The latest clarification issued by Central Board of Direct Taxes (CBDT) is sparking retrospective taxation fears among the overseas investors investing in the stock markets.

According to the latest clarification issued by the tax authority, indirect taxes would be applicable on internal transfers India-dedicated funds-investment vehicles that deployed more than half of their total investments in domestic securities.

According to industry estimates, such funds constitute account for nearly a third of the total foreign investments in the markets.

Although the CBDT clarification issued on Wednesday was a mere clarification of the original tax rules notified by the authority in 2012, legal experts fear this could have retrospective ramifications.

"We have been receiving a lot of enquiries from our clients since CBDT has put up the clarifications. They fear tax authorities would levy withholding tax on any transactions that occurred in the last four years and it would become difficult for the fund to determine which of its investor will have to take the tax burden," said a tax consultant.

Legal experts say as indirect transfer rules were primarily aimed at offshore merger & acquisitions (M&A) activity involving domestic assets, this is the first time portfolio investments would come under the ambit of withholding tax.

Experts say the new interpretation is difficult to be enforced as funds investing in India operate through a multi-tier structure, where the previous end beneficiaries would be difficult to trace.

Just like a mutual fund, FPIs are funds pooled from various investors and computation of taxes is done at the fund level. Later depending on the holding of the each investor, the fund transfers the liability to end investors. Now if an investor has completely exited the fund say in 2013, the fund will no longer be able to collect tax from him. However, based on the transaction the fund will be subject to withholding tax.

Further, such transactions could have also been taxed in the respective jurisdiction. It would be double taxation for the FPI if they are asked to pay taxes in the India as well.

"The circular will have an adverse impact on FPIs as it increases compliance. In fact, some of the clarifications are impossible to implement. Now the FPIs will have to track and report all such transactions to Indian tax authorities, which won't be easy," said Punit Shah, Partner, Dhruva Associates.

Taxing indirect transfers is implementable if there are fewer investors involved. However, extending the same to broad-based funds with investors spanning across geographies is something no jurisdiction has attempted, say experts.

"While the circular doesn't make any new announcements, it was generally understood that indirect transfer rules were applicable only to private equity deals involving transfer of Indian assets. In that sense, the circular would disappoint FPIs. Tax authorities may now want to now probe offshore transactions happening in the case of India focused funds and try to determine whether such transactions are taxable under Indian law. This could also have interest and penal consequences for such funds and their investors," said Rajesh Gandhi, partner, Deloitte.

The issue of indirect transfers shot to limelight for the first time during Vodafone-Hutchison tax dispute, when authorities slapped Rs 22,000 crore tax notice to Vodafone over its $11 billion acquisition of Hutchison Essar.