The impact of Retrospective tax

Anil Paranjape, Independent Director, Avalara India Board_1

Earlier this month, India made waves across the business world by announcing the scrapping of one of its most controversial tax laws. The retrospective tax law. This law has led to a bitter legal battle between giant foreign investors and India for nearly a decade and tainted India’s image as an investment hub. India is now not only scrapping this controversial policy, but the Ministry of Finance has also announced giving a full refund of the principal amount to litigants. While we will briefly dwell on why this law came into existence, this article will also cover the reasons it will be binned and its potential impact on the Indian economy.

Retrospective tax: A quick overview

Back in May 2007, when telecom giant Vodafone purchased a majority stake in Hutchison Whampoa for $11 billion, the Government of India had demanded ₹7,990 crores in capital gains and withholding tax from Vodafone. They cited that the organization should have deducted tax at source before making a payment to Hutchison. In the same year, Cairn UK transferred shares of Cairn India Holdings to Cairn India. Almost immediately, the Indian Income Tax department made a demand of ₹24,500 crores. These demands were contested in a legal battle by both Vodafone and Cairn.

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Vodafone won when the Supreme Court of India ruled that the group’s interpretation of the Income Tax Act of 1961 was correct in 2012. However, the court also ruled in favor of Cairn and ordered the Indian government to pay $1.23 billion in damages to them, plus costs and interest. As a counter bid to circumvent the Supreme Court’s ruling, the then Finance Minister Pranab Mukherjee proposed amending the Finance Act. This move gave India’s Income Tax department the power to retrospectively tax businesses with mergers dating back to 1962 if the underlying asset was present on Indian territory.

Impact of the retrospective tax

The retrospective tax meant that the government could impose and collect tax on a transaction or a deal that occurred in the past. This is not an uncommon occurrence. There have been instances of retrospective amendments in tax laws, but the amendments have been clarificatory whenever that has happened. In this case, itwas pretty evident that the amendment made by the Government of India in 2012 was to overcome the judgement of the Supreme Court in the Vodafone case. This led to plenty of criticism of the Indian government on home grounds and overseas. While it is debatable whether or not a country should impose a retrospective levy, the context of the levy, in this case, made the whole scenario entirely controversial.

The Government of India did admit that this move turned out to be pretty counterproductive. Additionally, the retrospective levy led to a labyrinth of complicated international arbitration proceedings stating that the levy breached the fair and equitable treatment promised under several bilateral investment protection treaties.

What has changed?

In a nutshell? COVID-19 happened. India’s economy contracted 7.3% in the fiscal year ending in March this year. At this point, recovering the economy is crucial. In a statement to the media, Finance and Corporate Affairs Minister Nirmala Sitharaman said, “In the past few years, major reforms have been initiated in the financial and infrastructure sector, which have created a positive environment for investment in the country. However, this retrospective clarificatory amendment and consequent demand created in a few cases continue to be a sore point with potential investors. The country today stands at a juncture when quick recovery of the economy after the Covid-19 pandemic is the need of the hour, and foreign investment has an important role to play in promoting faster economic growth and employment.”

India is potentially looking at billions of dollars worth of arbitration awards, some of which were ruled in favor of parties like Vodafone and Cairn; not to mention the additional expenses of interest due and legal costs – there will be a massive liability of paybacks. Adding fuel to this fire is the loss of confidence of foreign investors keen on investing in India.

How will this impact our country?

Once the various companies withdraw their limitations and present an undertaking, they will no longer be claiming damages. Additionally, the tax on indirect transfer of Indian assets from 1962 to May 2012 will be nullified. India promised to initiate any new disputes or appeals on litigations around indirect transfers before May 2021. The Government of India will be settling the past disputes by refunding the entire principal amount to the organizations. At this point, India is not willing to pay back the interest or the legal expenses incurred in these high-profile cases. Organizations are yet to respond to India’s proposal – it could cover some of the damages that were incurred by them but not in their entirety.

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With China and the USA clashing over import and export control policies, several businesses are looking to switch their operations to other Southeast Asian and South Asian countries. Therefore, the scrapping of the retrospective tax is a welcome move and is likely to garner the attention of foreign investors. Moreover, the new changes will end long-running litigations and showcase India in a new light, hopefully as a fair and equitable taxing nation.

India ranked 63rd among 190 countries on the Ease of Doing Business scale jumping 14 positions higher from Rank 77 in 2018. This was the fastest level of scaling for a large country in nearly a decade. Scrapping of the retrospective tax is likely to be a lynchpin that could set the dominoes rolling and create an image of India as an investor-friendly nation. Hopefully, this will lead to other significant reforms to accelerate growing FDI interest, including better compliance laws, efficient tax management, and further digitization of tax operations

Views expressed in this article are the personal opinion of Anil Paranjape, Independent Director, Avalara India Board.

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