There are more people in India who use a mobile phone than a toilet. According to the 2011 census, 49.8% of India’s 1.2 billion population will do their business in the open, while at the same time, 53.2% of households own a handheld device. A lack of education and limited low-income housing with reasonable amenities are some of the reasons for the first statistic. The bottom line is that India needs to invest in its people.

This fact may help explain one reason why India’s government is so hell bent on enforcing a $2.2 billion tax claim on mobile operator Vodafone’s 2007 purchase of Hutchinson Whampoa’s India operations.

The mobile phone industry makes money in India. Vodafone’s service revenues in the country increased 20% in the fourth quarter of last year. If the Indian government can take the world’s largest mobile-phone operator for $2.2 billion that would set the tone that access to India’s growing consumers comes with a strategic cost.

India’s income tax laws presently require that tax should be deducted before a payment is made to a foreign company or nonresident for assets in India. Vodafone has long argued it is not liable to be taxed on the deal, which was executed offshore. India’s supreme court supported Vodafone’s position in March and rejected the government’s tax claim.

The government’s dogged pursuit has now led it to sidestep its own judiciary and propose a new law that allows tax authorities to make retroactive claims on overseas corporate deals dating back to the 1960s and brings in new anti-avoidance measures.

This has drawn widespread consternation domestically and it has also infuriated the global business elite. In an open letter to India’s Prime Minister Manmohan Singh, on March 29, a group of international business organisations, representing 250,000 companies wrote: “The sudden and unprecedented move (on tax) has undermined confidence in the policies of the government of India towards foreign investment and taxation and has called into question the very rule of law, due process, and fair treatment in India,” the letter stated.

Strong words indeed and most editorial pages around the globe share the same view. India’s government is losing the PR war on this front.

This magazine is not convinced companies will simply run away from investing in India based on the government’s recent behaviour — the potential income in India is simply to great.  But the country does have a history of flip-flopping on important investment-related regulation and this ham-fisted tax proposal is just the latest example.

The government has every right to want to bring in revenue from business deals that directly impact India but are technically cut offshore — no doubt Vodafone makes more money in India than it does selling to customers in the Cayman Islands (population 60,000). So while we understand Vodafone wanting to be tax efficient it should recognise India’s government simply sees such actions as avoidance of paying for the right to do business.

India should carefully re-write its tax laws to protect against future purchasing of real Indian assets without appropriate taxation, rather than chase deals that have already happened.

Focusing on re-writing its damaging 29-year old tax relationship with Mauritius —where 40% of portfolio and 42% of foreign direct investment into India comes from the island — is a good place to start.

More importantly it needs to work with businesses that want to buy into India’s strong growth story. The government and corporations would gain from a sensible tax regime. India should commit to placing new tax revenue accrued from capital gains into tackling its huge infrastructure and corruption problems, one of the many reasons why foreign direct investment into the country is erratic.

Improvements here will clearly translate into a better living environment for its people and help nurture a middle class to which companies like Vodafone can cater.

Vodafone would have escaped but there will be plenty of other large companies desperate to tap India’s vast potential in future. They may not be happy at having to pay capital gains but they may be more prepared to live with it if they know where they will stand in the long term.