The Panama Papers reveal that countries with much simpler tax laws, lower costs of compliance and a stronger administrative capacity to enforce laws than India have not been able to prevent the use of tax havens. In India, tax rates are higher, the system is complicated and capital controls restrict foreign financial transactions. Tax havens are more likely to be used not just for illegal activity but even for legitimate businesses.
The government has ordered a probe into the leaks. But there are thin lines between the legal and the illegal. The difference between tax evasion and tax avoidance is one such line. Tax evasion involves not paying taxes on your income and is illegal. Tax avoidance, on the other hand, is about managing your taxes across different tax jurisdictions to take advantage of differences in tax rates, such as corporate tax rates, in tax treatment of different kinds of income, such as capital gains, and in tax treaties among countries. Tax havens such as Panama, the British Virgin Islands and the Bahamas try to attract business by offering low tax rates and easy compliance.
Officials from OECD countries on the Panama list are under public pressure because they have been advocating that tax avoidance, though legal, is cheating. A number of OECD initiatives have been taken to reduce tax avoidance: An agreement on Base Erosion and Profit Shifting (Beps) aims to prevent companies from choosing low-tax jurisdictions to book profits in. The Automatic Exchange of Information (AEOI) framework will facilitate information flows among signatories. The Foreign Account Tax Compliance Act (Fatca) targets non-compliance by US taxpayers and compliant countries have to provide customer information to the US government.
In addition to tax avoidance, as tax havens have laws to ensure greater confidentiality of companies and banking secrecy legislation, the companies may be used for money laundering. In general, there is a widespread perception that offshore companies are conduits for money laundering, illegal transactions, tax evasion or parking unexplained wealth. While offshore companies may be used for illegal purposes, law-abiding citizens may hold them for making investments in other countries to help navigate the complex maze of tax treaties and multiple jurisdictions involved in managing tax liabilities. Hedge funds that manage money in multiple countries often use tax havens to reduce compliance costs arising from different tax treaties among jurisdictions.
The Indian case is more confusing than those of OECD countries. It has been made complicated by a set of tax laws that makes compliance more costly than in the OECD. We rank 157 in the ease of paying taxes. Further, the effective tax on profit is higher: The corporate tax rate and the dividend distribution tax put together make the tax rate on profits nearly 50 per cent. The capital gains tax makes financial transactions even more unattractive. This regime is made more tortuous by an onerous set of capital controls.
As a consequence, companies operating globally have every incentive to set up companies in such jurisdictions.
There are some cases in which the actions are clearly illegal. The first, for example, is when the underlying activity is criminal,
say, drug or arms trade. These activities are covered under the Prevention of Money Laundering Act. As a member of the Financial Action Task Force, India works with other member countries to prevent the use of the proceeds of crime.
The second is when there are cases of tax evasion: A person does not declare to the tax authorities in her home country her income, which is paid into a bank account of her company in Panama, and no taxes are paid. Here, a distinction between tax evasion and avoidance is relevant. If taxes have been paid in the tax haven at its lower tax rate, then there may be no illegality. When India introduces the General Anti-Avoidance Rule (Gaar), some of these activities may become illegal.
The third case is if there is a violation of capital controls. This is an India-specific issue. Under the Liberalised Remittance Scheme (LRS), every Indian resident is allowed to invest $2,50,000 abroad every year. In 2004, the limit was one-tenth of this. Money remitted abroad is from income on which tax has already been paid. If the amount invested abroad exceeds the amount allowed by the RBI, it is a violation of the law.
Fourth, the illegality may be the non-declaration of assets held abroad. A provision in the Finance Bill introduced in 2015 made it criminal not to declare foreign assets in annual tax returns. If the assets held in tax havens have been declared, then it is not illegal to hold them.
OECD countries have simpler tax laws with lower tax rates and lower compliance costs than India and no capital controls. The focus of the authorities is to broadly keep business in the country and to tax the income of its residents. Yet, the Panama Papers show that even with much simpler systems and more effective enforcement, it is a challenge to prevent illegitimate cross-border flows.
In India, it is not just entities engaging in crime and tax evasion that have offshore companies. Reports suggest, for example,
that many Indian technology start-ups are moving their headquarters to offshore locations due to our complexities. These muddy the waters as both legal and illegal activities move abroad.
Looking forward, first, rationalisation of capital controls should be a top priority. Many government reports have laid out the path forward. Second, India must move to a simple tax regime with lower compliance costs. The blueprint is ready in the Direct Taxes Code. When countries with simpler laws and better enforcement are not able to prevent violations of the law, we cannot hope to do so with our labyrinth of capital controls, maze of tax laws and much weaker tax administration.
The writer is professor, NIPFP, Delhi
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