India and Vodafone are now fighting on several fronts in a high-stakes battle over whether the British phone company should have withheld $2.2 billion in capital gains taxes when it bought a roughly 67% interest in an Indian mobile phone business from Hong Kong-based Hutchison Whampoa for $11.2 billion in 2007.

The Vodafone CEO met with the Indian finance minister on May 1 to explore a possible settlement where the company would pay $700 million rather than the full $2.2 billion. However, the Indian government refused to negotiate and announced that the tax bill had increased to $3.7 billion due to additional interest on the back tax liability.

Vodafone insists it does not owe any taxes. A Dutch subsidiary of Vodafone bought a Cayman Islands subsidiary of Hutchison Whampoa that owned an interest in a mobile phone company in India through several tiers of Mauritius companies. Even if there was a tax, the seller should have paid it on its gain. However, Indian law requires a buyer to withhold tax from the purchase price where the seller is outside the Indian tax net. The Cayman company that Vodafone purchased owned only a 52% stake in the Indian phone company. Vodafone was given options to buy another 15% directly from minority shareholders in the Indian company.

The government lost the case in the Indian Supreme Court in January, and the court declined in March to hear an appeal.

The government then moved to amend the law retroactively to require taxes be paid on indirect sales of assets in India back to April 1, 1962. However, there is a six-year statute of limitations on back tax claims. The government is under international pressure not to put the bill through parliament. The lower house of parliament passed the bill on May 8. The Indian finance minister dismissed concerns about driving away foreign investors during debate on the bill in the lower house. “Please remember, when the investment was also not there, we did not eat lizards,” the minister said.

Vodafone filed notice of its intention to force the Indian government into arbitration under a bilateral investment treaty between India and Holland over the Indian threat to amend the tax law retroactively to overturn the Supreme Court decision. Such arbitrations can take years. This is not the first time the Indian government has faced arbitration. It lost an arbitration in February brought by White Industries, an Australian mining company, under a bilateral investment treaty between India and Australia, and the Indian government was ordered to pay a fine of about $4.15 million plus interest and other fees. It also faced a case over the Dabhol power project in the early 2000s that was settled, but reportedly at a cost of roughly $1 billion. It is not clear whether the Vodafone arbitration demand will work since the bilateral investment treaty with Holland does not cover tax disputes.

The saga is a warning to other international companies buying or selling interests in Indian businesses or projects to price in risk that a capital gains tax will have to be paid in India.

Keith Martin