The INR has fallen at an alarming rate over the past few months. In terms of depreciation this year, it’s been the worst performer among Asian currencies at the same time the Indonesian Rupiah, the Philippine Peso, the Malaysian Ringgit and the Thai Baht have plummeted to record-lows.
Though there are several reasons for this depreciation, what makes India’s case special is the government’s retroactive tax policies: they are scaring foreign investors away.
Foreign direct investment (FDI) has been a major factor in the growth of the Indian economy. A well-regulated FDI regime ensures a steady inflow of foreign exchange into India. The rupee’s value is directly linked to the amount of U.S. dollars in the market. Since FDI is one of the main routes for inbound dollars, a decline in offshore investments has further devalued the rupee.
It all started in 2007 with Vodafone.
Vodafone’s acquisition of Hutchison Essar Limited (HEL), an Indian telecommunications company, was one of the biggest cross-border deals in the country. India was a favorite FDI destination at the time.
However, through a series of complex corporate maneuvers in which a sale of shares was conducted between off-shore entities, Vodafone was able to avoid taxation on the $11 billion deal. The Indian tax coffers were left undisturbed in the transaction.
In September 2007, the income tax department of India sent a notice to Vodafone enquiring after taxes on capital gains in connection with the deal. Vodafone maintained that the transaction had no link with India since no HEL shares had actually been transferred. A conflict arose when the taxability of a transfer of shares in an Indian company between two non-residents was challenged. The income tax department alleged that the transaction involved the purchase of assets in an Indian company and was therefore liable to be taxed in India. Vodafone argued that the deal was not taxable as the funds were paid outside of India for the purchase of shares in an offshore company, a subsidiary of the Hutchison Group.
Vodafone petitioned the Bombay High Court but was dismissed: the court ruled that since the purpose was acquisition of a controlling interest in an Indian entity, the transaction was subject to municipal tax laws. Thereafter, Vodafone approached the Supreme Court of India and the decision swung back in favor of Vodafone. The Indian Supreme Court ruled that the transaction was a bona fide structured FDI into India beyond India’s territorial tax jurisdiction, and was therefore not taxable.
By January 2012, what started off as a multi-billion dollar tax dispute snowballed into a major investment standoff. After the Supreme Court upheld the legality of Vodafone’s transaction, the Indian Government implemented a policy of retroactive taxation which allowed authorities to reopen cases dating back to 1962, thus “creating major uncertainties in the business environment”. This led to a vicious witch hunt of cross-border transactions from the past. Other foreign companies including pharmaceuticals major Sanofi-Aventis and the British beer company SABMiller have also been pursued by tax authorities.
Experts agree that retroactive taxation will have a negative impact on the Indian economy. Though there may be a short term benefit from tax revenue, there may be longer term consequences. Last year, in the World Bank’s “Ease of Doing Business list”, India was ranked a lowly 132 out of 183.
In March 2013, the Finance Ministry made another retrospective tax call – this time on Nokia, later freezing its assets in the country. In June 2013, the Finnish company wrote a letter to the government claiming a breach of the bilateral treaty between India and Finland, indicating that this conflict has now extended beyond the corporate sector.
In an attempt at reconciliation, Vodafone and the government of India agreed to hold informal talks to resolve the tax issue amicably a few months ago. While a proposal for ‘pre-conciliation’ was being seriously discussed by both parties, they began bickering again over the rules under which a settlement could be reached. Vodafone has indicated its preference for the United Nations Commission on International Trade Law (UNCITRAL) while India proposed a settlement under the domestic Arbitration and Conciliation Act. As of now Vodafone is refusing to proceed with further talks unless the retroactive tax laws are amended first.
However, not all is lost. Despite all these issues, Vodafone is still considering further investments in India. While the whole world waits, it is in India’s best interest to amend the retroactive tax laws and further relax regulations on investment. Though this will be a risky move before the upcoming 2014 Parliamentary elections, it could be the first step towards attracting foreign capital to stop the depreciation of the INR. It’s time to give Gandhi a reason to smile again.