Modi's in danger of losing some of his pro-business shine.

Source: Hindustan Times/Getty Images

How to End India's Tax Terrorism

Dhiraj Nayyar is a journalist in New Delhi. Trained as an economist, he has worked at the Financial Express, India Today and Firstpost.com. He is editor of "Surviving the Storm: India and the Global Financial Crisis."
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Under Prime Minister Narendra Modi, India’s government has gone to great lengths to distinguish itself from the supposedly anti-business policies of its predecessor. Finance Minister Arun Jaitley assured foreign companies and investors that India would no longer engage in “tax terrorism” -- suddenly levying huge retrospective tax bills on corporations such as Vodafone, which was charged with more than $2 billion in back taxes in 2012.

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Now the government is in danger of undoing any goodwill it might have earned. Rather than moving to repeal the 2012 law that allowed for the retrospective charges on Vodafone, Jaitley merely said that the government would no longer apply it. Yet just last month, Cairn India, an oil exploration company owned by the U.K.-based Vedanta group, was slapped with a tax notice worth $3.6 billion for a transaction that occurred in 2006-07 (well before Vedanta bought the company). Indian officials claim Cairn did not pay capital gains tax for a set of transactions that involved the transfer of shares from its U.K. parent to its Indian subsidiary.

A second case is even more egregious. Tax authorities have issued notices to collect $6.4 billion in taxes from a group of 100 foreign institutional investors (FIIs) for the year 2012-13. The investors are being penalized under something called the Minimum Alternative Tax, a 20-percent levy that’s meant to apply to companies who would otherwise pay zero corporate tax because of various exemptions and deductions.

Until last month, the levy had never been applied to foreign investors, only to entities that had business income in India. (FIIs pay a Securities Transaction Tax and a 15-percent capital gains tax on securities held for less than a year.) Indeed, in his February budget speech, Jaitley specifically said that the tax would not apply to FIIs. India’s tax officials insist that Jaitley’s change applies only prospectively; their demand is retrospective. Worse, notices may be issued to several other FIIs on the same grounds.

Jaitley has tried to argue that foreigners cannot expect India to be a tax haven: Legitimate taxes must be paid. But advising unhappy companies to take their cases to court, as Jaitley has done, is no solution. The molasses-slow judicial system only prolongs uncertainty.

The basic problem is the morass of Indian tax laws, a legacy of the socialist era. The system is adversarial and tilted towards enforcement rather than compliance. Ridiculously high rates of direct taxes -- topping 90 percent in the 1970s -- were gradually reduced through the 1980s and 1990s. But even then corporate tax rates between 30 and 40 percent stood well above those in competitor nations. To incentivize the private sector, policy makers have tried to bypass the system with a maze of deductions and exemptions. While these may have boosted some sectors, they’ve also created ambiguity and opportunities for rent-seeking.

They’ve also also led to a lopsided scenario where large, profitable firms pay lower taxes than smaller, less profitable ones. The government's 2015 budget documents revealed that the effective tax rate for firms whose profits are above $100 million is 20.68 percent, while the same rate for firms with a profit of $170,000 is 26.89 percent (both are lower than the actual corporate tax rate of 30 percent). The fact that the country needs a Minimum Alternate Tax at all is a symbol of all that’s wrong with the system: The levy wouldn’t exist if loopholes didn’t allow some corporations to avoid tax altogether.

Modi’s government is caught in its own trap. It wants to stick to the letter of the law even as it acknowledges that those laws are counterproductive. It’s possible the prospect of extra revenue is too tempting to resist for a government looking to ramp up spending; Jaitley has said that he could use the $6.4 billion from foreign investors to solve India’s irrigation problems. Or possibly, the government may be concerned about being labeled pro-business and is going out of its way to prove that it’s not.

Whatever the reason, the outcome threatens to torpedo investor confidence. What's needed is a dramatic overhaul of the tax code. Instead of applying bad laws indiscriminately, Jaitley and his taxmen should invest their energies in simplifying the system. Some years ago, when the previous government proposed a nationwide goods-and-services tax to replace India’s complicated indirect tax system, it also floated the idea of ending exemptions and moving to a lower direct tax rate. Vested interests derailed the proposed legislation. In his budget speech, Jaitley, too, proposed lowering the corporate tax rate from 30 percent to 25 percent over four years while lifting exemptions. That’s where he should concentrate his efforts, not in holding up companies and investors for what looks disturbingly like ransom.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Dhiraj Nayyar at dhiraj.nayyar@gmail.com

To contact the editor on this story:
Nisid Hajari at nhajari@bloomberg.net