Proposed Indian Tax Rule Could Impact Free Trade Talks with the EU and Canada

The latest Indian annual budget for 2012-2013, revealed by India’s Finance Minister Pranab Mukherjee last Friday, takes India a step backward toward its previous economic protectionist policies and could derail its discussions for free trade agreements with Canada and the European Union, its biggest trading partner.

The government proposed to levy a heavy retrospective tax on some international mergers that would allow it to tax any overseas merger dating back to 1962 when an underlying Indian asset was transferred, according to taxation experts such as KPMG. India’s Finance Secretary R.S. Gujral has since hurried to clarify that India will claim capital gains tax on cross-border acquisitions completed only in the past six years. An official statement of clarity is still awaited on ambiguously worded budget provisions.

“If passed, this tax legislation will be a shot in the foot of India’s economy,” said Bundeep Singh Rangar, Chairman of London-based advisory firm IndusView UK Ltd. “It sends a message of ever changing goalposts to foreign investors and fund managers and could make India’s risk profile unpalatable to them.”

The announcement in India’s budget comes at a time when India and Canada are in talks to finalize the Comprehensive Economic Partnership Agreement (CEPA) or Free Trade Agreement by 2013. Bilateral trade is expected to nearly quadruple to $15 billion by 2015 from $4 billion in 2010. Since 2007, India and the European Union (EU) have also been negotiating a free trade agreement, officially known as the Bilateral Trade and Investment Agreement (BTIA), that covers trade in goods and services aside from rules pertaining to cross-border investments, competition policy, government procurement and state aid.

For India, free trade with the EU will help its rapidly growing companies expand into the EU, the country's biggest trade partner that purchased more than €40 billion (€53 billion) worth of Indian goods and services in 2010. While trade with India represented only 2.4 percent of the EU's total, that percentage has been steadily increasing. With many EU countries still stuck in recession, the EU wants access to India’s vast, young and vibrant market. The total value of EU-India goods and services exchanged was €86 billion ($113 billion) in 2010 and is expected to reach $200 billion by 2015.

“Free trade agreements are premised on economic openness,” said Mr. Rangar. “The new tax sends a dangerous signal to the contrary and brings back memories of India’s socialist past that made it one of the world’s slowest growing economies,” said Mr. Rangar. “It would not be a surprise if foreign multinationals pressed their governments to bring up this proposed tax in World Trade Organization (WTO) discussions. Or they will simply walk away from India. In either instance, India stands to damage its international standing.”

India is hoping to accelerate its GDP growth to 7.60 percent in the year to March 2013 from 6.90 percent in the year to March 2012. That was far less than the 8.50 percent achieved in year to March 2011.

The disturbing thing is that the tax is retrospective irrespective of whether it is applied for the past 50 years or six years. The Indian budget stated it would seek to change India’s laws to enable the Indian taxman to tax capital gains made by foreign companies after it lost a $2.2 billion court battle with Britain’s Vodafone Plc in January. Today, India’s Supreme Court dismissed the Indian tax department’s appeal to review that decision.

“Foreign investors will seriously and understandably question the stability of the regulatory environment in India,” said Mr. Rangar. “India is entitled to tax local companies for capital gains and corporate income tax. Taxing overseas entities for Indian assets purchased over the past 50 years, however, is a step too far, very impractical to implement and could lead to reciprocal tax treatment for Indian companies that purchased overseas assets. That would be a double blow to India Inc.”

Vodafone’s purchase of Hutchison Essar, since renamed Vodafone India, was intended to expand revenue in the face of saturated mobile telecoms markets in Western Europe. India presents itself as one of the world’s fastest growing economies, a position achieved via the opening of its economy and flood of Foreign Direct Investment (FDI). India’s latest budget, however, threatens to squeeze that tap of overseas funding. FDI in India is expected to cross $35 billion in financial year to March 2012 compared with $19.43 billion in the previous financial year.

The Indian government’s motivation seems to be to increase its tax collection and reduce its budget deficit to 5.1 percent of gross domestic product next fiscal year, from 5.9 percent this year by capping subsidy spending and raising taxes. India had targeted a budget deficit of 4.6 percent for the current fiscal year ending in March 2012 and will miss that by a wider margin than many economists had expected.

“Increasing tax revenue is a laudable goal for India,” said Mr. Rangar. “That should, however, come from encouraging the number of new financial transactions not squeezing those that do take place. Besides, India has a dismal income tax base of 2.77%. The government should focus on increasing that tax base rather than punishing corporate buyers of Indian assets.”

The Minister of State for Finance S.S. Palanimanickam said in a written reply to a question posed in India’s Parliament last August that the number of taxpayers was 33.57 million out of a 1.21 billion population.

Another clause in the Union Budget 2012, which proposes to tax angel investments, has been termed by more than a dozen industry watchers as “a death blow” which has the “potential to kill entrepreneurial-startup ecosystem” in India. The decision has already created negative feedback among entrepreneurs and might lead to depressed valuations for these companies. Under this proposal, the government will treat all individual investments in a company as “income from other sources” and they will be subject to a tax of 30% at the hands of the companies.

For capital markets, the government announced a number of measures, including tax incentives for small investors in equity savings schemes, reducing taxes on securities transactions, allowing qualified foreign investors in the domestic bond market and easier norms for listing of corporate bond offerings in exchanges.

The budget also sought to restrict subsidies and move to a direct cash transfer system, both seen as positive moves. The government proposes to limit subsidies to 2% of GDP over the next three years and 1.7% thereafter. It also encourages adoption of the Unique Identification (UID) system to provide for direct cash transfers to recipients.

The budget was also positive for investments in infrastructure. More infrastructure sectors were added as eligible for gap funding from the government. The amount of tax free bonds which state-owned infrastructure companies can issue was doubled from $6 billion to $12 billion (from Rs.300 billion to Rs.600 billion); spending on key infra sectors was increased significantly; foreign financing through the External Commercial Borrowing (ECB) guidelines was opened for capital spending on highways, working capital for airlines, low cost affordable housing, among others.