No. 53, May 2013

No. 53
(May 2013):

The FIIs: Difficult to Please

The Finance Minister says he has no choice but to heed the direction of the foreign institutional investors (FIIs), since the economy is desperately dependent on foreign capital inflows. Given the alarming condition of the current account deficit (which soared from 1.3 per cent of GDP in 2007-08 to an unprecedented 4.2 per cent in 2011-12, and seems certain to be well over 5 per cent in 2012-13 – the third quarter figure touched 6.7 per cent), this appears at first a candid admission of the reality.

In truth, however, the rulers’ prostration before foreign capital is not contingent on the precariousness of the present balance of payments. It was amply in evidence in 2001-04, when there was a current account surplus.[1] It was equally in evidence in 2007-08, when foreign capital inflows (8.6 per cent of GDP that year) were vastly in excess of the current account deficit (1.3 per cent of GDP), and the inflows thus had to be added to the foreign exchange reserves, burdening and distorting the economy in multiple ways. The subordination before foreign capital is not a response to a particular situation, but has deep historical roots in the very process of the formation of the present ruling classes of India.

So the dramatic deterioration of the current account is not the actual impetus for the steps being taken; rather it is an alibi for carrying out all sorts of measures which face resistance, such as the opening of the retail sector to FDI. To those who oppose such measures, Chidambaram says in his Budget speech: “My greater worry is the current account deficit (CAD). The CAD continues to be high…. This year, and perhaps next year too, we have to find over USD 75 billion to finance the CAD. There are only three ways before us: FDI, FII or External Commercial Borrowing (ECB).”

The first, and main, way in which the Budget aims to please foreign capital is by suppressing Government expenditure. Moreover, since the fiscal deficit target of 4.8 per cent for 2013-14 is inflexible, and the revenues projected in the Budget are unlikely to be realised, further expenditure cuts during the course of the year are almost a foregone conclusion. Chidambaram has already shown us in 2012-13 that he can slash spending blindly to meet a fiscal deficit target.

Secondly, foreign capital should be pleased that the Budget gives its final stamp of approval of the Shome Committee’s recommendations. In the last Budget, the then Finance Minister Pranab Mukherjee had announced the application of the General Anti-Avoidance Rules (GAAR), which empower tax officials to deny tax benefits on transactions or arrangements which do not have any commercial substance or consideration other than achieving tax benefit (e.g., the Mauritius route). They sparked off a furious response from the FIIs. When Chidambaram replaced Mukherjee, he set up the Shome Committee with the task of finding a way to dump the GAAR; the Committee promptly handed him the recommendations expected of it, and he announced the acceptance of most of them on January 14. The Budget speech thus incorporates this decision, more or less burying the GAAR. The finance ministry is also trying to work out an amicable deal with Vodafone, which attempted to avoid taxes precisely through such an arrangement (without commercial substance, but purely to achieve a tax benefit).

Further, the Budget speech gives considerable prominence to facilitating FII investment in India, their participation in currency trading, the removal of caps on their investment in specific sectors, and so on.

However, on Budget day, the FIIs ignored all these provisions , and noted with fury just one clause in the Finance Bill. That clause concerns foreign investment coming through countries with which India has a tax treaty. India has a treaty with Mauritius whereby companies resident in Mauritius will pay capital gains tax only in that country and not in India. Hence foreign investors set up companies on paper in Mauritius (which has no capital gains tax), and route their investments through these shell companies. Indeed, Mauritius is far and away the single biggest source of both FDI and FII into India (the second biggest source is Singapore, with which there is a similar treaty). The offending provision in the latest Finance Bill appeared to suggest that a certificate showing that a company was resident in Mauritius would not suffice to get the benefit of the treaty; the company would also have to reveal the ultimate beneficiary. This suggested that if the ultimate beneficiary were not a Mauritian entity, the capital gains could be taxed by the Indian tax authorities; such a measure in fact seems an obvious necessity if Indian tax laws are not to be rendered a joke.

The FIIs flexed their muscles on Budget day itself, by selling shares; the market crashed. The Finance Minister made a statement the very next day to the effect that “the income tax authorities in India will not go beyond the Tax Residency Certificate and question [the foreign investor’s] residency status.” In other words, he reassured foreign investors that they could could continue to make a mockery of Indian tax laws.[2]

Despite his best efforts, it appears the Finance Minister has not satisfied foreign investors with this Budget. They have signalled their continued vigilance on the actual delivery of the promises he has made to them, and have kept up their pressure for more measures and concessions.



[1] Take two striking decisions from this period which benefited foreign financial investors at the cost of the Indian exchequer and public. First, when the Delhi High Court ruled in May 2002 that it was the duty of the tax administration to find out if a foreign investor was taking advantage of the Double Tax Avoidance Treaty with Mauritius to avoid tax (by routing investments through shell companies in Mauritius), the Government went in appeal to the Supreme Court in October 2002 against this ruling. The Supreme Court overturned the Delhi High Court order, and the use of the Mauritius route for massive tax-avoidance continues to date. Secondly, in the Budget for 2003-04, the sale of any share held for more than a year was exempted from capital gains tax. (back)

[2] The entire episode was a replay of a similar event in 2000, which culminated in the Government issuing a circular (Circular 789) which clarified that the Government would not look beyond the tax residency certificate. (back)

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