Retrospective tax: A bad idea gets buried
Iremember choking on my morning coffee on reading a news report which said that India’s finance minister (FM) had made a statement in Parliament that Indians won’t have to eat lizards if foreign direct investment (FDI) flows are affected.
It was 2012, and Pranab Mukherjee was responding to a question about whether he expected the amendment in tax laws, popularly known as the retrospective tax amendment, to affect foreign investment. A pragmatic man on most occasions, his display of irritation at the thought that India’s tax policy changes would be unpalatable to foreign investors was palpable.
Tax policy has always been regarded as the sovereign right of each nation State; so why would the global investment community have a problem? Well, because just as in the case of any other investment, capital moves to economies which give investors a sense of security. And one of the foremost factors to induce such security is the transparency and stability of tax policies. Even if tax rates are high, investors will still move capital to nations as long as they know what to expect since the tax rates can be factored into their business plans. The converse, however, is repulsive — unpredictable and non-transparent rates muddied with ifs and buts, even if low, drive away capital.
The administration of the day, however, had a single-minded focus on raising revenue, coupled with the belief that it had the sovereign right to do so. This was a shortsighted approach, unmindful of the impact of the move on the overall investment rating of the country, as demonstrated by the FM’S indignant attitude to the question.
The saga of the retrospective tax started when the holding company of Essar Telecom was acquired by Vodafone. Extant tax laws required Vodafone to withhold tax on the transaction and deposit the amount with the revenue authorities, except for one crucial fact — the obligation to withhold tax did not arise on transactions between two non-resident entities. The holding entity being acquired was not domiciled in India i.e. it was a non-resident entity for tax purposes, and Vodafone did not withhold tax on the deal value.
The revenue authorities believed that since the holding entity was a shell company, its value was in the underlying Indian entity and, therefore, tax ought to have been deducted and deposited. Consequently, Vodafone was slapped with a huge tax demand, including the amount of tax which the authorities believed that Vodafone ought to have withheld.
The dispute reached the Supreme Court (SC), which looked closely at the issue and ruled that there was nothing whatsoever on the statute books which required Vodafone to withhold tax on the offshore transaction. The Union government, therefore, chose to amend the law to provide that even transactions with no connection with India would give rise to the obligation to withhold tax if, as a result of such an offshore transaction, an undertaking or asset in India was acquired.
Consequently, SC’S decision, which was the strictly correct legal interpretation, was effectively reversed. Moreover, the reversal became applicable with retrospective effect. This ensured that Vodafone, which had already completed the deal, did not get away with what some mandarins in the corridors of power believed was “being cute”.
The amendment also impacted other transactions which were structured relying on the same provisions of law upheld by the apex court, no less. Since the liability of the payer can extend to bearing the tax not withheld, interest and penalty, the amounts in question were significant. Tax officers, who often have to meet collection targets no matter what, started to raise huge tax demands.
The government’s move was seen by the global investment community as a violation of the unwritten rule of transparency and stability in fiscal policy. Vodafone had genuine reasons to believe that Indian law did not seek to tax such transactions — a view upheld by SC. But it discovered much later that the government would reverse its own tax law and policy to rub your nose in the ground, and make you cough up the money it believed it is owed. Taxpayers may be held liable for tax arising on historic transactions, even though they had no inkling of the liability.
Unfortunately, the mandarins in the corridors of power had forgotten that India had inked several investment treaties under which the actions of investee States considered to be expropriation, are subject to claims for compensation. Vodafone, and others similarly affected, sought recourse to arbitration proceedings under the treaty provisions. And so it was that international treaty arbitrations held that a retrospective amendment in the law is expropriatory in nature.
When one is starved of capital and technology, you do not ride the high horse and take the position that they need us more than we need them. This is a delusional view which had percolated down into the administration, based on a belief in the success story of the Indian middle class. The chickens were bound to come home to roost. Once having strenuously, but unsuccessfully, argued that tax policy being a sovereign issue is not the subject matter of investment treaties, the government has now finally decided to cut its losses and cancel the demands.