India's tax plan hits foreign investors

Just two months ago, worried about their slowing economy, Indian officials were promising to promote policies to make the country more hospitable to foreign investment.

Instead, the government has done the opposite, proposed a budget festooned with new taxes that would make it more difficult and expensive for outsiders to invest here.

No wonder foreign investors are putting off deals and new investments in India while they wait for Parliament to consider those proposals, according to executives, lawyers and accountants.

Political handicappers expect legislators to approve the new taxes later this month because the government desperately needs to raise money to reduce its fiscal deficit.
“There is an ‘Oh, my God’ factor,” about the tax proposals, said Nandan S Nelivigi, a partner at the law firm White & Case in New York who advises companies that do business in India. He said he knew of at least two foreign acquisition deals involving Indian firms that had been delayed while executives wait to see what happens with the tax measures.

“New deals - there is no question that they are on hold until the tax implications are clear,” Nelivigi said.

Last week a group of business associations representing 250,000 companies in the United States, Canada, Britain, Japan and Hong Kong sent a letter to the Indian prime minister, Manmohan Singh. They warned that India would “lose significant ground as a destination for international investment” if it adopted the tax changes.

Any slowing of foreign investment would come at a difficult time for the Indian economy, which has cooled considerably from its blistering 9.9 per cent growth rate of only two years ago. Last year, it was down to 7.4 per cent and is expected to do no better than 7 per cent this year.

And recent data shows that India has become increasingly reliant on capital from the United States, Europe and Japan to help offset not only its budget deficit but also its ballooning trade deficit, which was estimated at $175 billion for the 12 months ending in March, largely a result of oil imports and a big trade imbalance with China.

Even before the government’s proposed budget was unveiled in mid-March, foreign investment in India had been slowing as the economy weakened and businesses fumed about the glacial pace of market-opening changes in the country.

India’s business reputation suffered a big blow late last year when policy makers quickly reversed a decision to relax restrictions on foreign investment in the retail industry after a political ally of Prime Minister Singh protested that the move would hurt small shopkeepers.

But that was a minor dust-up compared with the fury of the foreign business community last month as they discovered two dozen tax proposals tucked away in the country’s fiscal budget, initiatives that they say could leave them responsible for billions of dollars in taxes they had not anticipated. One change would empower the country to tax any offshore transactions involving assets in India dating to 1962. Another measure would levy a 10 percent tax on any software imported into India since 1976.

Securities investors have registered their concern in measurable ways. In the 10 trading days after introduction of the proposals, foreign investors had net sales of about $600 million in Indian stocks and bonds, according to government data. By comparison, they had net purchases of 57.7 billion rupees in the 10 days before the budget.

Perhaps the most far-reaching change is one that would give tax collectors the power to challenge long-standing legal maneuvers and tax treaties used by foreign investors to limit or avoid taxes. That change would enable India to tax investment funds that route their investments to India via the African island nation of Mauritius, which has a nearly three-decade-old tax treaty with India. In recent years, about 40 percent of all foreign direct investment into India has come through Mauritius.

Investors and analysts say the changes, considered together, would give too much leeway to tax collectors to determine who, and what kind of activity, can be taxed.
Moreover, critics say some of the retroactive proposals are written in a way that would override court judgments in favor of taxpayers. That includes an Indian Supreme Court ruling in January that Vodafone, the British telecommunications giant, did not owe $2.2 billion in capital gains taxes demanded by Indian tax officials.

Pranab Mukherjee, India’s finance minister, has said the nation “is not a tax haven.”
“People are concerned regarding the ramifications these provisions can have on their corporate actions,” said KPMG India partner Punit Shah. “Foreign investors are rethinking their strategy. Some people are holding back their plans for three months to see what makes it into law.”

One chief executive of a large American corporation who spoke on the condition of anonymity to avoid offending Indian officials said he and other executives he had spoken to were not doing anything to change existing investments in India. But they were “taking time to think about” new projects.

That executive and others said that while they remain convinced of India’s long-term growth prospects, right now they were focusing more on other fast-growing countries like China, Indonesia and Brazil. And some portfolio managers say they are paralyzed because they have no way of knowing what kinds of income and profits could be taxed in the future, or be hit for back taxes. Some advisers, including Shah, say certain types of foreign funds could reduce their tax burden by moving from Mauritius to Singapore, which has a slightly different tax treaty with India. But other experts are not sure that such moves would make much of a difference.

“We are still trying to decipher this,” said Baring Private Equity Partners India managing partner Rahul Bhasin, which has invested $1 billion of foreign capital in India through Mauritius-based funds over the last 10 years. “My biggest concern is good faith. I don’t think these laws will be used in good faith.”

Indian policy makers have defended their proposals, saying they were meant to clarify the intent of the country’s tax laws and ensure that investors did not use tax havens to avoid paying taxes on the capital gains they earned by investing in India. It has defended its use of retroactive laws by pointing out that countries like Britain have also changed some tax laws retroactively.

“If someone offered to invest $200 billion in India only if there is no tax, I will not allow it,” the finance minister, Pranab Mukherjee, said recently. “This is because India is not a tax haven, zero-tax or low-tax country.” Still, he has tried to allay some of the concerns of investors. Last week, after the Indian stock market fell sharply, Mukherjee announced that he did not intend to tax a derivative financial instrument known as participatory notes. The notes are used by traders who want to track the performance of Indian stocks without directly investing in them.

Stocks recovered after his statement, but lawyers and accountants remain skeptical about his assurances because the proposal seems aimed at financial derivatives.
“The manner in which they are going about it, that is sending a chill down the spine of many investors,” said Mukesh Bhutani, a prominent Indian tax lawyer.