Why tax terrorism is counterproductive

The tax department’s move to send demand notices worth INR 6,500-7,000 crore (around $1 billion) to foreign portfolio investors (FPIs), asking for payment of minimum alternate tax (MAT) on capital gains related to transactions on Indian stock markets has once again raised the ugly spectre of ‘tax terrorism’ that the Indian IT department has been infamously known for.

MAT is a 20% levy meant to apply to companies which would otherwise pay zero corporate tax due to various exemptions and deductions. Until last month, the levy had never been applied to foreign investors—it was applied only to entities that were generating business income in India. Though Jaitley said in Budget speech in February that the tax would not apply to FIIs, the tax officials insisted that what Jaitley claimed applies only prospectively while their demand is retrospective.

This has further tarnished the image of the country as an investor unfriendly one which has already been dented by innumerable previous instances of ‘tax terrorism’, notable those involving Vodafone and Vedanta.

Vodafone was slapped with Rs 3,200-crore tax demand for issuing new shares to its parent company at ‘an unduly cheap price’. According to the tax department, this violated ‘transfer pricing norms’ which require parent-subsidiary dealings to happen at a fair price. Tax authorities argued that by undervaluing the shares issued to the parent, Vodafone had saved a sizable amount on taxes which resulted in the tax demand.
Recently, oil exploration firm Cairn India, owned by the UK-based Vedanta group, was slapped with a tax notice worth $3.6 billion for a transaction that occurred in 2006-07. Indian officials claimed Cairn did not pay capital gains tax for some transactions that involved the transfer of shares from its UK parent to its Indian subsidiary.

While the long drama involving Vodafone hurt inflow of foreign direct investment (FDI) the punitive action against FIIs is expected to dilute the inflow of funds from these institutions.

While the IT department calculated that by slapping tax demand on Vodafone, it could amass more than Rs10, 000 crore, the move effectively resulted in the government losing many times that amount in FDI. Numbers clearly support this—following the Vodafone fiasco, investments from FIIs in the country fell to Rs 51,000 crore from Rs 1,68,000 crore.

The term ‘tax terrorism’ was first used by Narendra Modi to criticise the negative approach adopted by tax authorities under the UPA regime. “The tax terrorism prevailing in the country is dangerous. One can’t run the government by thinking that everyone is a thief,” he said, in his address to FICCI members in January.

Modi’s remark was not without reason. Domestic tax laws allow the authorities to issue ‘demand notices’ even to people who have duly paid their taxes. They can send notice if the scrutiny officer disputes calculations of a tax payer or believes that he/she has under-reported income. Also, if the government is running short of cash, it can delay refunds and reopen old returns for scrutiny. While the tax department can take its time with refunds, if a tax payer delays paying annual taxes, the penalties can be really huge.

Hugely high tax rates—corporate tax rates between 30% and 40% in India are much higher than what is levied in most countries—is a crucial lacuna that needs to be fixed if the government is serious about transforming the rotten tax system.

Another key problem arises from the very nature of Indian tax system which is tilted towards enforcement rather than compliance. Instead of flexing muscles to apply outdated, insensible tax laws aggressively, the government and the tax department need to focus on simplifying the system, in line with better models elsewhere including that followed by Singapore which boasts of tax compliance of more than 90% simply by the virtue of lesser taxes and simpler systems.

In fact, Jaitley proposed lowering the corporate tax rate from 30-25% over four years while lifting exemptions, in his budget speech. If what he said is implemented in letter and spirit that will be the first step towards revamping the labyrinthine Indian tax regime which if left as it is will seriously dent the government’s efforts to attract foreign investments for building the nation.