Unnerved by tax demands on capital gains, foreign funds flee for safety

The minimum alternate tax row has damaged the credibility of government promises to enforce an investor-friendly tax regime and made the Indian stock market Asia’s worst performer this year

New Delhi/Mumbai: Castleton Investment Ltd, a unit of GlaxoSmithKline Plc (GSK), in 2012 asked an arm of the Indian finance ministry a simple question: Would it have to pay tax on a share transfer it wanted to effect that involved an India-incorporated entity?

Mauritius-based Castleton had held shares in GlaxoSmithKline Pharmaceuticals Ltd, the Indian unit of GSK, since 1993 and wanted to transfer the shares to GlaxoSmithKline (Pte) Ltd, a Singapore-incorporated entity.

Having held the shares for almost 20 years, Castleton didn’t have to pay capital gains tax on the off-market transaction. To boot, India has a double taxation avoidance treaty with Mauritius. Plus, Castleton didn’t have either an office or employees in India, and being a foreign entity, it wasn’t required to maintain books of accounts in India.

So Castleton, reasonably, thought it wasn’t liable to pay any tax in India on the deal.

It had a surprise coming.

The Authority for Advance Rulings (AAR), a quasi-judicial body under the finance ministry, ruled on 14 August 2012 that the company was indeed liable to pay a tax, called minimum alternate tax (MAT), levied on companies that don’t pay income tax because of incentives and exemptions.

MAT is calculated at 18.5% of book profits, plus applicable surcharge and education cess, and foreign institutional investors (FIIs) had been hitherto exempt from it.

That’s the ruling that has returned to haunt the Bharatiya Janata Party (BJP)-led National Democratic Alliance (NDA) government, which wasn’t even in office when it was delivered by the AAR, and undermined the credibility of its promise to put in place a fair, transparent and non-adversarial tax regime.

Overseas funds took flight as the tax department, armed with the AAR’s verdict, sent notices to 68 foreign portfolio investors (FPIs) demanding a combined Rs.608 crore as MAT on past capital gains, and amid reports that it targeted netting a total of Rs.40,000 crore through the levy.

Market mayhem

The BSE Sensex entered a correction phase on 7 May, with the gauge extending the drop from its 29 January lifetime closing high of 29,681.77 points to 10%. As of Wednesday (13 May), it has fallen 0.9% year to date and 9.24% from its record-high, making it Asia’s worst performing major benchmark stock index this year, and the only one to deliver a negative return among the BRIC (Brazil, Russia, India and China) markets. Brazil’s Bovespa, China’s Shanghai Composite Index and Russia’s RTS Index have logged gains of 13.57%, 35.28% and 36.63%, respectively.

The Sensex is also the second worst performing major global equities benchmark after Turkey’s Borsai Istanbul 100 Index.

Sure, other factors contributed to the drop, including concerns over corporate earnings and worries that a less-than-bountiful monsoon predicted by the weather office would hurt food production, fan inflation and crimp the Reserve Bank of India’s (RBI’s) ability to lower interest rates.

But MAT was doing the most damage as foreign investors registered their anger by taking their money out. Although FIIs have bought a net $6.6 billion of Indian equities so far this year, they sold in 15 out of the 17 sessions ending 9 May. In May so far, FIIs have sold $557.29 million of Indian shares.

The government blinked on Monday, 11 May, saying the tax department will not act on demands for MAT it has already slapped on FPIs nor will it make any fresh MAT claims.

The embargo will prevail until a committee headed by A.P. Shah, chairman of the Law Commission, submits its report to the government on the applicability of MAT on foreign investors.

“A lot of FIIs who have not received notices so far have been quite concerned and anxious to know if and when they will receive a notice and how they should approach the matter, given the uncertainty on the MAT issue,” said Rajesh H. Gandhi, a partner at Deloitte Haskins and Sells Llp.

“FIIs should, therefore, be relieved to know that no further notices will be issued till the committee submits its report,” he said.

Fairness misunderstood

The climbdown must have been galling for a government that had been insistent that the MAT issue was a part of the legacy it inherited from its predecessor, the Congress-led United Progressive Alliance (UPA), and it could do nothing about it.

Finance minister Arun Jaitley said on 6 April that India didn’t aspire to be a tax haven and every tax demand could not be equated with an act of “tax terrorism”, which he had accused the UPA of.

“An emerging economy (like India) that expects investment cannot really indulge in tax terrorism or aggressive tax policy. But our fairness is partly misunderstood. The converse of tax terrorism is not (being a) tax haven,” Jaitley told a conference organized by the lobby group, the Confederation of Indian Industry.

On another forum, Jaitley also ruled out retrospective amendments in the law for the benefit of investors, noting that quasi-judicial bodies such as the AAR had been created to reassure investors that the tax system would be free of political interference.

“But some of the rulings went against foreign investors (others have gone in their favour). We have had little choice but to respect these decisions… The rule of law cuts both ways. We cannot say it is undermined when we take retroactive actions and, at the same time, seek to override, retroactively, the decisions of our institutions,” Jaitley wrote in a column for the Financial Times.

“However, we have made clear that these rulings can be contested in the higher courts, which will respect due process and have the power to quash faulty decisions,” he wrote.

The government also argued that aggrieved investors could take recourse to tax treaties India has with other countries to fight MAT notices. But this provided a measure of relief to only around one-third of the FPIs investing in India that route their funds from countries such as Mauritius, Singapore and the Netherlands. India’s double taxation avoidance agreement with these countries do not allow tax on capital gains .

Leaving a bad taste

A majority of the FIIs, from countries like the US, UK, Luxembourg and the UAE, got no relief. India’s tax treaties are unlikely to get any relief in the near term. India’s treaties with these countries allow capital gains taxes.

“The guys who came in from genuine jurisdiction without thinking much about short-term gains taxes are getting battered. What I mean to say is that the investors who were paying taxes on short-term gains are the ones getting further taxation demands,” said Prabhat Awasthi, managing director and head of equities at Nomura Financial Advisory and Securities (India) Pvt. Ltd.

“From the perspective of how you look at India’s tax regime, and from a government which has said that the tax regime would be stable and predictable, the bigger issue is that this kind of retrospective and unexpected demands do not leave a good taste with the investors.”

In his national budget speech on 28 February, Jaitley said MAT would not be applicable on capital gains accruing to foreign investors starting in the 2015-16 fiscal.

He went on to provide further relief on the MAT front by exempting interest income, royalty, fees from technical services and capital gains accruing to foreign companies from the MAT net by moving amendments to the finance bill 2015.

But the finance minister kept the doors open for retrospective taxation, saying it was up to the judicial authorities to decide.

The latest tax dispute is hurting both the markets and India’s image, Shankar Sharma, vice-chairman and joint managing director of First Global Securities Pvt. Ltd, said in a 24 April phone interview.

“If the government can exempt FIIs in future, why can’t they do so retrospectively? If they do so, the problem is resolved in one stroke. And if this tax was indeed due, why wasn’t the tax department levying MAT since 1994 when FIIs entered India?” Sharma said.

Taxation has been a grave concern for foreign investors in India in the past few years.

In 2007, Vodafone International Holdings, a Dutch unit of the British telecom firm Vodafone Group Plc, bought the Indian operations of Hutchison Telecommunications International Ltd in a $11 billion deal.

The income tax department held that capital gains was payable and should have been withheld by Vodafone. The matter went to court and resulted in a ruling favourable to the telecom company in January 2012.

But the government introduced retrospective amendments to tax laws and held that the tax was payable in India.

Vodafone has filed for international arbitration to resolve the issue. At stake is a tax demand for Rs.20,000 crore, including interest and penalty.

This year, Cairn India Ltd, a subsidiary of Anil Agarwal’s London-listed Vedanta Resources Plc, was served with a tax demand of Rs.20,495 crore for its failure to deduct withholding tax on capital gains arising during 2006-07 in the hands of Cairn UK Holdings Ltd, its erstwhile parent company. Cairn India has approached the Delhi high court.

“This issue has been very confusing. Taxation should always be predictable and transparent. Retrospective taxes are totally unacceptable,” Hertta Alava, director of emerging market funds at FIM Asset Management Ltd, said in an email to Mint on 24 April.

In letter and spirit

To be sure, Jaitley has over the past one year done his bit to reduce tax disputes. The government has categorically stated that it will not amend laws which will retroactively increase the tax burden of investors. It also decided against appealing an adverse high court ruling in transfer pricing cases involving Royal Dutch Shell Plc’s India unit and Vodafone India Ltd, wherein share issuances by the Indian subsidiary to the foreign parent were under the tax scanner.

The government has deferred the implementation of general anti-avoidance rules—a provision that gives the tax department powers to check tax avoidance—for two years. It has also provided clarity on the taxability of global mergers and acquisitions transactions in India. It has said that only those transactions will be liable to be taxed in India wherein more than 50% of the underlying assets being bought are located in the country. Also, tax will be levied proportionately and the size of the transaction should be more than Rs.10 crore.

“Let me reiterate once again that in matters of taxation, the government is fully committed to the principles of certainty of taxation, avoidance of retrospectivity and providing an enabling environment to business and investment, both domestic and foreign. We will ensure that these principles are adhered to in letter and spirit,” were Jaitley’s words of comfort for foreign investors.

But the MAT controversy has overshadowed the good work done by the government in matters of taxation.

The government may have won peace with an embargo on further MAT notices and by barring follow-up action on notices already slapped on foreign investors.

Still, until the dispute is resolved for once and for ever, it will keep investors on the edge.

“The matter will now be decided when the Supreme Court delivers its judgment in the Castleton case,” said Sudhir Kapadia, national tax leader at the Indian unit of EY, formerly known as Ernst and Young.

Castleton Investment recently moved the Supreme Court for an early hearing of its case. The government has told the court that it has no objection to an early hearing. The case is likely to be heard in August.

Until then, investors may prefer to stay on the sidelines. “There is no clarity on who bears the tax liability—the investor, fund or AMC (asset management company)—if FIIs lose the judicial review. New investors (are) taking a wait-and-watch attitude,” said Rahul Chadha, co-chief investment officer of Mirae Asset Global Investments (HK) Ltd.