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Understanding Issues Related to Black Money

Table of Contents

Introduction    

Tax Heavens    

Offshore Financial Centers    

Money Laundering    

Hawala System    

Round Tripping    

1.    Participatory Notes    

2.    Raising Capital by Global Depository Receipts    

3.    Money coming in NGOs and Charitable Institutions    

4.    Transfer Pricing    

Effects of Black Money on economy:

Steps taken by Government 

Rationalizing Income tax rates 

Introduction of Tax Deduction at Source (TDS)

Voluntary Compliance Schemes/ Amnesty Schemes   

Prevention of Money Laundering Act,2002

General Anti Avoidance Rules (GAAR)

Improving Currency note

Some Institutions for combating black money  

India joined – ‘ Global crusade against black money’  

Special Investigation Team 

 …………………………………………………………………………………….



Introduction

India’s black economy is humungous and complex. It has been a major issue since independence and recently is on boil due to civil society activism and interventions by Supreme Court. It is hard to precisely define black money, let alone reliable estimation of its quantum. But time and again there have been attempt to quantify it with estimates ranging from 10 % to 100 % of GDP. Black money menace is though more in developing countries, but developed countries too have their shadow/black economies. Recent financial crisis in west has forced huge number of laid off employees to be freelance workers and to not to report their incomes. An estimate suggests that US has $ 2 Trillion of shadow economy, which constitutes of narcotics, gambling, prostitution etc. and loss to US exchequer is $500 billion. For Europe unreported income is put at Euro 1 trillion. However, for developing countries problem is more serious and magnificent as they have limited resources and uphill task of bringing social development. They have weak institutions such as banking system, enforcement mechanism etc. which are opaque and to some extent, corrupt and this is exploited to fullest by evaders and criminals alike.

Generally speaking, black money is one in which ownership is fully or partially illegal. This illegality is primarily because it went concealed from government violating laws of the country. There can be two circumstances, one is where source activity of that money is also illicit and other where source activity was legitimate but income was concealed from taxation authorities. In former case activities can be smuggling of arms, drugs etc., or human trafficking, counterfeit notes, gambling or any activity which is prohibited by law. Incomes from such activities are concealed with great effort as avoiding tax is not main interest but safeguard of that activity is. On the other hand, 2nd type of activity is legitimate, its income is taxable and it is concealed only to avoid tax (or any civil law of land). Government claims that its 2nd type of income which is dominant and its treatment of two types is obviously different. In 1st type there has to be zero toleration, but in other it attempts to persuade, pressurize and at last coerce evaders to pay taxes.

It should be noted that not all the unaccounted money is black. It is only that money which was legally required to be disclosed, but was not disclosed. Income tax provisions permits income below certain threshold without disclosure. Majority population of our country earns below this threshold and doesn’t report its income. For e.g. tea shops, small snacks bar, agricultural income etc. doesn’t need disclosure. It may be called shadow economy and its very near Impossible to distinguish it from black economy. Much of the shadow economy doesn’t even get calculated for calculation of GDP, national Income etc.

Tax evasion problem has been there from colonial times and till 1960’s it was not this rampant as income tax rates were around 30%. In 1970’s due to repeated draughts, heavy investments in agriculture and after effects of wars government increased maximum income tax rates to the levels of 85% with surcharge of 15 %. This resulted in backlash from businesses who found it compelling to conceal income and this was the time when capital flight from India to low tax countries, more particularly to tax heavens picked up. This was also the time when strong underground networks such as hawala developed. After LPG reforms tax rates were brought down to around 30%, but by this time strong networks has already been developed. People were aware of weaknesses of the government which historically failed to bring evaders to the books.

Post LPG era witnessed expansion of the black economy and also escalation of offshore black money flow. Main reason of this was globalization as it reduced costs and regulation over transfer of funds abroad. After this there was increasing flow of transnational investments MNCs started mushrooming, stock markets became robust and attracted FIIs. This all resulted in increased Round Tripping of investment.

So main sources of black money are Crime, corruption, counterfeit/fake notes and tax evasion.

Tax Heavens

Generally, tax havens are countries with small jurisdiction which deliberately pursue policy of no or very low taxation. They allow great deal of secrecy to companies and investors operating in their jurisdiction. Overtime, these countries become hubs of Money both black and white. Based in these areas companies operate their operations in other countries and try to shift incidence of tax incidence in these areas.

Offshore Financial Centers

Some of the old tax havens have adopted the more benign designation of ‘offshore financial center’ (OFC) and tend to describe themselves as financial centers specializing in non-residential financial transactions. But they are just extension of old tax heavens.

Thus, many OFCs have the following characteristics:

  1. Jurisdictions that have ‘financial institutions’ engaged primarily in ‘business with non-residents’
  2. Financial systems with ‘external assets and liabilities’ out of proportion to ‘domestic financial intermediation’ designed to finance domestic economic; and
  3. Centers which provide some or all of the following opportunities: low or zero taxation; moderate or light financial regulation; banking secrecy and anonymity.

    E.g. Cayman Islands, British Virgin Islands, Mauritius

Vodafone hutch deal can be taken as example –

Indian operation of Hong Kong based Hutchison was owned by its company registered in Cayman Islands. To transfer Indian operations to Vodafone it simply transferred shares of this company in name of Vodafone. So Vodafone became owner of Indian operations, while transaction took place in Cayman Islands. In this Hutchison gained huge profits out of Indian operations but escaped taxation. When Indian authorities asked this Cayman Company for books of accounts, answer was – as per laws of Cayman Islands they don’t need to maintain books of accounts!


Money Laundering

Once black money is generated it is under continuous threat of being discovered by investigation/ Tax agencies. It will attract penalty and can unearth some lucrative scandals, illegal ventures, scams, crimes etc. Further, one who holds this money can’t freely invest it in any legal venture which requires disclosure of source of income. To get rid of these risks and problems he’ll attempt to convert this money in legitimate money. This is done by exploiting loopholes in laws, undergoing series of transactions or investing money in some physical asset like gold or land. After these efforts it is hard for authorities to trace money trail and original source. Some techniques adopted are –

  1. Investment in land, flats etc. – majority of black money in India remains invested in immovable property. In fact this is primary reason behind recent real estate boom. Suppose Mr. A has Rs. 1 crore black money and Mr. B wants to sell his land for Rs. 1.2 crore (which is market value). Then in reality land will be sold at price of Rs 1.2 crore and Rs 20 Lakhs will be paid (formally) by Cheque/Bank. While balance Rs 1 crore will be paid in Cash. Now Mr. A has become owner land worth Rs. 1.2 crores and he can retain this land or latter resell it at formal amount that he needs legally.

    Government will get Stamp duty on Rs 20 Lakh while transaction was at 1.2 crore. Further, income accruing to Mr. B will be meagre as in books he sold this land for Rs. 20 lakhs and he’ll escape income tax on Rs 1 crore.

    In our country state governments Issues ‘Circle Rates’ of immovable property. These are minimum rates on which a transaction in land can take place, but it is generally far below market prices which leaves ample scope to launder money.

  2. One can invest illegal money in gold and claim that it was Inherited or gifted.
  3. Involvement of banks – couple of years back employees of a reputed international bank were caught on camera agreeing to handle black money, allotting them lockers and transferring this money abroad. It is alleged that they violated ‘know your customer’ norms of RBI, used multiple accounts to launder money of the client.
  4. Laundering by corporates – while issuing shares, debenture, bonds etc. to the public promoters can use their own black money to subscribe securities of their own company and turn it into usable white money.

     

    A reputed Indian company recently issued ‘optionally fully convertible debentures’ (debentures) to public and collected money to the tune of Rs 14000 crore. SEBI found irregularities and ordered company to file details of investors. Reluctant company finally filed details which are found by SEBI to be fictitious.

     

    It widely perceived that company promoter used its own money to subscribe to debentures. Each application was below Rs 20000 (payment below 20000 can be legally done through cash and bank account is not required) and there was truckload of applications, without any address, repeated names, same handwriting and pen used.

    So as per allegations promoter attempted to convert black money into white money. This money once reached company as debenture could have been disposed of legally.

     

Hawala System

Hawala System has its origin in South India, more particularly in India. This now extends to middle east, Asean countries, Far East and even Latin America. This is an underground, cheap and instant medium to transfer huge amount of money. It is cheaper and less cumbersome than formal remittance channels such as banks, Western Union or Money Gram.

There’s suppose Mr. HA, hawaladar based in India and his counterpart Mr. HB in Dubai.

Client in India comes to Mr. HA with cash to be remitted to recipient In Dubai. After taking cash a code will be given to client in India which will be communicated by him to recipient in Dubai. Recipient in Dubai will communicate this code to Mr. HB and will get money. Note that there is no actual movement of cash. Mr. HA and HB are maintaining account among themselves and such transactions will be bi-directional. They will settle their account on someday in future. In all this hawaladar will get commission of 0.25-1.5 % of the funds transferred. Obviously no paperwork or disclosure is required and money will be transferred under complete anonymity.



Hawala system is used by Criminals, Businessmen, and Nonresidents to remit money. This system is back bone of underworld, drugs/arms mafias, terrorists and smugglers. Businessmen use it transfer money to evade tax. Suppose someone India buys machine costing Rs 1 crore from Italy and custom duty is 16.67 %. To avoid custom duty he might get import invoiced at Rs 50 lakh, which will be paid through legitimate banking channel and custom duty will be paid on Rs 50 Lakhs. Balance 50 Lakhs will be sent by Hawala.

Politicians and Bureaucrats are alleged to have cooperated with this system as they use this to stash corruption money abroad.

India has one of the weakest laws in this regard especially after repeal of Prevention of terrorism Act. Foreign Exchange Management Act (FEMA) treats hawala operations as Civil Offence (not criminal) and penalty is 3 times the funds involved. This is despite of the fact that our political establishment is aware that this is backbone of organized crime in India. But under Prevention of Money Laundering Act, hawala operations are criminal offence if their involvement in money laundering is established.

Jain Hawala scandal broke out in mid-1990 in which many politicians were implicated and more recently Pune businessman Hasan Ali who had lot of political connections was arrested on charges laundering money through hawala.

Few years back Global Financial Integrity (GFI) report revealed that from 1948 to 2008 about $213 billion of black money was sent out of India and total money pegged abroad including interest on this money was $ 462 billion. We Indians from beginning are obsessed with Swiss banks holding most of this money. After crash in global economy in 2008, resentment against tax havens and non-cooperating counties such as Switzerland was there in all the victim countries. In G-20 meetings which followed crisis, this was central issue of negotiation and non-cooperating countries were threatened by G-20 countries of sanctions if they doesn’t cooperate. This remarkably changed stance of many countries and they agreed to share information. Under this information revealed by Switzerland claims amount of Indians in its banking system to be merely around $ 2 Billion. Now there is strong possibility that either possessors of this money diversified its destination or money has been brought back to India through Round Tripping.

Round Tripping

This is also a method of Money laundering in which black money is send abroad, it moves from one country to another so that money trial becomes complex and original source is never discovered. Once this money gains legitimacy, it is then brought back to India. Some methods that facilitate round tripping are:-

  1. Participatory Notes


    – Participatory notes are the derivative instruments issued by registered FIIs to persons in foreign countries who invest in India but don’t want to go through procedures mandated by SBI. Money moves from – Investor (participatory note holder) to FIIs and then to Indian Stock Markets. As they remain outside preview of SEBI there are apprehensions that these are used for round tripping. (Foreign Institutional Investors are investors in financial markets and they need to get registered with SEBI). Investment through participatory notes is allowed only if investor is registered with authorities of home country. So there is ample scope of verifying source of such investments if other countries cooperate. But any attempt toward this transparency results in significant outflow of FIIs and crash in stock market. Participatory mode constitutes significant proportion of FII investment at about 25%.

  2. Raising Capital by Global Depository Receipts

    Indian companies are allowed to raise capital from abroad by issuing GDRs. These might be subscribed by persons who hold Indian black money. This will result in round tripping.

  3. Money coming in NGOs and Charitable Institutions

    – these institutions are treated a bit liberally in almost all countries. In India they need to file annual return with home ministry in which they need to disclose name and address of foreign donors. Now case may be that donor is XYZ ltd Company in which shares are held by some other PQR ltd. This effectively conceals real source of money.

  4. Transfer Pricing

    – This happens between related companies/firms in different countries. For e.g. Mr. A is in India having Rs 1 crore. His accomplice Mr. B is in Singapore. Mr. A can buy some goods, machinery etc. for Rs 5 crore also using Rs. 1 crore (1 crore paid in cash and 4 crore in Cheque). Then he transfers these machinery/goods to Mr. B at Rs 4 crore. Hence money value of that Rs 1 crore is moved from his Indian office to Singapore Office. Similarly, these transactions can be undertaken to bring back money in India. Income tax act has some provisions to treat these transactions at ‘Arm length Price’, but it Transfer Pricing is still a reality.

In all these cases, money will move back to India and will be treated as legitimate while its source may be illegal.

Effects of Black Money on economy:-

  1. Government losses tax revenue as tax on this money is not paid.
  2. It is hard for RBI to frame effective monetary policy. Black money floating in economy is impossible to estimate and remains out of preview of government. RBI increases interest rates, CRR, SLR etc. to regulate money supply but more there is black money, more is ineffectiveness of these measures.
  3. Corruption – Black money is both cause and effect of corruption. To handle this money at macro level political support is essential and it is widely perceived that politicians are biggest beneficiary of this system. This we can realize if we see money spend in Indian elections and its opaqueness.
  4. National Security – as we have already seen that black money provides finance to criminals and anti-state actors. Black money can be used to support wide range of illegal activities.

    Black money in itself is curse for economy and anti-state actors can attempt to destabilize economy by pumping counterfeit currency in economy. Time and again it has been revealed that terrorist groups are actively involved in this activity.

  5. Overpriced real estate prices – as immovable property is perceived as safest avenue for black money, most of the black money moves in to this. This resulted in unrealistic real estate prices which deprive genuine and needful buyers.
  6. Lack of innovation and research – When black economy is dominant there is less incentive for R&D for industry. Most of their effort is toward getting favorable treatment in allocation national resources. In India vast majority of billionaires have their interest in those areas where active support or patronage of government is needed. These sectors and Iron and steel, mining, telecoms etc. in contrast billionaires in US generally are normal people who invented some useful thing and seized opportunity.
  7. Capital Flight – in order to escape domestic rules and regulation scarce capital in India moves out to Tax heavens. It stalls process of capital formation in the economy. Any black money brought back to India shall be in foreign currency and will supplement Indian FOREX reserves.

Steps taken by Government –

Rationalizing Income tax rates

After LPG reforms Income tax rates were brought down to around 30 % so that more people will disclose their incomes. It is generally believed that good tax structure is one whose base is large (covers number of people) and tax rates are lower.

Introduction of Tax Deduction at Source (TDS) –

Under TDS system when payment is made to someone then there is onus on payer to deduct tax from the payment and deposit it with government.

In Vodafone case, Income tax department demanded Tax money from Vodafone while profit on transaction accrued to Hutchison. Hutchison sold its Indian operation at huge profit to Vodafone. Profits were taxable in hands of Hutchison. Vodafone was supposed to deduct TDS while making payment and deposit it with Income Tax department.


Voluntary Compliance Schemes/ Amnesty Schemes

These schemes give chance to holders of black money to declare their money without getting penalized. This method is criticized because it provides incentive for Tax evasion and is unfair for honest tax payers. Honest ones will think – why to pay tax if tax at all if evasion is not penalized?

Prevention of Money Laundering Act,2002

It is aimed at combating money laundering in India with three main objectives – to prevent and control money laundering, to confiscate and seize the property obtained from laundered money, and to deal with any other issue connected with money laundering in India. Currently many 2G scam accused are facing trials under the act.

General Anti Avoidance Rules (GAAR)

It was to be introduced wef. 1st April, 2014 to check aggressive tax planning and flouting of income tax laws. It gives more power to Income Tax officials on how treat a suspicious entry in books of accounts. Onus to prove that entry is bonafied is on assesse. But, budget 2014 didn’t mention anything about GAAR, after budget, MoS for finance replied in parliament, “GAAR will be applicable from 1st April 2015.”

Improving Currency note

RBI continuously improves currency so that it will be difficult to be duplicated. Currency has inbuilt feature which can distinguish genuine from fake notes. RBI has plans to introduce ‘plastic notes’ which are even harder to counterfeit.

Some Institutions for combating black money

  1. Central Board of Direct Taxes (CBDT) – Under Department of Revenue, Ministry of Finance – It oversees direct tax administration in India and is primarily responsible for combating black money. A new post Director General of Income Tax (Investigation) was created for investigation of cases of evasion. DGIT heads investigation wing of the Board.

    Similarly, for indirect taxes ‘Central Board of Excise and Customs’ is in place and it has Directorate General of Central Excise Intelligence (DGCEI)

  2. Enforcement Directorate – The ED has currently been entrusted with the investigation and prosecution of money-laundering offences and attachment/confiscation of the proceeds of crime under the Prevention of Money Laundering Act. It also enforces provisions of Foreign Exchange Management Act.
  3. Financial Intelligence Unit – It was established in 2004 for coordinating and strengthening efforts for ‘national and international intelligence’ by investigation and enforcement agencies in ‘combating money laundering and terrorist financing’. FIU is the national agency responsible for receiving, processing, analyzing, and disseminating information relating to suspect financial transactions.

     

    It is an independent body reporting to the Economic Intelligence Council headed by the Finance Minister. For administrative purposes, the FIU-IND is under the control of the Department of Revenue, Ministry of Finance. Its functions are defined under Prevention of money Laundering Act.

    Apart from these there are other institutions which have bearing on corruption and black money such Serious Fraud Investigation Office SFIO, Central Bureau of Investigation (CBI), National Investigation agency, State Intelligence Agencies. Further attempts are underway for building ‘National Intelligence Grid’ which will integrate investigation and work of all the intelligence agencies in India.

     

India joined – ‘ Global crusade against black money’

  1. G-20 countries – This group was formed in aftermath of global financial crisis. This group had more representation of developing countries as their economies were better as compared to countries in recession/slowdown.

    India played a major role in developing international consensus for taking action against tax havens and as a result G-20 decided that sanctions will be imposed on non-cooperating countries (as already explained).

    Many countries were insisting on conclusion of ‘Double taxation Avoidance Agreements‘ in which tax sharing mechanism for income which is taxable in jurisdiction of two countries is negotiated. DTAAs take long time to come to force. India insisted that instead of waiting for DTAAs, Tax Information Exchange Agreement (TIEA) be signed immediately. Under this a country can’t refuse to disclose information when demanded by any other country in relation to latter’s citizens or their related financial information. Consequently many countries agreed to share information. Further, now negotiations for ‘Automatic exchange of Information’ is going on under which relevant information will be exchanged without demand.

    DTAA/ TIEAs has clause that information shared can only be used for tax purposed and confidentiality needs to be maintained. Information can only be shared in judicial proceedings or when investigation is over, guilt has been established and persons are under prosecution.

    This was the reason that recently at first government disclosed names of only those persons against whom prosecution was underway. On Supreme Court orders it handed over complete list to SC.

     

  2. Multilateral convention of Mutual Administrative Assistance in tax Matters – . In response to the call by the G20 for a global instrument to fight international tax evasion and avoidance, the Convention has been brought up to the internationally agreed standard on information exchange for tax purposes, in particular by requiring the exchange of bank information on request. A unique feature of this convention is the facility for serving of notices issued by one tax administration through another tax administration. It is also hoped that the convention will facilitate tax examination abroad, which is being included in all TIEAs

     

  3. Financial Action Task force –It mandates and enforces following of FATF norms of KYC and customer due diligence, illegal transfer of funds and their recovery, and international cooperation. India was given fulltime membership in 2010. Other groups India is member of are – Eurasian Group on Combating Money Laundering and Financing of Terrorism (EAG), and the Asia Pacific Group on Money Laundering (APG)

 

Apart from this India ratified many conventions including United Nations Convention against Corruption, United Nations Convention against Transnational Organized Crime, International Convention for the Suppression of the Financing of Terrorism

Special Investigation Team

Recently Indian Government constituted a Special Investigation Team for Black money on directions by Supreme Court. It is headed by Retired Chief Justice of India and is being assisted by the revenue secretary, directors of CBI, IB, RAW and ED, the CBDT chairman and an RBI deputy governor. The SIT has been charged with the responsibility and duties of investigation, initiation of proceedings and prosecution in cases of Hasan Ali and other matters involving unaccounted money. This body would report to the SC directly and no other agency will be involved in this.

With all this it appears that a lot has been done for black money. But, to no avail, black money problem is has not yet got a solution. There is yet no landmark success that could convince Indian people that this problem will soon be arrested. Main reason behind this pessimism is political environment of India. It is popular perception (and acceptance) that Elections are being fought on support of black money. Further, on this issue public opinion doesn’t seem to be as cautious as it should.

Some corners of the society believe that black money is not such a big menace as most of the jobs are in unorganized sector and it is helps the poor. They also believe that corruption is just speed money to get work done fast which might be good. But this belief is pure ignorance. Costs of black money are significant as we have seen. Administration, if corrupt, will deliberately attempt to create artificial bottlenecks which could be opened only by bribe and this is breeding ground for crony capitalism. Much talked about Inspector raj, License raj are results of this mentality. This results in favor and patronage, over distribution of public goods and services, which deprives poor. India’s huge social spending and subsidized products gets leaked into black market. For eg. It is estimated that for every 1 kg of food grains delivered by PDS in India, Food Corporation of India releases 2.5 kg. Kerosene, LPG, fertilizers, subsidized medicines are no exceptions.

To bring lasting change, public perception and acceptance of this system needs to be changed. This can be done by efficient administration, easy laws which facilitates life of people, this will increase faith of people in government and over the time, they will feel more responsibility to pay their taxes.