Age Of Carpetbaggers

The Finance Ministry’s decision to treat any Foreign Institutional Investor (FII) who has a Branch office in as a Mauritius Company under the Double Taxation Avoidance Treaty with Mauritius will lead to tax loss of about Rs.3,000 crore to the national exchequer. It is surprising that the Finance Ministry should have come out with such a circular, when the Income Tax Department had rejected the claims of the FIIs and proceeded against them. This, it may be noted was at a time when the Finance Minister was refusing to roll back price increase of even PDS food grains to the people below poverty line.

Before we look at the implications of this decision, let us examine some of the facts of the case. There are today 521 FIIs registered with SEBI with cumulative investments of $11,830.7 million dollars (i.e, about Rs. 38,000 crore based on the rates of exchange at the time of investment). While the amounts traded by the FIIs are about 5% of the total transactions on the stock exchange, SEBI has said in its Annual Report of 1998-99  “Thus as a proportion of total turnover of the exchange, the FII figures do not happen to be substantial. However, since FII trades are delivery based, the actual impact is much higher.”  Thus the FIIs have had a large impact on the Stock Exchange and the Sensex, which is out of proportion to their actual trade. This makes it easier for them to manipulate the market and make speculative gains.

Under the Income Tax Act, a foreign Company is liable to pay tax in India if the income accrues in India. Obviously, any profit from buying and selling shares in the Indian Stock market is income in India; an FII operating in India is therefore to be taxed in India under the Income Tax Act.  If it is a short term gain (profits made due to such sales within the year), the short term capital gains tax of 30% apply and if the stocks have been held for more than a year, a 10% capital gains tax apply on such proceeds. Thus, this is the range of taxation that should apply on the FIIs’ profits from stock market.

The Double Taxation treaties that India has with most countries are meant for not taxing the same income at both ends. Thus if a US company operates in India, under the double taxation treaty with US, the Indian income will not be taxed in US again as this has already been taxed in India. Under the special provisions of the Double Tax Avoidance Agreement with Mauritius, individuals and companies that are residents of Mauritius can pay their tax there, instead of in India. However, to qualify as a resident of Mauritius under the clauses of the Treaty, the company’s management will have to be located in Mauritius; Mauritius, it may not be noted has no capital gains tax. If the double taxation treaty with US is considered, an American FII will have to pay capital gains tax in India and dividend tax in the US. However, this does not help these FIIs; therefore adoption of the Mauritius route.

The FIIs have tried to use the Mauritius route to avoid paying capital gains tax. Out of the 521 FIIs registered with SEBI, only one is shown as registered in Mauritius. What these FIIs have done is that they have registered a branch office as an “Overseas Company” in Mauritius. For this purpose, they only need to have two directors from Mauritius and a back account. This entitles this branch to be recognised as a “tax resident” of Mauritius and route the FII investments in India through the Mauritius branch. The FIIs then claim that under the Double Taxation Avoidance Agreement with Mauritius, they are exempt from any capital gains tax in India. It may be noted that out of 521 FIIs, only 132 have followed this route though their investment – according to Finance Ministry — constitutes about 60% of the total FII investment of $11.8 billion in the Indian stock market.

The Income tax department has been investigating these claims for the last 3 years. After investigating 37 such companies in Mumbai they decided to proceed against 24 of them, as it was clearly established that these FIIs were essentially operating a tax dodge and are not entitled to “resident” status under the above Double Taxation Avoidance Agreement. Their place of management was not Mauritius and their claim of resident status there was only meant, not for avoiding double taxation, but to evade any tax. However, when notices were issued by the Income Tax Department to the FIIs, the Finance Ministry got into the act. It instructed the Central Board of Direct Taxes (CBDT) to issue a circular that all companies who had been issued a certificate of tax residency in Mauritius will be treated as residents of Mauritius. Thus the entire investigations of the Income Tax Department was negated at one stroke and FIIs using the Mauritius route have been made exempt from any taxation. Unfortunately, the CBDT circular not only covers FIIs but any capital invested in the country. It is not surprising that even foreign direct investments are now coming only through the Mauritius route.

The India Fund Inc is a good example of what the American FIIs are doing. It’s Investment Manager is Punita Kumar Sinha, who happens to be Yashwant Sinha’s daughter-in-law. The fund is incorporated in Maryland, USA and in its Annual Report for 1999 has stated that it has a branch office in Mauritius for the purpose of tax residency. It has further said in the Annual Report that it routes all investments in India through its Mauritius Branch to take advantage of the tax breaks given to Mauritius companies. The Annual Report shows that the Net Asset Value of the fund has grown from $300 million to $ 700 million in the financial year 1999. Out of  9 million dollar administrative expenses, only 25 thousand dollars was incurred in Mauritius. The fund manager’s fees was 5.3 million dollars a lions share of which comes to Punita Sinha, Yashwant Sinha’s daughter-in-law. It is clear from the above, that this fund’s effective management is in US, and it is only maintaining a postal address in Mauritius. It is unfortunate that such companies should be encouraged by no less that the Finance Minister of the Country. The Finance Minister needs instead to allow the Income Tax Department to proceed vigorously against tax offenders.

The question here is simple. On one hand, the government claims it has no money to pay subsidies for the poor. However, it is not only lowering the rate of taxation on the rich — the tax to GDP ratio to India is one of the lowest in the world — but also exempting then from even legitimate taxes. At a conservative estimate, the government is losing about Rs.2,000-3,000/- crores in capital gains tax by this CBDT circular and also providing incentives to be dishonest.

The loss of tax revenue, under a situation where the government claims it is short of resources, is one of the issues. The other major issue is the impact of hot money flows in and out of the Indian stock exchange. In order to reduce short term flows and encourage long term investments, the short term capital gains tax is 30% as against long term capital gains tax of 10%. However as Mauritius has no capital gains tax, this means that the FIIs can take money in and out of the Indian bourses at will. For those who have followed the East Asian crisis of 1997, the dangers of such hot money flows are obvious. The danger of short term capital is that it can flow out the minute there is a run on the stock exchange, thus accentuating the crisis. As has already been emphasised, the higher short term capital gains tax helps in reducing the danger of such catastrophic flight of capital. The danger of such capital flight is not only of the Sensex collapsing but also the erosion of foreign exchange reserves and the collapse of the rupee. This is exactly the scenario that the East Asian economies want through. Thus, legitimising the Mauritius route, as the Finance Ministry has done, not only leads to huge tax losses but opens the economy to the danger of catastrophic capital flight.

Even World Bank economists such as Joseph Stiglitz, has warned against the danger of short-term capital flows. With regards to the East Asian crisis, he states “But the seeds of calamity had already been planted. In the early 90s, East Asian countries had liberalized their financial and capital markets — not because they needed to attract more funds (savings rates were already 30 percent or more) but because of international pressure, including some from the U.S. Treasury Department. These changes provoked a flood of short-term capital — that is, the kind of capital that looks for the highest return in the next day, week, or month, as opposed to long-term investment in things like factories”  (quoted from Joseph Stiglitz – IMF Exposed). Further, he points out that the short term capital terms went into fuelling real estate speculation and capital flight followed when the real estate bubble burst.

For a country as short of resources as India, it makes little sense to lower tax revenues, specially as the taxes on the corporate sector and the rich have already been brought down to very low levels by international standards. Further, after the East Asian crisis, to encourage short term capital flows make little sense. Then why is the Finance Ministry behaving in this way?

There is little doubt that the Finance Minister seems to have taken an undue interest in the matter of FIIs. After the Income Tax Department passed assessment order on 7 FIIs, the Finance Minister appeared on television to state that the notices were “incorrect” and he would ensure that these companies were not taxed in India. A few days later, the CBDT issued the circular exempting from Indian taxes, all companies with residency certificates from Mauritius.

Why did Yashwant Sinha take such a personal interest in the matter? Is it because India Find Inc, a major US based mutual fund, which has routed its transactions through its branch in Mauritius, is headed by his daughter-in-law? Or is it mere capitulation to the pressure of the FIIs, who threatened to leave and brought down the Sensex after they were issued notices from the Income Tax Department?

The government also needs to make it public how much we are collecting in terms of capital gains tax. It is interesting that while the Sensex has grown substantially in the financial year 1999-2000, there has been very little growth in revenues collected through the capital gains tax. In all other countries, revenue from capital gains tax rises along with the Sensex. In India, those seem to be totally divorced from each other.

In any country, the government generally passes a public message that crime does not pay. However, lately we seem to be functioning in reverse gear. The message emanating continuously from the government is that the laws are bad and therefore crime is legitimate. Thus when the cricket to match fixing scam came to light, the eminent Minister for Sports, Shri. Dhindsa suggested that betting should be legalised. The Income Tax Department through its VDIS Scheme, has legalised all tax violations till 1997. And now, the government is busy suggesting that the Mauritius tax avoidance route is entirely legitimate. Presumably, all FII’s who believe otherwise and have paid up their taxes are extremely foolish. This is age of carpetbaggers and we now have Yashwant Sinha’s seal of approval for them.