When 5% appears too small and the government decides to take it all …

The Beatles had a song for virtually every human condition, taxation being transcendent as a part of the human – and corporate – experience. Taxation can either enable investment or kill it, and in particularly pernicious scenarios do both in succession over time. For this reason, foreign investment is very 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 capital intensive projects which are exposed over time to changes in laws and policies around taxation.

‘Let me tell you how it will be … Should 5% appear too small’

Expropriation risk for foreign investors is on the rise due to a confluence of factors, such as resource nationalism, the energy transition from fossil fuels to clean energy, and a sustained rise in populism and nationalist sentiment around the globe. While direct takings, which occur when the state seizes title to or ownership of an asset, remain a live risk for foreign investors especially in the extractive sector, indirect expropriation through taxation has become an acute risk. This can occur in a wide variety of scenarios, such as an increase in taxes, the imposition of new taxes, changes to the royalty regime applicable to the investment, changes to the cost recovery regime applicable to the investment, the revocation of tax free entitlements, changes to the interpretation of legislation that result in the assessment of taxes, as well as the enactment of new legislation imposing fees or charges on the investment, such as a carbon tax. All of these scenarios can result in a dramatic change in the economics of the investment – so dramatic in some cases as to reduce the reasonably expected return on investment to nil.

At one end of the spectrum, such a loss may be attributable to the state’s exercise of its police or regulatory powers and not compensable for this reason. At the other end, the loss may be attributable to an unlawful state measure purposely designed to destroy the value of the investment and compensable for this reason. Often, tax and other similar 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.

‘If you drive a car, I’ll tax the street …’

Extractive sector investments are particularly exposed to expropriation risk because of their long-term, capital intensive nature. As governments are now fully seized of climate change concerns, extractive sector investments are being more closely scrutinized than at any previous point in history. While extractive sector investments typically generate substantial revenues for the host state through negotiated government take, royalties, profit tax and withholding tax, among many other taxes and charges, the long-term trajectory of such investments coupled with changes in government and shifts in national priorities can generate pressure to extract more out of the investment for the state or rebalance the costs, real or perceived, of hosting the investment on the local environment and its people.

‘Don’t ask me what I want it for … If you don’t want to pay some more …’

Protections against a changed tax environment commonly come in the form of stabilization clauses included in agreements negotiated with host governments. Investment treaties also offer some protection in the form of general conduct standards that are increasingly invoked to address measures adopted by host state governments that erode or extinguish investment value through taxation. However, many new generation treaties contain carve-outs to exclude taxation measures from the scope of claims that may be advanced under the treaty.

Not all of these carve-outs are drafted in the same way. Some require claimants to provide notice to the home country government and host country government of claims in respect of a taxation measure and, where the governments jointly determine that the measure does not contravene the treaty or does not constitute an expropriation, the claim may either be at an end or narrowed in scope. The contracting parties may have also agreed in advance that only certain conduct standards would apply in respect of measures characterized as taxation measures, thus at an early stage narrowing the scope of protection that may be available for foreign investors.

‘Now my advice for those who’ invest …

Even the most detailed and diligent planning to protect an extractive sector investment over the long-term cannot in every case insulate the investment against changes that threaten to deprive a foreign investor of the substantial value of its investment. However, recourse is available in many cases to seek redress. When tax and other similar measures threaten to erode investment value – when the tax man comes knocking –it is important to seek advice in order to understand what options are available and how to exercise those options optimally.

MARTIN VALASEK is Norton Rose Fulbright Canada LLP’s head of International Arbitration

ALISON FITZGERALD is Of Counsel, International Arbitration.