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GAAR and FIIs: 5 key thingsyou need to know

The deferral of the General Anti Avoidance Rules (GAAR) by the government to April 2016

has laid most foreign institutional investor (FII) concerns to rest as this provides enough

time for investors to review their investment structures. The deferral is likely to support

capital flows in the coming years.

Finance Minister P Chidambaram said yesterday that GAAR would not apply to non-

resident individuals who route their money through FIIs. The announcement came as a

huge relief for investors who park their money in participatory notes (P-Notes) a

derivative instrument that draws its value from investments made in Indian stocks

floated by the FIIs.

GAAR will make P-notes more attractive to foreign investors

When announced in Budget 2012, investors had perceived GAAR as draconian as it targeted

companies and investors routing money through tax havens such as Mauritius that allowed

investors to use P-Notes for investing in India.

However, the central governments approval of the major recommendations proposed by

the Shome Committee now includes relief for non-resident investors using FII vehicles.

While it is not clear whether investment through P-Notes will come under the anti-

avoidance regime, some experts believe it will surely make P-Notes more attractive to

foreign investors since it hides their identity while routing black money.

P-Notes allow foreign investors to invest in India without registering with the market

regulator Sebi and are considered as a means of gaining quick exposure to the underlying

Indian equity market.

The total value of P-Notes in equity and debt currently is around 14 percent of the overall

assets under the custody of FIIs. According to the latest data released by Sebi, the total value

of P-Note investments in Indian markets rose to Rs 1.77 lakh crore at end-November after

falling to a near three-year low of Rs 1.28 crore in May.

GAAR deferral gives FIIs time to review their investment structures so that

GAAR is not invoked at the time of exit

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Daksha Baxi, ED-Taxation of Khaitan & Co, told CNBC-TV18 that the much awaited

clarification on GAAR was a significant relief for FIIs as it gives them a chance to rejig their

structures and ensure that GAAR will not be invoked when they sell.

FIIs have recognised the governments need to prevent tax evasion and The clients are now

getting smarter to arrange their affairs in such a manner that they can address GAAR as andwhen it becomes effective, Baxi added.

FIIs and sub-accounts of FIIs taking advantage of tax treaty benefits will be

subject to scrutiny under GAAR

Tax residency certificates furnished by investors in the recently prescribed format would

now be subject to verification for bonafide substance of the residency. This implies

government would try and restrict the treaty benefit to investors who can prove the

substance of their Mauritius residency. Under the India-Mauritius double tax avoidance

treaty, capital gains can taxed in one country cant be tax in the other. Since taxes are

minimal or zero in Mauritius, many investors use the Mauritius route to mitigate/nullifytheir tax liabilities in India.

If an FII is investing from Mauritius or Cyprus or Singapore and if they claim the treaty

benefit, they are prone to invocation of GAAR, explained Baxi.

Pre-August 2010 investments would be grandfathered

The finance minister said in a statement that only those investments made before the

introduction of the Direct Taxes Code Bill 2010 in Parliament will be grandfathered

meaning that investments before that date remain subject to the old rules. For such

investments no questions on residency will also be asked. In other words, all those

investments which have been made prior to August 2010, irrespective of when they are

disposed of, will be not covered by GAAR and stand protected.

Since the tax department can reopen cases from the past six years, this will ensure all

investments made after August 2010 will be open to scrutiny under GAAR.

GAAR will clearly overwrite tax treaties

GAAR will override Indias tax treaties with countries such as Mauritius, but only if the tax

arrangement is deemed impermissible. Hence, if an FII derives benefits from the

double-taxation treaty, GAAR will override the treaty.

This is likely to bring postbox structures and round-tripping of funds from tax havens under

the scanner.

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Inflation was still high and there was no room for monetary stimulus.

When growth is slowing down you can stimulate the economy either by monetary easing or

by fiscal stimulus, but both monetary and fiscal side have no room for stimulus. So that is

the big concern,

Everyone knows the difference between the Olympics and the Paralympics. In the former,

we learn how the limits to human achievement are being regularly extended; in the latter,

we learn the importance of being inclusive with differently-abled people.

For obvious reasons, we dont mix the two games. It wouldnt be fair.

The Indian stock market is a peculiar combo of the Olympics and the Paralympics where

gifted and powerful athletes compete with the handicapped in the same race: the muscular

foreign institutional investor (FII) competes with the skinny Indian investor. Little wonder

Indians barely invest in equity.

We are not pointing here to the unequal nature of the contest alone, but to the fact that if

you want a genuinely robust market, the players need to be evenly matched.

The Indian government has, however, been signalling repeatedly that it will not level the

field for Indians.

The most recent exhibit in this case is GAAR theGeneral Anti-Avoidance Rules (GAAR)

which have been deferred for two years for FIIs and anyone investing in India from the

outside, directly or indirectly.

FIIs investing in India pay practically no tax now, and this will continue for two more years.

Not only FIIs, but crooked Indians, who have money stashed abroad in tax havens, can use

GAAR to evade Indian taxes. In short, the government in actually encouraging Indians to

stash money abroad for two more years. But hapless aam Indian investors are subject to all

the taxes of the land especially capital gains.

The question is: why is the finance minister so indulgent towards foreign investors and non-residents, when Indian taxpayers and investors are being told they have to pay more taxes

higher taxes for the rich, strong anti-avoidance measures, possibly an estate duty on

inheritance, maybe more capital gains and dividend taxes, and many other things?

The answer, of course, is clear. Having run the Indian economy into the ground, where the

rupee is being pulverised by a soaring current account deficit and high dollar demand, the

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UPA finance minister has no option but to court foreign hot money flows and this means

telling them GAAR will not apply.

So, the short-term inequity in favour of FIIs is understandable.

What is less acceptable is the long-term inequities built into the system, and also thedangers in depending on only FIIs for market growth.

Just as it needs two legs to compete in the Olympics, it takes at least two for the Indian

markets to rise to its true potential.

The only way to move the markets based on genuine demand is by giving it two legs one

FII and the other domestic.

Heres what P Chidambaram, who is currently playing to market sentiment, can do to grow

the other leg.

First, he needs to convince the provident and pension funds that they should invest in

equity. Indians will not invest in mutual funds due to the risks involved. But asking pension

and provident funds to do so in a safe way by earmarking, say, 10 percent of the

incremental corpus (or more, after obtaining subscriber consent), will minimise risk and

improve returns. Currently, while the New Pension Scheme (NPS) has equity options, the

Employee Provident Fund Organisation does not thanks to its composition. Many unions

oppose investments in equity, but their objections can be got over with if the government

can guarantee returns for the lowest-income subscribers.

Second, avoid using the LIC as a dustbin for public sector stocks. Today, only the LIC has

the size and long-term orientation to hold on to stocks for long periods without flinching.

Unfortunately, Chidambaram is using the insurer to offload public sector stocks. The LIC

has effectively been neutralised as an offset to FII funds.

The market will behave in a manic-depressive way depending on which way FII funds are

flowing. If they want in, we have a boom. If they want out, its out. But if domestic long-term

money is available for stocks, including that of the LIC, the volatility of the stock markets

will be lower.

Third, taxation of capital gains can be both reduced and enhanced. If short-term and long-term capital gains are both levied tax at, say, 10 percent, the market would boom. Long-term

gain can be treated slightly better by giving it cost indexation benefits. So instead of zero tax,

investors would pay some tax, but it would be less than the 15 percent now paid on short-

term gains. Short-term players, now levied just 10 percent on gains, would trade more,

bringing higher liquidity and paying more taxes overall.

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Fourth, the securities transaction tax has worked well in India. It should not be tinkered

with in the budget.

Fifth, the dividend distribution tax has also worked very well. There is no need to fool

around with rates as the government earns easy revenue that cannot be evaded by anyone.

Sixth, all investments in any equity or balanced fund should receive the same 80C benefitsas investments in equity-linked savings schemes (ELSS) or the hare-brained Rajiv Gandhi

Equity Savings Scheme. The distinction between first-time investors and old investors

which the latter tries to create is farcical and impossible to police.

Mr Chidambaram needs to realise that India is not growing because Indians are not

investing both as companies and individuals. Luring foreign players is silly when you cant

get Indians themselves to invest in India. It can only increase our vulnerability to hot money

flows.

The Indian stock market will not grow in a healthy fashion if Indians do not invest in stocks.

This should be Chidambarams prime consideration in this budget.