Lack of clarity and transparency in taxation, as well as overzealousness of tax authorities, have been a cause for great concern to the foreign investors. Read on to know the taxing vows of India’s foreign direct investments.
The intent and objective of the Government of India in formulating the foreign direct investment policy (FDI) is to attract and promote foreign direct investment in order to supplement domestic capital, technology and skills, for accelerated economic growth. FDI enhances the production capacity, helps in transfer of latest technologies, strengthens infrastructure, generates employment opportunities, improves the living standard of people by introducing new products in the market, and expands the infrastructure of the country.
But according to experts, the FDI Policy currently needs more clarity, transparency and elaboration for the sake of potential investors. They say FDI Policy formulation needs more deliberations on continuous basis with stakeholders, including law and policy experts. Of late, companies in India seem to have been upset with unpredictable tax rulings, changes in interpretation of law by tax authorities and the resultant scope for litigation. Most foreign investors, as well as Indian companies, are at sea by the lack of clarity in law regarding application and contexts.
Taxation is an important component of the central government’s policy on macroeconomic management, especially economic growth and its distribution. A robust and efficient taxation system is the foundation of a successful economy and a pre-requisite for sustainable growth The following principles are said to underlie a good tax system:
But India has seen quite a significant numbers of tax disputes in the recent past. They have captured headlines globally. Is this because of flaw in the tax policies governing foreign direct investments in India? According to a Tax Administration Reform Commission (TARC) report, the current practice of blind pursuit of revenue targets has an adverse impact on tax officer equilibrium and leads to harassment of taxpayers. The TARC Report says, “In the direct tax area, ordinarily, transfer pricing examination between associated enterprises should be used as a tool to minimize tax avoidance. In India, transfer pricing measures are used for revenue generation, which comprises a completely wrong approach. This is revealed through the allocation of revenue targets to transfer pricing officers (TPOs) from transfer pricing adjustments. This is unheard of internationally. Accordingly, India has clocked by far the highest number of transfer pricing adjustments, demanding adjustments even for very small amount. There is also a high incidence of variation among TPOs in their adjustments for similar transactions or deemed transactions. Taxpayers reported that they often succumb to such adjustments simply to carry on with business activity for, otherwise, they would have to allot or divert huge and unavailable financial and staff resources to such activities. Several other avoidance measures are also interpreted by the administration to be used for revenue generation, which comprises wrong policy”.
The report also calls for the minimisation of tax disputes. The growing volume of tax disputes in India has earned the tax administration the label of “tax terrorism”.
Understandably, this has raised big concerns, particularly with foreign investors. They have become doubtful of the intent of the government because of the prolonged litigation and the time it is taking to resolve a dispute. So, clearly, India’s image as an investment destination has been tarnished by a reputation for unpredictable rules. From a business standpoint, income tax remains the most important tax for companies because of its impact on corporate bottom-line. Let us look at some of the major tax disputes of India in recent years.
There are about 3 lakh pending direct tax legal disputes with about $ 73 billion locked up in these cases. The number of transfer pricing cases have arisen from 1,0161 in 2004-05 to 2,638 in 2011-12. The Indian government said in 2013 that 27 companies, including units of HSBC, Standard Chartered and Vodafone, underpaid taxes in the fiscal year 2011-12 after they sold shares to their overseas arms.
The TARC report recognizes that the credibility of tax administration depends to a very great extent upon the credibility of its dispute resolution mechanism. So, it recommends the clarity in law and procedures, timely intervention to clarify contentious matters, avoidance of tax demands which are not on merits, predispute consultation, and proper control over quality of show cause notices, demands, or questionnaires issued to the taxpayers and an approach to resolve conflicts before conclusion of audits.
Vodafone has been involved in a string of tax disputes in India. On February 11, 2007, Vodafone International Holdings acquired CGP Investments (Holdings) Ltd., a Hong Kong corporation resident in the Cayman Islands, for about $11 billion, from Hutchison Telecommunications International, Ltd. CGP controlled 67% of Hutchison Essar Ltd., and Vodafone’s acquisition of CGP gave Vodafone control over the Hutch-Essar joint venture, which owned cellular telecom licenses in several parts of India. As the acquiring and acquired companies were both located outside of India, and as the deal occurred outside of India, Vodafone and Hutchison believed this to be a tax-free acquisition under Indian law. However, the Indian tax authorities assessed a tax bill of about $1.8 billion (Rs 11,000 crore). The Indian government based this assessment on the theory that CGP holds an underlying Indian asset, and that all of the profits from the sale of CGP were therefore generated in India from Indian assets. As the acquirer, Vodafone in this case, had the duty to withhold and pay about $1.8 billion in taxes to the Indian government before paying Hutchison.
The case was eventually appealed to the Supreme Court of India. The Court held that a sale or transfer of shares is not equivalent to the sale or transfer of the capital assets owned by the company whose shares are transferred. The Court emphasized that the legal structure of the transfer should be respected unless it can be established that there is a deliberate intention of evading taxes. The Court ruled in Vodafone’s favour and held that Vodafone did not owe any tax from the transaction.
But the government decided to change the law and said that it would apply the taxation retrospectively. Experts point out that retrospectively changing the rules of business and tax is not consistent with the rule of law because it reduces the predictability of business transactions. However, recently Finance Minister Arun Jaitley has announced that the government would not appeal the court ruling in favour of Vodafone. He has also said India will soon work for making the tax regime “civilised” to attract overseas investments. The government, in view of the acceptance of the judgment of the High Court, has directed that the ratio decidendi of the judgment must be adhered to by the field officers in all cases. The FM has also said that there will be no further retrospective cases without clear consultation by High Power Committee. ARC report has also said that retrospective amendment should be avoided as a principle.
Nokia’s tax litigation in India is an alleged missed royalty payments dating back from the year 2006. The Income Tax Department issues ` 2,080 crore tax demand (later rectified to ` 2,649 crore) on Nokia India, alleging that it has failed to withhold tax on the payment made to its parent as ‘royalty for the software’ used in its mobile phones since 2006.
Microsoft has become embroiled in the dispute through its pending $7.2 billion acquisition of Nokia. One of the major issues in international corporate tax law is figuring out how to transfer profits between subsidiaries and across affiliates. As part of Nokia’s international business plan, Nokia India, which manufactures phones in India, would pay royalty fees to Nokia Finland for the software that was downloaded into the handsets made in India.
According to Indian tax law, Indian residents require to withhold 10% of royalties paid to foreign companies as a tax. The Double Taxation Avoidance Agreement between India and Finland does not provide a different result. Nokia was informed that it could not transfer its Chennai factory to Microsoft until the tax issue was resolved.
An Indian High Court decision in December 2013 held that Nokia could transfer the Chennai factory to Microsoft if it paid its tax bill. But in February 2014 the High Court held that Nokia could not transfer the Chennai factory to Microsoft if the income tax authorities changed their demand for tax. And the income-tax authorities had approximately tripled their tax assessment which would prevent Nokia from transferring the factory to Microsoft. Nokia continues to explore all possible options to find a quick and amicable resolution to the ongoing tax disputes in India. However, the government is planning to tell Nokia that the matter cannot be resolved under a bilateral investment promotion and protection agreement (BIPPA) with Finland, which does not cover taxes.
In March 2009 Shell issued 870,000,000 shares of Shell India to Shell Gas BV for `10 per share. The income-tax authorities disagreed with Shell’s valuation of Shell India, and assessed a tax deficiency based on their own value of `180 per share. On Shell’s direct foreign investment into Shell India of about $160 million, the incometax authorities assessed a tax deficiency of over $1 billion. This tax dispute is representative of the increasing number of transfer pricing disputes being raised by the Indian income-tax authorities. However, Shell India moved the Bombay High Court in April last year. The court rejected the tax department’s argument that the Shell case was distinguishable from Vodafone’s case, which won a similar reprieve.
It is an $865-million (` 5,357 crore) alleged tax dispute based on IBM under-reporting its income from export manufacturing in a Software Technology Parks of India (STPI) zone. STPI zones which has been created to promote the development and export of software and software services including Information Technology (IT) enabled services enjoy 100% tax exemptions on income from software exports as defined in the Income Tax Act. These also enjoy a tax holiday under section 10AA of the I-T Act if the units are in a SEZ. To qualify for the exemption, a company must sign a software development agreement with a client to export software, and these agreements are the basis for the STPI authorities to certify export invoices and Software Export (Softex) forms. The income-tax authorities claim that IBM’s Softex forms were cleared with software development agreements, and therefore IBM did not qualify for the exemption.
GAAR is basically a set of rules designed to give Indian authorities the right to scrutinize and tax transactions which they believe are structured solely to avoid taxes. The rules would be applicable to all taxpayers. Throughout the world, companies often structure their businesses and investments in ways that saves them taxes. Many large U.S. companies, for instance park their profit outside country so that they don’t have to pay a higher U.S. corporate tax rate.
If GAAR starts in India, any transaction that carries a tax benefit could be questioned. The government may potentially want to know whether the transaction was done in the normal course of business or conducted simply with an intention to avoid taxes.
Some of the hardest hit by the new rules could be money managers who invest in India via tax havens like Mauritius. Since Mauritius has a double-tax avoidance treaty with India, investors who trade Indian securities through their Mauritius units don’t have to pay India’s high capital gains tax.
If GAAR comes into place, it would override the tax treaty and some investors that created shell companies in Mauritius will be exposed to paying more taxes. According to industry sources, everybody in the industry is looking to general anti avoidance regulations (GAAR), when will it come, how soon will it be imposed or will they be in the current form which is pretty much criticized or will it be diluted? On the pressure from the industry, however, the government has decided to increase the date of application of GAAR, which will now apply from April 2016.
However, things have started improving. According to a recent report by global credit rating agency Moody’s, FDI inflows have increased significantly in India in 2014-15. This, according to Moody’s, is due to India’s current pro-growth policies. Net FDI inflows totalled US$ 14.1 billion in the first five months of 2014-15, representing a 33.5% increase from the same period in 2013-14. Total FDI inflows into India in the period April 2000–November 2014 touched US$ 350,963 million. Total FDI inflows into India during the period April–November 2015 was US$ 18,884 million.
There has been a series new policy initiative in attracting FDI. The Department of Industrial Policy and Promotion (DIPP) has moved a Cabinet note to allow 100 per cent FDI in medical devices as part of a strategy to not only reduce imports but also promote local manufacturing for the global market, which will be worth over US$ 400 billion next year.
The government has cleared a proposal which allows 100 per cent FDI in railway infrastructure, excluding operations. Though the initiative does not allow foreign firms to operate trains, it allows them to do other things such as create the network and supply trains for bullet trains etc.
The government has notified easier FDI rules for construction sector, where 100 per cent overseas investment is permitted, which will allow overseas investors to exit a project even before its completion. It also said that 100 per cent FDI will be permitted under automatic route in completed projects for operation and management of townships, malls and business centres.
With the objective of encouraging foreign firms to transfer state-of-the-art technology in defence production, the government may increase the FDI cap for the sector to 74 per cent from 49 per cent at present. India is expected to spend US$ 40 billion on defence purchases over the next 4-5 years, mostly from abroad.
The Union Cabinet has cleared a bill to raise the foreign investment ceiling in private insurance companies from 26 per cent to 49 per cent, with the proviso that the management and control of the companies must be with Indians.
The Reserve Bank of India (RBI) has allowed a number of foreign investors to invest, on repatriation basis, in nonconvertible/ redeemable preference shares or debentures which are issued by Indian companies and are listed on established stock exchanges in the country.
According to a study, foreign investment inflows are expected to increase by more than two times and cross the US$ 60 billion mark in the year 2015 as foreign investors start gaining confidence in India’s new government. The global investors are positive about the Indian economy which is expected to witness over 100 per cent increase in foreign investment inflows – both FDI and FIIs – to more than US$ 60 billion in the current financial year.
India will require around US $1 trillion in the 12th Five-Year Plan (2012–17) to fund infrastructure growth covering sectors such as highways, ports and airways. The need of the hour is the flow of investments from outside India and this could be only when the policies are made favorable and unnecessary litigation is avoided. This requires clear policy guidelines from the government. This requires support in terms of FDI. With government announcing that it will not further pursue the case of Vodafone and will apply restraint in applying retrospective tax and the new policy announcements by the government, the stage seems set for more investor friendly regime. The government also must improve ease of doing business, where India ranks poorly at 142nd position. However, the experts and government officials are optimistic that the various initiatives taken by the government would yield results in 2015. The government has sent a strong signal to foreign investors by announcing that it would not appeal against the High Court’s order in transfer pricing tax demand. With Budget 2015 round the corner, there is a hope that more such investor friendly measures will be announced by the finance ministry. As more investments are coming, the clarity on regulatory and taxation is very much desirable.
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