Some of the leading foreign institutional investors (FIIs) are telling clients not to take any new positions in Indian shares till clarity emerges on norms related to the taxation of indirect transfers of assets and General Anti-Avoidance Rule (GAAR) in the Finance Bill.
Hong Kong-based Asia Securities Industry and Financial Markets Association (ASIFMA), which has FIIs like Goldman Sachs, Credit Suisse, Bank of America-Merrill Lynch and Morgan Stanley as members, expressed concern in a strongly worded letter to finance minister Pranab Mukhejee on Thursday.
In its letter, ASIFMA has said if these tax uncertainties are not resolved quickly, it fears FIIs will decide the tax risks are unacceptable and may proceed to liquidate their India investments.
“Such a disorderly dissolution of large positions held by these overseas investors could seriously disrupt the Indian capital markets,” Nicholas de Boursac, CEO of ASIFMA, said. The letter has also been marked to finance secretary R S Gujral and Securities and Exchange Board of India (Sebi) chairman U K Sinha.
French brokerage CLSA is reported to have stopped selling derivatives through which foreign investors buy into Indian securities because of the tax uncertainty.
The Bombay Stock Exchange (BSE) benchmark, Sensex, has lost 3.5 per cent since the Budget announcement on March 16.
Some FIIs met finance ministry officials yesterday and sought more clarity on the taxation of such instruments. “We want the finance minister to assure the markets that portfolio investments by overseas investors will not be subjected to these new norms,” Boursac told Business Standard. He said the association had not received any reply from the ministry yet.
"As and when the position will be clarified, you will come to know, don't worry," Mukherjee told reporters on Thursday, in reply to concerns of FIIs regarding possible taxation of participatory notes (P-notes).
Meanwhile, a ministry official said FII fears were unfounded because GAAR did not target any particular asset class and it would be used only in case of abnormal situations. “As the name suggests, these are general rules to be used only in case of tax avoidance.”
The chances of the ministry diluting its Budget proposals with regard to taxation of international transactions are not bright, but it could come up with a clarification to address the concerns raised by FIIs.
The official clarified retrospective changes in Section 9 were not intended at targeting portfolio investments. “We don’t understand how portfolio investments will come under that. We have asked them to explain it in writing,” said the official, adding a clarification could be provided if needed.
GAAR would come into force from April 1, which means it would only be used in case of transactions where income accrued in that financial year.
Some officials said these were pressure tactics to avoid paying tax on such investments as was the case currently. One official said the proposals in the Finance Bill would not have much impact on FII inflows, as feared by many, because such investments were coming to India because of the fundamentals of the economy and that Mauritius was just a route to bring down the transaction cost.
There is a fear among FIIs that the new tax rules could subject foreign investment through instruments like P-notes to double or triple taxation. On Monday, Indian shares had slumped on fears the tax authorities would go after P-note investments in equities once GAAR would come into effect from April 1.
"If the government clarifies GAAR provisions do not apply to portfolio investment by a foreign institution, which is less than 10 per cent of the equity capital of the investee company, the prevailing uncertainty will be laid to rest. However, if they keep vacillating for too long, foreign investors might start giving up on India," said U R Bhat, managing director at Dalton Capital Advisors (India). "If India had the potential to attract $20-30 billion per year in the relatively good times before the Budget, it will attract only a fraction of that amount if these new norms stay. It will also put a huge question mark over the existing investments of FIIs in India," he added.
Vikas Khemani, president and head, wholesale capital markets, Edelweiss Financial Services, believes till the uncertainly is removed, market activity will remain low.
In February, investments through P-notes stood at 16.4 per cent, or Rs 1,83,151 crore, of the total of Rs 11.15 lakh crore in assets owned by FIIs in the stock market. A majority of these P-note positions are routed via Mauritius, which has a double tax avoidance treaty with India. Unwinding of P-notes rattled Indian markets in October 2007 after market regulator Sebi, under chairman M Damodaran, clamped down on the issue of these instruments. At that time, Sebi had asked FIIs and their sub-accounts not to issue or renew P-notes with the underlying as derivatives. Also, they were asked to unwind their positions within 18 months. The Sensex had fallen about 1,500 points, or nearly eight per cent, in just three days after Sebi’s decision on October 16, 2007. The ban was reversed by Sebi in 2008 during C B Bhave’s tenure.
