India’s firm stance on tax could actually help investors

Just make sure you get a receipt. Tom Miller/PA

India’s firm stance on tax could actually help investors

Just make sure you get a receipt. Tom Miller/PA

India keeps getting into arguments with foreign firms over tax; is it wise to do so?

The Financial Times, for one, is in no doubt that India is scaring off foreign investors, and that it is making a mistake. A recent editorial had the unambiguous title: India’s tax laws are deterring investors.

The immediate trigger was yet another twist in a long and complex tax dispute between the Indian authorities and Vodafone, the British-owned mobile phone operator. The dispute is over a demand that Vodafone pay US$2.6 billion in capital gains tax following its acquisition of an Indian phone operator from a Hong Kong conglomerate in 2007.

But the deal was more complicated than a foreign firm simply buying an Indian business. It actually involved the sale of a company registered in the Cayman Islands to one of Vodafone’s Dutch subsidiaries. As this was a transaction between two foreign firms, the Indian Supreme Court ruled in January 2012 against their own tax authorities and in favour of Vodafone, holding that the Indian authorities did not have jurisdiction to tax the deal.

The Indian government then passed legislation that permitted tax cases to be reopened and demands to be made retrospectively. The tax authorities and Vodafone then reopened negotiations, which have continued ever since. The latest twist is the news that the Indian Ministry of Finance is likely to pull out of the talks.

Among critics of India’s position, the main charge is that the country’s tax regime is arbitrary. There is a great deal of truth to this. Individual Indian tax officers have considerable freedom to interpret tax law on a case by case basis, and court decisions are hard to predict. Retrospective legislation can also be a cause for uncertainty.

So it is no surprise that large transnational companies are giving warnings about their willingness to invest in the country. There are hundreds of tax cases before the Indian courts that involve large sums of money and some big names – IBM, Nokia and Shell, as well as Vodafone.

Following India’s general elections in May, the new government will face a barrage of demands from businesses to force the tax authorities to back off. There will be dozens of stories suggesting India’s tax officials are stuck with an old-fashioned mind set, hostile to the private sector and to foreign investment, which dates back to the post-Independence decades of “planning raj”. Don’t believe it. The issues at stake are very contemporary.

It has been well reported that transnational companies can use a wide variety of legal and accounting structures, which are in themselves perfectly legal, to funnel the profits that they earn from their global operations into a small number of low tax jurisdictions. When those jurisdictions offer both low taxes and secrecy about who owns what, we label them “tax havens”.

The Vodafone dispute concerns capital gains taxes on asset sales, but most of the hundreds of current disputes between the Indian tax authorities and foreign companies hinge around allegations of “transfer mispricing”.

In essence, the Indian tax authorities allege the subsidiaries and affiliates of transnational corporations fix the prices at which they “book” transactions with one another to show low profits in India. These transactions could include transfers of goods in a production chain, services like management advice or back-office functions, loans, or intellectual property rights like the use of consumer brand names.

Recent court rulings and increases in revenue collections suggest there is little doubt that the tax authorities are right, at least some of the time – and enough of the time for the issue to really matter to Indian taxpayers and citizens. But it is only in the past few years that India’s tax authorities have begun to properly assert themselves.

In 2009-10, the Indian tax authorities audited – that is, seriously investigated – transfer pricing information of just 670 firms. By 2012-13, there were about 3,200 such cases, leading to significant increases in revenue collections. Hundreds of tax cases have become backed up in India’s crowded courts; the tax authorities have won some cases, and the companies have won others. There is no evidence that the courts have been biased in one direction.

The other reason for the rash of disputes is that large-scale foreign investment is still relatively new to India. The legal and taxation systems are still catching up.

If India were a small country, there would be no big tax disputes and this would be a non-story. Its authorities would not have the skills, the resources or the legal back-up to seriously challenge the tax returns of big transnational companies.

India may still be poor, but it is big, relatively powerful, has a fast growing economy, and provides a very attractive consumer market. While its tax authorities may not be beyond criticism, they are competent enough to know when big businesses might be offering their country a raw deal, and what they can do to try to level the playing field.

The current situation is far from ideal, and India’s economy would benefit if the application of tax law could be made more consistent and predictable. Potential investors deserve a better idea of where they stand.

As all sides stand to benefit from further clarity and stability, the current conflicts might actually move things in the right direction. Within a few years, India could have a system that benefits everyone. But scare stories about how the tax authorities, courts and government are spoiling the investment climate are neither accurate nor helpful.