(co-authored with Chetan Rao)

Bilateral Investment Treaties (BITs) evolved as important legal instruments for capital-exporting countries to ensure legal stability for their investments. In a world where there was once a clear division between capital exporters and importers, the objectives of investment protection and promotion served both sides. Over time, however, this line blurred, with developing countries also becoming capital exporters. More significantly, international investments today do not cross borders in simple structures. Tax experts have increasingly scrutinized complex arrangements, ensuring that treaty benefits are denied where the principal purpose of an investment is tax avoidance.

Against this backdrop, the need to preserve regulatory, and more precisely, tax sovereignty in BITs remains a live issue. Post-BEPS, tax laws are being continuously updated to rationalize incentives and combat treaty shopping. It is imperative to consider whether the lofty standards of fair and equitable treatment (FET) should apply unquestioningly in cases where the genuineness of the investment is suspect.

International investment disputes increasingly involve tax measures, with 32 such disputes recorded since 1999. Emerging tax standards like the global minimum tax could inadvertently trigger BIT claims, posing fresh risks. How can a country safeguard against such claims of 'policy uncertainty'? The Cairn Energy arbitration demonstrated how fluid the definition of “investment” can be under BITs, especially when the corporate structure involves routing through multiple jurisdictions. Defining qualifying investments strictly, and denying favourable treatment where investment structures are abusive, has thus become critical.

One essential safeguard is a robust tax carve-out. India’s 2016 Model BIT ensured this by excluding taxation measures from its scope, thereby preserving regulatory space. The European Union has similarly introduced carve-outs to shield certain tax standards from BIT obligations. The UN Tax Committee in its 2025 report endorsed this approach, proposing clear clauses to exclude taxation matters or subject tax disputes to exclusive state-to-state resolution. Yet, globally, only 16 percent of BITs have comprehensive tax carve-outs, while 83 percent feature partial ones.

The rationale for tax carve-outs is compelling. First, taxation is a sovereign function, fundamental to development financing. Subjecting tax measures to investment arbitration risks undermining fiscal stability and democratic control over revenue decisions. Second, there is an inherent duality: tax treaties provide cooperative, state-to-state dispute mechanisms, while BITs allow investor claims without mandatory prior consultation. Allowing tax matters to be second-guessed by tribunals under BITs creates legal incoherence and undermines agreed tax processes like Mutual Agreement Procedures (MAP).

To address this, precedence must be clearly established—tax treaties should prevail over BITs where both apply. Additionally, the pursuit of local remedies can serve as a useful filter. India’s 2016 Model BIT required investors to pursue domestic remedies for five years before accessing international arbitration. However, in the evolving treaty practice, including in India’s 2024 BIT with the UAE, a more balanced period of three years has been adopted.

In parallel, it is important to deter speculative or opportunistic claims. An important innovation in the India-UAE BIT is the inclusion of a clause prohibiting third-party funding of disputes. This step is significant, as it prevents external funders from financing claims purely for financial gain, helping to ensure that only genuine disputes reach arbitration.

As India moves to update its Model BIT following the announcement made by the Finance Minister in the Union Budget 2025, certain core redlines must guide the new framework. The first redline is the complete exclusion of tax matters from the scope of the treaty. Taxation is an essential function of the state and should not be subject to private investor claims. The second is the requirement that investors must exhaust or meaningfully pursue domestic remedies for a reasonable period, three years, before bringing claims under international arbitration. This will ensure that national courts have the first opportunity to resolve disputes. The third redline is the denial of treaty protection to investments tainted by fraud, corruption, or round-tripping. Only genuine investments made in accordance with the law should benefit from treaty rights. Finally, the Model BIT should include a clear and limited definition of the fair and equitable treatment (FET) standard, focusing only on protection against denial of justice, manifest arbitrariness, and discrimination, without opening the door for challenges against legitimate regulatory measures taken in public interest.

In particular, a more balanced FET clause should be introduced, maintaining sovereignty protections while clearly committing to non-discrimination, transparency, and procedural fairness. This calibrated standard would avoid open-ended interpretations while reassuring bona fide investors of a minimum level of legal security.

A broader dialogue between tax and investment authorities is especially crucial for developing countries like India, where balancing growth imperatives with sovereignty is both a legal and developmental necessity.