In Obama’s unfriendly tax stance lies an opportunity for India

As the US struggles to rebuild its battered banking and fiscal systems, grow domestic economic activity and restore employment levels, the Obama administration has taken initiatives to modify the current international taxation provisions of the US tax code.

These proposals are expected to yield $210 billion over 10 years. This is relatively modest revenue in relation to projected US debt over this period of $17,000 billion. Nevertheless, the proposal will have profound implications for international tax arrangements, including for India. 

The current system of international taxation by the US is exceedingly complex, with high statutory rates, which are then drastically lowered to a varying extent by a host of exemptions, deductions and special provisions applied to specific types of businesses and entities. Thus, effective tax rates are much lower than statutory tax rates and vary widely among firms and activities. 

A 2004 study estimated that US companies paid an effective tax rate of 2.3% on their overseas profits totalling $700 billion. In contrast, statutory corporate tax rate in the US is 35%, among the highest in industrial countries. 

The complex arrangements are to an important degree necessitated by the US practice of taxing its corporations and individual taxpayers on income earned overseas, rather than on the territorial base used by most other countries. 

International taxation is arcane, extremely complex, and is usually debated within the confines of a small group of experts, policymakers and industry lobbies. But the recent global attention on tax havens, bank secrecy laws (see my column in DNA Money dated May 6, 2009), and Obama’s tax proposals have led to wider-than-usual debates in making these arrangements more compatible with the measures needed to cope with the current global economic crisis.

It must be emphasised that in the US political system, tax proposals by the President are often substantially altered by the Congress after an extensive debate. It is probable that these proposals will be discussed in the larger context of corporate tax reform in the US, with the objective of providing more equitable tax treatment between small and medium businesses and multinational corporations. 

Obama’s proposals will:
Tighten, but not entirely eliminate, the current provisions, which allow US companies to defer taxes on their overseas profits, which are permanently invested abroad; 

Change the legal treatment of many international subsidiaries that companies have used to shift earnings to low-tax offshore tax havens;

Would put new limits on the abilities of corporations to use offshore subsidiaries to generate unjustified foreign tax credits, for example by transferring patents or other intangible property;

Increase tax rates on households earning more than $250,000 a year; and 

Tighten the requirements for US taxpayers to declare offshore accounts, increasing transaction and regulatory costs of managing money for US citizens in Asia and elsewhere. 

As may be expected, the proposals have drawn several adverse comments and reactions. Some, particularly the industry lobbies have argued that increasing taxes on US corporations at this juncture will reduce their competitiveness. Countries that have relied extensively on fiscal incentives and fiscal dumping have also been particularly anxious about these proposals.

The Economist (May 9, 2009) has argued that these proposals would add even greater complexity to the US tax code, would not encourage domestic job creation (Obama’s reference to Bangalore when introducing these measures was singularly inappropriate, as Indian tax rates are already on the higher side, and research suggests that off-shoring work done in Bangalore increases competitiveness of US firms and generates considerable economic benefits to the US), and will not fundamentally improve the current international tax system.

The proposals are likely to give fresh impetus to more fundamental reforms of international fiscal and financial regulatory cooperation and coordination. Pressures for exchange of tax and other related information such as bank accounts of overseas citizens will also increase considerably.

The merits and demerits of unitary taxation of corporations, under which companies are taxed according to a formula on their worldwide profits, are likely to become more prominent in debates about corporate tax reform. Any such change in this direction is, however, unlikely to be rapid or smooth as such a shift will profoundly alter the current locations and practices of many businesses. Lobbying power of the multinationals and the tax jurisdictions benefiting from the current arrangements is also considerable.

India currently has double taxation avoidance agreements (DTAAs) with over 70 countries; and is rightly emphasising totalisation agreements in which there is mutual recognition of social security taxes paid by the Indian citizens in other countries and vice versa.

India must take the opportunity of the debate generated by Obama’s proposals to reform its own taxation regime. 

First, the current debate about international taxation underscores the fact that tax policies must be integrated with broader development goals, and made consistent with the current phase of globalisation. The proposals implicitly recognise that tax arrangements impact business and individual location decisions. 

The next government must give priority to rationalising the existing tax —- and fiscal —- system. In particular, abolish such dysfunctional taxes as the fringe benefit tax; broaden the tax base, curb excessive use of cesses and surcharges; and implement the goods and service tax. The tax treatment of special economic zones also requires rationalisation. 

Second, India must reconsider its current tax regime, which, like the US, attempts to tax its companies and individual tax payers on the basis of global income. Like its other economic partners and competitors, India must shift towards a territorial basis of income taxation. 

Third, India’s income-tax department must hasten a shift towards developing functional specialisation in international taxation. The traditional practice of rotating existing income tax officials from varying domestic-oriented responsibilities, to administer and develop international taxation rules and policies must be urgently re-examined and rationalised. The Planning Commission recent proposals to hire experts could also merit consideration by the income tax department, albeit with suitable modifications.

Fourth, India should re-examine its DTAAs, and preferential trading agreements (PTAs) to ensure that they do not distort efficient and equitable economic decisions, and do not undermine India’s fiscal base.