gfiles magazine

November 13, 2011

gfiles Magazine November Issue 2011

government misfeasance stashing money abroad
Designing Loopholes
The state is partially responsible for the thriving black economy
JULIAN Assange, the brain behind Wikileaks, has claimed that the bulk of the account owners in Swiss banks are Indian. His whistle-blower, the Swiss banker who gave him the details of 2,000 such accounts, said that the Indians included politicians, cricketers and film stars. Under pressure, the Swiss authorities then disclosed that Indians had a mere $2.5 billion, and not $1.4 trillion as claimed by BJP leader LK Advani, in individual, corporate and numbered accounts in their country.
One can debate the extent of black money that has been stashed away by Indians in tax havens, especially Switzerland. But, shockingly, in the past two decades of economic reforms, critical government agencies and Ministries like the Reserve Bank of India, the Income Tax (IT) Department and the Finance Ministry may have either deliberately or otherwise encouraged the outflow of illegal income. In effect, it is the state which is partially responsible for the thriving black economy.
Diluted Acts related to foreign exchange, case-by-case interpretations by IT officials, corporate pressure to leave gaping holes in laws, and weak monitoring systems have ensured that, despite reforms, the extent of the black economy has increased enormously. The Global Financial Integrity Report last year gave two reasons for this trend: lack of regulation that provided “an added incentive for those seeking to transfer illicit capital abroad”, and increasing income inequality that ensures more money in the hands of the rich, who are the “primary drivers of the illicit flows….”
FERA versus FEMA
The old Foreign Exchange Regulation Act, introduced in 1973 by Indira Gandhi, was draconian, unfair, and a relic from a socialist past. But its substitute, the Foreign Exchange Management Act (FEMA) of 1999, was positioned at the other extreme. If the RBI is to be believed, the new Act did not impose any responsibility on it to monitor foreign exchange flows. The onus for this was placed on the recipient/payer, and the banks, from whose accounts the money was paid or received.
Under pressure, the Swiss authorities disclosed that Indians had $2.5 billion, and not $1.4 trillion as claimed by BJP leader LK Advani, in individual, corporate and numbered accounts.
For instance, in a recent letter the RBI wrote to the Finance Ministry, it admitted that in cases of foreign direct investment (FDI), it is not interested in either the source or the end-use of the money. So, the central bank has no idea how the foreign investor has earned it (it could be from dubious sources) and it is unconcerned at how the Indian firm has deployed it (it could be siphoned off into personal coffers). This might be especially true of unlisted companies, where owners, being the majority shareholders, call the shots and which have received huge sums from global private equity (PE) players.
Consider two real-life cases, although we are withholding the names of the companies. In one case, an unlisted arm of a leading business group re-routed its own black money stashed abroad, and showed it as the purchase of a minority stake by an international PE firm. More important, this firm was able to hike its valuation, since it was its own money, to give a false sense to potential institutional and retail investors that it was worth more. It finally went in for an IPO at an even higher valuation.
In the other case, an owner asked a renowned PE firm to buy a minority stake in his unlisted firm at a valuation that was twice those of its competitors in the same sector. The PE firm obliged for a simple reason: it was assured a fixed return on its investment if the IPO of the unlisted firm did not happen within a fixed period (four years), and it was logical that the IPO price would be much higher than the valuation at which it had invested in the company. A win-win for PE and the Indian owner!
Clearly, in such cases there is immense potential to either convert black money into white, or generate more black money. For example, in the second case, the Indian owner could easily siphon off the PE money into his pockets, or for his personal use. What is even more disgusting is that the RBI is totally blasé about these trends. Look at how it justified its hands-off policies regarding FDI in the same letter written to the Finance Ministry.
Both the PE and exports routes offer Indian companies an easy and legalized opportunity to launder their black money, ie convert it into almost tax-free white money.
One, it stated that the onus of ensuring that a particular FDI deal has complied with the existing FEMA and other rules was “on the Indian company (which received the money) and the banks routing the FDI transaction”. Two, it contended that the process of reporting these FDI inflows by the banks to the RBI was “essentially a post-investment
reporting for Balance of Payment statistics”. Therefore, the FDI irregularities could only be investigated by official investigation agencies like the Enforcement Directorate if they received complaints or tracked them on their own.
Merchandise exports versus receipts
In the 1970s and 1980s, when India placed restrictions on several importers to finance their purchases through export earnings and exporters to ensure that they brought back the entire earnings to the country, the deals were closely monitored by the RBI, Finance Ministry and nodal Ministries. Surprisingly, this is no longer the case. Yes, there is a mechanism whereby the RBI does receive details which can be reconciled in the case of exporters. Unfortunately, the central bank has neither the time, manpower nor other resources to do this job efficiently and effectively.
Under the existing rules, when Customs clears the merchandise exports – physical goods as opposed to services (software) – copies of the invoices are sent to the RBI. Similarly, when the bank where the exporter has his account receives the proceeds, it duly informs the central bank. By comparing the two, one can easily find out if the entire export income has come into the country. Sadly, the RBI is unable to do it because it does not have an internal system to go through the thousands of documents.
Here is an example of what happens in practice. In its recent report on illegal iron ore mining involving the Bellary brothers, among others, the Karnataka Lokayukta said that the RBI has to “collate and compare the two databases (Customs and banks), and monitor whether the realization of export proceeds is as per law. This is not happening effectively”. The RBI had bank records for only a fifth of the 5,000 iron ore export transactions in the State between 2006 and 2010.
Julian Assange (above) of Wikileaks, claimed that the bulk of the account owners in Swiss banks are Indian politicians, cricketers and film stars.
Now, look at the catch. India’s merchandise exports are over $250 billion. So, even if there is a mismatch of 1% between Customs and banks records, i.e. 1% of the export income has been stashed abroad, the annual black money generation on this count is $2.5 billion.
Legalized money laundering and tax avoidance
What is important to note is that both the PE and exports routes offer Indian companies an easy and legalized opportunity to launder their black money, i.e. convert it into almost tax free white money. I have mentioned that this is possible with PE inflows, which is tax-free. In case of other FDI inflows, from tax havens like Mauritius, the IT department has consistently accused Indian promoters of round-tripping or bringing back their black money as legal and tax-free FDI.
In the case of exports, given the RBI laxity and Customs’ collusion, the Indian seller can over-invoice, or over-inflate, his prices; on the invoice, he can say that the goods or services are worth five times the real price. To complete the cycle, the goods and services are sold to fictitious firms abroad – in some cases the goods are dumped in the sea –but the entire proceeds are brought in. Since there has been no real transaction, the money that comes in is actually the exporter’s black money stashed abroad.
So, why is the government encouraging these trends, or turning a blind eye towards them? The first reason is related to what a former Finance Minister told me in private a few years ago. “How does it matter if black money is coming back as export, FDI, and FII (foreign institutional investment)? As long as money is flowing into the legal system in a legal manner, we should be happy as it boosts economic growth. Moreover, it reduces the quantum of black money.”
The counter to this is that if enough safe opportunities exist to legalize black money, there are also enough incentives for the businessmen to create it. If they realize that they can convert it into white through several methods, without getting caught or being asked questions, they will be encouraged to do so. This also explains why so many politicians and businessmen have recently been caught openly transferring abroad the black money they generated in India.
Efforts by the IT Department to force the Finance Ministry to change the treaty clauses to stop round-tripping have fallen on deaf ears over the past decade or so.
Second, there is too much pressure on the government from Indian business houses and foreign investors. The latter don’t want the state to plug these holes. Since Mauritius is a tax haven, and India has signed a double-taxation treaty with it, there are tax implications on money coming or going through Mauritius. For foreign investors, it is the best way to save on taxes. So, all efforts by the IT Department to force the Finance Ministry to change the treaty clauses to stop round tripping have fallen on deaf ears over the past decade or so.
IT was with great difficulty that IT sleuths were able to file cases to stall another possible fraud – tax evasion through cross-border deals. In such cases, as in the Vodafone-Essar telecom deal which is being fought in the courts, a Mauritius based entity, owned by an Indian promoter, sells the stake it has in a legitimately Indian company with assets in India, to a Mauritius-based foreign investor. Since the deal is between two foreign entities in Mauritius, there is no tax implication. No TDS is cut by the buyer and paid to India’s IT Department because of the double taxation agreement.
In the Vodafone case, the IT Department has stated that since the deal involves assets based in India, TDS has to be deducted. Now the Supreme Court will deliver this landmark judgment, which will impact FDI deals. At the same time, the IT Department is pushing the government to amend the double taxation agreement with Mauritius to stop or curtail round-tripping. Finally, the IT officials are complicit in decisions that enable tax evasion or avoidance due to political pressure or individual corruption.
Clearly, the blame for an increase in the size of the black economy rests with the government. The “black” buck, as they say, stops with it. If the government is really interested in curbing black money, it needs to drastically improve its regulatory and monitoring mechanism as well as introduce systemic changes in key sectors such as real estate, construction, mining, and financial services which generate, propagate, and help legalize black money. g

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