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Economy Jan 15, 2013

GAAR and FIIs: 5 key things you need to know

By Firstbiz Staff

The deferral of the General Anti Avoidance Rules (GAAR) by the government to April 2016 has laid most foreign institutional investor (FII) concerns to rest as this provides enough time for investors to review their investment structures. The deferral is likely to support capital flows in the coming years.

Finance Minister P Chidambaram said yesterday that GAAR would not apply to non-resident individuals who route their money through FIIs. The announcement came as a huge relief for investors who park their money in participatory notes (P-Notes) - a derivative instrument that draws its value from investments made in Indian stocks - floated by the FIIs.

GAAR will make P-notes more attractive to foreign investors

All those investments which have been made prior to August 2010, irrespective of when they are disposed of, will be not covered by GAAR and stand protected.Reuters

When announced in Budget 2012, investors had perceived GAAR as draconian as it targeted companies and investors routing money through tax havens such as Mauritius that allowed investors to use P-Notes for investing in India.

However, the central government's approval of the major recommendations proposed by the Shome Committee now includes relief for non-resident investors using FII vehicles. While it is not clear whether investment through P-Notes will come under the anti-avoidance regime, some experts believe it will surely make P-Notes more attractive to foreign investors since it hides their identity while routing black money.

P-Notes allow foreign investors to invest in India without registering with the market regulator Sebi and are considered as a means of gaining quick exposure to the underlying Indian equity market.

The total value of P-Notes in equity and debt currently is around 14 percent of the overall assets under the custody of FIIs. According to the latest data released by Sebi, the total value of P-Note investments in Indian markets rose to Rs 1.77 lakh crore at end-November after falling to a near three-year low of Rs 1.28 crore in May.

GAAR deferral gives FIIs time to review their investment structures so that GAAR is not invoked at the time of exit

Daksha Baxi, ED-Taxation of Khaitan & Co, told CNBC-TV18 that the much awaited clarification on GAAR was a significant relief for FIIs as it gives them a chance to rejig their structures and ensure that GAAR will not be invoked when they sell.

FIIs have recognised the government's need to prevent tax evasion and "The clients are now getting smarter to arrange their affairs in such a manner that they can address GAAR as and when it becomes effective," Baxi added.

FIIs and sub-accounts of FIIs taking advantage of tax treaty benefits will be subject to scrutiny under GAAR

Tax residency certificates furnished by investors in the recently prescribed format would now be subject to verification for "bonafide substance" of the residency. This implies government would try and restrict the treaty benefit to investors who can prove the substance of their Mauritius residency. Under the India-Mauritius double tax avoidance treaty, capital gains can taxed in one country can't be tax in the other. Since taxes are minimal or zero in Mauritius, many investors use the Mauritius route to mitigate/nullify their tax liabilities in India.

"If an FII is investing from Mauritius or Cyprus or Singapore and if they claim the treaty benefit, they are prone to invocation of GAAR," explained Baxi.

Pre-August 2010 investments would be "grandfathered"

The finance minister said in a statement that only those investments made before the introduction of the Direct Taxes Code Bill 2010 in Parliament will be "grandfathered"- meaning that investments before that date remain subject to the old rules. For such investments no questions on residency will also be asked. In other words, all those investments which have been made prior to August 2010, irrespective of when they are disposed of, will be not covered by GAAR and stand protected.

Since the tax department can reopen cases from the past six years, this will ensure all investments made after August 2010 will be open to scrutiny under GAAR.

GAAR will clearly overwrite tax treaties

GAAR will override India's tax treaties with countries such as Mauritius, but only if the "tax arrangement" is deemed "impermissible". Hence, if an FII derives benefits from the double-taxation treaty, GAAR will override the treaty.

This is likely to bring postbox structures and round-tripping of funds from tax havens under the scanner.


by Firstbiz Staff

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