A raft of international taxation measures unveiled by Indian Finance Minister Pranab Mukherjee in last week’s 2012-13 federal budget has rattled foreign investors.
“The budget proposes a number of regressive, retrograde and extra-territorial provisions that would significantly increase tax costs and alter the dynamics of cross-border transactions, mergers and acquisitions,” says Nishith Desai, founder of Nishith Desai Associates, an international law firm.
It could force foreign investors to think twice if they want to place their bets on India, he adds.
Take for instance, says Desai, the proposal that seeks to introduce a new law that would tax the share transfer of an asset situated in India, regardless of where the deal is struck.
Essentially, this clause tweaks the Indian Income Tax Act to assert the state’s right to retrospectively tax cross-borders transactions.
Such a law would overturn the landmark judgment of the Supreme Court in January this year that dismissed the government’s tax demand of more than $2 billion of capital gains tax from England-based Vodafone for its 2007 purchase of Hong Kong-based Hutchison Whampoa Ltd (13)’s India operations.
Some, like Desai, are worried that if the law is passed, it would impact other deals involving foreign companies acquiring Indian businesses, such as SABMiller’s acquisition of Foster’s India for $120 million and GE’s $500 million acquisition of Genpact.
While Vodafone lawyers call the new budget proposal “totally unconstitutional” as well as displaying “lack of long-term vision”, Desai says it is the impact on foreign investors that would be the most critical.
Besides making it nearly impossible for investors to plan cross-border mergers and acquisitions and group restructurings, it will also expose foreign investors to double taxation without any credit for taxes paid in India, he says.
A case in point would be when a US investor transfers its share holding in an Indian company to local or foreign investors. It will be subjected to taxation both in India as well as in the US.
“Clearly this is ridiculous,” says a strategy analyst with one of the largest foreign banks in India, requesting anonymity.
“The initial feedback that we have received from investors reveals a sense of confusion. They feel it is a contravention of international treaty and since they do not know what shape this proposal will ultimately take, many have preferred to wait on the sidelines before investing in India.”
Deal-makers also feel the government proposal to tax offshore share transfers through the introduction of general anti-avoidance rules (GAAR) could prove to be a deal-breaker. GAAR arms officials with wide discretionary powers to tax transactions on grounds of tax avoidance.
According to Shefali Goradia, a partner in BMR Advisors, a services organization offering tax, risk and other consultations, this proposal enables tax authorities to disregard a transaction that aims at deriving tax benefits even though the transaction has no commercial substance.
“Without adequate safe harbors for genuine transactions, GAAR is bound to enhance hardships for taxpayers, particularly foreign private equities,” says Goradia.
“The burden of proof falls on the taxpayer to prove that a transaction is not undertaken for tax avoidance. This could end up being very litigious and will vitiate the investment environment in India.”
Onerous compliance challenges, too, will stem from the new rules. To claim tax benefits from deals made in countries with which India has signed a double tax avoidance agreement, non-resident taxpayers must obtain a tax residency certificate issued by the Revenue Department.
“This is likely to create uncertainty about eligibility of foreign private equity funds to claim tax treaty benefits,” says Goradia.
The proposal seeking mandatory disclosure of offshore assets, including any financial interest in a foreign entity even when no income is derived, is the other irritant that could turn off foreign investments from India, say experts.
Small wonder then that Desai feels this year’s budget “is a sure-shot way to drive away foreign investors”.
However, it does contain some bright spots that could come across as money-making opportunities for foreign investors in a few core sectors.
Mukherjee has proposed allowing “two-way fungibility” for Indian depository receipts (IDRs) to encourage greater foreign participation in the Indian capital markets. The two-way fungibility would enable Indian investors in a foreign company to convert their holdings into shares of the parent company in the country of origin.
This would benefit companies like London-listed Standard Chartered Bank which has listed IDRs in India. Under the new measure, those IDRs are now eligible for conversion into original shares of the bank.
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