The problem with backdating taxes is that the taxpayer will have to continuously guess how much of his current income will be taken away at a later date. This is the crux of the Parthasarathi Shome committee report on retrospective taxation of cross-border acquisition of Indian assets, like
Vodafone's $11.2 billion purchase of Hutchison's stake in the country's third largest telecom service provider in 2007.
The Supreme Court in January ruled against the taxman, who was claiming as his Rs. 11,200 crore in tax, penalty and interest. The court conceded that Indian law was incapable of plugging a widely used tax dodge by inbound foreign investment.
The message for the government in the verdict was that the law needed to be changed to curb treaty shopping, the practice of routing investments through letter-box companies in havens like Mauritius to avoid paying taxes in India.
Presenting his last budget in March, the then finance minister Pranab Mukherjee, altered the Income Tax Act to tax such deals with retrospective effect. His argument was since the court felt the intent of the law was not clear, it had to be explicitly clarified for the entire past life of the Income Tax Act, which was enacted in 1962.
This last bit - that deals done earlier could be taxed - raised a chorus of protest from the investing community, and the finance ministry under P Chidambaram sought an independent review of its stand. Mr Shome, a tax expert of international standing, has now told the government what it knew all this while: taxes in retrospect are best avoided.
Specifically, they must never be used to merely raise tax revenue. In the Vodafone case, the Shome committee is unequivocal: the company to claim tax from is Hutchison, which made the profit from the sale of its stake in the telecom company.
Vodafone was not required by the extant law to withhold capital gains tax. Since Vodafone made no profit in the deal, the question of interest and penalties on back taxes does not arise.
Mr Chidambaram has indicated his desire to reverse the decision as soon as possible, even before the next budget when, normally, amendments to the Income Tax Act are undertaken. He reckons investors will return to the table once the fog over retrospective taxes is lifted.
If India manages to block the tax loophole for future cross-border deals, it will have accomplished its main purpose. The sideshow over its retrospective impact was spilling over unnecessarily into the broader economy.