Unmuddling the tax

The decision to reduce withholding tax for foreign investors is timely

Written by The Indian Express | Published: May 2, 2013 3:25:03 am

The decision to reduce withholding tax for foreign investors is timely

An amendment to the Finance Bill reducing the withholding tax applicable on foreign investors buying rupee bonds from 20 per cent to 5 per cent,is a welcome move. The high withholding tax had made investment in Indian rupee bonds less attractive. At a time when the current account deficit is high,and foreign capital inflow can prevent rupee depreciation,this is an apt decision.

A core principle guiding discussions on tax policy and globalisation is that taxation should not cause distortions that influence the economic decisions of individuals or firms. Taxation should neither generate a bias in favour of doing business at home,nor in favour of doing business abroad. Tax neutrality for trade in goods and services has been achieved by focusing taxation on the point of consumption through the destination principle. Similar issues arise in the treatment of capital account integration. Internationally,two systems exist for taxing capital gains on financial products. In the first,a country taxes such gains in the case of residents but exempts them from tax in the case of non-residents. Consequently,while determining the distribution of the rights of taxation of such gains between countries,the country where the capital gains have occurred cedes the rights of taxing capital gains of non-residents to the other country. Most developed countries follow this system,though there are exceptions.

Many developing countries,including India,follow a source-based taxation system. A non-resident global investor would prefer to invest in a country with a residence-based taxation regime because then he is not taxed in the source country,so his entire income (domestic as well as foreign) is taxed only once in his country of residence. In contrast,under the source-based system,he would pay tax in the source country and would have to seek credit for such taxes in his home country. This raises his compliance burden and may not fully mitigate the tax burden in all cases if the tax rate in the source country is higher than the rate he faces in his home country,as was the case for many foreign investors with the withholding tax of 20 per cent. Traditionally,developing countries that have had source-based taxation have sought to reduce the compliance and tax burden by reducing tax rates for non-residents. A shift towards a residence-based system could be one of the components of India’s financial reform.

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