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Jaimini Bhagwati: Rationalising FDI taxes

The goal should be to make it immaterial whether investment is made via Mauritius or G20 countries

Jaimini Bhagwati 

India’s statement at the plenary session of the in on November 12, 2010 included valuable insights and proposals. For example, “recycling surplus savings into investment in developing countries will not only address the immediate demand imbalance, it will also help address developmental imbalances”. Additionally, the Indian intervention mentioned that “even as we try to avoid a destabilising surge of volatile capital flows to developing countries, there is a strong case for supporting long-term flows to these countries to stimulate investment, especially in infrastructure”. This article reviews foreign direct investment (FDI) flows to India over the last 10 years and suggests changes in to encourage inflows.

Table-I lists the FDI equity and portfolio investment numbers from 2000-2010. Although FDI has grown steadily, compared to our capital requirements, these flows are still fairly low. From 2006-07 to 2009-10, FDI flows have been greater than the relatively volatile portfolio inflows. Table-II details the top-10 countries from where was received and the top-10 sectors in which these investments have been made. It appears anomalous that 42 per cent of investments into India in the last decade have come from Mauritius. Adding the 9 per cent FDI received from Singapore and the 4 per cent from Cyprus, these three countries accounted for 55 per cent of FDI equity inflows over the past 10 years. Clearly, since tax rates in Mauritius, Singapore and Cyprus are negligible or extremely low, FDI investors have taken advantage of the Double Taxation Avoidance Agreement (DTAA) between India and these countries to route their FDI investments through them.

India expects that $1 trillion or more will need to be invested over the next 5-10 years in the infrastructure sector alone. For instance, in the power sector, coal-based thermal plants account for 53 per cent of generation. Hydropower stands at 6 per cent while nuclear power generation constitutes only 1 per cent of installed capacity. India needs foreign technology and investment in renewable energy, hydro and nuclear power segments. FDI will be needed to achieve the envisaged staggering levels of investment. Abstracting from the bottlenecks associated with land acquisition, resettlement of people and environmental clearances, foreign investors seek higher rates of return. Therefore, at this stage of India’s development and our requirements for foreign capital and technology, it would be counterproductive to try and revise our DTAAs with Mauritius or other low tax regime countries.

India has concluded DTAAs with most G20 countries, including the US, Germany, France, the UK and Japan. However, we do not receive significant amounts of FDI from these large economies, which are our largest trading partners. China does not show up in Table-II even if we go down to the 10th-largest investor. India could revise its tax policies on FDI from such G20 countries with which we have DTAAs so that these investments are accorded the same tax treatment as investments via Mauritius. For instance, we could tweak the tax rates on dividends and interest income for FDI investments. Further, net income from FDI investments could be exempt from taxes for longer periods of time. We could also further slant tax policies in favour of FDI in the power and construction sectors since, as can be seen from Table-II, these are currently way down in priority for foreign investors. However, it is possible that despite reductions in tax rates, FDI from our major economic partners may not increase. The interesting conclusion would then be that FDI investors from G20 countries prefer the anonymity of routing their investments via third countries or alternatively there is round tripping of funds which originate from India.

It could be argued that we should not reduce taxes on dividends and other FDI income since we collect taxes principally on the 45 per cent of FDI which comes from countries other than Mauritius, Singapore and Cyprus. Obviously, taxes cannot be collected on FDI income if the FDI is not made in the first place. The question then is: would the development gains from potentially additional FDI compensate for the taxes foregone if applicable FDI tax rates were to be lowered? On balance, reductions in taxes could be effected prospectively and not for existing FDI investments.

At the same time, FDI equity investment should be equity rather than disguised debt. That is, we have to ensure that foreign investors do not make arrangements for Indian partners to buy out foreign collaborators at prices which effectively provide returns at pre-agreed “interest rates”.

To summarise, taxes on FDI income should be rationalised for the long term, aimed at making it immaterial for foreign investors whether their investment comes via Mauritius, Singapore or directly from G20 economies. FDI investors also need to feel assured, particularly to induce investments in long gestation projects, that tax treatment for FDI will not be revised in a hurry.

The author is India’s ambassador to the European Union, Belgium and Luxembourg. The views expressed are personal. He can be contacted at:  

First Published: Fri, December 17 2010. 00:56 IST