Rattled by the exodus of foreign investment due to uncertainty over tax proposals in the current budget, India’s Finance Minister Pranab Mukherjee has rolled back a few prickly recommendations this month.
Over the last 12 years, India received nearly $247 billion of foreign direct investments, of which about 40 percent flowed from tax havens. Indian tax authorities believe a large part of this is routed by Indian companies and individuals to evade taxes.
Subsequently, the current budget proposed new regulations this month, like the General Anti-Avoidance Rule (GAAR), and a retrospective amendment to tax offshore transfers.
GAAR empowers revenue officials to deny tax benefits from transactions or arrangements originating from destinations like Mauritius, the Cayman Islands and Luxembourg, with which India has double taxation avoidance treaties. In other words, it aims at taxing short-term stock profits foreign investors make through shell entities in these tax-haven countries.
The other shocker is the proposal to tax, with retrospective effect, any share redemption by foreign companies with substantial assets in India.
This means all profits made by foreign investors from selling investments that represent Indian shares, even if the transaction takes place outside India, will be subject to tax in India.
Foreign investors usually do not invest in Indian shares directly. They route investments through institutions called foreign institutional investors.
This retrospective tax also applies to the sale of foreign companies that have investments in India.
The new proposals have hit private equity investors hard. However, now succumbing to pressure from foreign as well as local investors, the relenting finance minister has announced a few relief measures.
Mukherjee now says the implementation of GAAR will be delayed by a year, becoming effective only from April 1, 2013.
He also says the move to amend income tax laws retrospectively will not override the double taxation avoidance agreements India has signed with 82 countries, including Mauritius.
However, while the rollbacks have addressed some of the anxiety temporarily, they have not taken away the uncertainty.
“Ad hoc policies have increased the risk premium for India considerably,” says the chief of a prominent foreign investment company in India, requesting anonymity. “There aren’t enough opportunities to generate returns to justify that risk.
“Weak fundamentals (like sliding economic growth, widening trade deficits, rising inflation and lack of policy initiatives) and the uncertainties in local tax laws have increased foreign investors’ anxiety and dampened their sentiments.”
Shefali Goradia, an international tax expert at BMR Advisors, a professional services firm with offices in India as well as abroad, says while the deferment of GAAR is positive, it is still not much help in the ultimate scheme of things.
“The minister has just delayed its implementation,” she says. “All concerns remain.”
Some of the major concerns are whether all offshore investors would be taxed, who will be eligible for exemptions and the rate of taxation. There is also uncertainty about the cut-off date for the applicability of tax and the way in which GAAR will be implemented.
Ketan Dalal, a tax partner at PricewaterhouseCoopers, echoes Goradia’s views. “Although the recent rollbacks could provide some comfort to foreign investors, they have not provided the much-needed long-term framework within which they can function,” he says.
A second foreign investor, who too requests anonymity, says foreign investors also need to know how Indian tax laws will safeguard their investments in India.
“Arbitrary policies like the ones announced in the budget and half-hearted clarifications don’t help,” the investor says. “It is almost like living in a black hole.”
According to the Business Standard Research Bureau, a statistical research unit run by a business daily, foreign institutional investors put in just about $106 million in Indian shares between March 16-May 4. However, before the budget was announced in mid-March, investment inflows between January 1 and March 15 stood at over $7 billion.
The drying up of foreign investment is reflected by the depreciation of the Indian rupee, which has slid from Rs 49 in early January to Rs 55 against the US dollar.
However, Raja Lahiri, a partner at Grant Thornton, a leading assurance, tax and specialist advisory services provider, is more optimistic. Lahiri thinks the current confusion is unlikely to last long as the government would be forced to relax the announced rules.
“I do not see the Indian authorities clamping down hard on foreign investors,” he says. “After all, foreign inflows are significant funding sources for an economy like India. We are expecting announcements that would strive to keep foreign investors’ interests alive in the country.”
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