The long arm of India's tax authorities

No one likes to see a tax demand dropping silently on to the doormat, but in India it comes with a special sense of dread. Foreign businesses such as Vodafone and Cairn Energy know the feeling only too well. Now it seems global fund managers might be next.

Until a few months back, only a handful of tax nerds had heard of India's minimum alternative tax (MAT), a levy that ensures domestic businesses must hand over a basic portion of profits. That was until some bright spark found a regulatory ruling from 2012, implying that foreign institutional investors might suddenly be liable, despite never having had to pay it before.

Over recent weeks demands have begun arriving at about 100 international funds. Many more of the 6,000 that invest in India could now be hit. Tax experts are peeved, arguing no other country charges foreign equity investors this sort of tax. Fund managers, needless to say, are not best pleased either.

"I think people are, for understandable reasons, a little leery of India, given all the tax issues with the Cairns and the Vodafones of this world," says Hugh Young, the avuncular head of Aberdeen Asset Management in Asia, which this week became the first big fund to admit it had received one of the demands.

Oddly, however, India's government is frustrated too. Prime Minister Narendra Modi has promised to end his country's record of "tax terrorism". In that spirit, his government recently changed the law, to ensure that MAT would not apply to foreign funds in future.

Perversely, however, this may even have emboldened the tax authorities to re-look at older cases. If the government claims foreigners are now exempt from MAT, their logic goes, they must not have been exempt before. "Our hands are tied," says one senior figure in Mr Modi's government. "We have fixed this issue for the future, but we can't just intervene randomly. In a democracy, we have to follow legal process. The foreign funds can appeal."

This is a fair point, although it doesn't disguise the fact there will be a terrible stink if hundreds more funds do now get the demands. Yet this episode also reveals a wider conundrum about tax in India. Mr Modi has pledged to bring harmony to revenue collection. Few doubt his sincerity. Yet seemingly with each promise to improve things, a new row emerges that he seems unable to fix.

Part of this is a rotten inheritance. India's last government introduced one especially egregious tax change: the so-called "retrospective" amendment, targeting Vodafone and allowing closed tax cases to be reopened. It also gave tax authorities stiff revenue targets, and made foreign companies fair game.

Unwinding this will take time. Meanwhile, taxes still have to be collected from somewhere. India rightly complains that foreign businesses are too ready to complain about paying even reasonable demands. "India is not a tax haven," Arun Jaitley, finance minister, thundered last week - although there was never much of chance of anyone mistaking it for one.

Yet Mr Modi's government has a case to answer too. It has taken some steps foreign investors should welcome, such as deciding against launching appeals in cases involving companies such as Shell. But equally it has often muddled through, ducking forthright action that could have stopped future tax flare ups.

On foreign funds, India's government says MAT will not apply in future, but it is powerless to stop investigations into older cases. Tax experts dispute this, claiming that legal changes or other rulings could make clear that the tax was never meant to apply to foreign funds.

Equally, Mr Modi has made slow progress fixing other structural problems underpinning India's history of tax disputes. The most obvious example was his unwillingness to scrap the retrospective amendment, meaning high profile cases involving Vodafone and others will now drag on for years. But there are other problems too, such as lengthy appeals processes, caused by courts that lack the resources to clear backlogs.

India's tax inspection system is highly decentralised too, arguably giving excessive power to individual inspectors. "A tax officer, under Indian law, is supreme. His power cannot be questioned," says Dinesh Kanabar, a Mumbai-based tax expert. "There is no accountability. Each officer can pass almost any order he wants, no matter how outrageous it is." Of course, not every tax demand made fits this description. But ending those that do would be in everyone's interest.

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