The 2015 final report of the Organisation for Economic Co-operation and Development (OECD)-led project on Base Erosion and Profit Shifting (BEPS) lays out 15 action points to curb abusive tax avoidance by MNEs. The BEPS project takes note of the erosion of a nation’s tax base due to the accounting tricks of Multinational Enterprises (MNEs) and the legal but abusive shifting out of profits to low-tax jurisdictions respectively.
- The BEPS project is no doubt a positive development for tax justice. As a participant of this project, India is expected to implement at least some of the measures proposed under this project. However, if the current political atmosphere continues, 2016 could be a bumper year for the ever-lucrative tax avoidance industry in the country.
- The postponement of the enforcement of General Anti-Avoidance Rules (GAAR) to 2017 and the issue of participatory notes, or P-notes all indicate the unwillingness of political leadership to proceed further in this direction. On the other side, MNEs are busy unearthing loopholes in the tax regime to avoid payment of taxes.
Why we need to curb tax evasion?
India’s recent economic history tells us that economic growth without public investment in social infrastructure such as health care and education can do very little to better the life conditions of the majority. Public investment improves only when tax collections improve. Thus, it is necessary to curb tax evasion to boost public finance. Notably, this is also part of the United Nations’ Sustainable Development Goals (SDGs).
Various reports, last year, indicated that the bulk of P-note investments in the Indian stock market were from tax havens such as Cayman Islands. Taking note of this, in 2015, the Special Investigation Team (SIT) on black money had recommended mandatory disclosure to the regulator, as per Know Your Customer (KYC) norms, of the identity of the final owner of P-notes.
- It was a sensible suggestion. But, looking at the prevailing market conditions, the National Democratic Alliance (NDA) government, which had come to power promising to fight black money, promptly issued a statement assuring investors that it was in no hurry to implement the SIT recommendations.
- Such patchy records water down the realistic chances of India actually clamping down on tax dodging.
India’s DTAA with Mauritius:
Mauritius accounted for 34% of India’s FDI equity inflows from 2000 to 2015. It’s been India’s single-largest source of FDI for nearly 15 years.
These facts raise the following questions?
- Is it possible that there are so many rich businessmen in this tiny island nation with a population of just 1.2 million, all with a touching faith in India as an investment destination?
- How can an island economy with a GDP less than one-hundredth of India’s GDP supply more than one-third of India’s FDI?
What do these figures indicate?
These figures indicate that Mauritius is a tax haven and is seen as a rising star for foreign investments. It is a popular hub for what is known as “round-tripping”. A wealthy Indian, say, will send his money to Mauritius, where it is dressed up in a secrecy structure, then disguised as foreign investment, before being returned to India. In this way, the sender of the money can avoid Indian tax on local earnings.
- Also as per the DTAA, capital gains are taxable only in Mauritius, not in India. But here’s the thing: Mauritius does not tax capital gains. India, like any sensible country, does. Hence, sensible businessmen set up a company in Mauritius, and route all Indian investments through it.
What can we conclude from this?
From the above example, it appears that India’s biggest source of FDI is India itself. Indian money departs on a short holiday to Mauritius, before returning home as FDI. Perhaps not all the FDI streaming in from Mauritius is round-tripped capital — maybe a part of it is ‘genuine’ FDI originating in Europe or the U.S. But it still denotes a massive loss of tax revenue, part of the $1.2 trillion stolen from developing countries every year.
- What makes this theft of tax revenue not just possible but also legal is India’s DTAA with Mauritius. Hence, DTAA is seen as a government-sponsored loophole for MNEs to avoid tax by channelling investments and profits through an offshore jurisdiction.
Changing profile of tax havens:
Tax havens such as Mauritius thrive parasitically, feeding on substantive economies like India. Back in 2000, the OECD had identified 41 jurisdictions as tax havens. Today, the whole world has understood the importance of their cooperation to combat tax avoidance.
- Tax haven countries are now called as ‘Jurisdictions Committed to Improving Transparency and Establishing Effective Exchange of Information in Tax Matters’.
- Distinguished members of this club include Cayman Islands, Bermuda, Bahamas, Cyprus, and of course, Mauritius.
What makes these tax havens attractive?
- Relaxed tax rules:
Tax havens are a place where a country’s normal tax rules don’t apply. So, for instance, country A can serve as a tax haven for residents of country B, and vice versa.
- The U.S. is a classic example. It has stringent tax laws, and is energetic in prosecuting tax evasion by its citizens around the world.
- But it is equally keen to attract tax-evading capital from other countries, and does so through generous sops and helpful pieces of legislation which have effectively turned the U.S. into a tax haven for non-residents.
The bigger attraction of tax havens is secrecy. Secrecy is important for two reasons: to be able to avoid tax, you need to hide your real income; and to hide your real income, you need to hide your identity, so that the money stashed away in a tax haven cannot be traced back to you by the taxmen at home.
- So, even a country whose taxes are not too low can function as a tax haven by offering a combination of exemptions and iron-clad secrecy.
- Tax havens as OFCs:
The extreme combination of low taxes and high secrecy brought about a new mutation of tax havens in the 1960s: they turned themselves into offshore financial centres (OFCs).
- The economist Ronen Palan defines OFCs as “markets in which financial operators are permitted to raise funds from non-residents and invest or lend the money to other non-residents free from most regulations and taxes”.
- It is estimated that OFCs are recipients of 30% of the world’s FDI, and are, in turn, the source of a similar quantum of FDI.
India signed this DTAA with Mauritius in 1983, but apparently ‘woke up’ only in 2000. India has spent much of 2015 ‘trying’ to renegotiate this treaty. But with our Indian-made foreign investors lobbying furiously, the talks have so far yielded nothing. Meanwhile, China, which too had the same problem with Mauritius, has already renegotiated its DTAA, and it can force investors to pay 10% capital gains tax in China.
- Such being the case, all India needs to do to attract FDI is to become an OFC, or create an OFC on its territory. OFCs are less tax havens than regulatory havens, which means that financial capital can do here what it cannot do ‘onshore’.
- That’s precisely what the U.S. did — it set up International Banking Facilities (IBFs), “to offer deposit and loan services to foreign residents and institutions free of reserve requirements”. Japan set up the Japanese Offshore Market (JOM). Singapore has the Asian Currency Market (ACU), Thailand has the Bangkok International Banking Facility (BIBF), Malaysia has an OFC in Labuan island, and other countries have similar facilities.
While it may be true that greater international cooperation to deter tax evasion will pay dividends over the medium term through higher tax revenues, it is equally important for the government to tackle tax dodgers in India. That should not be done through rough methods but rather by better mining and usage of data generated by the Tax Information Network, simplification of tax laws, as well as clarity and stability of policies.