Fears that the double taxation avoidance agreement (DTAA) between India and Mauritius may be renegotiated ? after which foreign institutional investors (FIIs) would need to pay capital gains tax on their equity investments in India ? spooked investors on Monday, sending the Sensex crashing. The bellwether 30-share index plunged 364 points, or 2.04%, to close at 17,506.63 while the broader 50-scrip Nifty gave up 104.5 points to end the session at 5,257.90.

Assurances by the Union finance ministry to the effect that capital gains tax was not on the agenda failed to restore investors? confidence. The collapse in share prices was widespread, as reflected in the weak breadth, with smaller stocks bearing the brunt of the fall; the BSE Mid Cap Index yielded 3.2% while the BSE Small Cap Index came off by 3.3%. At one point, the Sensex had plummetted 556 points to touch 17,314.4.

Approximately 40% of FII holdings in Indian companies, estimated at about $280 billion, is believed to have been routed through Mauritius. FIIs today own about a fifth of the Indian markets, which is valued at R64 lakh crore or $1.4 trillion. The issue of FIIs paying capital gains tax in India has been hanging fire for several years now and on one occasion, the finance ministry was willing to compensate the Mauritius government in cash.

?That there is round-tripping from tax havens like Mauritius, Cyprus or even Singapore is known. However, many countries have avoided taxing foreign investors for fear that the market will be exported,? said the head of a leading brokerage, adding that FIIs may pull out money if their profits are taxed.

With Monday?s fall, the Sensex has now lost nearly 15% or R10 lakh crore in market capitalisation since January 2011, and is among the worst-performing markets in Asia.

While Korea?s Kospi index has done well by losing just 1.5%, the Shanghai Composite has given up 6.7% and Taiwan market is down just under 5%. Foreign fund managers remain underweight on India and FIIs have sold stocks worth $470 million between January and now whereas, in the comparative period last year, they had bought stocks worth $5.6 billion.

Says Pradip Shah, chairman, IndAsia Fund: ?Changes in the tax treaty with Mauritius were the trigger for the fall in stock prices. However, fund managers continue to be bearish on India given the difficult macroeconomic environment in which inflation remains high and interest rates are set to rise higher and the government appears to have no solutions to tackle inflation through supply-side measures.?

Shah believes that a further correction of 10% from these levels cannot be ruled out.

Adds C Jayaram, executive director, Kotak Mahindra: ?The markets have been range-bound for some time despite all the negative news flow, but the Mauritius tax issue seems to have pushed them.?

Jayaram, however, believes that despite the tough environment, the markets shouldn?t come off by more than 5% at the worst. ?Valuations would turn more attractive at lower levels and India would still be growing faster than most other countries,? Jayaram says.

According to Nilesh Shah, head of investment banking at Axis Bank, while the mood may be somewhat bearish, the market is comfortably valued. ?The market is trading at around 15 times forward earnings and if corporate earnings decelerate, it will trade at 15.5 times. So, every correction is a buying opportunity.?

Meanwhile, a downgrade of the IT sector to underweight from neutral, by brokerage CLSA which also downgraded TCS and Infosys pulled down the BSE IT Index by 2.5%. ?The Indian IT holds little promise of sustainable absolute returns hereon,? CLSA said in a note.

On Monday, the turnover in NSE?s F&O segment was Rs 1.7 lakh crore, way higher than the daily six-month average turnover of R1.3 lakh crore. The turnover in the cash segment was R12,099 crore, higher than the daily six-month average of R11,888 crore.