Black Money

CA Rashmin Sanghvi
4th February, 2011

One question which agitates many people’s minds is : “Can Black Money be eliminated?”

The answer is very simple. “Can greed be eliminated?”

In other words, if greed can be eliminated, black money can be eliminated. As per the Indian philosophy, this whole society (Samsar) is a product of Nature (Maya). Maya has two instruments (relevant to present subject): (i) Greed & (ii) Fear. Most people are greedy to achieve material wealth which does not belong to them. Hence most people are running towards temptations (a consequence of greed) and away from fear. As long as there is Samsar, there will be people who do not want to pay taxes, who want bribes and so on. Monetary result of all crimes will be black money.

It is also said that: “The more greedy a person, the more fearful he is.” If this were true, it would be very simple to eliminate black money. Put the fear of law in the minds of tax evaders & you eliminate black money. Experience shows that the game played by Maya is not so simple. The highest authorities that are supposed to eliminate black money, them selves are greedy. Law has generally been proved to be ineffective against the authorities. And when the businessmen, bureaucrats & politicians form a cartel, hardly any thing can be done.

Is there any purpose of having discussion on attempts to eliminate black money? While black money cannot be eliminated, it can certainly be regulated. And should be regulated. How to regulate black money is the issue we discuss in this paper.

I do not propose to discuss detailed income-tax sections and the complex technicalities involved (except for one specific section on FIIs). Instead, I present here some thoughts on black money.

1. Black money is not just money without payment of income tax. Black money can be generated by bribe, theft and other serious crimes. Hence black money is present even in the countries where there is no income-tax. A manufacturer may want to avoid excise & sales tax. He would sell the goods in black and create black money. School & college donations are an important reason for black money. When a student gets admission by paying black money, the society has corrupted a young person even before he graduates. That student is most likely to consider black money as normal and essential part of the life.

Black money is universal. Indians do not have the monopoly of black money. I believe claims by media that : “the largest amount of black money in Switzerland belongs to Indians” are just innocent ignorance. Indian economy had been comparatively small economy. It is only recently that in terms of purchasing power Indian economy has become a large economy. So far the U.S. economy has been the largest. And the U.S. tax laws are far worse than the Indian tax laws. Considering the fact that all human beings are equally susceptible to the forces of nature (greed), it is a simple arithmetic that the black money owned by U.S. citizens should be many times larger than the black money owned by Indians. Add to this black money arising from the European countries, black money owned by Kings & Sheikhs and so on. Indian black money cannot be more than a small fraction of the global black money.

So, black money is universal (geography) and forever (history) present. It is omnipresent.

2. Black money is “Omnipotent”. Dawood Ibrahim could wage a war against India (in the years 1992 & 1993) and cause tremendous losses to India by bribing several customs officers & others in India. Since black money is free from all taxes, sometimes it is more powerful than white money.

Consider a simple illustration. Mr. H is an honest man. He pays full direct tax on his income and pays full indirect taxes whenever he buys goods. He buys everything by insisting on receiving proper invoice.

Mr. E evades all taxes wherever possible.

Both of them want to purchase a refrigerator (fridge). For the manufacturer of fridges, the sales price is say, ` 10,000. When excise, sales tax & octroi are added, the retail price is ` 20,000. The manufacturer is ready to sell the fridge: (i) with invoice after charging full taxes or (ii) without invoice and without any taxes.

Mr. H will earn ` 30,000, pay a tax of ` 10,000 and purchase the fridge at a price of ` 20,000. In other words, he has to earn ` 30,000 to be able to buy the fridge.

Mr. E will earn only ` 10,000 and purchase the fridge in black without paying any direct or indirect taxes.

This illustration clearly shows how a tax evader has three times the financial power as compared to an honest tax payer. There is a huge temptation for evading taxation. Is it logical to expect ordinary mortals to be moral enough to avoid such strong temptation!

Let us see some important developments which caused a black money economy in India. Government of India’s responsibility : paragraphs 3 to 6 below. Tax Payers & Tax consultants’ responsibility : paragraphs 7 & 8 below.

Probable Solutions : paragraph 9 below.
Result : Paragraphs 9 & 10.
Future : Paragraph 11.

Does Government of India Cause Black money!

3. A History of High Tax Rates :

Consider the maximum marginal tax rates in the year 1974. Income-tax rate for was 98%. Wealth-tax was 8% and estate duty was 80%. Let us use some arithmetic to understand the economics.

Assume that Mr. H had a wealth of ` 10,00,000 and he was earning an income @ 15% on his wealth. Thus he earned ` 1,50,000 per year in addition to his normal business incomes.

Now he would pay income-tax of ` 1,47,000 (@ 98%). He would pay wealth tax of ` 80,000 (8% of wealth). Thus on a total income of ` 1,50,000 he would pay total direct tax of ` 2,27,000. If he had to remain honest, he would have to sell part of his wealth every year just to pay the taxes. Presumably no honest tax payer would have any substantial savings left. And yet the Government imagined that there will be people with large estate & imposed an estate duty @ 80%. GOI ministers were really imaginative.

Consider a large industrial house in India. Chief promoter of the industrial house held 1,00,000 shares in the company where market price was ` 100 per share. Market value of the shares was ` 1 crore.

On his death, the heirs would be liable to pay an estate duty of ` 80,00,000. There is no arithmetic error. 80% of the market value of estate was payable as duty.

Naturally no industrial house would have liquid assets to pay a tax which amounts to 80% of their total estate. Hence the heirs would have to sell a significant portion of their inheritance. When the family members of the industrial house come forward to sell their shares in the market; the word spreads and the share prices crash. Let us assume that the price goes down from ` 100 per share to ` 60 per share.

Even if the heirs sold 100% of the inherited shares, they would get only ` 60,00,000. This would be insufficient to pay the whole of the estate duty. It means the heirs would have to sell their personal assets to pay the full estate duty. Well, thankfully, there were provisions so that one would not pay more than what he inherited.

Tax evasion was a compulsion in those times. Government was the cause. Only people having incomes & wealth below taxable limits or irrational people paid full taxes. India did have some irrational specimen. (Please see paragraph 9.1 below. Today India has one of the best direct tax rate system.)

4. Absurd Laws :

FERA will go down in Indian history as a classic piece of absurd law. It went directly against the business interests of the citizens. Result was, FERA was violated by almost every one who had any thing to do with foreign exchange. Following is a summary of long essays I have written earlier on the subject.

(i) Absurd FERA together with the facts that (ii) rupee was continuously depreciating (iii) and tax rates were usurious; made hawala (transfer of one’s savings outside India) necessary to protect one’s wealth. Stiff customs duty rates with absurd import licensing made smuggling profitable. Gold Control Act which wanted to prohibit Indian women’s natural desires, made gold smuggling profitable. All these became complimentary to each other. We had a black money market larger than white money market.

More serious was the issue that Indian wealth was running out & government of India was begging before the “Aid India Consortium”. I submit for your consideration the statement that: “GOI was chief reason for black money & poverty in India”.

Thankfully, Dr. Man Mohan Singh (as Finance Minister) & Late Mr. Narsimha Rao (as Prime Minister) started a liberalisation process in India in the year 1991. Our prosperity today (though limited) is due to the liberalisation.

5. Does Government abet tax avoidance!

In the current case going on in the Supreme Court of India on black money (the public interest litigation filed by Mr. Ram Jethmalani) Honourable Supreme Court has asked Government of India to disclose the names of the people holding black money abroad. As per media reports Finance Minister Mr. Pranab Mukherjee has said that the Government cannot disclose the names of the people alleged to have black money in Swiss Banks. His reason is that the Double Tax Avoidance Agreement (DTA) prohibits disclosure of information.

5.1 Extract of the relevant article from OECD Model is given below :

Article 26 (1) – The competent authorities of the Contracting States shall exchange such information as is forseeably relevant for carrying out the provisions of this Convention or to the administration or enforcement of the domestic laws concerning taxes of every kind and description imposed on behalf of the Contracting States, or of their political subdivisions or local authorities, insofar as the taxation there under is not contrary to the Convention. The exchange of information is not restricted by Article 1 and 2.

Article 26 (2) – Any information received under paragraph 1 by a Contracting State shall be treated as secret in the same manner as information obtained under the domestic laws of that State and shall be disclosed only to persons or authorities (including courts and administrative bodies) concerned with the assessment or collection of, the enforcement or prosecution in respect of, the determination of appeals in relation to the taxes referred to in paragraph 1, or the oversight of the above, such persons or authorities shall use the information only for such purposes. They may disclose the information in public court proceedings or in judicial decisions.

{There is no typing error. Double Tax Avoidance Agreements (DTA) are written in such a language that most people cannot understand them. I don’t think it is deliberate.}

5.2 However, the agreement with the Swiss Government does provide that the information exchanged under DTA shall be maintained as secret information.

(i) OECD Model provides for the disclosure of information before the courts. (ii) In the year 1994 when GOI executed DTA with Swiss Government, every one knew that the Swiss banks store world black money & Swiss Government passes laws which help Swiss banks. One wonders why the Indian Government did not insist on a clause similar to the OECD clause.

5.3 We have no Double Tax Avoidance Agreement (DTA) with Liechtenstein. Hence there is no restriction on Government of India against disclosing information about Liechtenstein information.

The German Government has offered information to any Government in the world which wants the information on tax evaders having money in tax haven banks. This information is not under the DTA. It is freely available. Hence there cannot be any restriction against publication of the information. Yet GOI refused to take the information.

5.4 Azadi Bachao Andolan (ABA) is an NGO from Allahabad. It made a claim that India – Mauritius DTA was abused by FIIs for avoiding huge amount of Indian income-tax. Delhi High Court agreed with ABA. At this stage Government of India went to the Supreme Court appealing against the Delhi High Court decision. One would expect a normal Government to be happy if tax avoidance through treaty shopping is held to be invalid by the court of law. Instead, Government itself went to the Supreme Court and claimed that India – Mauritius treaty is a valid treaty. Is it not a big surprise!

5.5 This Government goes on signing Double Tax Avoidance Agreements with several tax havens. And then makes public noises against tax avoidance and treaty shopping!!

5.6 A lot has been said in the media about Mr. Hasan Ali Khan and the allegations against him. Even more has been said about how Government of India appears to be protecting him.

6. There has to be an incentive to pay tax. It is not that every citizen is dishonest. Some people realise the value of having a good Government providing law & order and all other services.

There are so many people who make substantial donations. They do not expect any personal benefit for themselves. If their money is used by the NGOs and if some poor family benefit, the donors are happy. And yet these vary donors would not pay full tax. Why? They see their money being wasted in huge corruption and wasteful expenditure by GOI. I submit, even today, GOI (which includes politicians) continues to be the chief reason for black money in India.

In the opening paragraph & paragraphs 1 & 2 we have seen the natural instincts which cause black money. Paragraphs 3 to 6 expose Government’s responsibility for black money. Now let us see our responsibility for black money: paragraphs 7 & 8.

7. Role of Private Sector in Black money :

Normal definition of black money is: “that money on which income-tax is not paid and which is concealed”. Now this definition needs to be broadened.

I would say that wherever tax is due but not paid – whether by legal or illegal means, it is black money. It may be concealed or it may be open. That does not change the fact that it is illicit money. In other words, there is no difference between tax evasion & tax avoidance. Both bleed Indian economy.

If a farmer genuinely earns agricultural income and does not pay income-tax, his income and wealth are white money. However, if an industrialist converts his black money by disclosing it as agricultural income, it is still black money. He may be able to produce some paper work showing the income as his agricultural income. It does not mean anything. Since the papers do not tell reality, they are worthless. This is plain & simple money laundering. (Prevention of Money Laundering Act does not cover black money as scheduled offence. Here I have used the term “Money Laundering” in the more popular sense of the term.)

Similarly, aggressive tax planning is also Money Laundering. For example, treaty shopping. Or use of tax havens. When the papers regarding tax haven companies (Certificates of incorporation, residential status, claims for DTA relief etc.) make a statement different from reality, in effect those papers are worthless.

Similarly, where an FII or an MNC does aggressive tax planning and avoids Indian taxes, by using treaty shopping or tax havens, their income is also black (illicit) money.

8. Effective Rate of Tax (ERT) :

8.1 It is very interesting to hear some professionals – especially those representing FIIs and MNCs. They claim that a foreign investor or FII is concerned with “Effective Rate of Tax” (ERT). For the investor Indian tax is a cost. They would like to minimise the cost to zero.

If these institutions & companies having billions of dollars of turnover and earning incomes in India do not pay tax then who is supposed to pay tax! It is one thing that in USA, the Government taxes the middle class and gives reliefs & exemptions to the rich. We know the results of such an inverted system of social justice. How can we in India adopt such absurdity!

8.2 However, our concern has no value. These FIIs are capable of making representations before the PMO and get their exemptions. It is known to every tax professional that today most of the FIIs do not pay any income-tax in India on one of the two grounds: (i) “We have business income, no PE in India and hence no tax.” or (ii) “We earn capital gains. We are investors from Mauritius or Singapore and hence under DTA no tax.”

8.3 Direct Taxes Code (DTC) was supposed to plug all kinds of tax avoidance. However, as per the DTC II draft it appears that this wide scale tax avoidance may continue even under DTC. As per the DTC provisions, incomes earned by FIIs will be treated as capital gains. Hence the FIIs investing in India through Mauritius or Singapore may escape the Indian tax even under DTC.

8.4 Treaty Override : DTC Section 314(141) (b) read with section 46 deem FII income as capital gains. This provision is not protected under section 291 (9). Let me elaborate. India has accepted the stand that: when there is a difference between the provisions of DTA and Income-tax Act (ITA), which ever provision is more beneficial to the assessee shall prevail. This position will continue under the DTC. However, section 291(9) provides that the specific provisions listed under the section will override the DTA. In other words, anti avoidance provisions like GAAR & CFC will override DTA.

However, section 314(141)(b) is not included in this list of protected provisions.

An FII investing in India directly from USA or UK can claim as under. It is earning business income. FIIs have large volume of transactions and all conditions of business generally satisfy the stand that they have business income and not just capital gains. Hence article 7 will apply. If they do not have a PE in India, they are not liable to tax in India. DTC deeming provision shall not apply to FII. The provisions of DTA shall override DTC. Their incomes from India will be tax free.

8.5 If Government of India wants, it can take following corrective actions regarding FIIs’ tax avoidance :

(i) Declare that treaty shopping will be clearly covered under GAAR provisions. Hence any one investing in India through a tax haven will not get DTA relief. This is of course an involved subject and detailed provisions have to be made.

Prima facie, treaty shopping is covered by GAAR. However, it is the discretion of Commissioner of Income-tax to hold it as an “Impermissible Avoidance Arrangement”. DTC Section 123. This means, there can be litigation. And there can be some decisions where treaty shopping may be permitted. It is better for Government to clarify & announce the matter.

(ii) When an FII does business in India where they have any two or more of the following in India: (a) Custodian (b) bank account (c) research organisation & (d) broker; then it will be deemed that the FII is conducting business in India. This deeming provision would apply even if the FII does not have its own office/PE in India.

Alternatively, it can be provided that when an FII buys & sells securities in India, the share broker will be considered as a PE of the FII. He will be liable to pay tax for & on behalf of the FII.

One has to see whether Government of India is determined to act against tax avoidance or would just make public noise about tax avoidance and then succumb to the lobbies.

8.6 It is necessary for the Government of India to declare very clearly that: “The effective rate of tax in India is 30%. If any one earns income in India, he is expected to pay 30% tax except where the law specifically gives a relief. It will not be accepted that a non-resident earns income in India and then does not pay any tax in India.”

9. Corrective Steps to reduce Black money (General) :

Black money can be reduced if it is made (i) either less profitable than white money, or (ii) by making it difficult to use black money. Let us see the steps taken so far by Government of India (GOI) in both directions.

9.1 Black money can be reduced by making it less profitable.

Government of India has taken huge steps to make the black money less profitable. From the earlier direct tax rates of 98% / 8% / 80%, the current position is that: estate duty & gift tax are abolished. Wealth tax is reduced to 1% after substantial concessions & exemptions. Income-tax rate is 30%.

Earlier black money was a compulsory and unavoidable part of the Indian economy. Now if the businessman wants, (purely from tax point of view) he can pay the normal taxes. In fact, today Indian tax rates are better than the rates prevailing in USA, Germany & Japan. With the absence of estate duty in India, there is a huge relief for the tax payer. No one can expect a better rate mechanism in an industrial country. (City countries like Hong Kong & Singapore are different. Oil rich countries like Brunei & Abu Dhabi are different. They may have zero tax or lower taxes.)

Such massive reduction of tax rates shows huge action by GOI. Have we, the citizens responded! Well, experience shows that there are more sophisticated tax avoidance & tax evasion schemes in operation now. Some of us have not responded positively. At the same time, GOI’s revenue has multiplied. There have been several years when GOI got more tax revenue than their budget estimates. Apart from the fact that our increased GDP has boosted revenue, there remains a fact that more & more people are now paying taxes more honestly.

Now when some people do not pay the tax, it is either a simple matter of greed or a compulsion because of Indian Government system.

9.2 GST & VAT :

My knowledge on indirect taxes is limited. However, I am told :

(i) Earlier system of all indirect taxes compelled people to avoid taxes. When tax rates are more than the profit margins, traders & manufacturers are bound to evade/avoid taxes.

(ii) The new system of VAT has already given good results. More & more businessmen are avoiding illicit trade & paying up indirect taxes. When GST will be introduced all over the country, there will be tremendous benefit for Indian economy.

9.3 Government has also taken steps for making the use of black money difficult. All the avenues of spending substantial black money are under the eyes of survey department. Hence to some extent the black money use has been curbed.

9.4 There is now incentive for more & more people to bring back their black money stored abroad. Rupee has stabilised. There are more chances that $ will go down as compared to rupee. And Indian economy offers far better chances for growth & profits than most markets in the world. All together, financial resources in India are increasing with substantial boost to the GDP.

Yet, life is like “Blow hot Blow cold”. (Idiom Definition from dictionary: “If you blow hot and cold on an idea, your attitude and opinion keeps changing; one minute you are for it, the next you are against”.) This is what Maya does. She simultaneously exhibits contrary trends.

10. Hopes belied :

Before the liberalisation started in the year 1991, Indian economy was extremely regulated. Excessive regulation meant that if any one wanted to do anything in India he had to bribe some one or the other. There were many individuals and institutions that canvassed for deregulation or liberalisation of the Indian economy. All these people hoped that once the economy is liberalised, the cause for bribe & corruption would disappear. Hence there will be considerable reduction in black money.

All these individuals’ and institutions’ hopes have been proved wrong. Corruption in India has only multiplied. Late Mr. Rajiv Gandhi lost his elections because it was alleged that in purchase of guns from Bofors, a bribe of ` 64 crores changed hands. Today for the Indian politicians & businessmen, ` 64 crores is petty cash. Scandals are far bigger.

Drama of Maya is difficult to understand or predict.

11. Concluding Observations :

The US economy has fallen because greed has been institutionalised in USA. Is India far behind? The series of scandals exposed in India and the frustration of the Honourable Supreme Court in bringing the corrupt to the books shows that greed is equally entrenched in India. Only the form is different. In India, Government itself is greedy. Is there any reason why India should not suffer a similar fate? I have two views :

(i) In USA greed has been institutionalised. The bankers who have caused the financial crisis are still getting huge bonuses. Government of USA has done precious little to change the system. It is likely that US economy will deteriorate further.

(ii) Even in India, Government would not do anything except making noises and passing laws which are selectively implemented or not implemented. If the same attitude continues, there is no reason why Indian economy should not crash.

However, in India democracy is dynamic. There are people who make noises. And there are courts which listen to these noises and do their best to tame the Government.

I hope Indian democracy will succeed and the corrupt will be regulated. Mere hope will not do. More & more people will have to make noises and take appropriate action. If this happens, we have a better future.

Thanks.

CA Rashmin Sanghvi