The response to the Bilateral Investment Promotion and Protection Agreement (BIPA) notice was finalised after a meeting of the inter-ministerial group, headed by the Finance Secretary.
The other members of the IMG were secretaries from Economic Affairs, the ministries of Law and External Affairs.
"Tax department has finalised its response to the notice saying BIPA does not cover tax issues. The reply has been sent the Finance Minister," an official source told PTI.
Once the ministry gives its go-ahead to the response, the final reply will be sent to Vodafone.
UK-based Vodafone is in the thick of Rs 20,000 crore capital gains tax dispute with the government that relates to its 2007 acquisition of Hong Kong firm Hutchison Whampoa's stake in India's Hutchison Essar.
While the basic tax demand for the acquisition is Rs 7,990 crore, outstanding dues, including a penalty of a similar amount and accrued interest, run into Rs 20,000 crore.
Vodafone had on January 10 served a supplementary notice to India invoking the India-Netherlands BIPA in which it said that dispute in respect of transfer pricing case between Vodafone India Services (VISPL) and VIHBV.
It said the amendment to the I-T Act will cause Vodafone International Holdings BV (VIHBV) substantial financial loss.
Since Vodafone has been insisting that tax issues are covered under BIPA, the source said the telecom firm is likely to approach Arbitration Tribunal under United Nations.
The Cabinet had in June 2013 approved a Finance Ministry proposal to go in for conciliation with Vodafone to resolve the tax dispute.
However, the talks broke down after Vodafone issued a supplementary notice to the government, invoking the BIPA and demanded that a separate transfer-pricing case be clubbed with the capital gains tax matter.
The company wanted to club a Rs 3,700 crore transfer- pricing case of Vodafone India Services with the capital gains tax issue. The transfer pricing matter is pending in Bombay High Court.
On the capital gains case, the Supreme Court had ruled in Vodafone's favour in 2012, saying it was not liable to pay any tax over the acquisition of assets in India from Hong Kong-based Hutchison.
Later that year, the government changed the rules to enable it to make retrospective tax claims on such deals, including that of Vodafone.