A key option is to extend the period of introduction of the new tax regime, so that foreign institutional investors (FIIs) get time to wind down existing commitments to their investors abroad. This means instead of making entire books of FIIs potentially taxable at the rate of 20%, the government will offer a sunset clause. This would allow investors who have put their money with FIIs using the Mauritius route to factor in the tax impact while investing in Indian markets.
The rethink came after FIIs met finance secretary RS Gujral last week. Taking note of concerns that GAAR could dampen portfolio investment flows, the department of economic affairs has begun working with the revenue department under Gujral to find a way out. FIIs have also approached the stock market regulator to step in.
Some FIIs have begun advising their clients to sign bonds which state there could be a withholding tax on their investments in the Indian markets.
Under GAAR, any arrangement made between entities to deliberately avoid tax can be invalidated and taxed. This acts as a treaty override provision, so that even investments made from countries with which India has double taxation avoidance agreements could be taxed. Also, since the onus is on taxpayers to prove that the arrangement was not made to avoid tax, this has unnerved many foreign investors.
Fear of GAAR has spooked stock markets with the BSE's benchmark Sensex losing 476 points or 2.7% from March 16 the Budget day till this Tuesday.
The FII logic is that a 20% tax on capital gains along with a possible depreciation in the value of rupee expected this year will be factored in by investors when they send their money in India. This will make India somewhat more expensive than markets like China, which could then create a cascading effect on further investment, said Gautam Mehra, executive director, PricewaterhouseCoopers.
Last week, there were several meetings between finance ministry officials and FIIs in which institutional investors suggested two options. Apart from a prospective clause, institutions suggested that small investments, defined as less than a 10% investment in a scrip, should be exempted from capital gains.
Finance ministry officials have termed the second option not feasible. They have also argued that FIIs knew GAAR provisions would be brought in from 2010 and should have made arrangements accordingly.
If they are permissible arrangements, clearly they are governed by the particular treaty and GAAR does not get invoked at all, finance secretary Gujral had said after meeting FIIs, including heavyweights like Goldman Sachs, Morgan Stanley, JPMorgan, CLSA and Credit Suisse.
When FE contacted Goldman Sachs, Morgan Stanley and JPMorgan on the issue, they refused to comment. While finance Minister Pranab Mukherjee has said he could revisit GAAR, if required, this has not improved sentiments. He had also said tax authorities would not go beyond financial investors to check details about holders of participatory notes. Accordingly, a question of liability for tax in India of the P-Note holder would not arise. However, experts say since P-notes are a subset of FIIs, they can't escape tax net. GAAR rules will be announced after the passage of Finance Bill and it will contain distinctions between impermissible and permissible arrangements.