The latest chapter in the Yukos saga has just been written. This saga concerns the relationship between the Russian Federation and the foreign investors in Yukos. The decision of the arbitral tribunal summarised in this note identifies the way in which international law can be used to protect foreign investors from unwarranted interference by state interests. This chapter reveals the subtle ways in which that interference can occur through otherwise legitimate processes (the taxation regime) and how international law can be used to combat that interference (if sufficient thought has been put into the structuring of the investment to start with).

The arbitral tribunal in Quasar de Valores et al v The Russian Federation, Award dated 20 July 2012, has handed down its decision on the merits of a claim by Spanish investors into the Russian oil giant Yukos against the Russian Federation for expropriation under the Spain-Russia bilateral investment treaty. After Mr Khodorkovsky's arrest, the Russian tax authorities re-examined Yukos' tax payments for 2000-2001 and found that Yukos had allegedly unlawfully underreported income by streaming it through Russian tax havens. The Russian tax authorities claimed that these were unlawful tax-avoidance schemes and that Yukos had to pay some 99.4 billion Roubles (ca US$3.5 billion) in tax arrears. When Yukos could not pay the debt, the company was liquidated and its prime asset ended up in the State-owned Rosneft.

The majority of shares in Yukos were held by a Russian entity, Menatep, which had no rights to pursue under international investment treaties. The claimants in these proceedings were Spanish investors which owned American Depository Receipts (ADRs) of Yukos and had contractual relationships with the Deutsche Bank affiliate incorporated in New York which was the formal shareholder/depository of the Yukos shares. In an award on preliminary objections (dated 20 March 2009), the Tribunal held that the ownership of ADRs by the Spanish investors was sufficient to constitute an investment into Russia for purposes of the Spain-Russia investment treaty.

The Spanish investors alleged that the Russian tax authorities' measures amounted to an indirect expropriation under the investment protection treaty and that they were due adequate compensation.

The Tribunal found that the investment treaty had indeed been breached and awarded some US$2 million in compensation to the Spanish investors.

This result is remarkable for a number of reasons and the whole ‘Yukos affair’ has and–it is suggested–will continue to attract a lot of media attention. The issue which will be highlighted here is that the Tribunal has confirmed that in international law taxation can amount to indirect expropriation.

In which circumstances might taxation amount to expropriation?

The Tribunal established the following test to determine whether tax, which by its nature involves the taking of the taxpayer's money, amounts to expropriation under international standards: ‘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’ (para 48), these could amount to expropriation for purposes of the investment protection treaty.

The Tribunal was led by the following considerations:

  • Yukos had already paid its taxes for the relevant year and, whilst being aware of Yukos' tax ‘optimisation’ scheme, did not question it at the time
  • Yukos' usage of the tax havens was not illegal and the tax authorities' claim that it was done in bad faith and disproportionately could not make it illegal–the authorities could and should have used other mechanisms to arrive at the appropriate tax (eg arm's length standard in transfer pricing) rather than the intangible concepts of bad faith and disproportionality which were not found in the tax legislation
  • there were indicia for the deliberate targeting of Yukos (although the Tribunal pointed out that expropriation is an objective standard; subjective intent is irrelevant): no other large company was subjected to a similar test of disproportionality; Yukos was not allowed to benefit from tax refund and the way in which enforcement of the newly assessed tax liability was carried out was unreasonable (inter alia, by imposing an asset freeze which made it impossible for Yukos to pay its debt); the quick and haphazard way in which Yukos' assets were subsequently liquidated.

The Tribunal, however, also highlighted that the starting point for an enquiry should be that taxation is not expropriation. ‘Yet there is a world of difference between incidental detriment, even of a substantial nature, and purposeful dispossession.’ The label of ‘taxation’ cannot be sufficient to remove a taking from the scrutiny of international tribunals under relevant investment treaties.

Based on the facts, the Tribunal found that the Spanish investors were expropriated and were entitled to adequate compensation.

Practical implication of this decision

This decision, although not of binding precedent value in international investment arbitration, highlights yet again the importance of investment structuring. It is clear that expropriation can be both direct and indirect.

Concerns about the regulatory environment of an investment country can be addressed by making the investment through a state with a suitable investment treaty with the host state so that the investor can benefit from its protections. A tailored approach is required in each circumstance and it is important to consider carefully the terms of any investment treaty prior to making an investment because the scope and nature of protection can differ. Some recent treaties seek to set out expressly which test is to be applied in determining whether a measure constitutes indirect expropriation. The Model USA bilateral investment treaty (2004), for example, states 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 expropriations.