Offshore Financial Services – Time for a New Strategy?

By R. Chand

Last week’s tax proposals in India’s 2012 Budget appear to be a definite game changer for the development of our offshore financial services. While investors from Mauritius will continue to be entitled to the benefits afforded by the provisions of the India-Mauritius Double Taxation Avoidance Agreement, especially to avoid taxation on capital gains incurred in India, the practical availability of such benefits will henceforth be subject to a host of bureaucratic impediments that go with the introduction of comprehensive General Anti Avoidance Rules (GAAR) in Indian Income tax legislation as from April 2013.

While the GAAR are standard means resorted to by fiscal authorities to check any misuse under international tax treaties, a number of accompanying safeguards to ensure the proper application of their wide discretionary powers are conspicuously absent. Worse, the specified exigencies on the need for commercial substance over form for DTAA eligibility, and the retrospective nature of certain other income tax amendments contained in the Finance Bill with the aim to bring the Vodafone-Hutchinson deal firmly into the tax net, are likely to significantly and adversely impact on the climate of certainty required by foreign investors.

The submission of a tax residency certificate containing prescribed particulars will thus be considered as a necessary, but not sufficient condition for availing of DTAA benefits, and it would become possible to retrospectively tax offshore share transfers of foreign companies, the value of which is substantially derived from assets located in India, from as far back as 1962. No wonder that some observers have concluded that these provisions may in effect constitute an override to existing international tax treaties.

Whatever may be the legality of this approach, especially the retroactive clauses, it cannot be denied that the uncertainty that has dogged foreign investor sentiment in recent years will be magnified. The Mauritian investment route into India has withstood, over the years the disclosure of numerous financial scandals and other shenanigans in the Indian press, but the resurgence of a strong anti-corruption movement led by Indian civil society and supported by the urban middle classes have meant a much lower tolerance for tax avoidance schemes. The Indian government held few options in trying to restate its commitment to combat corruption and strengthen the country’s financial rectitude.

For the Indian income tax authorities, the disputed Vodafone-Hutchinson deal represented an estimated amount of USD2.2 bn of tax foregone. The Netherlands-based Vodafone International Holdings BV acquired Cayman-based CGP Investments from Hutchison Telecommunication International Limited, also based in the Cayman Islands. CGP Investments held a number of underlying subsidiaries in the British virgin islands and Mauritius which ultimately held a 67% stake in Hutchison Essar Limited, one of largest players in the Indian telecom industry. There are many such pending share transfers relating to Indian assets that amount to billions of dollars in unpaid taxes.

Who can blame the Indian press for waging a relentless campaign against so-called tax havens, or Indian tax officials for ignoring the legal niceties of international taxation principles, in confronting the undermining of their fiscal base, and urging a restoration of their tax sovereignty? Mauritius made good hay while the Indian sun shined. Other countries were far less patient with our offshore business. The U.K. amended its tax treaty with Mauritius unilaterally to check what it considered as evident abuse. Indonesia revoked its tax treaty with Mauritius, when it became clear that Mauritius had become one of the largest sources of foreign investment in Indonesia, originating from Singapore and also suspected by the Indonesian government to involve round tripping by Indonesian businessmen. The treaty revisions made by China to its Mauritius tax treaty are said to have duly emasculated the potential of a booming investor route into China.

And what of South Africa, the initial target and rationale for creating a Mauritian offshore centre? Through its internal regulations, South Africa blocked Mauritius every step of the way, rendering the tax treaty ineffective. South Africa even pressured SADC countries to adopt a Protocol on the Avoidance of Harmful Taxation, OECD style. The handful of South African financial institutions that dot our financial services landscape, many of them functioning as mere booking centres, is testimony to our dismal success at seizing the potential of the South African hinterland, in the manner that Singapore and Hong Kong have done vis-à-vis China, and Dubai towards Gulf countries.

The lessons are clear. In our relationships with partner countries, we need to grow out of insubstantial and potentially contentious offshore activities. The 2012 Indian budget could well spell a less prominent role for the offshore sector as a passive conduit of investment capital into India. But it could also create new opportunities by compelling us to move towards activities of greater value and substance in channelling investments into India, and by also by a greater diversification of activities, particularly to meet the needs of the African continent. Mauritius must agree to foster a renewed relationship with India that is less threatening to its tax sovereignty. The recent attempt to propose a limitation of benefits clause in the DTAA to promote substance, during the Mauritian PM’s visit to India, may have been too timid, and come too late.

As a sign of growing maturity, it is time for Mauritius to give strategic pre-eminence to value added and substance in offshore financial services. There will be plenty of voices arguing for a preservation of the status quo in a denial of the new realities, or blaming Government for failing to preserve long-standing treaty preferences. Some will miss the wood for the trees, and press, as in the past, for a reduction of the effective tax burden on offshore companies even by 0,1% (yes, 0.1%!) as a life-and-death issue for preserving our attractiveness as a financial centre, against such non-comparable competitors like Seychelles and Singapore. Others will propose ever more inventive and opaque investment structures, trusts or foundations, as industry-saving product enhancements.

The right answer, however, lies in making a paradigm change. Mauritius overcame the loss of its sugar market preferences, and squarely confronted a major reduction in sugar prices. The clothing and textile industry was badly hit, but survived the shock emanating from a termination of the Multifibre Agreement. Every crisis proved to be an opportunity for Mauritius to free itself from preferences that were beneficial, but limited the scope for value addition and substance. In financial services too, we can provide an adequate strategic response.

The growing activities of Mauritian banks, insurance and investment companies, as well as private equity funds, in Africa, is already pointing to a more sustainable path, even if associated with greater risks. It is time to look beyond the fading free lunch in global business.

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Whatever happened to the Central Bank’s independence?

Some time back, the Governor of the Central Bank had raised the question: “Should a Central Bank be truly independent on … technical matters or its assessments continually second-guessed by political placements by the government?” He had suggested that the selection of members of the Monetary Policy Committee (MPC) be carried out through hearings or through parliamentary committees. Indeed, some other institutions or bodies should be having a droit de regard on these appointments. None of the external persons appointed on the MPC, including the representative of the Ministry of Finance, has the required expertise.

Monetary theory, empirical research, practical experience and modelling which are the foundations of monetary policy have evolved over the past two decades. The policy environment has become more complex and is now the exclusive preserve of specialists. The practice of monetary policy now relies in large part on the use of a common class of models. These models as for e.g. the dynamic stochastic general equilibrium (DSGE) models that integrate optimizing behaviour with nominal rigidities, are shaping policy discussions and practice.

The appointment of external members should be designed to ensure that the MPC benefits from their expertise in addition to that gained from inside. At the Bank of England, each member of the MPC has, among others, expertise in the field of economics and monetary policy. Members do not represent individual groups or areas; they are independent. The minutes of the MPC meetings should be made public in due course. It should give a full account of the policy discussions and explain the thinking and decisions of each member including differences of views. Like elsewhere, MPC members should also speak to audiences throughout the country, explaining the MPC’s policy decisions. Greater public accountability from MPC members will help in getting rid of some of the political appointees and restore to the Monetary Policy Committee its independence and effectiveness.

* * *

Mexa clamours for a Ministry of Planning

Undermined by the faltering demand in its traditional export markets and constrained by the strong rupee and the rising costs in terms of water and energy, transport, land prices and labour, the Mauritius Export Association (Mexa) believes that only a holistic approach to these challenges will enable Mauritius to improve its competitiveness. It joins the long list of institutions, intelligentsia and corporate leaders that have been feeling the absence of a comprehensive strategic planning exercise at the national and sectoral levels. There is no link between sectoral and national objectives and a well-coordinated medium- to long-term development strategy for the country is increasingly being felt.

Mexa feels that the Export-Oriented Enterprises are now like patients on life support grabbing for the oxygen mask, simply trying to survive. It refuses to be forced into a mental straight-jacket of piece-meal reforms and the short-termism of the stimulus packages. Its enterprises need to embrace new mantras – reduce, recycle, recover, replace and refuse — in a bid to remain competitive in today’s challenging economic environment. Its rapidly scaling workforce requires professional development platforms that can deliver consistent high quality learning outcomes. Mexa is convinced that it is time now to do away with the groping years of amateurism, operating in a fragmented and dispersed manner, which give rise to a lot of inconsistencies, incoherence and confusion, like the new Economic and Social transformation Plan which is just another long term Programme-Based Budget and does not provide a roadmap for improved future outcomes.

Success in addressing the underlying challenges requires more coherent and holistic approaches for policy analysis and for the development of strategic plans within a consistent macroeconomic framework and a medium- to long-term perspective. Indeed, the demand for «l’élaboration d’une stratégie de développement coordonnée et la création d’un véritable ministère de planification économique » (MEXA) could not have come at a better time now that government is embarking on the next phase of its economic reform and transformation programme.

* * *

Overvaluation of the rupee

In its 2012 Article IV Public Information Notice, the IMF notes that our real exchange rate is broadly in line with fundamentals and in selected economic and financial indicators it posts an appreciation of 5.7 % in 2011 for the real effective exchange rate. The real appreciation of the exchange rate, as in 2009 and 2010, are largely due to the record FDI inflows. But what is more interesting is that in 2011, the Article IV staff report had reported an overvaluation of the rupee that has increased from about 4½ percent for 2009 to about 10% in 2010.

It noted further that the overvaluation of the rupee is projected to be eliminated over the medium-term in the current macroeconomic framework. “In addition, continuation of structural reforms to increase productivity, reduce trade restrictions, and price rigidities are likely to appreciate the equilibrium rate and would thus reduce measured overvaluation of the real exchange rate.” I do not think that we have succeeded in achieving these structural reforms to be able to assert that in 2011 the rupee is no longer overvalued.

It is necessary to constantly assess whether the exchange rate is properly aligned for it is likely to lead to macroeconomic difficulties if policies are not adjusted. Exchange rate estimates are an important input to forecasts of economic growth and inflation, and estimates of equilibrium exchange rates provide an anchor for exchange rate forecasts. It is important to note that an appreciation of the real exchange rate per se does not tell us anything about the overvaluation or the undervaluation of the currency. It is from its position relative to its equilibrium value that we can infer whether it is misaligned or not. Moreover, an overvaluation does not necessarily imply that the only recourse is the depreciation of the currency; it only means that the policies have to be adjusted accordingly including reforms to reduce supply bottlenecks and improve productivity and the business environment, etc..

There are different methodologies that are being currently used — the purchasing power parity (PPP), the PPP adjusted for the Balassa-Samuelson and Penn effects and assessments of macroeconomic balance (two variants). It is surprising that we are still relying on the IMF for an assessment of our equilibrium exchange rate.

The Central Bank has the skills and should be in a position to provide estimates of our equilibrium exchange rate and its misalignment. As for the Ministry of Finance some of their recent interventions on monetary and exchange rate policies lack depth, reflecting to some extent the absence of solid research by its macroeconomic division in these areas to substantiate their views. The Ministry of Finance has to catch up. It seems to have difficulties in moving up the learning curve and assume its new role in an economy faced with new realities.

* Published in print edition on 22 March 2012

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