Are international financial centres worth the incentives being doled out?
The government has doled out a myriad number of incentives for companies that operate in international financial services centres (IFSCs). It has waived transaction taxes, dividend distribution tax and long-term capital gains tax, and has decided on a lower 9% minimum alternative tax rate for these companies, versus an 18.5% rate for companies situated in the mainland. News reports suggest that it is also considering a proposal to waive some provisions of the Companies Act for these companies.
With the government seeming to bend backwards to make IFSCs a success story, it looks like something may well come out of this experiment. But some experts say that a liberal relaxation of rules will cause market participants to engage in regulatory arbitrage, which can eventually end in disaster.
About a year ago, when the Reserve Bank of India (RBI) released its rules for banking units that operate in IFSCs, it said that it had been extra careful in framing rules because it had concerns about money laundering and financing of terrorist activities if rules are too lax. Recently, it has eased some of the initial restrictions it had put, giving the impression that it is also coming around.
Of course, clarity is still awaited on some matters such as dispute resolution, and hence it may be a while before things take off. Besides, there is some confusion relating to the Maharashtra government’s plan to have its own IFSC in Mumbai. Some companies may well wait and watch how things develop on this front, before committing to set up a new unit in the up and running Gujarat International Finance Tec-City Co. Ltd, or GIFT City.
With the race to set up IFSCs hotting up in the country, and with the government itself being keen to see them succeed, it’s likely that some prudent norms may be overlooked. Percy Mistry, who had chaired a government-appointed committee on Making Mumbai an International Financial Centre, told Business Standard recently that given the problems with regulations in India, the competition to set up IFSCs will eventually lead to chaos. “It will be the kind of madness that the RBI will not be able to contain or manage... The RBI has not been able to manage even its own simple business of banking regulation/supervision. Its gross regulatory/supervisory failures from 2010 onwards are now visible for all to see, in the egregious level of non-performing assets (NPAs) that have emerged in the state-owned banks,” he said.
This column has argued before that the government should rather work towards reforms that make India’s existing markets in the mainland attractive for overseas market participants. Having a dual policy, with one regime being relatively lax with rules, and another with archaic and regressive rules, can prove to be counter-productive.
If domestic companies are permitted access to exchanges in IFSCs, many of them will be happy to shift their trading operations to venues with the lowest costs. It will be a tragedy if liquidity in existing markets, which has been built over years, drops because of the IFSC experiment.
Also, serious participants may choose to stay away from IFSCs, despite relaxed rules in areas such as taxation, because who is to say that these rules may not be changed on an ad-hoc basis, as they regularly have been in the markets that operate in the mainland. The main users of these markets could then be those who are looking to make quick gains from regulatory arbitrage.
One of the arguments for having IFSCs is that it will be a while before India will have full capital account convertibility. And since many transactions cannot take place in markets situated in the mainland, it makes sense to carve out a special zone where these transactions can take place. Be that as it may, this can also work as a disincentive to pursue reform in the mainland.
There were some glimpses in this regard in this year’s Union budget, which introduced a tax on dividend income amounting to over Rs.10 lakh. This amounts to triple taxation, as some experts put it, with the first level of taxation on the income generated by a company; the second as dividend distribution tax; and now a third level of taxation on promoters and other large shareholders who receive dividend.
Rather than doling out incentives for companies operating in certain zones, it would be better to have fair and reasonable taxation for all firms operating in the mainland. Likewise, factors that keep away a myriad of foreign participants from markets in the mainland should be addressed expeditiously.
Ironically, this dual policy assumes that regulators such as RBI and Securities and Exchange Board of India have a vast amount of surplus capacity, to be able to oversee entirely new and different markets, which operate under a different set of rules. The needless distraction can end up hurting existing markets and eventually Indian finance.
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