Tax Reform: The Key to Foreign Investment

While India remains better placed than ever to receive foreign investment, India’s tax policy continues to be one of the biggest challenges to doing business in the country. The Modi government inherited an income tax regime that was widely seen as adversarial and aggressive. It continues to make reforms to address the concerns of foreign investors. However, more reforms will be required before some of the structural problems plaguing India’s tax structure can be resolved. The scale of the challenge can be understood by the fact that despite improving its overall ranking on the World Bank’s Ease of Doing Business Index 2016, India’s taxation regime ranks 157th in the world, one place behind last year’s ranking.   

Regulatory uncertainty lies at the root of this problem, and is best exemplified by the recent spate of transfer pricing disputes between foreign investors such as Vodafone, Shell, Nokia, Cairn, IBM and the Indian government. In the run-up to the general elections last year, Prime Minister Modi promised to end the “tax terrorism” of the previous government and usher in a “non-adversarial” tax system. Three major tax-related issues that are witnessing some movement under the present government are retrospective taxation, the Minimum Alternative Tax (MAT) and the Goods and Services Tax (GST).

Apart from these measures, the government has taken several other steps to assuage the concerns of foreign investors. The Ministry of Finance set up a ten-member committee last month to simplify and rationalise the income tax law. Earlier this year in the annual budget, the Finance Minister acceded to the request of investors and deferred General Anti-Avoidance Rule (GAAR) from April 1, 2015 to April 1, 2017. The budget also announced a progressive lowering of the corporate tax rate from 30 percent to 25 percent over the next four years.

Retrospective Taxation

The most notable example of India’s adversarial tax regime was in 2012 when the previous government decided to go against the Supreme Court’s judgment and retrospectively tax Vodafone’s purchase of Hong Kong-based Hutchison’s telecom business, which included operations in India.

While the Modi government has not withdrawn the 2012 notification that allows Indian tax authorities to claim capital gains tax on previously concluded transactions, it has acknowledged the adverse impact of such provisions and greatly reduced their scope. To provide comfort to foreign investors, the government has clarified that the capital gains tax will be applied to all transactions involving indirect transfer of a foreign company’s assets if 50 percent or more of the company’s assets are based in India. Further, only the portiont of the income that pertains to India will be taxed.

In a separate case, on the application of transfer pricing norms to transfer shares of Vodafone’s India entity to its parent company in Britain, the government retrospectively amended the Finance Act in 2012 to include business restructuring transactions like these within the ambit of transfer pricing norms. The Bombay High Court ruled in favor of Vodafone and in a significant decision, the government did not decide to appeal this judgment in the Supreme Court, thereby giving a positive signal to foreign investors.

Stakeholders have long believed that any dispute between the Indian government or an Indian company and a foreign investor would be decided to the foreign investor’s disadvantage. The efforts to resolve both the Vodafone tax disputes have been an important first step towards changing this view.

Minimum Alternate Tax (MAT)

MAT was originally intended to apply to companies paying no or low taxes by claiming deductions and exemptions available to them. It was a settled position of law that MAT is not applicable to foreign companies not having a place of business or permanent establishment in India. However, the Authority for Advance Rulings (AAR) in 2012 held that MAT is applicable to foreign companies even in the absence of permanent establishment in India. This ruling triggered notices from revenue authorities to several foreign companies including foreign portfolio investors who began to lose confidence and started exiting the Indian market.

The government subsequently clarified, first in the annual budget and then by accepting the recommendations of the A P Shah Committee, that MAT provisions will not be applicable to foreign investors that do not have a permanent establishment in India. These decisions have provided more comfort to the foreign investors and substantially reduced the scope for AAR to change a settled position of law.

Goods and Services Tax (GST)

The GST aims to replace India’s complicated central government and state-level indirect tax structure with a single national tax. Experts believe GST is the biggest economic reform since the opening of India’s market in 1991, and once passed, it will increase India’s GDP by one to two percent. This GST Bill was introduced in the parliament and was passed by the Lok Sabha (Lower House) in the Budget Session earlier this year. However, the government does not have a majority in the Upper House and could not pass it in the Budget Session or the Monsoon Session of the parliament due to opposition. The Prime Minister has made a public commitment to roll out the GST in 2016 and it remains a top priority for the government, which will try to get it passed by the Upper House in the Winter Session of the parliament starting in December. Industry experts and political commentators believe that the GST will overcome political opposition and ultimately be passed.

Over the last 18 months, the government has taken several positive steps on India’s taxation regime, but it is too early to comment on whether this will improve investor sentiment. Given the government’s stated goal of becoming one of the top 50 countries on the World Bank’s Ease of Doing Business Index, we are likely to see a more focused effort on undertaking fundamental reforms to India’s taxation regime to make it fairer, more understandable and easier to navigate for foreign investors.