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Photo: iStock
Photo: iStock

There’s a flip side to Vodafone’s case of ‘retrospective’ taxation

India has a sovereign right to tax sales of Indian assets and capital deserves no special treatment

The government has got excessive flak for retaining India’s “retrospective" tax on asset transfers after it recently lost a case against Vodafone in an international arbitration court. The case relates to the purchase of a controlling stake in Hutchison Essar in India through a 2007 offshore deal routed through the Cayman Islands.

Two broad critiques are important to note, if only for the principles that underlie them. One is that governments should never make tax changes with retrospective effect. This was what the late Pranab Mukherjee did in 2012 when he was finance minister, after the government lost the Vodafone case in our Supreme Court. And two, tax regimes must be stable in order to attract foreign (or even domestic) investment. No one can disagree with such motherhood statements, but that does not mean the government—be it under the current alliance in power or the previous one—does not have a case. Given that the Indian taxman has a tendency to harass taxpayers and is known to make large demands on flimsy grounds, public sympathy tends to be with Vodafone.

But there is also a more nuanced view. First, Vodafone must have been aware that asset transfers in India would attract capital gains taxes. By shifting the relevant jurisdiction to a tax haven, it probably got a lower price from Hutchison, majority owner of the telecom company. So, a key objective appears to have been tax avoidance by using a grey area in Indian tax law. The Bombay High Court ruled against Vodafone, which won its appeal in the Supreme Court largely on the basis of a technicality. The government’s legal case was not iron-clad, but its moral case was largely justifiable.

Second, the technicality that got the apex court to rule in favour of Vodafone in 2012 was the question of what constituted a business connection between Vodafone abroad and the Indian business it acquired. The bench, headed by the then chief justice, said (among other things) that the business connection rule that would have enabled India to tax an asset transfer abroad applied only to revenue transactions and not capital ones. This was a debatable interpretation, for financial gains are gains, regardless of whether it comes from operations or an asset transfer.

So, no, there’s no point criticizing the government excessively on the case.

Two other points, on avoiding retrospective taxes, and the need to bend over backwards to invite foreign capital, also need some contestation. The “retrospective" aspect in this case was a clarification of the existing law, not a completely new tax applied to Vodafone. Moreover, even prospective taxation tends to have retrospective implications.

For example, if I buy a house on the assumption that I will be able to set off my loan interest costs against annual income, and this deduction is withdrawn prospectively, the government is essentially penalizing me for a long-term investment decision I took when this wasn’t the case. Similarly, if a government decides to impose a wealth tax from the current year, the tax will not be on wealth accumulated prospectively. It will apply to wealth created in the past.

All governments, especially in democracies, face expenditures that need to be financed, and when circumstances so warrant, they occasionally make destabilizing policy moves. So, while long-term tax stability is a valid demand, sovereigns cannot make it an open-ended promise for all time to come. Companies must see occasional changes in tax policies as part of their business risk, especially in a world where high growth rates and commensurate jobs are no longer a sure thing.

This brings me to another point: How long are we going to give capital special tax treatment compared to labour?

The argument for giving tax breaks on investment flows is essentially an argument for giving capital-based income special tax treatment over wage income. It is, of course, true that there can be no growth without capital investment, but if we are going to offer lower tax rates for returns on capital compared to wage earnings, why are we surprised that entrepreneurs are using more capital to replace labour? Today, even as we make our labour laws more flexible, special treatment to capital will continue to skew investor orientation in favour of machines and technology over human workers.

In India, the 10% long-term capital gains tax on equities introduced in the 2018-19 budget has drawn much flak, and so has the decision to shift dividend taxes from the corporate end to individuals. We have also had tax-free bonds issued by many public sector entities in the past, and capital gains on sovereign gold bonds are tax-exempt.

The case for mollycoddling capital is non-existent. Fair and non-arbitrary treatment is a reasonable expectation; special treatment is not.

What should the government do, now that it has lost the Vodafone case in an international court of arbitration? The answer is to close the chapter and not prolong it needlessly. Vodafone, in any case, has been hit with massive demands for past spectrum payments after the Supreme Court interpreted the term “adjusted gross revenues" rather expansively last year.

R. Jagannathan is editorial director, ‘Swarajya’ magazine

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