to legitimately collect taxes.”47

As Stephen explains it, the Russian Government maintained “a veneer of legality while communicating clearly to the private sector that the state could act ruthlessly whenever it wished. At the end of the day, Yukos ceased to exist as a legal entity, a great energy empire ended up in government hands, and the Yukos shareholders ... received nothing in return.”48

Just as the facts were central in this case, they had also been central to the tribunal’s finding in the earlier case arising from the same facts, but heard under the United Kingdom – USSR Investment Treaty, RosInvest Co v Russia.49 In this case, the tribunal asked whether the “cumulative combination” of the taxation measures and the consequential auctions

46 Quasar de Valors, above n 39, at para 48.

47 At para 133.

48 Stephan, above n 40, at 4.

49 RosInvest, above n 44.

expropriated RosInvestCo’s property, and concluded that the State’s measures went beyond mere application of the tax law and could not be considered as a bona fide and non-discriminatory treatment. The tribunal accepted that the Russian tax authorities may change their positions regarding the interpretation and application of the tax law and that they have a certain discretion in this respect. However, if such changes and the use of discretion occur in so many respects and regarding a particular tax payer as compared with the treatment accorded to comparable other tax payers, doubts remain regarding the objectivity and fairness of the process. The tribunal also commented that States have “wide latitude in imposing and enforcing taxation laws” even if resulting in substantial deprivation.50

F Tza Yap Shum v Peru51

Tza Yap Shum was the majority shareholder of TSG, a Peruvian food products company and one of the largest manufacturers and distributors of fish flour in Peru. In 2004, Peru’s tax authority, the Superintendencia Nacional de Adminitracion Tributaria (SUNAT), commenced an audit of TSG, during which it concluded that its books did not adequately reflect values for the raw material used in the production of fishmeal. As a result, SUNAT used a “presumed basis” in its analysis rather than using TSG’s books and records. Using the presumed basis, SUNAT found that TSG had underreported sales volumes. SUNAT imposed back taxes and fines totalling approximately 10 million Peruvian solares. After the audit, SUNAT also imposed interim measures that had the effect of attaching certain limited assets of TSG and directing all Peruvian banks to retain any funds passing through them in connection with TSG’s transactions. Peruvian law permitted SUNAT to impose interim measures as a means to ensure payment of tax debts in “exceptional circumstances”, being when the debtor has been uncooperative or when efforts to obtain payment of the tax debt would otherwise be unsuccessful. SUNAT had based its interim measures on what it referred to as TSG’s “irregular behaviour”, which it cited as being failure to accurately reflect its total sales volume.

As a result of the interim measures, TSG was unable to use Peruvian banks for its transactions. TSG unsuccessfully challenged SUNAT’s audit determinations and the interim measures through a domestic administrative procedure. The claimant, who held 90 per cent of shares in TSG, then submitted a claim under the Peru China Bilateral Investment Treaty, arguing, inter alia, that SUNAT’s audit determinations and interim measures constituted an unjustified expropriation of its investment, as they had resulted in the total destruction of TSG’s operations. The

50 Ibid, at para 574.

51 ICSID Case No ARB/07/6, Award (7 July 2011). The award is available in

Spanish. The description here relies on a case report prepared by Kenneth

Juan Figueroa for the School of International Arbitration, Queen Mary,

University of London. Available online at:


claimant alleged that the liens imposed by SUNAT were unlawful and arbitrary, prevented his company from operating, and forced it into bankruptcy. As a result, he claimed, his investment was no longer economically viable.

The tribunal noted the general rule that a State is not responsible for a loss of value or other disadvantages resulting from the imposition in good faith of general taxes and regulations.52 However, it also noted that the deference that is due to a State in this respect is nonetheless limited by the international law principle of reasonableness and non- arbitrariness, and that an indirect expropriation can result from the actions of taxation authorities if their effect is confiscatory, arbitrary, abusive or discriminatory.53

The tribunal found that SUNAT’s interim measures, which were arbitrary, and taken on the basis of insufficient factual and legal justification, did constitute an indirect expropriation of the claimant’s investment. Like other cases involving taxation measures, this finding was heavily dependent upon the specific factual circumstances. A critical factor was that the measures, which were legally binding on all affected banks, prevented TSG from transacting with those banks.54

This represented a “severe and substantial” impact on TSG’s business. The tribunal said that SUNAT should have known that the interim measures were a “strike at the heart of the operative capacity of TSG”.55

It made a factual finding that TSG’s sales had fallen from an average of S/. 80 million for the 2005-2006 period to S/. 34 million for 2005-2006. It further found that SUNAT had failed to comply with its own internal guidelines and procedures which required, inter alia, a reasoned basis for the “exceptional” remedy of interim measures accompanied by detailed evidentiary support, and efforts to avoid interfering with the debtor ’s business operations. SUNAT had also failed to make relevant inquiries or requests for additional information from the auditor before imposing the interim measures. These factors led to a finding that SUNAT’s actions were arbitrary in nature.56 Other factors that influenced the tribunal’s decision included a finding that the administrative and judicial bodies that had heard the claimant’s challenge had failed to sufficiently address and analyse TSG’s claims and had simply adopted SUNAT’s positions without a reasoned basis.57 Thus TSG had only had access to formal, rather than substantive, legal recourse.

52 Award, between paras 171 and 217, as cited by Figueroa.

53 Award, between paras 171 and 217, as cited by Figueroa.

54 Award, between paras 152 and 170, as cited by Figueroa.

55 Award, between paras 152 and 170, as cited by Figueroa.

56 Award, between paras 171 and 217, as cited by Figueroa.

57 Award, between paras 223 and 240, as cited by Figueroa.

G Paushok v Mongolia58

The claimant in Paushok v Mongolia was the sole shareholder in two companies constituted in accordance with the laws of the Russian Federation – Golden East (a gold mining company) and Vostoneftegaz (an oil and gas company) and operating through investments in Mongolia. In May 2006, Mongolia introduced a “windfall” profit tax on gold sales at a price in excess of US $500 per ounce, with the exceeding amount being taxed at a rate of 68 per cent. In July 2006, the Mongolian government amended the requirements applicable to employment of foreign nationals in the mining sector. Under the pre-existing rules, mining companies were required to pay a fee for every foreign national employed. Under the new rules, foreign companies had to pay a penalty for every foreign national employed of 10 times the minimum monthly wage in cases where foreign nationals constituted more than 10 per cent of the company’s employees. Close to 50 per cent of the claimant’s employees were Russian nationals.

In July 2006, GEM entered into a contract with the Central Bank of Mongolia to place gold into the bank’s custody with the ultimate purpose of selling it to the bank. The sale was to take place upon instruction from GEM. GEM received 85 per cent of the purchase price at the time the gold was placed into safe custody. In November 2007, GEM became aware that the Bank had moved its gold to the UK. GEM sought to attach this gold but its claim was dismissed in the English courts. In the meantime, Mongolia’s tax authorities made a number of claims against GEM seeking payment of tax arrears with respect to the windfall profit tax. When GEM failed to make payment, Mongolian authorities eventually seized its assets and bank accounts in December 2008.

The claimants submitted an unsuccessful claim that Mongolia’s windfall taxes levied on gold sales breached its obligation under the Russia-Mongolia BIT, inter alia, not to expropriate without compensation. They argued that the windfall profit tax would be extraordinary, punitive in amount, arbitrary and discriminatory, and not in the public interest. The tribunal acknowledged that it may well have been the case that the burden of the windfall profit tax on GEM was very heavy, and the evidence it had received included that a number of gold mines had suspended or closed their activities after the adoption of the tax. However, it found that the loss suffered was not in the order of magnitude so as to lead to the destruction of an ongoing enterprise, especially one with a history of strong annual profits, and in the context in question which included substantial increases in the price of gold in the subsequent years and legislation repealing the windfall profit tax.59

58 Sergei Paushok, CJSC Golden East Company, CJSC Vostokneftegaz Company v The Government of Mongolia, Under the Arbitration Rules of the United Nations Commission on International Trade, Award on Jurisdiction and Liability (28 April 2011).

59 Ibid, at paras 332 to 336.

H Summarising the case law

The cases outlined above demonstrate that in the sensitive area of taxation policy, tribunals have acknowledged the need to tread carefully, while also recognising that in certain factual circumstances, taxation powers give governments the opportunity to take actions against foreign investors that constitute indirect expropriation and therefore require compensation. However, the cases described where there have been findings of expropriation are ones where extreme facts were present that reveal arbitrary or punitive taxation measures that, in the words of the Quasar de Valors tribunal, were “designed to effect a dispossession outside the normative constraints and practices of the taxing authorities”. Of course, it is reasonable to ask whether there might not be cases that are far more marginal, and that would raise valid concerns about whether tribunals would strike the right balance in such cases. Certainly the tests outlined by tribunals suggest that in marginal cases (such as where it is not clear that a tax was arbitrary or punitive), they would come down on the side of finding that there was no expropriation. Nevertheless, in recognition of the possibility that not all cases will be so straightforward, the United States has included in its Model BIT provisions specific to taxation that are designed to address concerns about how decisions would be made in such cases, and these are noted briefly in the next section.

IV Procedural treatment of expropriation in relation to taxation in investment agreements

The United States 2012 Model BIT contains provisions that modify the way in which a claim for expropriation in respect of a taxation measure will be addressed. The BIT allows expropriation claims to be made in respect of taxation measures, but provides that where a claimant asserts that a taxation measure involves an expropriation, they may only submit a claim to arbitration if they have first referred to the competent tax authorities of the host state and the home state of the investor the issue of whether the taxation measure in question involves an expropriation. The claim may only proceed if the competent tax authorities fail to agree within 180 days of referral that the taxation measure is not an expropriation.60 The effect of this provision is that in a case where an investor seeks to challenge a taxation measure, it is the domestic authorities with real expertise on taxation who have the first opportunity to consider the claim. It can be seen as a kind of filtering mechanism where taxation experts have the authority to determine at the outset that the measure or action complained of does not constitute an expropriation, and to prevent a tribunal looking into the matter any further.

When two countries enter into an investment agreement, both

60 Article 21.2. See the use of this provision in, for example, the Central America – Dominican Republic – United States Free Trade Agreement, signed August 5, 2004, at Article 21.6.

governments will have an interest in safeguarding their regulatory space in the taxation area. While a country entering into investment obligations under an international agreement will have offensive interests in ensuring that its outward investors have an adequate degree of protection when investing offshore, it will have an equally strong interest in protecting its own regulatory autonomy.61 Therefore, even in the case where an investor of a country makes an expropriation claim under an investment agreement, the taxation authorities of that country can be expected to have a strong interest in ensuring that the expropriation obligation is properly interpreted so as not to impinge on regulatory freedom in the taxation area. This type of procedural safeguard recognises that taxation is a highly specialised and technical area, and that taxation experts are the most appropriate individuals to be making that initial determination as to whether or not an investor ought to be able to proceed with their claim.

V Conclusion

The US Restatement of Foreign Relations Law has suggested four basic situations when a tax measure may turn into an expropriatory act. It refers first to confiscatory tax measures; second, to tax measures that prevent or unreasonably interfere with the use or enjoyment of property; third, to discriminatory tax measures; and fourth, to taxes designed to force an alien to abandon property or sell it at a distress price.62 Commentators have also suggested that this outcome might result where there are taxes that violate or repudiate an explicit commitment given to the investor by the host state (such as a tax stabilisation agreement), arbitrary taxes, when it is manifestly clear that there is no taxable event according to the tax code or if the application of the tax to the facts is unfounded; and taxes that violate or repudiate the law of the host state upon which the foreign investor was entitled to rely under international law.63

The cases discussed in the previous section are consistent with these characterisations. In the cases referred to in this article, tribunals have made strong statements indicating that in the normal course of events, taxation measures will not constitute expropriation. They have, however, found an expropriation in cases where, on the facts, the taxation measure has been found to be extraordinary, confiscatory, punitive in amount or arbitrary or discriminatory in its incidence, or part of a set of measures designed to effect a dispossession outside the normative constraints and practices of the taxing authorities. The statements made by tribunals set a high threshold for when a taxation measure will be found expropriatory.

61 This mutual interest will be more pronounced in agreements where both countries party to the agreement have outward investment flowing to the other country. Where outward investment flows are largely one directional, then the home country will have less cause to be concerned about potential threats to its own regulatory freedom.

62 Doak Bishop, Craig Miles, Roberto Aguirre Luzi, “Tax Arbitration” (LatinLawyer, Vol 5 Iss 7) online at

63 Ibid.

This is appropriate, given the important and sensitive nature of this particular policy area, and it indicates that international investment law has thus far found the right balance of legal and policy interests in this area. The fact that tribunals have declined to find expropriation in cases that involved less extraordinary facts (Occidental v Ecuador; EnCana v Ecuador; Paushok v Mongolia) should be of comfort to governments entering into agreements that provide the opportunity for investors to bring claims against host states under investor state dispute settlement mechanisms. Innovations, such as those found in the US 2012 Model BIT, may also provide additional comfort for governments in the more marginal cases by ensuring that taxation authorities have an opportunity to filter out a claim before it reaches the tribunal stage.

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