The economics of an independent power project or of an oil and gas project can be severely impacted if a host State changes the tax regime applicable to the project after an investor has committed its capital. Investors in energy projects in developing countries are increasingly using international arbitration in an effort to obtain compensation from the host State in such circumstances. Arbitral disputes relating to tax measures fall into two main categories: (1) claims that a tax measure violates the investment protections contained in an investment treaty between an investor's home State and a host State; and (2) claims that a tax measure breaches an investor's rights under a contract with a host State or entitles it to compensation or indemnification under a contract with a state enterprise.

Investment Treaty Claims

Investment treaties are agreements between States providing substantive protections to investors of one contracting State who make investments in the territory of the other contracting State and typically entitling them to submit an investment dispute with the host State to international arbitration. In addition to several multilateral investment treaties (e.g., the Energy Charter Treaty and Chapter 11 of the North American Free Trade Agreement), there is a web of more than 2,500 bilateral investment treaties (BITs) between States from all regions of the world. For example, the United States has concluded BITs with 40 other countries, including Argentina, Kazakhstan, and Senegal. Investment protections under these treaties generally include the right to adequate and effective compensation if the host State expropriates the investment, the right to “fair and equitable treatment,” and the right to treatment no less favorable than that accorded to nationals of the host State (so-called "national treatment").

In Occidental v. Ecuador, Occidental claimed that Ecuador violated its rights under the U.S.-Ecuador BIT when it changed a policy regarding the right of Occidental and other international oil companies to reimbursement of a Value Added Tax (VAT) paid on purchases of goods and services required for their exploration and production activities. [1] In 1999, Occidental had entered into a participation contract with Petroecuador, Ecuador's national oil company, entitling Occidental to a percentage of the oil production. For 14 months, Ecuador's tax authority granted Occidental's applications for VAT refunds. Beginning in 2001, however, the tax authority took the position that the VAT was already reimbursed through the participation percentage that Occidental received under the contract.

The arbitral tribunal rejected the tax authority's position that the VAT was already reimbursed and upheld Occidental's claims under the BIT's fair and equitable treatment and national treatment clauses. The preamble of the BIT made clear that the stability of the legal framework for investment was an essential element of fair and equitable treatment, and the tax authority's denial of Occidental's applications for reimbursement of the VAT significantly changed the framework under which its investment had been made. Ecuador also failed to accord national treatment to Occidental's investment because Ecuadorian companies that exported non-petroleum products continued to receive VAT refunds.

Investment treaty claims relating to tax measures may face hurdles, however. Some BITs (including those entered into by the U.S.) exclude tax matters from the scope of the treaty, subject to specified exceptions. While the Occidental tribunal held that it had jurisdiction over all of Occidental's claims under one of the specified exceptions in the U.S.-Ecuador BIT, the tribunal in Burlington Resources v. Ecuador, a dispute relating to Ecuador's 2006 windfall profits tax, more recently concluded that this exception did not apply and that it only had jurisdiction over Burlington's expropriation claim. [2] Moreover, tribunals are generally reluctant to hold that a tax measure violates the protections contained in an investment treaty unless the host State made a specific stabilization commitment to the investor or the challenged tax measure deprived the investor, in whole or in significant part, of the use or reasonably expected economic benefit of its investment.

Contractual Claims

Investors in energy projects in developing countries almost always conclude a contract with the host State or a state enterprise establishing the terms and conditions of the investment. In some cases, the contract provides the investor with protection from adverse changes to the host State's tax regime.

In Duke Energy v. Peru, Duke Energy claimed that Peru breached the parties' legal stability agreement (LSA) when the Peruvian tax authority changed its interpretation of a law granting companies the right to reorganize without tax consequences. [3] Based on this interpretation, the tax authority ruled that the law did not apply to a merger involving Duke Energy's local subsidiary. The tribunal held that the tax authority's ruling breached the LSA because its prior stable and consistent interpretation of the law formed part of the tax regime stabilized for Duke Energy.

Conclusion

When a host State changes the tax regime applicable to an energy project, international arbitration may offer a neutral forum for the investor to challenge the measure. The success of such a challenge will often turn on whether the investor obtained a specific stabilization commitment from the host State at the time it entered into the investment.