P R Srinivasan
Drug smugglers and third-world dictators laundering ill-gotten wealth through secretive banking systems in tax havens is an anachronistic image from crime novels. Leveraging US' remarkable success in compelling tax havens to block terrorist financing, the G20/OECD have successfully persuaded tax havens to improve tax transparency and participate in an international regime of information exchange.
All tax havens have committed to OECD standards for tax transparency and are executing Tax Information Exchange Agreements (TIEAs) wherever needed. Stringent know-your-customer (KYC) regulations and TIEAs are making it difficult, albeit slowly, for round-tripping black money through tax havens. However, tax havens continue to suffer an 'image problem' due to a Swiss tradition that has gone with the wind, i.e., not accepting tax evasion as grounds to lift the veil of banking secrecy.
Today, capital is globally mobile seeking to optimise risk-adjusted returns from international investments! Investors are willing to take higher risk by investing in emerging markets and seeking to reduce 'capital gains taxes' (CGT) to optimise risk-adjusted returns. Three large investor categories, controlling significant part of global capital, use tax havens to optimise risk-adjusted returns from emerging markets:
The largest demand comes from tax-exempt investors (TEIs) such as pensions funds and university endowments domiciled in OECD countries. Initially, TEIs chose international investments only in other OECD countries, where the OECD model of 'residency-based taxation' exempts non-residents from taxation. In recent years, TEIs have sought tax havens to access emerging markets that follow the UN model of 'source-based taxation', which requires non-residents to pay taxes at source.
For example, being a tax-exempt US resident, a pension fund will not be subject to source-country taxes on its OECD investments or home-country taxes in the US. But source-country taxes would make risk-adjusted returns low for the same fund, unless it channelises its emerging market investments through funds domiciled in tax havens (FTH).
Demand also comes from residents in countries that don't tax capital gains and/or that don't tax global income. For example, financial investors from Hong Kong (no CGT) and US (15% CGT) would find India (22% CGT onunlisted investments), a competitive destination only through FTH.
Another source of demand arises from residents in jurisdictions that limit overseas tax credits to what is paid directly and not through an intermediate vehicle. For example, Indian investors will seek to invest in an international fund only if it has a tax pass-through status and/or through FTH.
Our country has periodically gone through convulsions about 'black money' and 'phoren investors' coming through tax havens. Unfortunately, public debate on this subject has been driven solely by the tax havens' image problem instead of the need to be competitive to access capital from one or more of the investor categories listed above. Also, no distinction has been made between strategic investors, who may invest directly, and financial investors, who will only come through FTH.
Public debate must focus on the OECD model versus the UN model of taxation. The FM, in a speech at Ficci on March 24, indicated that following our induction as the 34th member of the OECD Financial Action Task Force, India intends to adopt the OECD model. Implementing this model will be a dramatic step in making India a competitive investment destination. The OECD model will also transform Mumbai into a financial powerhouse and will enable the growth of a globally-competitive Indian fund management industry.
But Budget 2012 is taking India in the opposite direction with amendments that stretch the limits of 'source-based taxation'. It also proposes to rush through the implementation of Gaar, without adequate safeguards, which could significantly impact India's attractiveness as an investment destination.
With the rupee near its all-time low, foreign reserves at a15-year low and investors struggling to make positive returns, this is not the time to be messing with capital flows. Gaar, as proposed in the Budget, is a poor choice for improving tax collections from foreign 'financial' investors, as all it may succeed in doing would be driving them out. Decline in trading volumes since April 1 are a stark reminder that foreign financial investors may stay away.
Implementation of Gaar must await the new DTC as originally planned and should be with the safeguards recommended by the Parliamentary Standing Committee. Meanwhile, we need a public debate on keeping India's status as a competitive investment destination: either by preserving the tax-haven route (albeit with restrictions) or by adopting the OECD model.
(The author is a private equity professional)
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