Foreign investors ask for too much

The fall in Indian equity prices should not be interpreted as a fallout of the tax administration’s decision to impose minimum alternate taxation (MAT) on foreign portfolio investors. Much of the foreign portfolio outflows are influenced by global factors such as fragility in bond markets and a rebalancing towards Chinese equity, which has risen sharply due to Chinese monetary stimulus.

That said, the MAT issue has had a strong effect on perceptions. This is despite the policy message aiming to make the system more predictable and user friendly, and the announcement that MAT would henceforth not apply to foreign portfolio investors (FPIs). Greater clarity should actually lead to more inflows. Savvy investors should be taking advantage of the correction.

A valid grievance is the delayed imposition of the tax, after FPIs had settled their accounts. It has reinforced the reputation of an administration out to squeeze as much revenue as possible.

But the quasi-judicial bodies that took the decision to levy MAT were created partly to make the tax system free of political interference.

There are legal remedies, since rulings can be contested in the upper courts. Even so, the message of a friendly tax administration needs to be clearly understood at all levels of the tax hierarchy, with restructuring to reduce multiple centres of power and discretion. Junior officers have too much power to make arbitrary demands as part of chasing tax targets.

India needs to develop its capital markets, and the country has opened up to foreign investors partly for that purpose. It has to honour its contract with them, but tax concessions given at a development stage cannot last for ever.

In order to move towards a transparent, friendly, low-tax regime, which foreign investors say they want, exemptions will eventually have to be removed.

This year’s Budget did announce a phased reduction of corporate tax rates to 25 per cent together with a removal of exemptions. This should apply uniformly to Indian and to foreign firms earning profits in India, subject to tax treaties. But then financial services will have to pay more than their current levels of tax.

A recent study by National Institute of Public Finance and Policy shows that across industrial sectors only 50 per cent of firms pay taxes above 25 per cent at present, and this is the lowest in financial and business services — only 7 per cent. The rationale of MAT was to ensure a minimum uniform level of tax despite the many concessions given, and it should go if the concessions disappear.

Corporates use double-taxation avoidance treaties to pay no tax. This is against the spirit of the treaties. There is a global initiative led by the OECD and G-20 against such ‘base erosion and profit shifting’ (BEPS). India should obtain legitimate tax by participating in such global initiatives, not by unilateral action.

Awareness of these issues seems to be lacking, in the Indian public debate, which seems to largely regard foreign investors as sinned against.

Under the OECD model tax convention, only the profits of a non-resident company with a ‘permanent establishment’ were taxable. Bilateral tax treaties tended to follow this convention. Such tax-by-residence clauses favour advanced economies from where the majority of portfolio investments originate.

But most of all, they favour mobile firms, who can set up residence in low-tax countries with lax rules. It is easy to locate strategically, using treaties designed to avoid double taxation, to achieve double non-taxation. For example, the India-Mauritius treaty allows tax by domicile (primary residence). Mauritius accepts registration as domicile so FPIs come into India through the Mauritius route. But international opinion has turned against such aggressive tax planning.

The convention aimed to prevent double taxation of the increasing number of firms with cross-border business, but has been misused to escape taxes. It is proposed, therefore, to replace it by ‘mutual agreement on place of residence’, in a necessary course correction to close loopholes.

At the 2013 G-20 meet in Petersburg, it was decided that under a new model tax convention: ‘Profits should be taxed where economic activities deriving the profits are performed and where value is created’.

Financial services, which tend anyway to be under-taxed, are especially mobile, and are often able to escape taxes. For example, consider VAT on cross-border retail sales. Financial services are VAT exempt but self-assess input VAT; they are able to escape this using inputs from abroad or from related firms. This is unfair to other entities which then have to pay higher taxes to meet government expenditure requirements.

There is a requirement, therefore, for simple tax regimes that prevent both double taxation and double non-taxation. The problem is one country acting alone can frighten away foreign capital, leading to the kind of pressures Indian has seen recently. Global co-ordination is necessary. G-20 has the potential to be very productive in areas that require co-ordination across countries.

Where there is treaty abuse, taxes are being applied on past incomes internationally. Many companies face this kind of action as part of the BEPS process. Countries that offer unfair tax advantages are also being pressured. They can no longer freely give tax concessions to attract foreign business to locate in the country. For example, the European Commission (EC) is investigating tax breaks given to companies including Starbucks, Fiat, Apple and Amazon.

In a preliminary decision, EC found Irish authorities had given a tax advantage to Apple, whose European headquarters are in Cork, Ireland. If the commission concludes the Irish government broke European state-aid rules and Apple paid less tax than if it had properly applied arm’s length transfer-pricing principle between its subsidiaries, it can require Ireland to recover up to past 10 years of taxes due under the disallowed tax breaks.

Apple has warned in its filing to the US Securities and Exchange Commission that “such amount could be material.” That is, it could exceed 5 per cent of the company’s three year average pre-tax earnings — more than $2 billion in Apple’s case. In that case, Apple would have to pay taxes on past profits like the Indian FPIs.

Legal processes are part of tax systems all over the world, not just in India. Especially those who have paid no tax in any country should be a little less quick to pass judgement.

The writer is professor, IGIDR, Mumbai

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