GAARbled tax rule leaves Indian markets sweating

The fear of substantial foreign institutional outflows on implementation of certain provisions in the General Anti-Avoidance Rules (GAAR) by tax authorities along with weakening rupee, caused panic in Indian markets on Monday.

The benchmark Sensex shed 308.96 points or 1.78% to close at 17052.78 points, while the Nifty fell by 93.95 points to end the day at 5184.25 points.

Experts believe that the fall was triggered by selling by domestic entities on concerns that the recent Budget proposal to implement GAAR with effect from April 2012, would lead to considerable amount of foreign instructional investments coming under tax scanner.

“All of yesterday’s selling in markets was driven by substantial concerns on taxation of FII investments as a result of GAAR clause in the Budget. The clauses in GAAR if implemented would make countries like Mauritius through which vast majority of money comes into India, less tax efficient.” said Saurabh Mukherjea, head of equities at Ambit Capital.

As per the Finance Bill 2012, GAAR will apply to cases of “impermissible avoidance arrangements” where the main purpose, or one of the main purposes, of entering into such an arrangement is purely to obtain a tax benefit and where such arrangement misuses the provisions of the tax laws and lack commercial substance.

Shefali Goradia, partner at BMR Advisors, said though the introduction of GAAR was known since the Budget, but the uncertainty in tax exemption for FIIs on sale of assets including equity investments is worrying.

“It’s a big change introduced in a hush-hush manner with only short time left for people to understand the implications. The GAAR provisions would override the bilateral international tax treaties, but there’s no clarity with regards to what rules would apply,” she said.

This lack of clarity has weighed on FII flows of late. Also, a weakening rupee, which has broken past 51 per dollar over last couple of sessions, has weighed on sentiment.

FIIs bought equities worth Rs1,363.30 crore last week compared with Rs5,471 crore inflows in the week before that. As per provisional data, FIIs on Monday were net sellers of shares worth Rs135.29 crore.

A foreign institutional investor that DNA Money spoke with stated the the absence of major FII selling does not mean that GAAR is a non-issue, it may only be a procedural delay.

“If something negative is going to happen then somebody is going to sell ahead of it. The FIIs will wait for their lawyers’ opinions, but the operators will sell ahead of that,” said the person.

The selling was seen across the board with two out of three stocks listed on BSE declining. All 13 sectoral indices listed on BSE closed in the red with realty (3.58% down), power (2.56%) and banking (2.44% down) among the worst performers.

Experts believe that we may in fact start seeing FII outflows in the coming days if the confusion on GAAR prevails.

“The foreign investors would need to reassess their strategy and many of them are likely to relocate from Mauritius to Singapore where they do not have capital gains tax either if fund has two years history in that country. But that would take time and so one may see destruction in Indian markets if the clarification does not come from ministry soon,” said Mukherjea.

KR Sekar, partner, Deloitte Haskins & Sells, said the recent government moves may disincentivise foreign investors. “The lack of clarity on the implementation of GAAR regulations and retrospective amendments to bring Vodafone-like deals under the tax net would certainly undermine the confidence of global investors. It also erodes India’s credibility as an investment destination.”