India: Ending “tax terrorism” not the only fix to regulatory challenges

30 Oct 2015

India: Ending “tax terrorism” not the only fix...
  •   Mumbai High Court’s ruling in favour of Vodafone in a USD 490 mn retrospective tax case earlier this month has been touted by the Indian government as a symbolic step towards the end of so-called “tax terrorism”, which has weakened investor confidence in India for several years. 
  •   Although important, several other taxation disputes between the government and multinational companies remain unresolved. Furthermore, political barriers to planned government reforms combined with remaining structural deterrents to foreign investment ensure India will remain a challenging operating environment, and the Modi administration may struggle to achieve its ambitious investment objectives.

Since 2012, India has been criticised for engaging in “tax terrorism” to extract revenues retrospectively from large international corporations such as Shell, Cairn Energy, Nokia Corp, HSBC Holdings and IBM, damaging investor perceptions. The disputes centre on the application of a Minimum Alternative Tax (MAT) law on foreign companies, which allows the retrospective levying of taxes for capital gains that may have occurred overseas but involved Indian assets. Typically, MAT had previously only been applied to domestic companies but was applied to multinationals under the former administration amid accusations that they were using transfer-pricing to record low or nil profits, thus avoiding income taxes. The Vodafone victory – a case concerning the 2008 sale of its call centre business in India to Hutchison – followed a ruling in favour of Shell in a USD 1.4 bn tax dispute with the government in November 2014. Several multibillion-dollar tax bills for Vodafone and Cairn Energy remain in arbitration.

Conscious of the damage to investor perceptions, Prime Minister Narendra Modi has prioritised resolution of the tax disputes as part of his broader objective of increasing foreign direct investment in India and achieving 8-8.5% annual growth. Since coming to office in 2014, Modi has abolished the Planning Commission responsible for developing nationwide five-year plans, has sought to decentralise the economy and has earmarked the “Make in India” campaign to boost growth in the manufacturing sector, amid several other market reforms. The government has also cut subsidy inefficiencies to ease India’s fiscal burden, and has sought to increase infrastructure spending and speed up stalled projects which have long impeded economic productivity and growth. For more on the challenges of infrastructure development in India, read PGI’s May 2014 Insight here .

Despite making a number of positive changes to the business environment, Modi’s push for greater FDI has been undermined by a political deadlock in parliament, which is slowing efforts to liberalise the economy and implement wide-ranging reforms. The opposition Congress Party’s majority in the upper house has blocked several key reforms, forcing Modi to push through policies by ordinance, an executive order that temporarily circumvents political opposition but ultimately lapses if unable to attract political support. Although Modi’s Bharatiya Janata Party (BJP) has had some success in state elections since the 2014 national election, staunch partisan politics are likely to continue to slow the pace of reform in some of the most critical areas for India’s economic growth.
Stalled reforms 
Tax reforms: Modi has so far failed to push through an overhaul of India’s tax system, leaving unaddressed the country’s complex patchwork of local and state taxes, long cited as a major business inhibitor. The Goods and Services Tax (GST), which was passed through the lower house of parliament in May but was blocked in the upper house in August, aims to create a single-rate nationwide system similar to Britain’s value-added tax. According to Finance Minister Arun Jaitley, this reform could generate a 2 percent increase to India’s GDP by reducing the amount of transit time and state border payments for cross-country movement of goods, and it has been touted by World Bank officials as the single most important tax reform for India in 2016. In order to take effect, GST requires a constitutional amendment necessitating not only upper house approval, but also ratification by at least half of India’s state legislatures. The finance minister said in September that the GST could be introduced in mid-2016 if parliament passes the legislation during the upcoming November-December session, although this appears unlikely in the current political environment.
Land laws: Modi’s failure to reform India’s restrictive land acquisition laws has undermined several key policy objectives, including efforts to speed up almost USD 300 bn worth of stalled infrastructure projects. Current land laws have been criticised by businesses for making land acquisition extremely challenging by allowing landowners to block projects, including those with central government approval. The law requires businesses to receive 70 percent approval from all landowners affected by a project before being able to acquire the land. Businesses are also obligated to pay for resettlement and alternative employment to people displaced by a land acquisition, significantly increasing the costs of investments. The slowness of India’s legal system further complicates efforts to expediently resolve land disputes.
To kick-start investment before attempting to pass the land reforms through parliament, Modi signed an executive order in December 2014 exempting projects in rural electrification, affordable housing, the defence sector and industrial corridors from needing to win the consent of affected landowners. The BJP has since failed to get amendments to the Land Acquisition Act passed through parliament and Finance Minister Jaitley has suggested individual BJP-controlled states pass their own land reforms. Modi also chose to not renew the executive order when it expired on 1 September to help BJP win farmer votes in the November Bihar assembly elections. The failure to pass the amendments combined with ongoing complexities in acquiring construction permits – which alongside taxation was one of the most commonly cited impediments to business in the 2016 World Bank Doing Business report – poses a major blow to Modi’s “100 smart cities” initiative and future infrastructure plans.
Labour laws: Modi’s attempts to streamline a complex set of 44 different labour laws and improve labour flexibility were blocked by Parliament in August 2015 amid strong public opposition. Current job security laws are extremely rigid and have led some companies to suggest they discourage employers from hiring. Although the government has initiated efforts to upskill the workforce and pledged to establish a social safety net for those out of work, resistance to reforms has been strong, as illustrated by the 150 mn workers who protested nationwide on 2 September. Failure to reform India’s complex and stringent employment laws also could impede investment needed to ensure the “Make in India” campaign succeeds. 
Modi’s ability to overcome political obstacles is vital for securing BJP-backed reforms to India’s regulatory environment. However, parliament is unlikely to pass reforms in the November-December session and with only 20 percent of the upper house seats, success for the BJP in the 29 November Bihar state elections will be important, but not enough to improve the party’s ability to pass legislation. Moreover, while BJP leader Shrikant Sharma’s suggestion to pass the reforms in individual BJP-controlled states may provide a short-term fix, it would exacerbate the country’s already-complex regulatory framework and could serve to strengthen longer-term geographical and partisan divisions that the Modi administration is seeking to overcome.
It is important to note that the reforms are not only hindered by politics and that the three core areas outlined above – tax, land and labour reforms – are not the sole remedy to improving India as an investment destination. Other issues, notably a slow, bureaucratic legal system, inadequate infrastructure, including power supplies, and inefficiencies within government departments continue to present barriers to Indian growth that require reform. Modi’s ability to manage public as well as political opposition to some of the key policy plans will also shape the speed and success of reforms.
Vodafone’s latest victory is a symbolic indication that “tax terrorism” by Indian courts is on the decline. The outcome of Cairn Energy and Vodafone’s other pending cases will provide further indicators of the government’s commitment to assuring investors of a more predictable operating environment. However, the end of retrospective taxation will not in isolation fix an investment climate burdened by problematic land, labour and tax laws. Success in reforming these key issues will determine India’s ability to speed up foreign investment and achieve its economic growth targets.  

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