General Anti-Avoidance Rules (GAAR) are foreign portfolio investors’ worst nightmare. Just as all smokers dread the Union Budget, as they are sure that they will be saddled with additional tax on their cigarettes, foreign portfolio investors (FPIs) too have had the Damocles sword of GAAR hanging over them since 2012. They are worried stiff about it falling on their necks in one of these Union Budgets.
What is it?
Overseas investors are justified in worrying about these rules. The GAAR will arm the Income Tax authorities with immense powers that will enable them to scrutinise arrangements or companies that have been set up mainly for tax-avoidance.
Now, many foreign investors have been routing their investments into Indian stock market through offshore business centres such as Mauritius. Many of these investors have formed shell companies that lack commercial substance, carry out no commercial transactions and are set up with the sole intention of making use of the double taxation avoidance agreement (DTAA) that the Indian Government has signed with these countries.
Mauritius, one such offshore centre, has been the favoured route for investing in India. Under the DTAA that India signed with Mauritius, investors pay capital gains tax in the country where they are domiciled. Since Mauritius does not charge any capital gains tax (CGT) on investments, these investors can evade CGT altogether.
Once GAAR is implemented, these shell companies will come under the taxman’s scrutiny. This is why there was a steep sell-off in the stock markets when GAAR was first introduced by Pranab Mukherjee in the 2012 Union Budget.
Dilution and postponement
Both the UPA government and the current NDA government have been sensitive to the impact these provisions can have on foreign fund inflows. To assuage market sentiment, the GAAR rules, introduced in 2012, were diluted considerably once P Chidambaram took over as Finance Minister in late 2012. He postponed the implementation of GAAR to April 2016, left participatory notes outside the purview of the Rules and said the rules would apply only if the tax benefit exceeded ₹3 crore.
The Modi government too appears to be aware of the consequences and Arun Jaitley played it safe last Budget by postponing the implementation of GAAR by two more years. It is now laid out that investments made till March 2017 will be exempted from these rules.
When procrastination pays
Some market experts were not too happy with the delay in GAAR implementation. Others felt that, while there could be some temporary setback to foreign fund inflows, it would help cleanse the stock market. But the Centre has been extra cautious, given the critical role foreign portfolio flows play in the country’s balance of payment. The deficit in the current account is being bridged largely with the help of these capital flows. And destabilising them could have serious consequences for the external balance.
The strategy adopted by the UPA regime and later the NDA government — to spell out the threat to foreign investors but postpone the implementation — has worked wonders so far. Those round-tripping through tax havens are now aware that this route will be open for just another year or so. They are probably pruning their investments into the Indian stock market through this route. The numbers put out by market regulator SEBI corroborate this view.
The share of foreign investors routing their investments through Mauritius was 28 per cent of the total FII assets in January 2012. This share had fallen to 21 per cent by December 2015. The share of investors from the US, on the other hand, has risen from 30 per cent to 34 per cent. While assets of investors from the US have increased 140 per cent between January 2012 and December 2015, the increase in assets held by Mauritian investors is just 64 per cent.
This suggests that the share of incremental funds received from Mauritius could fall further in the coming years. This also means that we are receiving more money from legitimate sources now. If the Finance Minister keeps quiet about GAAR in the Union Budget that is due towards the end of this month, this trend will gather pace and the black money entering Indian stock markets from overseas could reduce further.