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Harmonise tax reforms with global aspirations
December, 09th 2010

Over the years, the role of tax policy has evolved from being a mere revenue generating mechanism to becoming a crucial component of a country's overall economic policy. This holds true for developing countries, several of whom have made innovative and pragmatic use of their tax policies to spur investment and boost growth.

India is currently on the verge of large scale tax reform through the introduction of the Direct Taxes Code (DTC). While there has been much debate on the nitty-gritty of specific provisions in the DTC, it is equally important to examine the proposed regime from the point of view of whether it is consistent with India's global aspirations and its long-term economic interests.

Impact On Foreign Investment: Following the opening up of the Indian economy, foreign investment has grown exponentially, contributing greatly to India's economic growth. Despite the high rates of domestic savings and investment, India will undoubted require significant amounts of foreign investment for the near future. Given this, India's tax policies ought to dovetail into its long term need to attract more foreign investment.

Typically, most foreign investors seek moderate tax rates alongwith simplicity and certainty in a country's tax system. While India's current tax rates can by no means be considered excessively high, a modest reduction to 25% as proposed in the original draft of the DTC will enhance India's attractiveness to investors. Such a move may not have a significant impact on tax revenues in the medium term. In fact, global experience show that moderate taxes actually result in an increase in tax collections through greater economic activity and better compliance.

Investors have also long complained about the lack of certainty in India's tax regime. Key concepts such as permanent establishments and royalties have been the subject of protracted litigation, resulting in a plethora of often conflicting decisions. The proposed introduction of a General Anti-Avoidance Rule (GAAR) under the DTC may only end up exacerbating this problem. The GAAR confers vast powers on the tax authorities to disregard or recharacterise transactions perceived to be "avoidance transactions". This could potentially increase tax uncertainties in India.

It has often been pointed out that despite the 'shortcomings' in its tax regime, India has continued to remain one of the top destinations for foreign investment. Yet, if India is to realise its aspiration to become a top investment destination, it is important that it have a tax policy that pro-actively encourages foreign investors and addresses their concerns. Given India's urgent need for foreign investment in key sectors like infrastructure, it cannot afford to be complacent on this count.

Outbound Investments: Over the last few years, outbound investments from India experienced remarkable growth. These outbound forays give Indian companies the opportunity to compete in the global marketplace by giving them access to new markets. It also contributes to India's strategic interests through investment in sectors such as oil and gas and also by cementing its reputation as 'soft-power'.

Given this, one would have expected India's tax policies to be in sync with its overall aspiration of becoming a top global investor. Yet, inexplicably, the DTC contains provisions that have the potential to nip India's outbound story in the bud. For instance, the new residency rules based on the "place of effective management" test could potentially result in overseas subsidiaries of Indian companies being treated as tax residents of India.

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