By R Jagannathan
If you can't beat them, join them.
The Parthasarathi Shome panel, set up by the Prime Minister to suggest changes to tax laws and soothe the ruffled feathers of skittish investors, has come up with a solution to beat tax havens at their own game by becoming a semi-tax haven yourself. At least for a while.
This is the true import of its suggestion that the General Anti-Avoidance Rules (GAAR), which spooked investors after the last budget, should be put off till after the next election (three years, to be exact), and that capital gains on securities transactions should be abolished. Since putting anything off till after the next regime change means another review, the Shome recommendation is essentially about putting off all bad tax news for later.
Most foreign institutional investors (FIIs) bring in their funds through Mauritius since the African island nation has no tax on capital gains. Under the Indo-Mauritius Double Taxation Avoidance Treaty, companies taxed in one country can't be taxed in another, and if Mauritius levies zero tax on capital gains, India's capital gains tax don't matter. Little wonder, Mauritius is where the bulk of foreign investment to India comes from.
It was to get around this Mauritius loophole that Pranab Mukherjee, before he went off to Rashtrapati Bhavan, introduced GAAR and the idea of the tax residency certificate to make the FIIs pay tax here. The tax residency certificate was intended to force companies with only post-box operations in Mauritius to relocate to India or pay taxes here.
But now Shome says that's not needed. Since we need all the foreign investment we can get right now, it's best to make our own capital gains taxes zero.
He told Business Standard in an interview: "Many countries have exempted capital gains to attract investment and, at this juncture, we certainly need investment in India. If you want to harmonise your tax framework with international practices, you have to look at it from that point of view. Whether it is foreign or domestic, you can't differentiate in this manner from the tax equity point of view."
In the bargain, Shome has suggested that even Indian residents should be free of capital gains tax - with the revenue loss being compensated by an increase in securities transaction tax (STT).
On GAAR - where Mukherjee's original purpose was to tax transactions and arrangements where the main purpose was tax avoidance, Shome says the implementation should be deferred for three years (till 2016-17), and it should apply only if the suspected tax evasion in question is more than Rs 3 crore in quantum. This, of course, is fine, since it makes no sense to go after the small fish - where the only gain can be for corruption, with taxmen harassing assesses.
The import of these proposals is clear: to beat Mauritius, become a near Mauritius yourself.
While the changes will be hugely market-positive, the problem is this: if capital is going to get privileged treatment, investors will be more interested in portfolio investment than long-term FDI of the job-creating kind.
This means the abolition of capital gains tax must be complemented with two other reforms to deliver optimal results: we need more liberal FDI laws (whether it is in insurance, or retail or telecom), and more flexible labour laws.
Easy access to equity means businessmen will be even more willing to substitute labour with capital.
This is both an opportunity and a threat: big business is already using more capital than labour in its incremental capacity-building. Unless labour laws, too, are made more flexible, the skew in favour of capital will work against employment generation.
Shome's recommendations will work if UPA takes all the related measures to build balance into the India Growth Story. Trying to woo only portfolio investors is a short-term palliative that can't deliver long-term growth.