The draft order sent by the department requires Cairn’s subsidiary Cairn UK to pay $1.6bn in tax and any applicable interest and penalties for 2006-2007 fiscal year.
The dispute notice, which has been filed under the UK-India Investment Treaty, will help the company to either negotiate with the Indian Government or turn to arbitration panel, it said in a statement.
The income tax notice is based on the amendments made to the Indian Finance Act in 2012 that allows the government to levy tax with retrospective effect.
The investigation, which started in 2014, is related to transactions that took place during 2006-2007.
Cairn Energy sold majority interest in Cairn India to Indian mining company Vedanta in 2011 for $8.67bn. It has since been planning to divest its remaining 10% stake, but is being restricted by the Indian tax authorities.
Its stake, previously valued at over $1bn, has now come down to $700m.
Cairn Energy CEO Simon Thomson said: "Cairn has consistently confirmed that it has been fully compliant with all relevant legislation and paid all applicable taxes in India and we are confident of our position under the UK-India Investment Treaty.
"Against a backdrop of regular engagement with the Government of India since January 2014 it is very disappointing to have received a draft assessment order at this time.
"This issue is confined to our interests in India and the Group remains well funded to deliver all of our objectives and commitments and we look forward to moving forward with our strategy whilst this issue is resolved under legal process."
