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Under GAAR, any bond deal can be brought under the ‘withholding tax’ net at the discretion of tax authorities
The draft general anti-avoidance rules (GAAR), outlined in the budget this March, will not only affect the equity market, but fixed-income securities as well, as foreign institutional investors (FIIs) may pull out of the Indian debt market if the proposals are implemented in their current form.
Under GAAR, any income will be taxable on a gross basis and the tax authorities will have sweeping power to ask any FII to pay levies on transactions they regard as having been tweaked to avoid taxes.
This would mean any bond transaction could be brought under the “withholding tax” net at the discretion of the tax authorities. FIIs have managed to avoid paying this tax thus far.
A 20% withholding tax comes into effect at the time of coupon or interest payment of the bond. FIIs typically avoid paying the tax by selling their bond holdings just before the coupon date and then buying them again. The trading gain is considered a “capital gain” and is not taxable in India, based on tax treaties with countries where the FIIs originate from.
However, if GAAR is implemented, the tax will be on the coupon and authorities can question such transactions and force FIIs to pay the withholding tax, bond dealers said. FIIs argue that this will lead to losses on their bond portfolio.
For example, the current yield on the 10-year bond is 8.7%. After paying the withholding tax on the coupon, an FII would be left with a 6.96% return. This, FIIs say, is not enough as they need to hedge their currency exposure (one-year hedging cost is now 6.75%) and incur other operational costs.
“The 20% tax on a likely 10% coupon will have a huge impact; existing investors will sell and go away, and new ones will not come,” said Manoj Rane, managing director and head of fixed income and treasury for India at BNP Paribas SA. According to him, some funds have already started pulling out of the market.
The government sought to reassure FIIs that genuine investments will not come under GAAR. Several FIIs, including Morgan Stanley, CLSA Asia-Pacific Markets and Goldman Sachs, met the finance minister on Wednesday to seek clarifications on GAAR.
Finance secretary R.S. Gujral told reporters after the meeting that FIIs may have to pay short-term capital gains tax if the arrangements are deemed “impermissible”, that is if the transactions are seen as having been undertaken to deliberately avoid tax. But the government maintained that genuine investors not looking to deliberately evade tax will not be scrutinized under GAAR.
“FIIs are really concerned about short-term capital gains. We have explained that if they are a permissible arrangement, then clearly they are governed by the particular treaty, and GAAR does not get invoked at all,” Gujral said. Only otherwise will GAAR be invoked, overriding the provisions in the treaty, he said.
India has double-tax avoidance agreements with several countries, including Mauritius, which is considered a tax haven. Many FIIs route their investments through Mauritius to avoid paying tax in India.
Gujral said that the government will issue rules only once the legislation is approved on what arrangements would attract provisions under GAAR to avoid confusion. He added that the government is not looking to issue a clarification before the Finance Bill gets passed.
“We have clarified verbally our intentions. The government is simultaneously framing rules under GAAR, and will notify them after the passage of the Finance Bill,” he said.
FIIs can invest up to $60 billion (around Rs3 trillion today) a year in Indian bonds. They can invest up to $15 billion in government bonds and $45 billion in corporate bonds. Of the corporate bond investment limit, $25 billion can be invested in infrastructure bonds.
The investment limits were increased recently to deepen the bond market, as well as to meet India’s need to raise $1 trillion for infrastructure spending by 2013.
As of 29 February, FIIs have reached the ceiling on government bonds and have invested a little less than $19 billion in corporate debt and debt mutual funds. Their investment in infrastructure so far has been about $2 billion only, according to Securities and Exchange Board of India data.
FIIs have written to the finance minister and the Prime Minister’s Office seeking clarifications on GAAR. They are demanding a cut in the withholding tax to 5% from 20%.
Overseas funds have invested more than $200 billion, or 17% of the capitalization of India’s equity market, and have infused a substantial amount in government and corporate debt, the Asia Securities Industry and Financial Markets Association lobby group said in a letter to the finance minister.
“FIIs fear that the new tax rules could subject this foreign investment to double or triple taxation,” it said. “Such onerous taxation—or even the risk of such taxation—could threaten this important source of capital for India’s businesses.”
According to Rane of BNP Paribas, FIIs will be driven away by any change in policy. “GAAR will probably wipe out whatever gains FIIs make in the bond market and, hence, make new investments unviable, and force them to pull out of the market,” he said.
According to another FII investor in bonds, unless there is clarity on GAAR, FIIs will not be interested in investing in India and the existing bond investments will not be rolled over when redemptions are due.
“The uncertainty is the main issue here. GAAR gives sweeping power to tax authorities and they can cancel any transaction and levy the withholding tax even when the transaction qualifies for capital gain,” said the FII investor requesting anonymity.
“The new rules put the onus on the tax officer to decide whether the FII has substance in the Mauritian structure. They have not clarified what they mean by substance, whether it is just a nameplate, tables and chairs, or a full-fledged office in Mauritius,” he said.
“We are still hopeful that this new law will not come into effect because the government has probably not yet realized what kind of impact this will have on inflows at a time when the country needs them desperately,” Bhat added.