The recent verdict of the Authority for Advance Ruling (AAR) on two foreign institutional investors Fidelity Advisory and Mathew International asking them to pay tax on short-term capital gains is drawing flak from market watchers.

Sending out a cue to other overseas investors, the AAR, in its ruling, had asked those FIIs investing directly in Indian equity markets to pay 10% short-term capital gains tax on their portfolio investments. This would mean that profits from investment in securities will be treated as capital gains, and not business income. In other words, foreign investors would be liable to pay capital gains tax on off-loading their holdings within one year.

Marketmen feel the ruling would impact investors from the US, Canada and Europe the most. Out of the 1,065 registered FIIs, as many as 409 come from the US and Canada and about 339 from various parts of Europe (including Luxembourg, Netherlands, Ireland, Switzerland France and Denmark). According to Sebi, only 23 and 50 foreign investors have registered offices in Mauritius and Singapore, respectively.

According to market analysts, about 30% of American funds come to India through Mauritius and the remaining portion invests directly into Indian equities. Active FIIs account to only about 11% of the total FII registrations. Though this ruling only has persuasive value, it will only add up tax uncertainties for foreign investors investing in India. FIIs have always been uneasy about taxation procedures in India, said UR Bhat, managing director, Dalton Capital Advisors (India).

In a similar case (also involving Fidelity), AAR had earlier passed a ruling, contradictory to the recent one, wherein the quasi-judicial body had held that profits from Fidelity Advisory Series-8 be considered as business income. The AAR had held that the trading income of this company would be taxable only in the US and not in India as it did not have a permanent establishment (PE) here. 
 
When you have regulations laid out, they should be well-codified and be consistent. We recently saw a classic example in Thailand, in December, when the government regulators decided to put a one-year lock-up on foreign capital. You cant have that kind of inconsistency. Doing so, you are sending a wrong message to foreign investors. Any drastic change such as a tax revision may have some impact, said Rohit Aggarwal, managing director, RAS Capital Management, adding, India is a tax-friendly country.

This particular issue (the AAR verdict) may not have any major impact because we are only talking about investors who are not coming through Mauritius, he said. Talking about the Permanent Establishment (PE) Clause, Mr Aggarwal said, The issue of PE is a bit tricky. There should be some middle-ground between overseas investors and the regulator in this regard. Most market players do not have immediate fears of foreign investors pulling out of the Indian markets. However, many foresee the situation to be a bit edgy once the markets begin to underperform.

Indian tax laws are very unclear. As an FII, we dont pay taxes on capital gains in any other emerging markets other than India. There is always tension among investors whenever there are revisions or changes in policy matters, said a US-based FII on the sidelines of the Ficci Annual Capital Markets conference on Tuesday.