1. Introduction
Special economic zones (SEZ) are specific areas within a nation with special treatment, generally in terms of customs, business law, and taxation. The free zone at Shannon Airport in Ireland, announced in 1959, was one of the first modern SEZs,Footnote 1 while in 2018, President Xi announced that Hainan province would be developed into a pilot free trade zone, making it one of the most major new SEZs.Footnote 2 There are many SEZs throughout the world. In fact, a comprehensive survey conducted by the World Bank (WB) in 2008 found out that ‘there are approximately 3,000 zones in 135 countries today, accounting for over 68 million direct jobs and over $500 billion in direct trade-related value added within zones’.Footnote 3 In the last decade, the number of SEZs has rapidly further increased to more than 4,300 in 2017, making SEZs a defining feature of many countries’ trade and investment policies.Footnote 4
Despite being widespread and virtually always established through a ‘top-down’ method by the central government,Footnote 5 SEZs represent a complex regulatory phenomenon. In this respect, SEZs have different sizes, ranging from single factories to large cities.Footnote 6 Free ports, which can include entire economic regions, are the largest type of SEZ.Footnote 7 In sharp contrast, single factory zones, whose office buildings may be just one floor, are the smallest SEZs.Footnote 8 Moreover, Free Trade Zones (FTZs), where certain goods can enjoy tax exemptions, lie outside the host state's customs territory.Footnote 9
Although SEZs are known to many and different jurisdictions, their legal definition remains a challenge. The geographic areas in which governments use different policy tools to attract foreign investment, such as tax holidays and other incentives aside from those generally available in the rest of the country, are generally treated as SEZs.Footnote 10 In fact, there is no single official definition.Footnote 11 In this respect, it is preferable to opt for a rather broad approach and use a frequent definition which presents SEZs as ‘geographically delimited areas, frequently physically secured, that are usually, but not always, outside the customs territory of the host country’.Footnote 12 Different variations of concepts, including ‘free trade zones, free ports, foreign trade zones, export processing zones (EPZ), free export zones, trade and economic cooperation zones, economic processing zones, and free zones’ should all be included in the term SEZ.Footnote 13 These different terms are merely based on the type of zone and the country that they are located in.Footnote 14 For example, in developing countries, SEZs producing mainly for export are called (and marketed as) export-processing zones but they fundamentally remain SEZs.Footnote 15
Countries establish SEZs with a variety of objectives and functions in mind. Among these aims, developing the economy of a specific region is the most common one.Footnote 16 While SEZs are often used to attract foreign investment, fiscal policies and tax incentives are also targeted at domestic investors, and domestic suppliers are welcome in the SEZs.Footnote 17 Developing countries can utilize certain territories to test reforms’ efficiency.Footnote 18 In other words, SEZs often function as ‘regulatory sandboxes’.Footnote 19 For instance, China created SEZs to experiment with new economic policies and attract investment starting in the late 1970s.Footnote 20 Like with FTZs, China has tested ways to improve its trade and investment regulations before attempting to deploy such regulations at a larger scale.Footnote 21 Vietnam has learned from China and has extensively used SEZs to introduce new economic policies to attract investment.Footnote 22 India has made export processing zones a feature of its policy since the 1960s.Footnote 23 Poland utilizes SEZs to attract mostly manufacturing enterprises.Footnote 24 SEZs are also utilized by developed countries.Footnote 25 In 2008, the US had 257 FTZ areas,Footnote 26 and from 2001 to 2006, hundreds of SEZs were also established in Japan.Footnote 27 In the UK, local governments have established enterprise zones to support small and medium-sized enterprises (SMEs) with some discounts on local property taxes.Footnote 28
The World Bank treats SEZs as an advanced policy tool.Footnote 29 First, tariff and non-tariff barriers still persist in a great number of states.Footnote 30 Exporters from developing countries have to compete with those whose business enjoys duty-free and tax-free treatment. Second, besides tariff barriers, there are some other obstacles affecting exports. Exporters face many kinds of distortions, such as procedural inefficiencies, which may be resolved only over a long period. As such, SEZs can be extremely useful, as a simplified regulatory environment promoting investment and exports.Footnote 31
There are many benefits of SEZs (for host states and/or traders and investors) which this article does not intend to explore. Instead, this article provides a comprehensive analysis of the issues raised by SEZs under international economic law (IEL), and, in particular, whether SEZs are lawful under IEL, which is an issue largely ignored by the trade law literature. Three main types of rules have to be considered when assessing the legality of domestic SEZs under IEL: international taxation, international investment law, and multilateral trade rules. The Base Erosion and Profit Shifting (BEPS) project was launched by the OECD and G20 countries in 2013 in order to deal with the serious tax avoidance problems and a series of action steps were released in 2015.Footnote 32 Among the BEPS packages, Action 5 is the basis to ‘counter harmful tax practices’, and the competition conditions between countries can be changed by tax incentives.Footnote 33 Regarding investment conditions, investment agreements, mainly bilateral investment treaties (BITs), are functional, and tax-related disputes can be resolved under mandatory arbitration of BITs when some conditions are met and they are not within the ‘general exception provision’.Footnote 34 Although the WTO does not regulate SEZs explicitly, the Agreement on Subsidies and Countervailing Measures (SCM Agreement), which mainly focuses on improving GATT disciplines, has a strong relationship with the incentives the SEZs make use of.Footnote 35
In this article, the question of SEZs’ legality is explored with respect to three dimensions. First is whether SEZs represent a lawful development under IEL or not. Second is what kind of specific issues SEZs may raise under IEL. Third is what measures governments can take in order not to be challenged before relevant tax, investment, or trade tribunals. In order to address these three issues and, fundamentally, answer the question as to whether SEZs are lawful under IEL, the article critically reviews the applicability of international tax law, international investment law, and international trade law to SEZs.
The article is structured as follows. The first section identifies and explains the main economic and regulatory drivers of SEZs’ rapid development; the second section considers the interaction between SEZs and international tax law, especially BEPS Action 5; the third section will focus on the relationship between SEZs and investment agreements and the disputes arising as a consequence; the fourth section will talk about SEZs and the WTO, as some incentives used by SEZs may not be compatible with WTO regulations. The last section is the conclusion.
2. The Phenomenon of Special Economic Zones: A Critical Overview
SEZs are now ubiquitous and a major instrument for many countries to attract foreign investors while boosting international trade. However, the omnipresence of SEZs does not equate to a harmonization (or standardization) of their design and operation. On the contrary, SEZs have become increasingly diverse. In this respect, Section 2 discusses the main commonalities and differences of SEZs (2.1). It then provides an explanation of the various factors which explain the proliferation of SEZs in very diverse economies (2.2). After that, the article reviews SEZs’ fundamental purposes, which should remain the benchmarks according to which SEZs’ success and failure should be evaluated (2.3). Finally, not all SEZs are successful, and some failed SEZs are considered (2.4).
2.1 Charting the Maze of Special Economic Zones
SEZs can be defined as ‘demarcated geographic areas contained within a country's national boundaries where the rules of business are different from those that prevail in the national territory’.Footnote 36 According to United Nations Industrial Development Organization (UNIDO), ‘industrial parks, special economic zones, eco-industrial parks, technology parks and innovation districts are all comprised in the term of economic zones’.Footnote 37 ‘Free economic zones’ can extend across borders and may also include international growth zones.Footnote 38 Different countries have utilized various names for zones with these features.Footnote 39 In Ireland, they are called ‘industrial free zones’ and ‘export free zones’.Footnote 40 In China, they are named special economic zones, and in India, they are called foreign trade zones.Footnote 41 In Mexico, SEZs are named ‘maquiladoras’.Footnote 42 And in the Republic of Korea, the zones are called ‘duty-free export processing zones’ or ‘free export zones’.Footnote 43 Finally, some ‘development areas’ can be established in some jurisdictions and, without hesitation, they can also be included in the definition of SEZ.Footnote 44
2.2 Explaining the Proliferation of Special Economic Zones
SEZs span the globe, with examples appearing in all regions, in a variety of shapes, sizes, and contexts. In Nigeria, an FTZ related to oil and gas was created in 1996.Footnote 45 In Dubai, the Airport Free Zone Authority (DAFZA) was established within Dubai International Airport.Footnote 46 In Russia, special industrial and innovative economic zones have been created to promote cooperation between Korea and Russia.Footnote 47 In Iran, Free Trade and Special Economic Zones have attracted foreign investors due to the state's huge domestic market.Footnote 48 Even a small island, Mauritius, also established an EPZ in 1970.Footnote 49 In India, by 2016, 491 SEZs had been formally approved, the majority from IT and IT-enabled-services sectors.Footnote 50 Almost all Indian SEZs are small.Footnote 51 Furthermore, regions where countries choose to locate their SEZs vary from high-growth regions to the poorest areas.Footnote 52 With the aim of attracting foreign investment or stimulating the economies of sub-national regions, SEZs offering many kinds of economic incentives are created.Footnote 53
Despite their diversity, it is common for SEZs to create a favorable, liberal, and effective business climate which is not available in the other parts of the state. Governments apply friendly policies and packages of incentives to attract investors in SEZs.Footnote 54 Fiscal benefits, relaxed regulations, and export promotion services are often included.Footnote 55 Based on the type of investment project, various lengths of tax breaks are provided.Footnote 56 Since the conditions to induce multinational firms can change quickly,Footnote 57 some investors sign stability agreements in order to better protect their investment. This was the situation that arose in Aguaytia Energy, LLC v. Republic of Peru (ICSID Case No. ARB/06/13 case).Footnote 58 SEZs have greater autonomous power in developing these regulations, tax reductions, and exemptions in order to facilitate these reform experiments.Footnote 59 For example, in Shenzhen, the SEZ management enjoys significant autonomy under local regulations.Footnote 60 While the management of SEZs can be by either the government or private sector,Footnote 61 the establishment of SEZs has to be approved by the central government, as ruled in the Gold Reserve Inc. v. Bolivarian Republic of Venezuela.Footnote 62
2.3 Rationalizing Special Economic Zones: Objects and Purposes
Although tax reductions and subsidies provided in SEZs may decrease government receipts initially, there are many long-term benefits of creating them and reasons to do so. A ‘greenhouse’ environment is created inside an SEZ which helps young companies to develop.Footnote 63 More productive firms can be attracted to the zone, resulting in productivity spillover to less established or smaller firms.Footnote 64 It should be noted that not only foreign investors but also local firms are attracted to SEZs.Footnote 65 Domestic companies can be connected with global value chains in SEZs.Footnote 66 Another reason for using SEZs is to catalyze economic development and facilitate trade, as was the case in China.Footnote 67 For example, the China (Shanghai) Pilot Free Trade Zone (SPFTZ) was founded to facilitate trade liberalization,Footnote 68 and currently, the benefits of the SPFTZ are already visible to foreign investors.Footnote 69
SEZs also play an important role as regulatory test sites when it is difficult to implement countrywide reforms.Footnote 70 In 1980, four SEZs were created in China, including Shenzhen, Zhuhai, Shantou, and Xiamen, in order to attract investors, especially from Hong Kong, Macau, and Taiwan.Footnote 71 These zones were allowed by the central government in order to experiment with reforms in regulations.Footnote 72 The Chinese local policy makers can make use of different SEZ policies in order to find the ones which work best.Footnote 73 These EPZs then demonstrate the best path for country-wide reforms.Footnote 74
The regulations utilized in SEZs are not only functional within the borders of the host states, but may have an effect on the host states’ international legal obligations. If the regulations in SEZs are not stable and the incentives utilized by host states are prohibited by international regimes, the international legal obligations of host states might be violated. The possible situations will be analyzed in detail in the following sections.
2.4 General Failures of SEZs
The history of SEZs has seen some failures; the Calabar zone in Nigeria is one example.Footnote 75 The location of this zone seemed perfect, as it was near the Calabar port.Footnote 76 Based on the development plan of the zone, after the port had been dredged, it could serve ships to export the goods produced in SEZs.Footnote 77 However, the related authorities failed to complete the dredging project.Footnote 78 Moreover, this zone had no connection with any highways in Nigeria.Footnote 79 What was worse, the power supply provided by the government was not reliable.Footnote 80 Consequently, few foreign investors chose to invest in this SEZ.Footnote 81 The Philippines’ Bataan SEZ is another example of failure.Footnote 82 This zone was built on the site of a former US military field. The government spent a great amount of money in upgrading its bridges, roads, and other infrastructure.Footnote 83 Nevertheless, the zone had weak business potential, and few investors chose to establish in this zone.Footnote 84 In this case, even though the government spent a lot in supporting one SEZ, the outcome was not positive.
3. International Taxation Issues: Comparative Analysis of Tax Incentives
SEZs in Asia heavily rely on tax incentives, aiming to attract more foreign investment.Footnote 85 However, tax incentives are not always successful in attracting foreign investors, and SEZs are also not always successful.Footnote 86 BEPS Action 5 is utilized to test whether tax incentives and reductions provided in SEZs can be potentially harmful to the competition standards among states. This section explains that tax incentives are a key aspect of SEZs, but they are not the main issue.Footnote 87 Instead, an SEZ creates a wider preferential base than that envisioned by BEPS Action 5, which may render SEZs illegal under international taxation law (and in direct opposition to one of the latest much needed tax law global reforms). This section starts with a topography of SEZs’ common tax advantages (3.1). It then discusses the adverse tax effects of SEZs (3.2).and the challenges raised by SEZs in the context of the ongoing BEPS implementation (3.3).
3.1 Topography of Tax Advantages
With the strong support of central governments, companies can enjoy incentives, such as tax breaks in SEZs.Footnote 88 Tax exemption, lower tax rates, and tax concessions are the most common instruments of tax policy.Footnote 89 In 1934, federal customs duties and excise taxes were exempted in the US FTZs.Footnote 90 Tax incentives were introduced in SEZs aiming at facilitating foreign investment.Footnote 91 The incentives can be substantial, especially for foreign investors. For example, foreign investment enterprises which have already engaged in a service trade for more than 10 years and have total investment exceeding five million US dollars can get a one-year tax exemption and a two-year 50% tax rate reduction, which begins in their first profit-making year.Footnote 92 In 1994, the uniform tax rate for profits of all enterprises was 33%, while it could be as low as 15% in SEZs in order to attract foreign investment.Footnote 93 In China, foreign investors have enjoyed preferential treatment in SEZs for several years.Footnote 94 Foreign investors initially enjoyed 15%, while local enterprises had to pay a 30% tax.Footnote 95 It should be pointed out that over time China tended to reduce its tax incentives for foreign investors, both quantitatively and substantively.Footnote 96 The establishment of special tax zones is also an illustration of the purpose of SEZs.Footnote 97 Different kinds of tax, including income tax, business tax, and value-added tax, are exempted or reduced.Footnote 98
Zones located in Asia use many tax incentives, including exemption from normal income tax for a period of three to ten years, and exports without taxes.Footnote 99 For instance, the incentives in FTZs in Malaysia include ‘duty free imports of raw material and capital equipment, simplified custom formalities and income tax relief which included Pioneer status, Labour utilization relief, Investment tax credit, Export promotion deduction and local incentives instead of Pioneer status and Labour utilization relief if the firm is located in a designated locational incentives area’.Footnote 100 In India, three types of incentives are provided to enterprises in SEZs.Footnote 101 The first incentive is related to taxes and tariffs.Footnote 102 Industrial units in the zones can enjoy unlimited duty-free imports of raw materials and long-term tax holiday concessions.Footnote 103 The reason why Hong Kong can be a successful SEZ is because of its low, simple, and transparent taxation system.Footnote 104 A favorable business environment is created as a result of the uncomplicated, transparent, and low-tax regime.Footnote 105
3.2 Adverse Tax Effects of SEZs
While a low-tax regime inside SEZs is beneficial for business, there are potentially detrimental effects resulting from these tax policies. In fact, SEZs, such as the former Turkish FTZs, which were free from value-added tax (VAT) and corporate and personal income tax, can be problematic, as they may lead to tax evasion and competitive disadvantages.Footnote 106 When officials abuse the tax-related provisions and give tax benefits to investments which are not eligible to get those benefits, tax evasion can occur.Footnote 107 Besides, regardless of the economic productivity, those which are given the tax benefits are more competitive than those that have got nothing.Footnote 108 Tax incentives and tax reductions have an effect on the competition standards between countries.Footnote 109 Tax incentives need to be carefully managed in order not to harm competition standards.Footnote 110 It is possible for tax competition to affect the fiscal systems worldwide negatively.Footnote 111 As a consequence, tax competition may result in a ‘race to the bottom’ situation, which means countries may decrease their tax rates to zero.Footnote 112 In this way, these countries want to improve their attractiveness for the foreign investors; however, growing pressure might be levied on them, as they cannot change their tax policies easily.Footnote 113 In Turkey, tax evasion increased because of the tax incentives issued in their FTZs.Footnote 114 When tax incentives are not utilized properly, such as when tax holidays are only available for foreign investors, the domestic investors may face a competitive disadvantage and the competition conditions are detrimental.Footnote 115 FDI and local firms are attracted to invest in SEZs because these zones have more liberal policies compared with other parts of the state.Footnote 116 Therefore, whether the tax measures in SEZs can be a kind of harmful tax practice should be considered.
3.3 SEZs and Base Erosion and Profit Shifting (BEPS)
In order to resolve the increasing base erosion and profit-shifting problems and establish a new international taxation regime, the OECD launched the ‘BEPS package’, comprising 15 actions.Footnote 117 The measures include minimum criteria and best practices.Footnote 118 As long as the participants, ranging from developed states to developing ones, commit to complying with the BEPS plan, they have to obey their commitments and also meet four minimum standards aiming to maintain the consistency of implementation.Footnote 119 Among those actions, BEPS Action 5 has been published with the intention:
[t]o counter harmful tax practices with respect to geographically mobile activities such as financial and other service activities, including the provision of intangibles… that unfairly erode the tax bases of other countries, potentially distorting the location of capital and services.Footnote 120
BEPS Action 5 prescribes that in comparison with the relevant state's general tax principles, ‘a regime is considered preferential if it offers some form of tax preference’.Footnote 121 Based on the definition of SEZs, the fiscal regimes are more liberal than those of the domestic economy.Footnote 122 An SEZ is accordingly a typical example of a preferential regime. In deciding whether a regime is harmful, BEPS Action 5 requires five key factors. However, not all the five factors have to be met at the same time to conclude that a regime is harmful. According to the OECD, the first factor is the gateway criterion. It considers ‘whether the regime imposes no or low effective tax rates on income from geographically mobile financial and other service activities’.Footnote 123 Consequently, referring to the tax incentives provided in SEZs, whether geographically mobile financial and other service activities enjoy no or low effective tax rates should be considered. The gateway criterion may be met if no or low effective tax rates are imposed in SEZs. Although tax incentives are one significant factor, they are not the main issue.Footnote 124 In reality, zero or low effective tax rates are not offered in every SEZ. For example, SEZs in South Africa provide no fiscal incentives.Footnote 125 Assuming the gateway criterion is met, the other key factors should be examined as detailed in the following paragraphs.
The second main factor is whether the SEZ regime exists in isolation from the domestic economy.Footnote 126 According to BEPS Action 5, ‘it is understood to mean where a regime implicitly or explicitly excludes resident taxpayers from taking advantage of its benefits or where an entity that benefits from the regime is prohibited from operating in the domestic market’.Footnote 127 SEZs ‘refer to spatially delimited areas within an economy that function with administrative, regulatory, and often fiscal regimes that are different (typically more liberal) than those of the domestic economy’.Footnote 128 As a result, SEZs are isolated from the domestic economy. Therefore, the characteristics of SEZs meet the second factor. The third factor is a lack of transparency.Footnote 129 This is a subjective factor, and it has to be considered in relation to a specific SEZ. Although it is hard to decide whether typical SEZs are transparent or not, as they are used to attract foreign investment, it is more likely for them to be transparent, as it may be more attractive for the foreign investors. The fourth factor related to the regime is a lack of effective exchange of information. This means that the host state should have an elaborate tax treaty network with other states, and it would be better if the host state has signed tax information exchange agreements. It has to be considered in relation to the specific country's tax treaty network. To cite South Africa as an example, it not only created a comprehensive tax treaty network with other African states, but also signed a tax information exchange agreement with Liberia.Footnote 130 Consequently, South Africa has an effective tax information exchange regime.
In BEPS Action 5, the 5th requirement is the substantial activity requirement. It requires that taxation should be realigned with the substantial activities generating them.Footnote 131 The goal of the substantial activity requirement is to make sure that any benefit given to a taxpayer in a preferential regime is directly related to the activities which generate the main income. A direct link between a company's expenditure and the tax benefits it is thereby entitled to should be maintained.Footnote 132 Although both IP regimes and non-IP regimes are available in the current SEZs, in analyzing this requirement, the IP (Intellectual Property) regimes are mainly considered. Compared with the traditional labor-intensive SEZs, IP assets are substantial for the technology-intensive manufacturing and especially for high-technology firms in SEZs, and they must be owned in the place where the expenditure is incurred for tax purposes.Footnote 133 The expenses of the actual research activity creating the IP should be related to the taxpayer's expenditure. The qualifying taxpayers are defined as ‘those taxpayers that undertook the core income generating activities required to produce the type of business income covered by the preferential tax regime’.Footnote 134 As a result, in order to meet the substantial activity requirement, the favorable tax condition provided in SEZs must directly relate to core income-generating activities.
With tax incentives, special tax zones (STZs), a type of SEZ, traditionally focus on attracting substantial economic activities.Footnote 135 Distortions can be created when the taxes are used to finance subsidy programs.Footnote 136 In short, the SEZ regimes have the potential to be harmful if the substantial activity requirement is not met. Tax incentives are one significant factor in the decision-making processes for MNEs when they consider new business locations, but they are not the main issue.Footnote 137 An SEZ creates a wider preferential base than that envisioned by BEPS Action 5, because of the liberal and favorable climate provided by it.
4. The International Investment Issues: Special Economic Zones before ISDS
Virtually all BITs include rules considering expropriation and dispute resolution mechanisms, while their main goal is to protect the property rights of foreign investors.Footnote 138 More specifically, in the world of investment law, expropriationFootnote 139 of property can take two forms. It can be either direct or indirect.Footnote 140 In addition, binding and independent arbitration under BITs is more favorable than local remedies from the perspective of foreign investors.Footnote 141 It should be noted that other BIT standards could be violated by SEZs, such as fair and equitable treatment (FET) and national treatment (NT).Footnote 142 As domestic investors within SEZs are treated differently compared with those outside, NT standards can be triggered in this situation. However, there are two reasons why in this article the expropriation is mainly considered. For one thing, there are a representative number of investment disputes which relate to SEZs and which involve expropriation claims. For another, the expropriation standard is relatively hard to meet, so if there is a breach of an expropriation clause, it is also very likely that the fair and equitable treatment clause is violated (while the reverse is not true). In order for the article to test the relevance of investment treaties to review the legality of SEZs, it is preferable to focus on the most challenging investment standard. Expropriation, which is the most basic type of protection, is the main form considered in this article (4.1). Some old BITs might only allow expropriation to be presented in international arbitration.Footnote 143 In the second section, a group of cases which deal with SEZs and the expropriation clause will be considered (4.2).
4.1 SEZs in the Context of Expropriation
The concept of indirect expropriation is generally recognized today – that is, the acceptance or recognition that there are measures that, apart from outright takings, constitute expropriation – both in decisions made by international tribunalsFootnote 144 and in legal instruments and the writings of scholars.Footnote 145 However, there is no clear line drawn between non-compensable governmental measures and measures amounting to indirect, compensable expropriation. Based as it is on competing interests, the relationship between a foreign investor and the host state is a delicate one. On the one hand, by making an investment in a foreign country, a foreign investor is subjecting its investment to the jurisdiction of the host state and therefore has the right to expect certain protections from that state. On the other hand, the state, owing to its territorial sovereignty, has the right to regulate within its territory. It is well recognized in international law that ‘states are not liable to pay compensation when, in the normal exercise of their police powers, they adopt non-discriminatory, bona fide regulations aimed at the general welfare’.Footnote 146 According to the commentary to the oft-quoted Restatement of Foreign Relations Law of the United States:
[A] state is not responsible for loss of property or for other economic disadvantage resulting from bona fide general taxation, regulation, forfeiture for crime, or other action of the kind that is commonly accepted as within the police powers of the states, if it is not discriminatory … and is not designed to cause the alien to abandon the property to the state or sell it at a distress price.Footnote 147
The Harvard Draft Convention on the International Responsibility of States for Injuries to Aliens of 1961Footnote 148 also identifies as non-compensatory measures ‘measures executing tax laws, general changes in the value of currency, actions of competent authorities of the State in the maintenance of public order, health or morality; or from the valid exercise of belligerent rights or otherwise incidental to the normal operation of the laws of the State’.Footnote 149 While, as noted by Professor Sonarajah, these types of measures have long been recognized as non-compensable measures, new developments show that many takings that would have been characterized as legitimate non-compensable regulation may now be subjected to compensation.Footnote 150 While the right to regulate was never absolute, the development of the law on indirect expropriation is continuing to place further restrictions on the right of the state to regulate. It is therefore all the more necessary to agree on criteria that distinguish between non-compensable regulations that are legitimate and bona fide, and regulatory expropriation, which, while legitimate, carries with it an obligation to compensate. That task is currently left to investment and other arbitral tribunals.
4.2 ISDS Case Law on SEZs
There are already a significant number of investment awards dealing with SEZs and the clauses on expropriation. In fact, a number of states have lost cases after having modified the regime of SEZs, which demonstrates the link between domestic law and practice on SEZs and international investment law.
For example, in the Lee John Beck v. Kyrgyz Republic case, the termination of foreign investors’ lease agreements has been challenged as an expropriation.Footnote 151 Middle East Cement v. Egypt is another example in which the revocation of the claimants’ license has been found to amount to expropriation.Footnote 152 Furthermore, in Empresas Lucchetti v. Peru, the claims occurred because of the revocation of permits previously granted to the claimants, which could amount to expropriation.Footnote 153 Consequently, it is challenging to maintain the balance between the rights of a foreign investor and the interests of host states. SEZs have both risks and opportunities at the same time.Footnote 154
As explained above, in SEZs market restrictions are suspended and investors invariably enjoy a lot of benefits.Footnote 155 However, within SEZs, the states can change and interpret regulations at will.Footnote 156 In the Yury Bogdanov v. Moldova case, the disputes arose because of the wrongdoings of the host state.Footnote 157 The changes of policies in SEZs may give rise to disputes which can be resolved under bilateral investment agreements.Footnote 158 In Bawabet v. Egypt, the government cancelled the claimant's free zone status, resulting in a claim brought by the foreign investor.Footnote 159 Disputes may also arise because of different interpretations. In the Albacora S.A. v. Ecuador case, the claims were caused by different views towards the claimant's company status.Footnote 160 When disputes arise, foreign investors in SEZs can sue the host state based on the related BIT, as the claimant in Gennady Mykhailenko v. Belarus did.Footnote 161 And, in Southern Pacific Properties (Middle East) Limited v. Arab Republic of Egypt, regulations concerning foreign investment and free zones were applied.Footnote 162 Stakeholders must take actions collectively to create a proper system of regulations based on the limited successful experience of SEZs.Footnote 163
In Ampal-American and others v. Egypt, the claimants were an American company and the East Mediterranean Gas company (EMG) – an Egyptian company which was owned by the American company.Footnote 164 EMG made profits by purchasing natural gas from Egypt and exporting it to Israel through a pipeline. As a free-zone company, Egyptian law provided EMG special benefits. The Egyptian General Petroleum Corporation (EGPC) was approached by EMG to purchase gas in Egypt, and a Preliminary Agreement was concluded between them in 2000, which was a long-term upstream supply agreement confirmed by the Prime Minister of Egypt. In 2001, the State-owned Egyptian Natural Gas Holding Corporation (EGAS) was created by Egypt to implement policies related to the gas sector. The Egyptian government authorized the EGPC and the EGAS as representatives of the Egyptian Ministry of Petroleum to execute a source gas supply agreement (GSPA) in 2004. EGPC, EGAS, and EMG created a tripartite agreement in 2005.Footnote 165
The main allegations advanced by the claimants were in five parts. Firstly, the free-zone status of EMG and its tax exemptions were revoked by the Egyptian government, which led to an increase in the expenses and tax burdens of the claimants.Footnote 166 Secondly, in order to coerce the claimants into making great concessions in signing an amendment to the Source GSPA (‘First Amendment’), during the negotiation process, the gas was withheld by Egypt.Footnote 167 Thirdly, because of Egypt's failure to meet its supply obligations based on the Source GSPA, EMG faced the growing possibility of contractual violations. Fourthly, the Egyptian pipelines were attacked several times, and Egypt failed to protect the security of EMG's pipelines. What is worse, the damage was not repaired by Egypt in a reasonable period. Lastly, the Source GSPA was unlawfully terminated by EGPC/EGAS, and claimants believed this termination was politically motivated. These measures were treated as a violation of the US–Egypt BIT by the claimants.
The tribunal considered whether the revocation of the tax exemption enjoyed by EMG or the termination of the Source GSPA could be treated as expropriation.Footnote 168 The tribunal found that the tax incentives in SEZs can be protected under the BITs if the measures are connected to the term of expropriation. According to Article III of the US–Egypt BIT, only tax measures which are equivalent to unlawful expropriation can be included in the treaty.Footnote 169 In this case, the tribunal considered whether the revocation of EMG's tax exemption amounted to expropriation. From the perspective of the claimants, the revocation of the license could be treated as expropriation, as the license was an important protected investment itself.Footnote 170 The tribunal agreed that it constituted a direct and total taking, which had the same effect as expropriation,Footnote 171 as it was a ‘defined and valuable interest that had been validly conferred according to Egyptian law’ and the claimants made their decisions based on it because it was ‘guaranteed by the State for a defined period’.Footnote 172 The tax-free status was a significant factor when the claimants made their investment decisions.Footnote 173 Although the Tribunal was convinced that the decisions made by the Respondent were for public interest reasons, prompt and adequate compensation was required based on Article III of the BIT.Footnote 174 The tribunal opined that compensation was essential no matter whether the expropriation was lawful or not.Footnote 175 Therefore, based on Article III of the BIT, the tribunal concluded that the revocation of the license was an expropriation. Investors should expect that governments will make legislative and policy changes, and it is an inherent risk they should consider in advance.Footnote 176
Antoine Goetz and Others v. The Republic of Burundi (I) is another case illustrating the relationship between policy changes in SEZs and BITs.Footnote 177 A free zone regime was created in 1992 by the Republic of Burundi, and companies could enjoy benefits like tax exemptions.Footnote 178 Based on the advice of a consultative commission, the business in some non-traditional sectors could enjoy a free-zone certificate.Footnote 179 In 1992, Affinage Des Metaux (AFFIMET) was formed under Burundian law and was owned by the Belgian-based Goetz family.Footnote 180 It was a mining enterprise, and its object was to produce, refine, and market precious metals.Footnote 181 A free-zone certificate was given to AFFIMET on 3 February 1993, but five months later it was informed that different opinions had arisen related to the proper scope of the free zone system. It was informed that if it wanted to enjoy the free zone status, a sum equivalent to the duties had to be deposited in advance during the investigation procedure. Following completion of investigations, on 20 August 1993 AFFIMET was told that its free-zone certificate had been suspended. However, in 1994, the certificate was handed back, while in 1995, it was withdrawn again. In 1995, based on the Belgium–Luxembourg Economic Union-Burundi BIT, the claimants filed a claim before ICSID.Footnote 182 The political instability of the Burundian authorities had to be responsible for the frequent changes.Footnote 183
One more case, Link-Trading Joint Stock Company v. Moldova, can also be considered. The company protested that the tax treatment change taken by Moldova violated the tax stability which was promised by the host state.Footnote 184 Additionally, the measures could be treated as an expropriation, and the lack of compensation violated the US–Moldova BIT. Moldova asserted that the changes related to the tax treatment were a proper government exercise. Based on Article X(2) of the BIT, the respondent should respect the claimant's investment according to the State's tax policy.Footnote 185 When tax measures are found to constitute a direct or indirect taking of the investor's lawful investment, Article X of the Treaty permits the claims of such measures related to the expropriation clause. Article X states that ‘[w]ith respect to its tax policies, each Party should strive to accord fairness and equity in the treatment of investment of nationals and companies of the other Party. Nevertheless, the provisions of this Treaty, and in particular Articles VI and VII, shall apply to matters of taxation only with respect to the following: expropriation, pursuant to Article III’.Footnote 186
If the application of tax measures violates a specific government commitment, such measures can also amount to expropriation.Footnote 187 Article II(3)(c) stipulates that a state is required to ‘Observe any obligation it may have entered into with regard to investments’. Footnote 188 The lack of prompt and adequate compensation is a common claim related to expropriation.Footnote 189 If measures interfere with investments substantially, they can be treated as indirect expropriation. The burden to prove the causal link between the measures and the negative effect on its business is on the claimant. The tribunal found that the elimination of the customers' tax exemption did not interfere with the claimant's business substantially. As it is normal for tax measures to have a cost influence on taxpayers, the tax measures themselves were not enough.
Based on above cases, two main lessons can be learned. On one hand, although the government has rights to regulate in SEZs, it should be careful in designing, implementing, modifying, and revoking the regulations in SEZs to avoid committing the expropriation clause. On the other, if a specific commitment is violated by the application of tax measures, prompt and adequate compensation is required.
5. The International Trade Issues: Are Special Economic Zones Compliant with WTO Law?
With reference to WTO agreements, SEZs have not been explicitly regulated.Footnote 190 But SEZs within the territory of WTO members will be bound by WTO law, unless otherwise specified.Footnote 191 The WTO's goal is to reach a balance between helping exporters and importers conduct their business and allowing governments to maintain their social and environmental objectives.Footnote 192 The states in the WTO have various economic development conditions.Footnote 193 In order to maintain the liberal nature of the WTO trading system, government restrictions on trade should be reduced.Footnote 194
The interactions between the incentives of SEZs and the WTO agreements will be considered in the following;. first is how to maintain a balance between the NT standard and SEZs’ incentives. It has to be noted that SEZs contravene the notion of NT which is found in GATT, GATS, and TRIPs to some extent (5.1).Footnote 195 Besides, the incentives of SEZs may trigger the SCM agreement, and countries should learn how to use the related measures properly (5.2). Lastly, the TRIMs agreement is also very significant, and governments should take actions to avoid possible challenges from other members (5.3).
5.1 The Problem of National Treatment
National treatment, which is found in GATT, GATS, and TRIPs, is the universal principle of WTO, but this presents a challenge to the ‘particularistic contracting’ feature of SEZs,Footnote 196 because based on the definition of NT standard, it prohibits discrimination and requires that ‘a WTO member may not discriminate on the basis of the national origin of the product’.Footnote 197 However, the ‘particularistic contracting’ characteristic of SEZs can be treated as a kind of ‘discrimination’, as different treatment does exist. To cite China as an example, ‘one of the most important characteristics of Chinese reform at both domestic and foreign levels was ‘particularistic contracting’, which means that the arrangements for foreign trade and investment were negotiated for each unit, namely province, locality, or firm’.Footnote 198 For example, the SPFTZ was founded to change China's low-value-added trade pattern with the development of technology, brands, quality, and service.Footnote 199 Offshore business is supported in SPFTZ, and headquarters and/or operation centers of multinational firms are encouraged to be set up.Footnote 200
5.2 The Problem of Subsidies
Although the policies of SEZs might be challenged, WTO members can (and do) establish SEZs. Referring to Article 1 of the SCM Agreement, a subsidy is regulated as ‘a financial contribution by a government or any public body within the territory of a Member’.Footnote 201 Footnote 1 of the SCM Agreement states that ‘the exemption of an exported product from duties or taxes borne by the like product when destined for domestic consumption … shall not be deemed to be a subsidy’.Footnote 202 To exempt products whose production is for domestic purchase and which are imported into the SEZs from import duties or taxes levied on like products is the most common SEZ incentive, and it is not included in the definition of subsidy.Footnote 203 According to Article 1 of the agreement on Trade-Related Investment Measures (TRIMs), it ‘applies to investment measures related to trade in goods only’.Footnote 204 In order to meet TRIMs requirements, China, for instance, promised to modify or abandon the existing provisions which are inconsistent with its commitments to TRIMs.Footnote 205 Besides, transparency is a basic WTO value, and it requires rules and procedures to be transparent. In order to fulfill its commitments, China has provided its trade-related regulations through different channels, such as ministry websites, newspapers, and some journals.Footnote 206
Developing states are concerned about WTO disciplines regarding subsidies for their SEZ programs.Footnote 207 There are two main components relating to WTO disciplines regarding subsidies. On the one hand, the use of subsidies in domestic markets is limited.Footnote 208 On the other, the use of countervailing measures is regulated in order to prevent trade barriers.Footnote 209 The SCM Agreement is aimed to improve GATT disciplines with respect to the use of both, subsidies and countervailing measures, while allowing members to make use of these two measures under certain conditions.Footnote 210 Based on both GATT Article XVI and Article 1 of the SCM agreement, the duty-free importation of intermediate goods for products destined for export is not treated as benefiting from subsidies in WTO rules.Footnote 211 According to the WTO, ‘the SCM Agreement requires that a subsidy must be specifically targeted to a certain enterprise or industry, to fall into the WTO and SCM Agreement regulatory regimes’.Footnote 212 Export subsidies and subsidies contingent on the use of domestic over imported goods are completely prohibited, as they amount to being ‘specific’ regardless of their details, and the allocation of resources has been distorted.Footnote 213 Export subsidies can be tax benefits for exportation.Footnote 214 If the subsidy is prohibited, a dispute settlement procedure can be requested by any WTO member to obtain a ruling in order to make the offending subsidies ‘be withdrawn without delay’.Footnote 215 India's export subsidy measures for SEZs were challenged by US in 2018 and WTO dispute resolution panel required India to withdraw these measures within 90 days in 2019.Footnote 216 Appropriate countermeasures can be taken if the violating party does not obey the recommendation.Footnote 217
To cite China as an example, it faced a growing number of trade-related disputes within the SCM area.Footnote 218 A number of measures taken by China, such as the exemptions from taxes on benefits available in the SEZs, were challenged by the US in 2007.Footnote 219 And refunds and deductions provided by China were also challenged.Footnote 220 From 2006 to 2008, there were five cases submitted by the US against China. The disputed measures included those ‘affecting imports of automobile parts; granting refunds, reductions or exemptions from taxes and other payments; affecting the protection and enforcement of intellectual property rights; affecting trading rights and distribution services for certain publications and audio-visual entertainment products; and affecting financial information services and foreign financial information suppliers’.Footnote 221 And it should be pointed out that specific tax exemptions are also among the main concerns as regards the countervailing investigations against China.Footnote 222 When China withdrew the related measures, the dispute was settled.Footnote 223 Based on the WTO regulations, subsidies can be actionable.Footnote 224 Some subsidies can be challenged under certain conditions, while they are normally not challenged altogether.Footnote 225 Based on the WTO regulations, ‘a subsidy is actionable if it is specific and if it causes one of three kinds of damage to another member: a) injury to a domestic industry; b) impairment of the benefits of a tariff concession, or c) serious prejudice to the interest of other members’.Footnote 226 As long as nations comply with the WTO restrictions, they do not need to worry about their measures being challenged.Footnote 227 For instance, when companies in SEZs purchase domestically made goods, the value-added tax is refunded to them and the refund is not prohibited by WTO, since such a refund is not regarded as a specific subsidy.Footnote 228
5.3 The Problem of Trade-Related Investment Measures
In the WTO Agreement, the Trade-Related Investment Measures (TRIMs) covers foreign investment.Footnote 229 TRIMs are government measures, and private foreign investors are encouraged to follow some specific behaviors.Footnote 230 This agreement lists the measures that members of WTO should not apply.Footnote 231 The goal of the TRIMs Agreement is to facilitate investment while ensuring the liberalization of world trade.Footnote 232 Amit and Tarum point out that ‘in general, the TRIMs Agreement merely reaffirms GATT disciplines and reapplies them to TRIMs, such as transparency requirements (Article 6), general exceptions (Articles 3 and 4), and dispute settlement procedures (Article 8)’.Footnote 233 If a TRIM is inconsistent with the regulations of Article 3 or Article 11 of GATT 1994, it will be prohibited by the Agreement.Footnote 234 The prohibited TRIMs must be abolished, and the time periods are various based on the different levels of development. Developed countries are required to eliminate prohibited TRIMs within two years; the grace time for developing countries is five years; and for least-developed countries, it is seven years.Footnote 235 For example, a ‘local content’ requirement, which requires the investor to purchase a minimum percentage of domestic resources, may be required by the government of the host state.Footnote 236 A subsidy can also be granted if the investors comply with the so called ‘local content’ requirements.Footnote 237 These measures aim to benefit the host country by altering the investment condition in SEZs.Footnote 238
There are four types of TRIMs inconsistent with GATT: (1) Performance Requirements: these require investors to do certain actions such as purchasing certain goods.Footnote 239 These requirements have been utilized by many countries.Footnote 240 (2) Local Content Requirements: these impose a mandatory condition, whereby a certain amount of domestic goods have to be purchased for the foreign investor to establish his enterprise.Footnote 241 (3) Export Restrictions: host states require the foreign investors to export a certain amount of their products.Footnote 242 (4) Local Equity Requirements: these allow foreign investors to invest in the host state only when the locals of the host country have a certain percentage of the ownership rights.Footnote 243 Based on some surveys, removing the export share requirements helps attract FDIs towards SEZs.Footnote 244 In the case of the SEZs in China, these types of TRIMS can be found in the initial laws issued by China to attract foreign investment, including the Foreign Equity Joint Ventures Law of 1979 and the Foreign Contractual Joint Venture Law of 1988.Footnote 245
In order to avoid possible challenges from other members, governments can provide non-discriminatory treatment for all investors, no matter whether they are in or out of the zone.Footnote 246 The measures do not have to be the same, and as long as all eligible enterprises can access the zones fairly without any discriminatory regulations, challenges can be avoided.Footnote 247
6. Conclusion
After analyzing the different aspects of SEZs, including their various names, their rapid proliferation, and their objectives, this article shows that the aims of SEZs are to create a favorable, liberal, and effective business climate which is not available in other parts of the state.Footnote 248 However, despite the states’ intentions in establishing SEZs, the article also demonstrates that SEZs can lead to a number of challenges and violations of international economic rules, which is a finding of systemic importance. As a matter of fact, SEZs have the potential to undermine a number of well-established rules of international law.
The emerging tension between SEZs and IEL is problematic for all stakeholders, whether host states, traders, and international organizations. For instance, political stability is one factor that is considered by investors in accessing SEZs.Footnote 249 Despite their unilateral character, SEZs have already come under the scrutiny of investment tribunals. This is a tangible warning, especially as a series of decisions suggest that investment treaties, by default rather than by design, lead to SEZs incentives not being easily modified or withdrawn.Footnote 250 When policies in SEZs change frequently, the foreign investors’ expectations may be affected and disputes arise.Footnote 251 The emerging tension between IEL and SEZs is also palpable in the context of trade and tax rules.
By considering the effect that the three main branches of IEL (namely international taxation, international investment law, and multilateral trade rules) can have on SEZs, this article discusses and assesses the legality of SEZs. The article demonstrates that SEZs have the potential to be harmful under international taxation law. In particular, if tax incentives are used to finance subsidy programs (while MNEs which enjoy tax benefits have no substantial activities in SEZs), the SEZ regimes can be considered harmful. In relation to international investment law, changes to policies in SEZs may amount to indirect expropriation. In such a situation, no matter whether the expropriation is lawful or not, prompt and adequate compensation by the host state is required. As regards WTO law, the measures provided in SEZs are also likely to constitute violations of international rules. In fact, it is only when governments can provide non-discriminatory treatment for all investors that possible challenges can be avoided before the WTO DSB.
Lawyers and policy-makers should carefully take into account IEL rules when designing and establishing SEZs. Not doing so could soon result in disputes and tribunals’ findings which are unfavorable to many states. In addition, not meeting the requirements and standards set by IEL could simply defeat the very reasons that drive the establishment of SEZ, which is to provide a stable and open environment to local and foreign companies engaged in international trade.
Acknowledgements
The authors thank Jacopo Dettoni, Georgios Dimitropoulos, Jędrzej Górski, Jiaxiang Hu, Yulia Levashova, Arpita Mukherjee, Sherzod Shadikhodjaev, and Elisabeth Tuerk for indispensable feedback and comments. The opinions expressed herewith are the authors’ own.
