Friday, March 7, 2008

Taxing Sovereign Wealth Funds

Just as hearings are being conducted before two subcommittees of the U.S. House of Representatives in relation to sovereign wealth funds (SWFs), and as the International Monetary Fund is stepping up efforts to formulate a code of conduct to regulate SWFs, a new story has emerged regarding the possible tax position of SWFs in the US.

Victor Fleischer, who is now an Associate Professor at the University of Illinois College of Law, has a post on the Conglomerate Blog. He notes that currently sovereign wealth funds are not subject to taxation in the US at all as they are entitled to take advantage of provisions relating to sovereign immunity. This puts them at a substantial advantage over other financial investors such as private equity, venture capital and strategic investors who will be subject to taxation on their investments in the US. Referring to taxation of SWFs in the US, he notes:

How They Are Taxed Currently. Section 892 of the Internal Revenue Code exempts foreign sovereigns from income tax on their passive investment activities. Foreign individuals and corporations, by contrast, pay taxes on most passive investment activities at rates ranging from 0% to 30%, depending on treaty agreements and the nature of the investment. With the exception of certain real estate investments, foreign investors generally don't pay tax on capital gains from portfolio investments. The tax code thus has the unintended effect of subsidizing state-owned capital over private capital, particularly on debt investments.

What To Do About It. The policy objective is to tax Sovereign Wealth Funds as we tax private foreign investors, and perhaps only on the condition that they are investing in a manner consistent with commercial portfolio investment.”

His call for taxing sovereign wealth finds is likely to have serious takers among US policy makers. He is currently researching on this issue and is likely to publish a paper on the topic.

After all, it was an earlier paper of Victor Fleischer that stirred up a hornet’s nest among US policy makers and private equity players, when he argued against the current system of taxing private equity players on their carried interest, whereby they were paying tax on the amounts as long-term capital gains (at a lower rate) rather than as business income (which was pegged at a higher rate). Reforms have been proposed in tax laws that are currently pending in the US Senate.

It would not be long before this issue gains prominence in the Indian context. Unlike the US tax laws, the Indian Income Tax Act, 1961 does not seem to contain any specific provision for taxing financial or commercial activities of foreign sovereigns in India. However, it is likely that the general principles of sovereign immunity as understood in international law will apply. This would largely leave it to the courts to discern the principles as they apply them to the facts of each case. Specific provisions of the double taxation avoidance treat between India and the country whose sovereign invests would also require consideration.

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