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FinMin clarifies on GAAR, FIIs will now be split 9 years 3 weeks ago #102

Assuring foreign institutional investors (FIIs) that their concerns on taxation of short-term capital gains will be taken on board, the government on Wednesday said clarifications will be issued on the anti-tax avoidance rules, GAAR, once the Finance Bill is approved by Parliament, adding that FIIs would have to pay short-term capital gains tax only on those transactions that are deemed to be impermissible.

This means that the new anti-avoidance rules will now create two classes of foreign institutional investors— those that will be taxed and those that won’t. The ones who have substantial interest in Mauritius and have been operating from there will be saved, while those using it as a post box or a tax haven will have to bear the brunt of Finance Minister Pranab Mukherjee’s new tax plan.

“We have clarified verbally our intention. Obviously rules will come (after) the Finance Bill 2012 is passed. Our people are working on the rules. So there won’t be any delay after the passage of Finance Bill,” Finance Secretary R S Gujral told reporters after a meeting with FIIs.

The FIIs have expressed concerns over the applicability of the General Anti-Avoidance Rules (GAAR) proposed by Finance Minister Pranab Mukherjee in his Budget. FIIs wanted clarification on permissible activities which will remain out of the purview of the GAAR. They also pointed out that certain aspects of the proposed law were vague and would give discretionary powers to the income tax officials.

Gujral gave this assurance to the FIIs at a meeting which was attended by representatives of JP Morgan, CLSA, Morgan Stanley, Goldman Sachs and Credit Suisse among others. CBDT Chairman Laxman Das was also present.

“We told them (FIIs) that we will take those points on board and try and clear them…,” Gujral said, adding that the main concern of FIIs relate with short capital gain on equity trading. “If they are permissible, clearly they are governed by the particular (double taxation avoidance) treaty and GAAR
does not get invoked at all. If it is an impermissible arrangement, then yes… GAAR gets invoked and then treaty does not help them,” Gujral added.

What this essentially means is that even if a foreign institutional investor hails from a tax-friendly jurisdiction like Mauritius, unless Indian tax authorities find significant commercial substance in a transaction, they will investigate and perhaps, tax the transaction. In the first three months of 2012, overseas institutional investors have pumped in around Rs 45,000 crore into Indian stock markets. Of these FIIs, around 80-90 percent are registered in India invest through Mauritius. This means, FIIs set up an investment holding company in Mauritius and invest through a company registered in that country.

Until now, FIIs had been investing in India through Mauritius, which has a tax treaty with India and where FIIs do not have to pay capital gains tax.But now foreign institutional investors FIIs will have to pay short term capital gains tax on transactions that were deemed impermissible. There will be no tax on a FII, as long as it is not operating through a post box or a letterbox company.The applicability of the provisions of general anti-avoidance ru­les (GAAR) will depend on the structure of the participatory notes (P-notes) issued by foreign institutional investors to their clients for investment in the Indian equity market.

Mukherjee had already clarified that persons investing in stock markets through participatory notes (P-Notes) would not be required to pay taxes in India. He had also said as P-Note holders invest in stock market through FIIs, the income tax department would examine the tax liability of the FIIs only.

The proposal, which aims at checking evasion of taxes through double tax avoidance agreements, has evoked sharp reaction from FIIs and even impacted the stock markets. FIIs have assets under custody of more than Rs 10 lakh crore, or 17 percent, of the capitalisation of India’s equity markets. Further, these entities also invest in the Indian government and corporate debt.

This is the second time this week that the government has made it clear that it is not rolling back some of the widely criticised proposals of last month’s budget, as it seeks to emphasise the point that India is not a tax haven.

On 2 April Britain criticised India’s plan to empower taxmen to scrutinise even 50-year-old deals, cautioning that this could dent the nation’s image as an investment hotspot because it made it difficult for companies to predict risks. However, Pranab Mukherjee cited instances including those in the UK to defend India’s case in imposing retrospective tax law changes and put forth the government’s view behind the proposed amendment to the I-T Act, 1961 with retrospective effect.

On 1 April, global industry associations had written to Prime Minister Manmohan Singh seeking reconsideration of the retrospective amendment to the tax laws warning that the proposed change has prompted widespread review of costs and benefits of investing in India.

Last week, finance minister Pranab Mukherjee had indicated the government was ready to bring changes in GAAR based on the parliamentary standing committee recommendations on the Direct Taxes Code (DTC), if required.

Mukherjee introduced a provision in the Finance Bill 2012 seeking to empower authorities to tax companies for acquiring assets in India even if the deal is concluded overseas, retrospectively from April 1, 1962. This is widely seen as a fallout of the long-running dispute between the government and British telecom giant Vodafone.

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