GAAR jitters: Winners and losers in market since 16 March

The government’s proposal to allow tax authorities to examine transactions that may be structured for the sole purpose of avoiding paying taxes has sparked an outcry among foreign investors, who, after purchasing about Rs 47,000 crore in Indian equities (net) since the start of 2012, the highest-ever in the first quarter since 1993, have been selling this month.

The jittery mood can clearly be seen in the markets. There are reports that foreign institutional investors (FIIs) have been short-selling Nifty futures owing to lingering concerns over the tax provisions under the General Anti-Avoidance Rules (GAAR). Even the clarification offered by Finance Minister Pranab Mukherjee about the new provision has not helped.

On Tuesday,Mukherjee said GAAR, which will give the tax department the power to deny double-taxation treaty benefits to FIIs based in tax havens like Mauritius, was aimed at tax evaders, but did not specify how it would be used in relation to participatory notes. However, shares of two-thirds of Indian companies in which foreign institutions have large stakes have fallen more than the benchmark indices, an _Economic Time_s article pointed out.

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[caption id=“attachment_259296” align=“alignleft” width=“380” caption=“To avoid tax altogether under GAAR, an investor may now have to prove the P-note was not set up specifically to avoid paying taxes or to prove that the deal has commercial substance. Reuters”]  [/caption]

Shares of Firstsource Solution, in which Mauritius-based Aranda Investment and Metavante Investment holds about 37 percent stake, have fallen 16 percent since the finance minister introduced GAAR in Union Budget 2012 on 16 March, the article said. Other stocks like India Infoline, Cox and Kings, Edelweiss Fin, IDFC, Titagarh Wagons and NCC which have Mauritius links have dropped around 10 to 12 percent in the same period, the report said.

Overseas portfolio investors, routing their investments via countries like Mauritius, currently do not pay any tax on short-term capital gains and will be taxed from 1 April, forcing them to wind up their positions. “FIIs domiciled in such treaty locations may have to prove that they have created this structure for genuine business purposes and not just for avoidance of tax,” domestic brokerage IIFL said in a note recently. If the institution is unable to prove this, traders will be charged 15 percent as capital gains tax.

The uncertainty over the tax treatment of FIIs led CLSA, an international brokerage, to stop selling the derivatives through which foreign investors buy into Indian securities. Analysts worry GAAR could also be used by the government to target participatory notes (known as P-notes). P-notes are derivatives that mimic an underlying Indian security and are sold by brokerages to foreign investors. Many purchasers of P-notes are believed to be overseas funds registered in countries safe from Indian taxes, such as Mauritius.

“CLSA has taken the position not to increase its current Indian P-note book as a way of minimizing the possible tax exposure,” the brokerage said in an email yesterday.

To avoid tax altogether under GAAR, an investor may now have to prove the P-note was not set up specifically to avoid paying taxes or to prove that the deal has “commercial substance,” Edelweiss told Reuters.

The tax would be imposed on the registered financial firm buying the security on behalf of the client, which is likely to be passed on to the client. That’s why markets have been gripped by fear.

Meanwhile, investors who put in money in FII-free stocks have reason to cheer as over 100 stocks in which FIIs don’t hold any stake have risen between 10 and 56 percent against the Sensex’s drop of 2.4 percent since 16 March, another Economic Times report pointed out. These include small- and mid-cap stocks like Ortin Labs, Pokarna Readymade, Mahaan Foods, Sahara Housing and Ahlcon Parenterals.