The inside story of the retrospective tax blunder

In August 2012, when I took charge as secretary, department of economic affairs, the Indian economy was under great stress. Apart from all the other causes — such as the galloping crude oil prices, huge fiscal deficit, 2G/coal and other alleged “scams”— the imposition of the retrospective tax on deals involving the transfer of Indian assets through an off-shore transaction by a foreign entity, which had assets in India, had a deleterious impact.

It was introduced through an amendment to the finance act of 2012. This amendment resulted in three major legal cases against the Government of India by Vodafone International Holdings BV, Cairn Energy Plc and Cairn UK Holdings Limited and Vedanta Resources. This not only resulted in a setback to India’s image as a country that had well-established and predictable legal framework, but also vitiated the investment climate.

Policymakers often ignore the fact that, in the assessment of investors, a stable and predictable legal policy framework is one of the key determinants of competitive advantage a country enjoys vis-à-vis others. While all countries have resorted to retrospective legislation to correct certain anomalies that may creep in during the implementation of a law, these amendments are largely to remove ambiguities and improve the business environment.

In India’s case, there were two weaknesses. One, the law was amended retrospectively, from 1962, which meant that every such transaction that may have occurred over the previous 40-plus years could technically be reopened and fresh taxes imposed. This created huge uncertainty for businesses. Two, the amendment was introduced to nullify the order of the Supreme Court of India, the highest judicial body in the country, thereby signalling that the investors could not presume finality in the legal process. In one stroke, India’s reputation as a well-run economy with a strong rule of law was damaged.

In some of my earliest meetings with the then finance minister, P Chidambaram, I had brought up the issue of retrospective taxation and how it would make our task of attracting private investors, especially foreign investors, difficult. This was crippling at a time when the need for fiscal correction had drastically reduced the capacity of the government to spend and substantive private investment was needed, even in public infrastructure, to revive the economy and to create jobs.

Chidambaram was visibly unhappy with the amendment and minced no words in saying that this act of the finance ministry was fatal for the economy. I suspect the move of RS Gujral, who was then the revenue secretary and spearheaded this amendment, to the department of expenditure, was a show of displeasure. But, when Raghuram Rajan, who, by then, had joined as the chief economic adviser, and I strongly recommended the scrapping the amendment, Chidambaram demurred. By then, there were too many so-called “scams” up in the air and rolling back the amendment would seem a deal had been made with Vodafone.

In May 2014, when Arun Jaitley became the finance minister, we started discussing the design of the full budget for 2014-15 that was to be presented in July that year. I brought up the matter of retrospective taxation with him. Before the elections, the Bharatiya Janata Party and its allies had termed retrospective taxation as “tax terrorism”. I recommended that scrapping of the amendment could be included in the Finance Bill. This would reflect the views of his party and would also send out a strong message that the new government was in favour of attracting private investment and creating a stable and predictable tax regime. Jaitley concurred without reservations, but suggested this matter be discussed in a meeting with the prime minister (PM).

In that meeting, there was a lengthy discussion in which I put forward the reasons for amending the “amendment”. Jaitley strongly supported the arguments. PM Narendra Modi also said he felt that the retrospective tax law had damaged the country’s image. But several senior bureaucrats from the PM’s Office opposed the finance ministry’s proposal vehemently. They put forward the argument that any change would appear that a deal had been made with Vodafone.

Jaitley then suggested that perhaps we could include this issue in the budget of 2015-16. I reminded him that no such allegation could stick on a government in power for only 45 days but if we missed this opportunity, there may not be another in the foreseeable future. I, of course, lost the argument and retrospective taxation remained.

Arvind Panagariya, in a scathing critique, wrote that the budget had been hijacked by the “babus” in the finance ministry and the political masters were not allowed to change the status quo. We, in the finance ministry, couldn’t defend ourselves as the responsibility for all government decisions is collective.

It has taken the government nine years to withdraw the retrospective taxation amendments, and, that too, perhaps because of the possibility of adverse rulings in international arbitration cases. This is a much delayed, but welcome move. This should also be a reminder to the government that the recent piecemeal and knee-jerk legal and regulatory responses to developments in emerging business areas such as e-commerce and big-tech will end up becoming as counterproductive as the retrospective taxation move, and, therefore, there should be a pause and a rethink.

As we have seen, any legal change, without careful and rigorous thinking about its implications, can cause huge damage, and it can take years to rectify.

Arvind Mayaram is a former finance secretary, Government of India

The views expressed are personal