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It's time to set our fiscal house in order

India must attract foreign investments, not scare away investors by taxing offshore mergers and acquisitions retrospectively. N Chandra Mohan writes.

india Updated: Jun 21, 2012 21:30 IST
N Chandra Mohan
N Chandra Mohan
N Chandra Mohan,Pension Fund Regulatory and Development Bill,UPA

To salvage the India growth story, the UPA government expressed its resolve to implement reforms to boost the confidence of investors in the economy. But shortly thereafter, it has had to hastily backtrack on the Pension Fund Regulatory and Development Bill. The prospects for introducing other reforms have receded. As if all of this weren’t bad enough, a global ratings agency Fitch has revised the country’s outlook rating to negative.

Earlier, Standard & Poor’s held out the grim prospect of India becoming the first “fallen angel” among the Brazil, Russia, India and China grouping.

Not surprisingly, this paralysis in economic policy has created a “sense of wariness in the investment climate”, according to a leading banker, Deepak Parekh, chairman of HDFC. At a time when investment inflows are urgently required to finance the yawning current account deficit — which is the broadest measure of the country’s imbalance in trade and services with the rest of the world — foreign investors remain worried over the government’s intention to retrospectively tax offshore mergers and acquisitions (M&As), among other things. Inflows have given way to outflows.

To be sure, the government has sought to allay some of these concerns by stating that in cases where assessment proceedings have become final before the first of April 2012 such cases will not be reopened. The introduction of a General Anti-Avoidance Rule — which is already there in China, Canada, Australia and soon in Britain — to counter aggressive tax avoidance has been deferred by a year. The government will reportedly tax only those offshore M&As in which Indian assets account for a ‘substantial’ value of the deal size. But what does ‘substantial’ mean?

Despite these measures, however, investor apprehensions still linger. The reasons are simple. As the government has not got its fiscal house in order, it is loath to forgo the huge revenues that can be tapped through taxing foreign M&A transactions on a retrospective basis. A ballpark estimate is that revenues of around R40,000 crore are at stake. But the truth is that by taxing global M&As it cannot set its fiscal house in order. It needs to cut wasteful subsidies and check other wasteful non-plan revenue expenditure than target those who have the potential to create jobs and invest in the country.

The urgent need is to attract foreign investments that will create employment and help finance the huge requirement of roads, ports, airports and other infrastructure — $500 billion over the next 10 years. When a non-resident sells his investment, all he is receiving is the net present value of future earnings in that entity. The entity will continue to generate taxable revenues after it changes hands. For the government to want a second bite of the cherry by taxing the gain made by the non-resident amounts to double-taxation, which can have negative economic consequences.

In fact, in the same legislation that sought to tax global M&A transactions, the tax rate was halved from 20% to 10%. This obviously implies that the government itself realised the potential negative effect of taxing such transactions. There are also deep-seated divisions within the government on the efficacy of such taxation. Prime Minister Manmohan Singh, in his speech at the G20 summit in Mexico, has clearly indicated that steps are being taken to “revive investor sentiment” and create an environment that would promote an atmosphere conducive to enterprise and creativity.

However, currently there are welcome signs of a go-slow of sorts on such tax demands, partly stemming from an apprehension that MNCs that have been targeted will seek international arbitration on their disputes with the government. At least six investors have served notices invoking some part of the various bilateral investment protection agreements signed by India. Although the government is not necessarily on a weak wicket in such disputes, the signals conveyed abroad will certainly be negative — that India is not an attractive destination for doing business.

This is the best way to formulate detailed guidelines that do not ‘tax’ genuine foreign investments. The signals conveyed abroad on the retrospective tax front are certainly negative. Policy-makers should not operate on the assumption that India is a large market and that MNCs have no choice but to invest in the country. Nothing could be further from the truth, especially at a time when its growth story is flagging. The misperception that its fiscal policy entails a knee jerk ‘tax grab’ must be dispelled.

N Chandra Mohan is an economics and business commentator

The views expressed by the author are personal

First Published: Jun 21, 2012 21:28 IST