There is a sense of cautious optimism that the change of guard in the finance ministry augurs well for reviving investor sentiment in the Indian economy. This is the key to reversing the downtrend in GDP growth, which might hit a low of 5.5% this financial year. The new finance minister, P Chidambaram, has sent out all the right signals that the UPA would seek to regain the confidence of all stakeholders in the economy; remove the perceived difficulties in doing business in India and modify or fine-tune policies, if necessary, for this purpose.
Relieved investors have stepped up inflows into the economy. Foreign institutional investments (FII) have started perking up since July. But foreign direct investments (FDI) still remain depressed. The latest numbers for April-June 2012 show that direct investments declined to $4.3 billion when compared with $6.8 billion during April-June 2011. Foreign investments by Indians abroad fared no better. Together with FII and FDI, other inflows like external commercial borrowings and non-resident Indian deposits reduced to a trickle in June 2012 when compared with June 2011.
Foreign inflows are required to fund the country's ballooning imbalance in trade and services with the rest of the world that hit a high of 4.5% of GDP during the last quarter of 2011-12. The exchange rate of the rupee has sunk like a stone in this milieu. At a time when domestic investment activity has also ground to a halt, foreign funds are a supplemental resource that can be used to fund the massive requirement of investments in infrastructure - pegged at a whopping $500 billion - like roads and highways, ports, airports, telecom and power generation.
Foreign investments have been affected by concerns over the country's difficult business environment, ranging from delayed clearances to the tax regime. The government itself is the "single biggest factor weighing on business confidence and economic outlook", argued Moody's Analytics in its latest report on India. A favourite bugbear has been the government's intentions to retrospectively tax offshore mergers and acquisitions and introduce a General Anti-Avoidance Rule (Gaar) to counter aggressive tax avoidance.
To dispel these fears, Prime Minister Manmohan Singh and Chidambaram have provided the strongest possible assurances that the Parthasarathi Shome panel is reviewing these matters. The unpopular Gaar has been deferred by a year. To encourage more FDI, parity has also been introduced in long-term capital gains taxation of 10% between FIIs and private equity investors, who constitute an increasingly significant component of FDI flows to India since 2000. Acquisition of shares amounted to a third of overall flows in the form of equity of $35.8 billion in 2011-12!
Private equity investors have also been exempt from long-term capital gains taxation on sales of unlisted securities in initial public offerings, subject to a securities transaction tax of 0.2%. This is as far as it goes. But it is still felt that if genuine non-resident investors can exit their private equity investments on a tax-free basis, it will provide a powerful incentive to invest via the FDI route. When a non-resident invests in private equity, he creates (or helps in the creation of) an Indian company that will, one, pay taxes on its profits, and, two, employ people who will pay tax on their salaries. This revenue base is unaffected when the investor exits his investment. Taxing the non-resident once again on his gain, thus, amounts to a second bite at the cherry.
To be sure, foreign and domestic investors are also concerned about red tape, bureaucracy, corruption and an expensive litigious environment. But a tax-friendly regime helps. The case for capital gains tax exemption also highlights the fact that amending section 9 of the Income Tax Act to tax the sale of non-Indian entities is not consistent with other tax provisions. If the shares of a Mauritius entity were sold, the gain would be taxed in India under this section, but if the Mauritius entity sold its Indian investment, there would be no tax in India. Therefore, should not the capital gains incentive in the Mauritian tax treaty be extended to all capital gains?
The upshot is that attracting more investments is the need of moment. To revive the animal spirits of investors, greater clarity in tax laws, a stable tax regime, a non-adversarial administration and a fair mechanism for resolving disputes, as indicated by the new finance minister, are certainly par for the course.
N Chandra Mohan is an economics and business commentator
The views expressed by the author are personal