Why FIIs fear GAAR?

The Finance Minister, Mr Pranab Mukherjee, has made the right move in not yielding completely to the demand of foreign institutional investors on general anti-avoidance rules (GAAR). He has made minor tweaks to the GAAR rules and notified that the provisions will apply only to income arising in FY2013-14 and thereafter.

The GAAR Impact

Stock market is in a tizzy ever since Mr Pranab Mukherjee included GAAR in the Union Budget. Stock prices have refused to move higher with the Sensex moving in a tight band between 17,000 and 17,500 since then. Foreign institutional inflows that had totalled $8.4 billion till the Budget day, dried up in the following weeks. The saving grace here is that there were no outflows either.

Foreign institutional investors have valid reason for being concerned about the imposition of GAAR. These rules would give the Income-Tax authorities the power to look in to companies that lack substance and those that are set up mainly for tax-avoidance. Structures used for round-tripping would also have come under the tax-men's lens once GAAR was implemented.

Now, it is no secret that most foreign institutional investors are routing their investments into Indian stock market through Mauritius. Many of them have formed shell companies that lack commercial substance, have no other commercial transactions and have been set up with the sole intention of making use of the double tax avoidance agreement (DTAA) that Indian Government has signed with Mauritius. Under this agreement investors pay capital gains tax in the country of domicile. Since Mauritius does not charge any capital gains tax on investments, these investors get off by evading CGT altogether.

Now that the Finance Minister has given FIIs one year to arrange their affairs, they can continue their operations without any fear till next April. Shell companies investing in India can wind up their operations by divesting their holding in Indian stocks in this period.

Genuine FIIs will have to brace up to the fact that they will now have to pay tax like other FIIs not routing their money through tax havens. The move will free Indian stock market of black money which is the prime motive of the Finance Ministry. Past data shows that while there can be temporary cessation in flows, it does not impact the FII inflow over the long-term.

Tax Residency Certificate

The Union Budget had included a statement that tax residency certificate will not be considered sufficient to evaluate if an entity is eligible for concessions under the DTAA. Mr Mukherjee is still silent on this, which means, that he has not altered his views on brass-plate companies that route money in to India. The only recourse left to such FIIs is to abandon this route.

COMMENT NOW