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India’s new investment norm

Rediff (India)

India’s new investment norm

August 16, 2005

It is an innocuous announcement: some of Colgate Palmolive (India)’s overseas shareholding is to be transferred from the parent US company to a group firm in Singapore.

Whatever the reasons for this switch (and none seems to have been given), one benefit will be that the Singapore holding becomes free of tax, following the "comprehensive economic cooperation agreement" signed with Singapore recently.

This could be the beginning of a trend as more overseas investment in India is routed through Singapore, already the regional base for hundreds of global companies.

The tax-free route so far had been Mauritius, with whom India signed a tax treaty long before its full implications became obvious (partly because India got little foreign investment in those days). Some tax officials tried to undo this unilaterally a few years ago, but had to give up when they came under flak.

India is not unique in offering international capital what is for all practical purposes a permanent tax holiday. What most people don’t know is that China taxes international companies at one-tenth of the tax rate that it applies to domestic firms.

That works out to a tax rate of barely 3 per cent — which is as good as paying no tax at all. You can understand, then, why so much FDI flows into China: if you have access to the Chinese market and pay no tax on your profits, then China will score as an investment destination over virtually any other place in the region.

It also gives you a big "cost" advantage, when you reckon that most companies have a gross profit margin that is between 10 per cent and 15 per cent.

This virtual tax holiday is an open invitation to domestic investors to take their money out of the country and bring it back in as foreign investment — what is called round-tripping. Everyone knows that a good bit of the $50 billion or so that China clocks annually as FDI inflows is accounted for by such round-tripping.

So, is the Singapore agreement an invitation to people in India to indulge in the same round-tripping game — take money out and bring it back in as FDI and portfolio investment? There has been widespread suspicion that some of the portfolio investment that has come in via Mauritius is domestic money that went out earlier. If the game does start in earnest, then India’s "foreign investment" numbers could take off into the stratosphere!

There is a larger point here. Almost all the global giants now operate their international investments through a network of firms that are technically housed in tax-free islands (for instance, a magazine investigation some years ago into Rupert Murdoch’s global media empire showed how he paid virtually no tax anywhere).

John Kerry, the US presidential candidate last year, made a point of highlighting the fact that many leading American firms were housing their profits in offshore tax holidays, and referred to them as Benedict Arnold companies — the equivalent of calling them Raja Jaichands or Mir Jaffers.

This made no difference to the electoral outcome (Kerry lost to Bush), and it has made no difference to corporate behaviour. No one is going to give up the opportunity to exploit a tax loophole.

If this trend gets more firmly established, it will become increasingly difficult to tax capital in almost any country, especially with the spread of capital account convertibility and the resultant ease with which capital moves across borders.

Even suspicious Indian authorities have opened up and allowed companies to take virtually limitless money out for overseas acquisitions. Soon enough, we should expect a web of international investments to develop, which no taxman anywhere can penetrate.

Don’t be surprised if this leads to the next step: governments come under pressure to not tax local capital so that local investors are not at a disadvantage against international ones. When you think about it, this is exactly what the government has done in India.

Dividends are now tax-free for all investors, and long-term capital gains too are not taxed when the money has been made on the stock market. In the age of international capital mobility, capital is getting a tax holiday.

 source: Rediff