Budget 2012 – GAAR and what it means for FIIs

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In the Union Budget 2012-13 the Finance Minister of India, Pranab Mukherjee, has stated that a General Anti Avoidance Rule (GAAR) will be introduced from April 2012 onwards. This legislation will act as a counter to various programs for avoiding taxes. But a GAAR panel will also be instituted to make sure that it is implemented only in cases where it is most appropriate.

As per the budgetary proposals, GAAR will enable the tax department to not provide tax benefits to companies if it is assured about the said company’s intentions to dodge taxes through its transactions.

For example, if an Indian company creates a subsidiary unit in Mauritius for getting exemption from capital gains tax then the tax authorities of India will have the right to refute the claim that is backed by the India-Mauritius tax treaty.

The Supreme Court had earlier issued an order whereby it had given the tax department the power necessary to investigate the business deals where the major objective or one of the various aims is to avoid paying taxes. This was evident from the ruling in the McDowell Ltd. case.

However, in the Azadi Bachao Andolan the income tax department was stopped by the apex judicial body of India which ruled that the certificate of residence provided by authorities in Mauritius was good enough for claiming exemption from capital gains taxes as per the India-Mauritius tax treaty.

The IT department has also been hindered, as in the Vodafone case, from taking steps against business transactions designed to evade taxes by the moderate views of the Supreme Court on such issues. It is expected, though, that with the introduction of the GAAR the IT department will be in a better position to take sterner steps against such deals.

Process of FII Investments in India

According to the RBI regulations, FIIs can invest in the secondary and primary capital markets of India through PIS (Portfolio Investment Schemes). Through these schemes, the investors can buy debentures and shares of Indian organizations that are being traded in the stock exchanges.

The FIIs are not allowed to invest more than 24 percent of the paid-up capital of an Indian organization. In case it is a public sector bank like the State Bank of India, the upper limit comes down to 20%. However, the ceiling can be upped till the statutory ceiling or sectoral cap if the board approves it or the company’s general body passes a special resolution for the purpose.

The operations of the FIIs are monitored on a daily basis by the Reserve Bank of India.

FIIs in India – Top Players

Approximately 50 percent of the offshore FIIs in India come from Mauritius, Luxembourg, and Hong Kong. It is important to note in this regard that all these countries offer significant tax privileges.

Before the global economic meltdown of 2008, Singapore and Switzerland were also regarded as being among the top institutional investors in India. India also receives a fair share of overseas FII from countries such as France, the UK, UAE, Australia, Norway, and Canada.

Reaction of FIIs regarding GAAR

The foreign investors have been affected by the possibility of GAAR coming into effect from this fiscal onwards. As per the GAAR proposals, the government could levy taxes on investment options such as P-notes (Participatory Notes) that are provided to overseas investors by foreign portfolio investors that are registered with the Securities Exchange Board of India (SEBI) and are exempted from taxes.

The buyers normally remain anonymous in these cases and are eligible for tax benefits – however, this facility might cease to exist once GAAR comes into force. This lack of leverage is the major issue of concern for the FIIs.

Majority of the brokerage houses in India are wary that if the GAAR is implemented, as has been proposed, it could severely affect the tax treaty between India and Mauritius as most of the private equity funds and FIIs investing in India are based in the Southeast African country. The situation will also be similar in case of investment being made through Singapore.

Investors, presently, are not clear as to how the rules will be implemented and what impact they can create. However, this confusion might result in these investors withdrawing their operations in India.

Impact of GAAR on FIIs

Every year the FIIs invest almost INR 1.8 lakh crores through the Participatory Notes. If the GAAR provisions are implemented exactly as they have been proposed in the Union Budget 2012-13 then several FIIs will have to rethink their plans. Financial experts, however, feel that the impact will not be limited to the investors only – there can be some significant effect on the share markets in India as well.

To start with, there will be a reduction in the substantial overseas funds flowing into India as the FIIs from Mauritius might be forced to change their strategy. They have stated that the government decision to tax P-Notes could be a major mistake as it will deter international investors from looking at India as a viable destination.

The exchange value of the Rupee is weak and if the government pursued this step, the worth of India’s national currency could depreciate further. The current account deficit is already in excess of 3 percent of the GDP and if this decision is implemented then the situation will become graver.

Finance Ministry stance on GAAR

Pranab Mukherjee has, in an effort to calm the turbulent share markets, stated that the GAAR is intended to put an end to tax avoidance that is done via complex business deals and does not aim to affect any investment option such as the P-notes.

He has stated that the changes in GAAR will be done through the suggestions made regarding the provisions of the Direct Tax Code by the Parliamentary Standing Committee on Finance.

Following his statements, the share markets have shown better performance. The Finance Minister, on his part, has stated that he was unable to incorporate the suggestions of the Parliamentary Standing Committee on Finance in the budget as he had received the report later than usual.

The Finance Ministry is also expected to hold meetings with UK Sinha, the chairman of SEBI, and several FIIs. The basic idea behind the meeting will be to come up with solutions that can do away with the apprehensions among the investors and the share market in general.

There is an important difference between the Union Budget 2012 and the Parliamentary Standing Committee on Finance regarding the GAAR. The panel has suggested that the duty of proving a business deal’s intention to avoid tax should be given to the concerned authorities while the budget has put the responsibility on the assessees.

Financial analysts are of the opinion that this will be a huge task for the assessees as any point they make to defend their deals can be countered by the tax officials. The committee also wants to include non-tax officials in the panel that decides on the justifiability of a business deal regarding tax avoidance while the Union Budget has proposed that only high ranking officials and tax authorities be included in the said committee.

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Last Updated on 30 March 2012