Time for a shift in the tax incentive regime?

By Pranav Raval and Riddhi Doshi
February 15, 2013

(Any opinions expressed here are those of the authors and not of Reuters)

The Indian economy is currently on the path of reform with the government liberalising FDI policy and relaxing overseas debt funding. And with the union budget just around the corner, investors are hoping for incentives on the tax front as well.

Traditionally, the government provides profit-linked tax incentives to promote investment in specified industries/states. However, considering the increasing need for investment in developing economies like India, the government is considering a shift from profit-linked tax incentive schemes to investment-linked tax incentive schemes. The desire for such a shift was clear under the proposed Direct Tax Code Bill.

The government has already started taking steps in this direction by introducing tax deduction for investment (capital as well as revenue expenditure) in certain specified business segments like setting up and operation of cold chain facilities, natural gas and petroleum distribution channels, building hospitals, luxury hotels, etc.

Such a paradigm shift to investment-linked incentives is likely to raise the concern of investors as it would cap their tax incentives to the amount of investment made and not on the profit generated from the venture (which is the current scenario).

Project funding and investment decisions are taken by investors who consider the anticipated Internal Rate of Return (‘IRR’) on the project. The shift away from profit-linked tax incentives would result in a re-evaluation on whether there is any downside impact on projected IRR. This can influence the confidence of investors and their future investment strategy in India.

Hence, Finance Minister P. Chidambaram has the tricky task of balancing the tax incentive strategy with one eye on the fiscal deficit and the other on investor sentiment.

The shift to investment-linked incentives can be considered by curtailing the current tax incentive schemes in a phased manner and giving a window to investors. Also, the government may consider some extra incentives in the investment-linked incentive regime. This would be helpful in lifting the morale of investors and infusing investment in some key sectors.

Extra incentives linked with investment can be in the form of weighted deduction (125 percent or 150 percent deduction of the amount of investment) or import duty/excise duty reduction on the capital import/manufacturing of capital assets in following areas:

  • Investment in infrastructure sectors – roads, dams and ports which indirectly assist in business development as a whole.
  • Location investment – which creates jobs in areas with high unemployment.
  • Anchor investment – which provides multiple effects by assisting development in the other industries. Eg: investment in power, oil and gas sector, water storage and distribution, etc.

The above incentives would help inspire confidence in investors who are ready to contribute to the development of the Indian economy and ensure that core sectors requiring huge investments on an ongoing basis are not adversely impacted.

To sum up, the recent approach of the government shows its intention to move from the current regime of profit-linked tax incentives to investment-linked tax incentives. However, bearing in mind the current economic situation of the country, the finance minister has to take a call on whether this is the right time for such a fundamental shift.

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Investment-linked incentives are necessary to attract private investment into certain highly capital intensive long gestation projects, which have so far been funded largely by the Government.
Indiscriminate extension of incentives to other sectors may result in overstatement of capital costs and an “Enron” (Dabhol)-like situation!

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