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Parthasarathi Shome: The Vodafone affair: the deconstruction

Policy makers should resort to retrospective taxation only in the most exceptional circumstances

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To deconstruct the affair in continuation of my previous presentation (“The Vodafone affair: the layout”, May 10), let us hypothesise a publicly listed Indian hotel conglomerate. It builds a hotel in Bogota, Buenos Aires or Caracas. It is publicly listed on where continuous share transactions take place. Would we want Colombian, Argentinian or Venezuelan revenue authorities to come after the Indian shareholders every time they buy or sell shares and insist that they have transferred property – a capital asset – and that they should pay tax on it to them? That would be onerous for them to collect and impossible for the Indian shareholders to sequentially keep paying. Just because the revenue authorities could identify Vodafone as the sole buyer, it does not hopefully weaken the thrust of the argument.

To conclude, we may feel some vicarious pleasure in seeing an in distress and increasing its global tax outgo – for, after all, which country does not lament the low tax liability that they are deemed to conjure? – or some empathy for the Indian revenue authorities for pursuing the right, or a moral, objective and taking a bold step, but their conceptual and legal interpretation has to be seamless and rational, not unconsulted and tied in knots.

The Supreme Court has given its judgment against the High Court, absolving Vodafone from paying additional tax. The subsequent reactive proposition in Parliament through the that would allow retrospective application of a new law is in contraposition of that judgment. It carries with it the potential of unbalancing the fine balance of powers among the different branches of government. This is because, if the legislature can pass a retroactive change in an existing law after the judiciary has made a ruling based on the prevailing law, then there exists the potential that a judgment of the judiciary – that has already been made in time t – can be nullified by a subsequent law in time t+1. This implies a subsumption that the legislature can actually go back and change an already passed judgment – based on existing law – of the judiciary. The resultant anomaly in the balance of powers certainly could not have been the intention of our Constitutional fathers.

India increasingly compares itself with its Brics partners. As in India, Brazil’s Constitution gives different levels of government the competence to impose taxes. They have to adhere to three important principles, however:

  • Legality: No tax can be imposed or increased, when it is not established by law. To introduce a tax (i.e. a tax base), a two-thirds majority of both (not just of those present) is required. To change a tax rate, 50 per cent+1 majority of those present in both Houses of Parliament is needed. Parliament also specifies the rate band for municipal taxes through “complementary law”. A municipality fixes the actual rate through “ordinary law”.
  • Prospectivity: Tax cannot be collected in the year when the law is published; and
  • No retrospective legislation: Prohibition to collect taxes related to facts or events that occurred before law came into force.

On the other hand, the UK Treasury has accepted a “wholly exceptional” criterion for retrospective legislation, though any retrospective measure involves public consultation. While there is no recourse to the UK Supreme Court in such cases, the European Court provides final recourse. Charles Sampford’s 2006 book, Retrospectivity and the Rule of Law, OUP, and Daniel Sandler’s 1993 article, “Retrospective Tax Decisions”, in the Cambridge Law Journal point amply towards the fallacy of retrospectivity.

The Indian finance minister has reassured the public that there is little to worry with retrospectivity. He has maintained his position with Mr Geithner, his US counterpart. Indeed, there is probably little doubt that he would break his promise. But the new provision may be expected to last, with windfall powers falling in the hands of the authorities, uncertainty in international and domestic business decisions, and an intrinsic inconsistency in the balance of powers envisaged among the three branches of government.

The correct step would have been to revise those double taxation avoidance agreements (DTAAs) that countered original intentions and objectives and whose deleterious impacts on revenue or the economy could not have been foreseen. This has been done by some countries when their direct interests were jeopardised. It is therefore understandable that the revenue authorities have indicated that the DTAA with Mauritius would be revisited, a matter that, if earlier corrected, would probably have minimised the current hiatus over the Vodafone affair.

To conclude, what detrimental ramifications might there be with retrospective taxation? To answer this, one should consider double aspects. On the one hand, large MNCs, including Indian ones, make a beeline every year to compete evermore for such incentives. Yet there is little doubt that economists view tax incentives as distortions in optimal resource allocation in the form of costs to economic activity. (1) They distort relative prices, thus affecting the equilibrium allocation of resources, i.e. causing “inefficiency” in resource allocation. (2) They treat selected sectors preferentially, which can be inequitable since it implies a heavier burden on non-preferred sectors for raising the same revenue. (3) This means the allocation of resources gets more distorted since non-preferred sectors pay more taxes. (4) Monitoring costs increase, implying tax administration becomes less simple. (5) Tax incentives could increase tax evasion in the resultant system that becomes more complex, with high selectivity, and administrative discretion and control.

On the other hand, retrospective taxation could be perceived not only to worsen the economic climate and deepen uncertainty in business decisions and result in a restrained willingness to invest, but also to exacerbate the iniquity in tax treatment similar to the effects of tax incentives. To conclude, neither do policy makers have to hand out tax incentives selectively – instead, focusing only on how to make it feasible to continually bring down headline tax rates – nor do they have to resort to retrospective taxation except under the most exceptional circumstances and that too after open, transparent, and long, as necessary, consultations with the stakeholders.



The first part of this article appeared on May 10. The author is Director and Chief Executive, Icrier. These views are exclusively the author’s. 

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