Don’t postpone GAAR, please

Just mention the word ‘GAAR’ and investors in stock market tremble, stock prices tumble and analysts begin to make predictions on how an exodus of foreign investors from the country will make the floor of the stock market cave in. Worse, it is government officials who panic the most and start issuing statements on how “they are looking into the matter” or “the matter will be given due consideration and a decision arrived at soon”.

This sequence was played out the day after the Union Budget when the equity market crashed, apparently peeved by the fact that the Finance Minister did not postpone implementation of the General Anti Avoidance Rules (GAAR) by another couple of years. The stock prices recovered only after the Revenue Secretary’s statement that the Government is yet to take a view on GAAR.

Rewind to 2012. A similar sequence of events had played out after the Budget that year. It was in that Budget that Pranab Mukherjee first mentioned the anti-avoidance rules. The Sensex had tanked more than 10 per cent in the months that followed and buying had resumed only after a reassurance from the Government that implementation of the rules would be put off by a couple of years.

It is time the Government called the market’s bluff. There is no reason for the Government to backtrack or postpone the applicable date for GAAR any further. While there could be some short-term pain as some foreign investors re-route their investments through alternate channels, these rules will be conducive to the long-term health of our stock market as it will help filter out funds from questionable sources.

India is not the only country with anti-avoidance rules. These rules give the authorities the power to scrutinise and impose tax on arrangements that have been made solely to avoid tax. The stock market’s worry stems from the fact that many foreign portfolio investors (FPI) invest in India through Mauritius in order to use the double tax treaty between India and Mauritius and avoid paying capital gains tax.

The GAAR will give powers to the tax authorities to investigate the antecedents of such companies — their ultimate owners and so on. Another concern of the stock market is that once GAAR is implemented, companies could be asked for further documents to prove they are eligible to claim tax benefits, besides the Tax Residency Certificate (TRC) issued by the Mauritian government. This can make things difficult for brass-plate companies.

Stock market participants in India appear apprehensive that once FPIs become uncertain about using the double tax treaty with Mauritius to save tax, they will no longer find it attractive to invest in India. They might then channel funds into other equity markets.

This fear is unfounded since foreign investors such as pension funds, sovereign wealth funds and insurance funds have a long-term investment horizon. If they sell their holding after a year, the capital gains tax payable in India is zero, anyway. So these funds would not mind investing directly in India.

It is also unlikely that the income-tax authorities will launch a witch-hunt against all FPIs. One, it is obvious that such a move will be detrimental to the economy and two, the tax authorities do not have the manpower to do so. Again, in cases where the tax benefit is less that ₹3 crore, GAAR will not be applicable.

Further many FPIs currently using the offshore route might reconsider investing directly in the country. The lure of the superior growth prospects of Indian equity further enhanced by a stable government could outweigh the inconvenience of the outgo in the form of capital gains tax.

It may be recalled that we faced a similar situation in October 2007 when the Securities and Exchange Board of India (SEBI) had clamped down on the issue of participatory notes (p-notes). These opaque instruments, issued to entities outside India by FIIs based in India, were then suspected conduits for round-tripping. P-notes made up 50 per cent of FII assets at that point. But despite fears that SEBI’s move would whittle down foreign fund flows, no such thing happened.

The number of FIIs and sub-accounts registering with SEBI recorded a dramatic increase in the year that followed. Despite the restrictions getting lifted a year later, the issue of these instruments dropped sharply in the years that followed.

It is quite likely that foreign investors using this channel already have a plan B in place. These are some of the adjustments they are likely to make:

Route the money through other countries with whom India has a double tax agreement, such as Singapore. The Singapore double tax treaty has a limitation of benefit (LoB) clause that lays down that only companies listed in Singapore or India or spending 200,000 Singapore dollars a year in Singapore can enjoy the benefits of this agreement. Using this route is therefore safer for FPIs. The Indian Government is trying to insert a similar clause in the Indo-Mauritian treaty. Once that happens, the fear of round-tripping and other illegal money entering India through this route will be laid to rest.

Use P-notes to invest in India. When GAAR was finally notified last September, it left participatory notes outside its ambit. This implies that overseas investors can buy and sell Indian equities through P-notes without SEBI or the tax authorities going after them. It is probably for this reason that the number of outstanding p-notes has risen to a six-year high of ₹211,740 currently.

Registering directly with the Indian regulator and choosing to pay tax according to Indian laws is another alternative for foreign investors. If they believe in the long-term growth story in India, this is perhaps the best option.

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