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Avoid tax cascades in the financial sector
February, 27th 2008

Growth means change and pro-active change does involve taking calculated risks for the greater good. Consider, for instance, policy change and reform, which is key to India sustaining the economic growth momentum. The Budget needs to draw up a road map for tax reform and attendant operational changes in a vital sectors like banking and financial services.

As the recent high-powered committee on making Mumbai an international financial centre emphasised, we have indeed dismantled an autarkic license-permit raj in industry and trade; but we need to do it again in finance. It would step up efficiency and productivity across the board, and lead to better allocation of resources.

The way ahead is to have a tax regime in finance that does away with cascading rates, including stamp duty, registration duty and the securities transaction tax. Instead, whats required is sound tax design for a goods and services tax (GST) in finance.

Given the practical difficulties in having in place a comprehensive GST for financial services, a staggered, multi-year approach needs to be followed through. And once such a tax regime is in place, it would be simultaneously possible to remove turnover taxes, including stamp duty and STT. Perhaps the finance minister needs to announce that a technical committee would be set up to workout the mechanics and logistics of going about it.

Theres a case for tax reform when it comes to the consolidation of accounts. As per Indian GAAP norms, a listed holding company has to present stand-alone and consolidated accounts. But for income-tax purposes, such consolidation of accounts is not permissible. However, at a conceptual level, it cannot be said that it is desirable to tax a group on the basis of its overall financial performance.

The idea is to incorporate the performance of all subsidiaries taken together. In jurisdictions abroad, including in the UK and the US, the standard practice is to levy tax on a corporate group as a single unit.

There are other anomalies in the tax treatment in finance. For example, when a subsidiary company pays dividend to its holding company, it pays a dividend tax of 14.025%. But a dividend payout by the holding company to shareholders means a second dividend tax of 14.025%.

So the tax code thoroughly disincentivises the holding company structure. Now, the aim of a holding company route is to support listing and operations of a set of finance companies that may span the entire gamut of financial services.

But the fact remains that Section 297 of the Companies Act constrains the utilisation of the services of any group company by another. And even when group companies have a common management structure, prior approval of the centre is necessarily warranted to unlock synergy.

It suggests excessive and quite needless oversight. Instead, whats needed is adequate provisions for transparency in corporate governance procedures. There are still other aberrations in Indian finance.

The most important deficiencies pertain to the absence of efficient and liquid bond, currency and derivative markets. The latter would include credit, interest rate and currency futures and options. All three markets need to develop rapidly with domestic and overseas participation. It would mean vigorous trading in the spot and futures markets, with much possibility for arbitrage opportunities to guarantee transactional liquidity in the marketplace.

The objective ought to be to chalk out a more realistic yield curve that shows the term structure of the going interest rates. A vibrant yield curve is a key signalling device in the mature markets. So the continuing absence of sufficient depth in the corporate bond and government securities market, together with shortcomings in the trading of currency and derivative instruments, does stultify informational and everyday operational efficiency in finance.

The lack of modern financial markets is actually counterproductive when it comes to public debt. For, in financing the fiscal deficit, a credible system requires that sovereign and sub-sovereign bonds be bought voluntarily by any kind of buyer, sans coercion, direction and restriction. And this is far from the case at present.

It needs to change. After all, a sophisticated financial system requires an active sovereign bond market as a credit bellwether. As the high-powered committee report concluded, the asset portfolios of banks, insurance companies and pension funds are much repressed by fiat at present.

With clear-cut financial sector reforms and opening up, the three sectors are likely to grow dramatically. In tandem, it will imply new sources of demand for government securities.

However, if greater demand for the bonds is not matched by increased supply, the prices of such gilts should rise with the coupon rates suitably reduced. It would mean more efficient financial markets. The Budget needs to set the ball rolling for the much needed financial sector reforms.

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