SENSEX PLUNGES 309 POINTS TO END AT 17,053 Tax Worries, Weak Rupee Throw Street Out of Gear

Lack of clarity on taxing of FIIs coming via Mauritius hurts

 April could well turn out to be a cruel month for the stock market and foreign institutional investors who drive it, if the government does not step in to clear the tax fog caused by sweeping Budget proposals. Amid a weakening rupee, Indian shares slumped on Monday to their lowest close in two months as investors looked for answers to two big questions: 

•Will FIIs coming through Mauritius have to pay tax on their short-term stock market gains? 

•Will offshore investors of participatory notes (PNs) — instruments to trade Indian shares — also have to pay tax on profits from their indirect exposure? 

With no clarity on these issues, FIIs as well as domestic investors sold shares worth . 135 crore and . 201 crore, respectively, on Monday. Their concerns emanate from the General Anti-Avoidance Rules (GAAR) proposed in the Budget, according to which tax authorities can override the tax avoidance treaty between India and Mauritius to tax FIIs that invest through special purpose vehicles in Mauritius without setting up an office or commercial establishment in the tax haven. Secondly, FIIs fear that the government's stance in the Vodafone tax case and its decision to tax indirect transfers of Indian assets could drag PN holders into the tax net because even though PNs are overseas instruments, the underlying assets are Indian shares. PNs are issued by FII entities to investors with no direct access to the Indian securities market. 

"There can be a view that since capital gains realised in the hands of the FII entity itself are not taxed, PN holders to whom the gains are distributed should also be spared of tax," said Siddharth Shah, principal and head-fund formation, Nishith Desai Associates. Even though finance ministry officials informally assured that GAAR, which many countries have put in place, will apply only above a threshold, investors looked for greater clarity. 

Sources said some foreign brokerages and FIIs have stopped issuing PNs and more may discontinue from April 1. Leading groups like CLSA, Goldman Sachs, Morgan Stanley and Deutsche have cautioned their clients about the tax confusion. They refused to comment when asked whether PN issuance will stop. 

"Some FIIs would not be comfortable with the probability of the taxman breathing down their necks with arbitrary powers to interpret the provisions under GAAR. This resulted in the selloff," said UR Bhat, managing director, Dalton Capital India. BSE's 30-share Sensex fell 308.96 points, or 1.78%, to end at 17,052.78. NSE's 50-share Nifty dropped 93.95 points, or 1.78%, to close at 5,184.25. 

Large banking groups with a base in Singapore will be able to lessen the tax burden by fulfilling conditions like minimum annual expenses of $200,000. Rupee Likely to Recover by April 

"Investors have to understand that GAAR is going to become reality though some of the provisions are over the top. Even before GAAR amendment came into the picture, we were advising many clients to use their Singapore operations to invest in India," says H Jayesh, founder partner of Mumbaiheadquartered law firm Juris Corp. 

But FIIs fear that relocating from Mauritius to Singapore will not help them shield their PN clients from the Indian tax department. Here, the tricky issue of taxing gains from transfer of underlying assets will continue to linger. 

"We are receiving so many inquiries regarding GAAR proposed in the Budget," says Akil Hirani, managing partner of Majmudar & Co. "For those who want to set up new funds, setting up base in Singapore is the only viable option. While for old funds that are already operating from Mauritius, there will be matter of concern," he said. 

A PN holder enters into a total return swap deal with an FII that agrees to pass on all gains — dividend, bonus, and profit from the sale of underlying shares — to the former. Under the circumstances, if FIIs are simply considered as passthrough vehicles or conduits, then there are chances that such gains could come into the tax scanner. 

The rupee closed weaker at 51.26 per dollar against its previous close of 51.17. It has appreciated 4% in this calendar year against the dollar. "There is genuine demand for dollars from oil companies and there is dollar buying for loan and other interest payments. But come April, we believe this kind of demand pressure will not be there. The rupee is likely to gain then, but again we will need to look at the capital flows, given that current account deficit has always been a driving force. By April, the rupee could recover up to 51 per dollar or thereabout," said Ashok Gautam, senior vice-president and head, global markets, Axis Bank.