Tax illiteracy is no solution for budget deficits

Dear Mr Chidambaram,

You have been globetrotting to convince the world you are dead serious about budgetary prudence, limiting your fiscal deficit to 5.3 per cent of GDP in 2012-13. You have also promised an investment-friendly climate to attract foreign investment.

Alas, your first objective is, unwittingly, sabotaging the second. Your tax officials are so desperate to collect revenue (to reduce the fiscal deficit) that they are issuing tax demands that defy logic. This can only discourage investment.

When your officials issued a tax demand of Rs 15,200 crore on the multinational Shell, I naïvely thought they must have uncovered a real scam. Yet, after reading the news reports repeatedly, I could not make out what income was being evaded. On checking with prominent chartered accountants, I was amazed to be told that there was no scam or tax evasion, just a nonsensical tax demand (which includes interest, adding insult to injury) from desperate officials trying to meet tax collection targets.

The Indian subsidiary of Shell had issued shares to its foreign parent at Rs 10 per share. Tax officials claim that the fair value was actually Rs 183. They claim that this “underpricing” constitutes hidden income that must be taxed. So they have sent a tax demand of a massive Rs 15,200 crore.

Sorry, but this is an issue of fresh shares, not a sale of existing shares at a profit. And an issue of fresh shares is not income at all.

To see this clearly, consider a company issuing bonus shares to shareholders. Bonus shares are, by definition, free of charge. Can this free issue be called under-pricing and income evasion? Rubbish!

The same logic applies to new share issues. If a company raises capital by issuing fresh shares to the public or a private investor, does the money represent the income of the company? Not at all. The money goes to the capital account of the company. This capital enables the company to start operations, from which will flow profits or losses (called the current account).

According to audit norms, money received from share subscriptions is a liability of a company, not income at all! Income is defined as a current account surplus. Fresh share issues denote an increase in liabilities. A tax official who doesn’t know the difference is illiterate.

Within days of the Shell fiasco, officials have sent a similar notice (for Rs 1,300 crore) to Vodafone for the same alleged offence, under-pricing a fresh share issue to a foreign group company. This is different from its earlier tax dispute relating to its purchase of shares from Hutchison. Chidambaram is telling the world that the old dispute is about to be settled, so all is well. But now his officials have created a fresh, illiterate dispute.

Why are tax demands being made only for shares issued to foreign buyers, not Indian ones? Because tax officials are invoking the rules on transfer pricing for multinationals.

A multinational has branches in different countries, and goods and services are sold between branches. The price for such internal transfers is called the transfer price.

Now, transfer prices can be manipulated to channel all profit into the branch with the lowest tax rate. To check this, all countries have transfer pricing laws, mandating some form of fair valuation (often called arms-length prices). So does India.

Conceptually and in practice globally, transfer pricing applies to sales of goods and services. It may apply to assets being sold at a profit. But it cannot apply to the issue of fresh shares.

The example of bonus shares makes this clear. If a company allots bonus shares free of charge to all shareholders, can the free shares given to foreign shareholders be called a trick of transfer pricing, subject to tax? Obviously not.

Mr Chidambaram, you want foreign investment to plug your dangerously high current account deficit. Do you think investors will flock to a country where tax officials don’t know the difference between income and liabilities, or between the current and capital account of a balance sheet?

Please do two things. First, ease the pressure on officials to meet budget targets. Your budget assumed 7 per cent GDP growth, but actual growth is only 5 per cent. The resulting tax shortfall is not the fault of your officials.

Second, send your officials on a crash training course in economics and audit. Sorry, I forgot, you have a ban on such spending because of budget austerity. So, allow me to offer a lecture free of charge. Provided, of course, your officials don’t accuse me of under-pricing my services, and so send me a note demanding income tax plus interest and penalty.

2 thoughts on “Tax illiteracy is no solution for budget deficits”

  1. There is some funny logic here. Why are you talking about bonus shares? these are issued to ALL share holders. What the companies are doing is to avoid the limitations of transfer pricing and sending income out of the country.
    The company issues shares at a rate much lower than the market value and then then these are sold at the market price ad since these are not individuals liable to pay taxes in India, they pay no taxes on these hidden transfers.
    Sorry! the officers are not as foolish as you imply and you are too clever for your own good.


  2. Shabbir Haidermota

    Dear Mr. Aiyar,
    Excellent piece worthy of sharing and forwarding. Indeed this seems like a monumental blunder by overzealous and illiterate tax officials desperate to meet their targets and driving away foreign investment in the bargain. Let’s hope this proves an eye opener to the Finance Minister as well as his tax officials and such ridiculous behaviour does not recur in the future.

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