The taxation of damages in international arbitration awards should be a significant consideration for any party embroiled in an arbitrable dispute. According to Keller and Leikin, the average tax liability in cases heard before tribunals established under the International Convention for Settlement of Investment Disputes (the “ICSID”) is an eye-watering USD 16-38.5 million.[1] Nevertheless, the question of taxation frequently goes overlooked. This note provides an overview of the main elements to consider in relation to the taxation of international arbitration awards.
Impacts of Taxation
The general principle for the calculation of damages can be traced back to the seminal case of Factory At Chorzów in which a tribunal decided that “reparation must, as far as possible, wipe out all the consequences of the illegal act and reestablish the situation which would, in all probability, have existed if that act had not been committed.”[2] This is sometimes called the doctrine of “full compensation”.
However, in calculating the damages needed to achieve full compensation, it is vital to take into account the impacts of taxation. If, for example, damages are calculated with reference to net-of-tax numbers, such as profits, and the winning party then has to pay taxes on an award rendered in its favour, the total value which it receives will be as though it had paid its taxes twice. This plainly falls short of the full compensation to which it is entitled.
Tax Rates
The tax rate applicable to damages in international arbitration awards is highly dependent on the jurisdictions involved. Typically, the applicable rate will depend on the legal status of the underlying loss which is being compensated for.
Lost profits, for example, might be taxed as income. Taxation for other losses runs the risk of being considered a capital gains tax instead. In the United Kingdom, the decision in Zim Properties Ltd v Proctor established that a right to take action or to obtain compensation can be an asset for tax purposes.[3] This has since been acknowledged by HMRC,[4] and means that any damages may be subject to a capital gains tax instead of an income tax, depending on the circumstances and the underlying source of the compensation.[5]
Ultimately, this is a question of the jurisdictions involved and the underlying facts of the case at hand.
Accounting for Taxation
One way to account for taxation is to calculate damages grossed-up for tax. For example, if a party has incurred USD 1 million in losses but faces a 30% tax liability on the entire amount, the “grossed-up” damages claim would be for USD 1.43 million, thus ensuring a USD 1 million net award.
However, in disputes arising out of complex international transactions that involve several tax regimes and entities incorporated in different jurisdictions, the grossing up approach may be easier said than done. It is also the claimant who carries the burden of proof in demonstrating that it has accurately and fairly incorporated taxation into its claims.
In investor-State disputes, such grossing-up approaches are unlikely to find success. For example, an ICSID tribunal in Mobil v. Canada stated that it was “not aware of a requirement under international law to gross up compensation as a result of tax considerations.”[6] In Servier v. Poland, a UNCITRAL tribunal dismissed a grossing-up claim altogether in a single paragraph, determining that this was instead a matter for the fiscal authorities of the States involved.[7]
Be that as it may, there are situations where a tribunal will order a respondent State to avoid levying taxes on an award granted to an investor. In Chevron v. Ecuador, for example, a PCA tribunal found that the respondent State had agreed not to levy taxes on the award and damages could therefore be calculated on a simple net-of-tax basis.[8] In Siemens v. Argentina, in the absence of any such agreement by the respondent State, an ICSID tribunal ordered Argentina to pay damages net of tax,[9] although this approach has not been consistently followed.[10]
Double Taxation
Care must also be taken to avoid the double taxation of international arbitration awards. One way to accomplish this is by looking out for double taxation agreements between the relevant states.
In Glencore International AG, the High Court of New Delhi was required to determine the status of damages paid to the claimant, a Swiss company, following an international arbitration award.[11] Specifically, the question before the court was whether the award was a form of income or a windfall. If it was a windfall, it would fall under Article 22.3 of the double taxation agreement between India and Switzerland, and would only be taxable in India.[12] On the other hand, if it was not, then it would be a form of income taxable exclusively in Switzerland under Article 22.1 of the same.[13] The court found that it was the latter, and the respondent was ordered to pay the claimant an amount net of tax in light of the double taxation agreement.[14]
Conclusion
The taxation of international arbitration awards is a nuanced and jurisdiction-dependent topic. Parties wishing to receive full compensation for the damages which they have incurred must have regard to the potential tax status of any damages award. To mitigate the impact of taxes, parties can either gross up their damages calculations or, in investor-State arbitrations, apply to the tribunal for an order preventing the respondent State from levying taxes on the award. Parties should also take care to avoid double taxation. Given the potential amounts involved, accurately accounting for taxes on international arbitration awards is crucial.
[1] M. Keller and E. Leikin, A Taxing Endeavor: Addressing the Tax Consequences of Investment Arbitration Awards, 37(2) Journal of International Arbitration 191, p. 195.
[2] Case Concerning the Factory at Chorzów, PCIJ Series A. No 17, Merits Judgment, 13 September 1928, p. 47 (emphasis added).
[3] Zim Properties Ltd v Proctor [1985] STC 90.
[4] His Majesty’s Revenue and Customs Extra-Statutory Concession, D33.
[5] His Majesty’s Revenue and Customs Extra-Statutory Concessions, D33.
[6] Mobil Investments Canada Inc. v. Canada, ICSID Case No. ARB(AF)/07/4, Decision on Liability and on Principles of Quantum, 22 May 2012, para. 485.
[7] Les Laboratoires Servier, S.A.S. v. Republic of Poland, UNCITRAL, Award, 14 February 2012, para. 666.
[8] Chevron Corporation v. The Republic of Ecuador, PCA Case No. 2007-02/AA277, Final Award, 31 August 2011, para. 352.
[9] Siemens A.G. v. The Argentine Republic, ICSID Case No. ARB/02/08, Award, 6 February 2007, para. 403(11).
[10] M. Keller and E. Leikin, A Taxing Endeavor: Addressing the Tax Consequences of Investment Arbitration Awards, 37(2) Journal of International Arbitration 191, p. 200.
[11] Glencore International AG v Dalmia Cement (Bahrat) Limited (2019) Ex.Appl.(OS) Nos.1216-17/2015, paras. 1, 4.
[12] Agreement for avoidance of double taxation and prevention of fiscal evasion with Swiss Confederation, effective 29 December 1994, Article 22.3.
[13] Agreement for avoidance of double taxation and prevention of fiscal evasion with Swiss Confederation, effective 29 December 1994, Article 22.1.
[14] Glencore International AG v Dalmia Cement (Bahrat) Limited (2019) Ex.Appl.(OS) Nos.1216-17/2015, para. 18.