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The worst of investment slowdown is not over

On one hand, the FM is reassuring investors and corporates, particularly MNCs, about stability of tax regime, reduced arbitrariness and resolution of the Vodafone dispute, and on the other new tax claim cases keep springing up. This is what makes India such a difficult place to do business in

Anirudha Dutta
Published: 16, Feb 2013

Anirudha Dutta is former head of research at CLSA India Limited, a leading foreign brokerage house. While every number tells a story, there are many stories beyond numbers and both are equally important. This blog will attempt to tell some of these stories.

The Finance Minister has been on an overdrive to shore up the confidence of investor's since September last year. To be fair, he has been able to impart some life into the UPA-II government with multiple announcements (statements of intent) and some action (deferment of GAAR, diesel price increase of Rs7/ litre till January, much awaited hike in rail passenger fares etc). His actions have ensured that the threat of a sovereign credit rating downgrade has now receded.

Over the last few weeks, the Finance Minister has been on road shows in Hong Kong, Singapore and London to assure investor's that "all's well" with India. Now on the fiscal deficit, it is clear to all and sundry that the targets cannot be met. As against the real GDP growth assumptions of 7.6% made in the FY13 budget estimates, growth is likely to be closer to 5%. This means there will be major shortfall in tax collections and there is nothing the Finance Minister can do about this. The increase in tax collections assumed in the budget are as follows: corporation tax (13.9%), customs duty (22%), excise duty (29%) and service tax (30.5%).

The  buoyancy in service tax and excise duty was led by a 20% increase in rates (10% to 12%), improvement in growth and additional services being brought under the service tax net. Not only is the growth impetus missing, but a 34% shortfall in assumed GDP growth (5% vs 7.6%) means that there will be a massive shortfall in all tax collections. Plus there is the shortfall in revenues from spectrum auction (budgeted Rs.400 bn and disinvestments (Rs.300 bn). Therefore, while Chidambaram has "drawn red lines" and reported fiscal deficit will meet targets, it is unlikely that the numbers will stack up.

Like all FMs, Chidambaram has asked the tax departments to be vigilant against evasion and to do everything to meet the expected shortfall. Therefore, all sorts of tax notices are being received by individuals and corporates, according to media reports. Two such notices caught my attention in recent weeks - the tax demand notices sent to Shell and Vodafone (yes, Vodafone again) under transfer pricing rules. Both the companies have been alleged to have issued shares to their overseas principals at a valuation which the IT department deems below fair value and therefore, has alleged that that two MNCs have under-disclosed their income and thereby, avoided paying due taxes.

While I am no tax expert, it seems strange that issuance of fresh shares comes under transfer pricing rules and the tax department thinks that income and/ or profits are under-stated. First, issue price of shares is decided by the shareholders of a company and secondly, the company issuing shares (in this case the Indian arms of Shell and Vodafone) does not make profits by issuance of new shares. In fact the money received by the companies is a liability for the companies. How is such a transaction taxable, whether the shares have been undervalued or overvalued? And the fair valuation of any company's shares is a function of market conditions, business outlook, past performance etc. Transfer pricing norms are applicable for transfer of goods, services and technology and issuance of fresh shares do not fall under any of these categories.

For a minute let's assume that the shares issued have been grossly undervalued, as is quite likely since the parent company will not want to pay a huge sum of money for increasing its stake. A tax in India will become due if and when the parent company sells these shares to say another entity outside India and makes capital gains. And under the new IT laws, as long as substantial parts of the underlying assets is in India gains from such an overseas transaction is taxable in India. This is the original Vodafone-Hutch case.

Now if such a transaction were to be undertaken by a Mauritius based entity, then under GAAR (which will now be introduced in the new DTC with a prospective effect), the capital gains will be taxable if such an arrangement of being based out of Mauritius is purely for avoidance of axes. Alternatively Vodafone India may be listed in Indian stock exchanges, and the parent company may sell the shares through stock exchanges and pay securities transaction tax and then the only tax they will be liable to pay is short term capital gains (if shares have been held for less than 12-months) or 0% on long term capital gains, if shares have been held for over 12-months.

Now I do not know all the details of the case and my reading is based on media reports. But it is exactly such arbitrary tax demands which worry corporates, both Indian and MNCs. These cases will probably take years as the companies will challenge the IT departments demand. On one hand, the FM is reassuring investors and corporates, particularly MNCs, about stability of tax regime, reduced arbitrariness and resolution of the Vodafone dispute, and on the other new such cases keep springing up. This is what makes India such a difficult place to do business in. In 2012, India was ranked 132 out of 185 nations. And these rankings do not include corruption, which is another story altogether.

All this when in an interview to Financial Times, Chidambaram was taking about resolution of the earlier dispute. To quote from the report in FT: "Vodafone has formally written to the government offering to engage senior government officials to find a way out of the problem," he said in an interview with the FT. "I'm confident we will resolve issue," he told the newspaper.

What is Vodafone or other investors to make out of this strange demands and behaviour? But India is nothing if not consistent. Last year during a visit to the Volkswagen factory in Pune, we heard this strange story - Volkswagen invested in its factory and in the MoU signed, the company was given sales tax exemption on vehicles manufactured in this factory till such time its investment was recovered. But when the after the company had made its investments, the rules were changed such that the exemption was available only on vehicles sold in Maharashtra. If we assume that only 15% or so of total cars sold in India are sold in Maharashtra, then the investment recovery period goes up by 6x - yes, if it was 5 years originally, then it becomes 30! What it does to the IRR of the project one can guess.

If after this, we as a country find it challenging to get FDI, is it at all surprising? My bet is that we have not seen the worst of the investment slowdown - the pipeline of projects will take time to revive even assuming all goes well and meanwhile on the ground implementation will continue to decelerate since the pipeline of projects has not got built up. If this was not enough, we have a looming consumer slowdown. More on that another day.

  • RM

    Underpricing of issuances especially to foreign entities, has always been monitored, both under FEMA and under the IT Act. I think "shares" come under the definition of "goods" and hence, any under-pricing will invite presumptive tax. There is a requirement for an independent business valuation to avoid under-pricing.The current action may be over-enthusiastic, but not wrong in principle (I think!).

    on Feb 16, 2013
  • Damien Hill

    How short sighted - after british colonisation that gave India a civilised railway system and even cricket now you want to con foriegn investors out for a few rupees even though your own high court said otherwise - dont you realise this will deter foriegn investors !!

    on Feb 16, 2013
    • Anirudha Dutta

      Damien, We are nothing if not impartial. So tax notices have been received by Indian companies like Hindalco that have large operations outside India and companies like M&M face the same tax issue that Voklkswagen is facing. I wouldn't see this in terms of Indian vs foreign.

      on Feb 17, 2013
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