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GAAR pushed back, but new tax rule may still drive away FIIs
May, 24th 2012

Foreign investors may be relieved over the controversial GAAR tax proposals being pushed back by a year but another new taxation framework could make their India investments riskier and expensive.

The proposals that are a part of the Finance Bill. They state that capital gains arising from the transfer of shares or interest in a non-Indian company in case the share or interest derives directly or indirectly its value substantially from assets located in India will be taxable in the country.

The new rules could force foreign investors to re-examine their structures for investments in India, while impact would be visible also on global mergers and acquisitions involving Indian businesses to take in to account the potential tax risks from the indirect transfer rules.

The FIIs are of the view that their gains from India are as such taxed in the country, and any repatriation of gains to its investors by way of redemption of capital should not come under the offshore transfer provisions.

A number of foreign funds, including a European association of the FIIs, may soon approach the Finance Ministry to seek clarifications and certain changes in the rules, sources said.

The previously proposed GAAR (General Anti-Avoidance Rule), which could have caused foreign investors huge tax liabilities despite investing through so-called tax-friendly jurisdictions, is estimated to have led foreign investors to withdraw or put on hold investments worth over $10 billion within just over a month of being announced.

However, the impact could be much higher from the now cleared restroactive taxation of indirect offshore transfers, which could lead to many more billions of dollars worth investments getting hit within a short span of time of their implementation in the current form, industry sources said.

Foreign Institutional Investors (FIIs) are hoping for certain changes and clarifications in the final form of the rules. Else, it is widely believed that they could consider exiting a vast majority their holdings in the country that are worth over Rs 11 lakh crore (about $200 billion), said a top manager of a leading foreign fund.

Asked for his views, consultancy giant PwC Indias Executive Director Mr Suresh V Swamy told PTI that the government needs to clarify that these rules would not apply to the FIIs, and small investors need to be exempted from any such tax liabilities.

It is difficult to quantify the impact from these proposals on the FII investments, but such an impact has to be in billions of dollars, he noted.

However, senior officials of various foreign funds with significant India exposure said that the new proposals could lead to exodus of overseas funds and the impact could be in high double-digit billions of dollars, depending on the level of clarifications and changes brought in by the government.

If no changes are made, and there are no clarifications either on various conditionalities of the rules, almost the entire FII holding of over $200 billion could see the impact, they noted.

Mr Swamy said it was good that some important changes have been made to the proposed GAAR rules, such as setting up a committee of independent members and shifting the onus of proving the tax liability to the tax authorities from the taxpayer as proposed earlier.

However, this proposal has been now pushed back by a year and certain amendments have also been proposed for the benefit of the investors.

However, even bigger issue than the GAAR rules right now is the taxation proposals for overseas transactions. Here also it is the uncertainty that is a bigger concern than the provisions themselves, Mr Swamy said, while adding that there must have to be a differentiation between the strategic M&A deals and the pure financial investments.

The proposal, which is said to have been brought in to tax Vodafone-like offshore transfers, has no thresholds prescribed and could have a significant adverse impact for FIIs investing into India.

For example, if there is a US Fund set up with capital from US investors and puts money into India, redemption of units for its clients could be liable to tax here in case the fund derives substantial value from Indian assets.

The high-profile Vodafone case involved the sale of shares of a Cayman Islands company by a Hutchison Group entity (in the British Virgin Islands) to a Vodafone entity in the Netherlands. However, the Supreme Court ruled that the situs (location) of the shares being sold was in the Cayman Islands and as such the transaction fell outside the jurisdiction of the Indian tax authorities.

The rules, which make part of the Finance Bill, call for any entity holding a substantial stake being liable for tax, but a definition is required for this substantial stake and a high threshold is required to define the same, Mr Swamy said.

The DTC (Direct Taxes Code) called for a 50 per cent threshold limit, but no such limit is there in the Finance Bill, he said, while noting that the proposal could affect the portfolio investments, which are not like investments made in the factories or other physical assets.

Mr Swamy said, Such investments can go anytime, they are like hot money. The fear of tax liabilities, which could occur even at a much later date and also for a much earlier period, under the proposed taxation rules would drive away the portfolio investments.

If changes are not made in the indirect transfer cases, the entire FII community would just stop investing in Indian markets, as India is not the only emerging and attractive market available to them.

The proposal, in its current form, could be of consequence in cases involving a repatriation of gains from an intermediary holding company to the fund and taxation of the investors in it.

Also, the proposals would come into force retroactively from April 1, 1961. In addition, the Budget proposed to amend the statute of limitation to 17 years from the end of the Indian tax year in cases where income relating to any capital asset located outside India has escaped audit.

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