The Panama papers have exposed that the rich and wealthy are evading taxes by making shell companies in tax havens like Panama City. The Government of Panama had recently agreed to share information with India. But the problem is not of information. The problem is that our tax collector is not doing his job properly.
Let us say you have a company in India named India Estates that has an income of Rs one crore. The rate of income tax in India is 30 percent. You are required to pay income tax of Rs 30 lacs on this income. You want to avoid paying this tax. So you visit Panama City and register a company, say, in the name of Panama Estates. You then pay a commission of Rs one crore from India Estates registered in India to Panama Estates registered in Panama. You, as owner of India Estates claim that Panama Estates helped procure the land for a real estate project for which it was paid the commission. The commission is deducted as an allowable expenditure in the books of India Estates. The profits earned by India Estates become nil and no income tax has to be paid in India.
The United States has enacted the Foreign Account Tax Compliance Act (FATCA) in 2010 to prevent such misdoings (tax evasion). The law requires all foreign banks to disclose the identities and transactions of United States’ nationals holding accounts with their branches worldwide. Refusal to disclose would lead to them being banned from undertaking business in the United States.
Panama Estates, however, earns an income of Rs one crore from commissions received from India. But this is not so much a trouble because the rates of income tax are low in Panama. Say, you have to pay income tax at the rate of five percent in Panama. Accordingly you pay a tax of Rs five lacs in Panama. Now you have tax-paid Rs 95 lacs sitting in your bank account in Panama. Now you, as owner of Panama Estates, “invest” Rs 95 lacs as FDI in an Indian company names in India Enterprises which too is controlled by you. At the end, the Rs one crore earned by you in India Estates comes back to you in the form of Rs 95 lacs of foreign investment in your own company India Enterprises. You have saved Rs 25 lacs from taxes that were not paid by India Estates to the Income Tax Department in India.
The Government of India is happy that India has got foreign investment of Rs 95 lacs. You are happy because you have saved Rs 25 lacs in taxes. Panama is happy because it has got Rs 5 lacs of taxes without doing anything. The real loser, however, is the Government of India. It has lost tax revenue of Rs 30 lacs in its anxiety to attract foreign investment of Rs 95 lacs.
There are many other ways of shifting income from India to such shell companies located in tax havens like Panama and Mauritius. The money can be transferred in the form of royalties. For example, Google USA made a gross profit of Euro 5.5 billion in United States in 2010. It paid out royalties and license fee of Euro 5.4 billion to its Bermuda Headquarters and other foreign affiliates. The income shown in the books of Google USA was a paltry Euro 45 million. The tax paid globally by Google at its United States, Bermuda and other foreign affiliates was only 2.4 percent of the income against 25 percent that it was legitimately required to pay in the United States.
Another method used by Multinational Corporations to shift income from is by manipulating the price at which they transfer goods from their branch in one country to branch in another country. Coca Cola USA, for example, can sell its concentrate to Coca Cola Panama at a low price. Then Coca Cola Panama can sell the same concentrate to Coca Cola India at a high price. The result will be that Coca Cola USA and Coca Cola India will both show small profits while Coca Cola Panama will show huge profits. The Company will pay nominal taxes in the United States and India despite high rates of taxes being applicable because incomes here are less; and it will pay nominal taxes in Panama because the tax rates here are low. It is estimated that 60 per cent of illicit capital flight from Africa is undertaken through such manipulation of transfer pricing. The entire process is legal.
The United States has enacted the Foreign Account Tax Compliance Act (FATCA) in 2010 to prevent such misdoings. The law requires all foreign banks to disclose the identities and transactions of United States’ nationals holding accounts with their branches worldwide. Refusal to disclose would lead to them being banned from undertaking business in the United States. For example, the State Bank of India is required to disclose accounts of all United States citizens to the United States Government. Failure to do so would lead to closure of the branches of the State Bank in the United States and also to its participation in any financial activities such as buying of US Government Bonds. The United States is able to arm twist foreign banks because of its domineering presence in global finance. That option is not available for India which is a marginal player in global finance.
We need to set our own house in order to face this situation. The mischief starts from the infatuation of the Government of India with attracting foreign investments. The Government of India does not ask the Government of Panama to disclose the identity of the investors lest that may scare the foreign investors away. That anonymity, in turn, opens the gates for transferring income from India to Panama in order to avoid paying taxes in India. The way out is to get out of the frenzy of attracting foreign investments. Large numbers of study show that more money is going out of India than the amount coming in because of free transferability of money. Freezing these transfers would help retain Indian money in India and force Indian companies to pay taxes in India. The case for foreign investments arises largely from the frontier technologies that the Multinational Corporations bring along with their investments in India. The same objective can be attained by buying technologies and by increasing government investments in research.
The second problem is laxity on the part of our Income Tax Department. In the example given above it was told that India Estates paid a commission of Rs one crore to Panama Estates. The Income Tax officer can ask India Estates to produce documents to establish that Panama Estates actually provided services for which the commission was paid. The ownership of Panama Estates can also be sought. The failure of the tax officials to ask these questions is behind the loss of taxes in India. We must repair our tax management instead of shouting at Panama.
Author was formerly Professor of Economics at IIM Bengaluru