Attracting Foreign Direct Investment (FDI) has received much attention from policymakers in the recent decades. Policy efforts in this direction have seen FDI inflows grow from around $5 billion in 2004 to a record $83 billion in 2021-22. India was ranked 7th in the list of top 20 host economies by UNCTAD in 2021.

FDI outflows from India have also witnessed an upsurge in recent decades with the liberalisation of overseas investment policies. FDI outflows originating in India have risen from $2 billion in 2004 to $15 billion in 2021, constituting around 1 per cent of the global outflows. Outward FDI (OFDI) has not received a great deal of attention from policymakers compared with the increased focus on enhancing FDI inflows.

The geographical distribution of India’s OFDI requires detailed examination as this may have implications for the economy going ahead as India integrates further into the global financial system. India’s firm-level OFDI data published by the RBI since 2007 indicates that around 68 per cent of the total OFDI flows were directed to Offshore Financial centres (OFCs) between 2007 and 2021.

Low-tax destinations

Low-tax jurisdictions, namely, Singapore, Mauritius, and The Netherlands together received around 51 per cent of the total outflows in the same period. Other OFC destinations that received Indian FDI include the Cayman Islands, the British Virgin Islands, and Bermuda.

The OECD defines a tax haven as “a country which imposes a low or no tax and is used by corporations to avoid tax which otherwise would be payable in a high-tax country.” One underlying reason for channelling OFDI to such OFCs is the often-cited case of “Round-Tripping,” where funds are taken outside to re-route them back to the originating country under the banner of inward FDI. This is often done with the motive of getting preferential tax treatment.

Major sources of FDI inflows into India include the OFCs mentioned above and countries like the US, the UK, and Japan, providing strength to the arguments on the existence of round-tripping. Another critical factor for such OFCs attracting massive inflows is that these destinations may often act as a transit point before investments reach their final destination. This is often done to take advantage of the tax treaties existing between various countries.

Tax revenue loss

One of the major implications of this trend is India losing out on precious tax revenue. OFDI, undertaken solely for tax arbitrage purposes, may have implications on the domestic productive activity of the parent firms such as production, employment etc., again indirectly impacting the government’s tax revenues. Policymakers will have to re-think the true productive nature of India’s OFDI flows, and more empirical evidence is required on the issue.

Although these issues plague other emerging economies as well, there is a lot of scope of work to be done by the authorities to track and tackle the issue. Tax treaties and other information-sharing mechanisms have not had the desired impact on the ground.

The lack of empirical studies examining the impact of such flows, both at a macro-level and firm-level, stems primarily from the absence of reliable data tracking such flows.

Data gaps

For example, the RBI data on OFDI fails to capture the final destination of such investments and only captures the first destination of investment.

Although the database provides information on the various modes of overseas investments such as equity, loans and guarantees issued, the final amount of OFDI made may vary because firms may not utilise the 100 per cent of the guarantees issued. Similarly, a reliable monthly database of inward FDI at a firm level needs to be developed.

Greater availability of data in the public domain will help spur research on the various aspects of India’s FDI flows, thus providing a proper direction for devising an effective policy framework. Although the recently notified Foreign Exchange Management (Overseas Investment) Rules have brought greater clarity on the many grey areas in overseas investments, effective implementation is the key to success.

India must actively participate to ensure the global minimum tax rate mooted by the OECD is successfully implemented, as synchronised efforts from countries are required to find lasting solutions to these issues. Finally, any measures to clamp down on these dubious investments must not scare the potential genuine investors and affect the ease of doing business.

Krishnan is a Research Scholar, and Padmaja M is Assistant Professor, NIT Trichy, respectively. Badri Narayanan Gopalakrishnan is the former Head, Trade, Commerce and Strategic Economic Dialogue at NITI Aayog