2013: Year-end Reckoning

India’s Macro-economic Woes:
Tax Disputes and Policy Distortions at the root
Indi’s GDP growth in the current fiscal is projected variously ranging from 5.5% of Ministry of Finance to 3.7% of IMF . RBI’s own estimate of GDP growth is at 4.8% and we may safely assume that, given the average WPI inflation at around 7.5%, the nominal growth rate may not exceed 12.5% - yielding a real GDP growth of max 5% for the year. This is a steep fall from the highs of 9.32% achieved in 2010-11, and average growth rate of 8.5% during the period 2004-2011.

The industrial production as indicated by the IIP has fallen by 1.8% in October 13, and has grown at a dismal 2% during the period Apr-Oct 2013. This compares with 9.32% growth achieved in 2010-11, which moved generally within a range of 9% to 12% during the previous seven years. The fall in production was conspicuous in key sectors like manufacture, mining and power generation.

Owing to a good monsoon, agricultural production rose by about 4.5% during the last three quarters, partly compensating for the fall in industrial production. The growth still falls short of 7.94% achieved in 2010-11, but corresponds to the average growth of previous 7 years, indicating perhaps this is the optimum that can be expected.

The Rupee exchange rate appears to have stabilised over the last few weeks, moving in a narrow range; however, even at current level the rupee is weaker by 13% as compared to the USD/INR rate as at end December 2012. Maximum depreciation witnessed in August was about 25%, and there is no certainty that the trend will not repeat, given the weak fundamentals, and continuing pressure from oil payments and short term trade credit repayments due by March 2014.

Net inflows of investment from FIIs in to debt and equity markets during 2013 at USD 12 bn have fallen by 60% as compared to that of the previous year.

Let us trace the origins of the malaise that has cost India the confidence of investors – both domestic and global – leading to a decelerating growth and free fall of rupee. We may identify three areas, viz. Taxation, Public Policy and Monetary Economy.

Taxation

The discomfort of investors started with the tax demand of USD 2.2 bn in respect of off-shore transfer of equity from Hutchison Whampoa to Vodafone in 2007, which the latter successfully fought in the Supreme Court. However, to defy the Supreme Court judgment, the Government went ahead with an amendment to tax law in the budget of March 2012 making it retrospectively effective from 1962. The amendment brings capital transfers in to the purview of transfer pricing for the first time. A further tax demand of Rs. 1100 cr has since been raised in connection with transfer of shares to its group company in Mauritius. As a result the tax dispute is continuing, and despite efforts for reconciliation, reputation of India as an investment destination is damaged. The investors gain an impression that (a) there is no finality in the tax disputes even after the judgment of the highest court (b) tax liability is unpredictable, as laws can be amended retrospectively, and (c) the Government is insensitive to the woes of foreign investors, even when they demonstrated their commitment to India with large long term investments (Vodafone has invested over USD 9 bn in India).

Investors could still bear it out if Vodafone was an exception. However, almost all major foreign enterprises in India are attracting huge tax demands, mostly under transfer price adjustment with retrospective effect. Following are a few cases under dispute:
  • Nokia – Initial tax claim USD 340 mn, expected to rise to USD 1.1 bn, currently under litigation
  • IBM – tax claim of approx USD 800 mn, referred to arbitration
  • Royal Ditch Shell – Tax claim of USD 2.7 bn, relates to their investment of USD 7 bn in Reliance Industries
Of all such cases, Nokia’s is an outstanding example in that the initial tax claim of USD 340 mn is higher than its investment in its Chennai plant, considered to be its largest in the world, providing employment to 8000 people.
Without prejudice to the on-going court case, at the heart of the tax dispute lies the contention of Income Tax Dept. that Nokia's payments for import of software from parent company amounted to royalty, which is subject to deduction of withholding tax, and the tax is payable with retrospective effect.

Nokia manufactures hardware of cell phones in India, uploads the software imported from parent company, and exports the phones to various countries. This is akin to Toyota assembling cars in India, with engines imported from Japan. However import of engine is considered as material imports and not as royalty payment to parent company.

Thus IT Department’s contention that Nokia’s payment to parent company amounts to royalty payment – even when the software is not being developed in India – is open to different interpretations. The tax demand has since been raised to USD 1.1 bn on various accounts. Nokia is simultaneously fighting a case with state government for the promised refund of VAT for last 10 years.
 

The IT department’s freeze on Nokia’s Indian assets has recently been lifted by High Court, subject to conditions including cash deposit.

IT Department also treated the advertisement, marketing and promotion (AMP) expenses of Rs. 550 cr incurred by LG India as unduly high (at 3.6% of sales turnover!), and made it subject to transfer pricing, claiming that the benefit has accrued to the parent company in Korea. A similar exercise is being carried out in respect of AMP incurred by Casio India. We would not know how the bizarre logic can be applied to other Indian companies like Hindustan Unilever (advt exp 12% of sales).

The concern of foreign investors was expressed recently by Ron Summers, Head of the US-India Business Council, who stated “In 2013, tax became a core risk for investors in India, clouding India’s investment climate” and leading to the “perception of gridlock” as a string of major companies found themselves in seemingly endless disputes.

It is not as if there is a prejudice against only foreign enterprises. I T Department refused to accept the tax exemption granted by Commerce Ministry to Information Technology units who export services through SEZ / Technology Park. Earlier, they also refused to recognise the onsite work being performed by Info Tech units outside India and grant export benefits to them (since corrected).

It appears as if our model of taxation is anti-growth and anti-exporter, if we look at tax disputes accumulating with companies like Infosys (Rs. 1175 cr), Wipro (Rs. 816 cr), I-gate (Rs. 738 cr) and WNS Global (Rs. 557 cr). It is reported that the IT claims on transfer price adjustments amount to over Rs. 70,000 cr out of which Information Technology sector alone accounts for Rs. 10,000 cr.

General Anti-avoidance of Tax Rules (GAAR) was also passed as part of the budget of March 1992. GAAR became controversial, despite its good intentions, as the interpretation of rules was subjective, and almost unlimited discretion was granted to the assessing officer. The application of the rules is for the time being deferred.

There is little concerted effort on the part of the Government either to stall retrospective application of the amendment to tax law, or to rein in the tax department from innovative interpretation of tax law. On the other hand, the Industries Ministry has recently written to the Ministry of Finance to put curbs on royalty payments of foreign companies, which would be a huge blow to companies involved in technology transfer.

The recommendations of Rangachary Committee have yet to be fully implemented. For instance, the Committee commented strongly that the cost+profit approach of IT Dept to the research outsourced to India, in preference to globally approved method of transactional net margin method, is ‘neither contractually appropriate, nor practicable’ – considering that the Committee is headed by former chairman of CBDT, Government should take the recommendations seriously.
 

The safe harbour rules, based on the Committee’ recommendations, announced in September 13, suffer from many deficiencies, chiefly in that they contemplate unrealistic profit margins, are limited only to six industries, cap threshold transaction value at Rs. 100 cr., and include prior approvals by the department which are subjective. The response from the industry was lukewarm, and the rules only confirm how the bureaucracy can make any meaningful measures infructuous.

Public Policy

The FDI Policy has been mired with fits and starts. Consider initial policy for FDI in retail – the very distinction of single brand and multi-brand retail was unique to India, giving rise to a host of rules and regulations. Finally when FDI in retail was permitted full scale, bureaucracy could not but intervene with restrictive clauses such as sourcing minimum 30% of the material from MSEs and invest USD 100 mn in back-end infrastructure. Recently relaxations were allowed expanding definition of MSEs with investment up to USD 2 mn (from USD 1 mn) and reducing initial investment from USD 100 mn to USD 50 mn.
The relaxations allowed are as absurd as the original restrictions. The FDI Policy cannot dictate the investors how to conduct their business unless the Government is guaranteeing their profits. Sourcing of material and building up a supply chain will in any case occur on their own merits and they will be incidental to FDI in retail, where all the players will be benefited. The futility of the FDI Policy, on account of many such infirmities, is evident in that even after 11 months from the date of announcement; no major retailer has shown interest in India.

It is reported that infrastructure projects of Rs. 1.1 lac cr were recently cleared by the Cabinet Committee at the instance of PMO. However, such clearances are final only if they include environmental approvals and other interministerial approvals for PPP, gap funding etc. We have seen how the PPP proposals for Kolkata and Chennai airports changed in the form and content due to non-cooperation of the state governments.

It has become customary to blame judicial intervention – at times construed as overreach – for total ban on mining and iron ore exports in Karnataka and Goa. However it appears that the Government did not vigorously defended its case for legally permitted part of the mining areas. It was quite possible to demarcate licensed areas afresh with the aid of Survey of India, and assert its administrative authority to grant mining licenses, and honour prior commitments. The government put on the defence, however remained inactive, partly on account of scandals elsewhere and partly owing to political compulsions. It has again fallen on the Courts to relax the restrictions on mining partially on practical considerations.

The Land Acquisition Bill (THE Right to Fair Compensation and Transparency in Land Acquisition, Rehabilitation and Resettlement Bill, 2013) recently cleared by the Parliament is going to become Land Acquisition Act w e f 1st January 2014. The Act makes it even harder for manufacturing and mining companies to acquire land with any certainty of cost. It is estimated that the acquisition process may take anywhere between 4 to 6 years to complete all the 10 steps envisaged in the bill, and increase cost of projects by about 3.5 times. It is even more difficult in specified areas where a Gram Sabha can defeat all the development policies formulated by Planning Commission or Govt of India. As Sekhar Gupta, Chief Editor, I E, commented in a recent article, India, with third largest deposits of bauxite in the world, will now have to import bauxite, only for the reason that a few illiterate tribals successfully laid claim to ownership of a range of hills, including the underground mineral deposits.

Even before the Land Acquisition Bill, Maruti Udyog received a notice for payment of Rs. 800 cr towards additional compensation for land acquired some 7 years back, for its Mannesar plant. The land was acquired from the state industrial development corporation, who was responsible to meet the compensation claims of the farmers, but it defeats the logic that they would now pass on the claims to the company. This is apart from the fact the land value has gone up only on account of the industrial activity after the acquisition process was complete.

I recollect from my first hand experience, that some 15 years back, an Indian company with moderate means was allowed to invest USD 10 mn in China, and was allocated required land near Dalian, within a record time of one week, complete with infrastructure like power and water connections. China has since moved far ahead of us in industrialisation and urbanisation. Granted that we are privileged to have a functional democracy, it is still worrisome that we are at the other end of the spectrum, where we are positively discriminating against investment.

Monetary Policy

Monetary Policy of Reserve Bank of India has largely been successful in controlling the inflation, despite the latest hick-up resulting from food prices. Even if the inflation is resulting from supply constraints, there is always a spill over to demand-led inflation – as the former economic advisor Dr. Kaushik Basu once alluded, increase in rural incomes on account of NREGS could be one of the reasons contributing to inflation. Those who are critical of RBI do not appreciate the fact that high inflation is growth negative, and a low level of inflation is a pre-condition, rather than a consequence, of growth.

However, some of the measures taken by RBI to stabilise exchange rate have been counterproductive. The measures relating to capital controls, in the form of reduction in ODI limits and entitlement for personal remittances, have shaken the confidence of overseas investors, even though the controls did not affect them directly. On the other hand, gains to RBI on account of these measures, in terms of conservation of foreign exchange were marginal or non-existent. Other measures relate to curbs on banks on trading positions, and on their participation in futures market. SEBI also put restrictions on currency positions, and margin requirements in futures market to discourage speculative trades – even though there was no established relationship with the far bigger OTC market. Despite such measures, Rupee value deteriorated steadily, with forward premiums and yields on G-sec shooting up simultaneously. A semblance of stability is witnessed only after recent positive steps taken by the new Governor of RBI, Raghuram Rajan.
 

RBI’s restrictions on use of OTC derivatives are still continuing. In particular, restrictions on cancellation and rebooking of hedges, on revenue as well as capital exposures, and limits on hedging anticipated business transactions, only help increase the hedging cost. RBI will do well to desist from micro-managing the use of derivative products, and focus only on the risks assumed by banks directly while approving the credit lines for derivatives.
 

While the regulators have shifted their focus to import of gold, the stock of gold already held by households and temple trusts in India, roughly estimated at 18000 tonnes, is escaping attention. The gold stock represents a huge reserve of freely convertible currency which can be accessed by RBI with appropriate tools. The RBI Working Group headed by Mr. K U B Rao made some constructive suggestions for tapping in to gold stock, including free use of gold derivatives. If banks succeed in pooling even a small part of the diversely held gold assets, through gold savings and deposit accounts (both paper gold as well as physical gold), the gold may be channelled back to RBI to strengthen the forex reserves, by innovative measures.
 

One suggestion is Banks may allow trading in paper gold – accessible to individuals through gold savings account (in addition to deposit of physical gold) – and hold only 10-15% of the gold as liquidity reserve. Banks would manage their price risk by use of gold derivatives, and deliver the gold to depositors on demand by buying in the open market or by using gold imported on consignment basis. While the assumption is that all the depositors are unlikely to demand delivery of gold at a time (particularly those who speculate may never need physical delivery), banks would still be able to meet all the claims, if they hedge the price risk with gold derivatives. The cost of hedging will be only marginal and will be adjusted to interest payable on the gold deposit accounts. There are also suggestions that RBI can use gold buying and selling as a monetary policy instrument, in addition to interest rates, to impact liquidity in the markets.

The measures would help limit the import of gold, and also sale of gold stock to RBI by the depository banks.
It is time that RBI formulates a comprehensive Gold Policy, keeping in view that (a) gold is a convertible currency asset and (b) it is a valuable policy instrument to impact interest rates and exchange rates.

Conclusion

There is a negative sentiment spread across the sectors, resulting from policy distortions and uncertainty in tax obligations that have impeded the growth of the economy. Following are the few steps that may help restore investor’s confidence and correct the growth trajectory.

  • Announce a taxation policy for next 5 years, where only rates of taxation may be reviewed in each budget, but the principle of taxation will remain unchanged. The Policy should narrow down the discriminatory powers of assessing officer, and prohibit retrospective taxation.
  • Finance Ministry should also announce a standing dispute resolution mechanism, providing for negotiated settlement, wherever the tax provisions are ambiguous. Simultaneously, there should be a cap on the no. of appeals by the income tax department, say, not more than two levels for any dispute ( e g the appellate tribunal and the High Court), and further appeals should be allowed only in exceptional cases with prior approval of the Finance Minister.
  • The Government should expand the meaning of public purpose, to include projects critical to the economy, such as infrastructure, oil exploration, mining and renewable energy. Projects for public purpose should receive active support from central and state governments for land acquisition.
  • The finance Ministry / Cabinet Committee should facilitate single window clearances for FDI proposals within a pre-defined time limit, with minimum built in conditionalities
  • RBI may restore the earlier limits on ODI and miscellaneous remittances, and relax the restrictions on use of derivatives.
  • A Gold Policy may be evolved to exploit domestic gold reserves, with the twin objectives to (a) add more gold to foreign currency reserves, and (2) to use gold as an instrument of monetary policy to impact interest and exchange rates. Free use of gold derivatives by banks and other investment institutions may be permitted immediately.
The government should not shirk from adopting pro-business policies – perhaps there need to be a permanent high level body to address investor concerns, and troubleshoot in case of delay in interdepartmental clearances.
Investors believe that the fundamentals of Indian economy continue to be strong, and a few confidence building measures as above should help revive the sentiment and help GDP grow at a trend rate of 9%.
……………………………………………………………………………………………………


C. Chandrasekhar
Senior Vice President, Mecklai Financial



1IMF estimate of GDPO growth for India is 3.8% for the year 2013 and 5.1% for the year 2014 (actual 4.7% for first 3 quarters of 2013)
2 P S It appears that on the last day of the year Vodafone has reached conciliation with Government, and investment by global retailer Tesco in a Tata Enterprise has also been approved. Hopefully the policy perspective will continue to be positive in the New Year.