Collateral Damage

Changes in tax treaties will reduce round-tripping and make FDI numbers less impressive than they are now.

Changes in tax treaties will make FDI numbers less impressive than they are now

India recently amended its tax treaty with Singapore – the third such amendment this year after introducing changes to the treaties with Mauritius and Cyprus – to plug a loophole that was being used to funnel unaccounted money into the country in the form of foreign direct investments ( FDI).

While the government has hailed the move as another milestone in the fight against black money, it could impact the quantum of FDI flowing into India in the short term. A major chunk of investments routed through these destina- tions were often not genuine FDI, but round-tripping of funds. Therefore, going ahead, FDI data may not look as impressive as it is now. However, future data would reflect genuine investments.

The amended treaties seek to tax any capital gains from sale of shares of any listed or unlisted company based in India from April 1. At present, such share sales were not taxed in India and, since capital gains tax was zero in the resident country such as Mauritius and Singapore, these transactions would not be taxed in both the source (India)

and the resident country (Mauritius or Singapore).

According to experts, a lot of money that was coming into India in the form of FDI was actually unaccounted money generated in India that was sent to other countries by dubious means, and was being routed back to India through no-tax regimes like Singapore, Mauritius and Cyprus. This, experts say, inflated the overall FDI figure.

No wonder, small countries, including Mauritius (33 per cent) Singapore (16 per cent) and Cyprus (3 per cent) account for 51 per cent of the FDI that came into India since April 2000. Even the white paper on black money released in 2012 by the finance ministry took note of this: “Mauritius and Singapore with their small economies cannot be the sources of such huge investments and it is apparent that the investments are routed through these jurisdictions for avoidance of taxes and/or for concealing the identities from the revenue authorities of the ultimate investors, many of whom could actually be Indian residents, who have invested in their own companies, through a process known as round tripping.”

“It is a fact that some of these countries were being used for round-tripping. If these routes were not available, round-trippings would not have happened and FDI inflows into the country would have looked slightly different from what they look today,” says Sunil Kumar Sinha, Principal Economist, India Ratings, adding: “Most of it would be genuine, but they were using this route because they wanted to take advantage of the treaty benefits.”

Changing Times

Though India is continuously liberalising its economy, and has opened up almost all sectors, including defence, for foreign investors, the perception about emerging markets among investors are changing. According to A.T. Kearney, “investors are turning their attention to developed economies in North America and Europe because of profound uncertainty in many emerging markets”.

And this trend is evident from its FDI Confidence Index. In 2016, only two emerging countries –China and India – featured among the top investment destinations, India sitting lowly at No. 9, though this was an improvement over the previous year when it was placed at No. 11. In 2012, India was the second best FDI destination.

Given the changing trend, and considering it would continue for a few more years, some tax incentive would have sweetened the deal for those who invest in India. India would also have to go beyond opening up sectors for foreign investors – ease of setting up and doing business, and how easy it would be to repatriate the profit to the parent country – if it wants to continue attracting FDI. However, despite the government’s claims of improving sentiments, India is ranked at 130 in the World Bank Ease of Doing Business ranking.

With return from investments is one of key consideration for foreign investors, and given that India was seen as the fastest growing economy till recently, FDI inflows in dollar term had increased 30 per cent in the AprilSeptember 2016 period.

However, the government’s decision to demonetise 86 per cent of the currency in circulation has not only raised concerns of a slowdown in economic activities in the lasting two-three quarters of the current fiscal, but has also derailed the roll-out of Goods and Services Tax ( GST) – a big reform initiative that could have further increased investors’ confidence in India. Besides, the government’s reluctance to settle some of the existing tax disputes with companies such as Vodafone and Cairn has further dampened their mood.

“The changes in tax treaties is not just an Indian phenomena. Globally, countries are tightening the noose around tax havens, and it is likely that by doing away with tax incentives, India may not lose much in terms of FDI flow as long as it continues to provide a predictable tax and regulatory regime for investors,” says Girish Vanvari, Partner and Head, Tax, KPMG in India.

While India’s move to plug loopholes in tax treaties is a bold step in curbing round-tripping of black money, it would certainly have some impact on the quantum of FDI coming into India. The extent of the fall in numbers, however, would be known only by the year-end. ~