INDIA ACCORDING TO GAAR

The World According to Garp was a bestselling novel written by John
Irving. In the book Irving famously wrote – In the world according to
Garp, we are all terminal cases. The rupee is once again taking a
dive, as capital flows out of the stock market. In an institutionally
driven market, foreign institutional investors get the heebie-jeebies
when policy mavens unveil new laws. In fact, it borders on a kerfuffle
when the new laws impact FII transactions.

Eh, now you will wonder what Irving’s Garp has to do with the Indian
stock market? Where am I going with this. Convoluted, perhaps, but
FIIs have been hit by a close relative of Garp, he is called GAAR.
Simply put, it means General Anti Avoidance Rule. But the genie that
was released from the bottle by the Union Budget in India spooked
investors to such an extent that money began to flow out of the
markets in a hurry. This resulted in FIIs pulling out money, the
trickle became a flood very soon. GAAR overnight emerged as the new
dreaded demon.

What GAAR does is that it allows tax authorities sweeping powers to
question any transaction with retrospective effect. Let us examine
some data now to bolster this argument. Events, liquidity and
valuations determine the course of stock markets. Almost overnight, as
the year turned, foreign investors found the Indian market which they
had ignored right through 2011 as under bought, driven by attractive
valuations, and reasonably decent third quarter earnings numbers from
corporates.

In the first three months of 2012, money came gushing in from bulge
bracket foreign investors – Rs 9469 crore worth of equities was bought
in January followed by a phenomenal Rs 23,236 crore in February and
finally Rs 6526 crore in March. All told approximately $7.84 billion
was pumped into the equity markets alone in 2012. The worm began to
turn in the immediate first flush of the Union budget. And since then
the trajectory has been downwards. In April, the figure is negative,
though negligent, but the rupee is closer to Rs 51.78 versus the
greenback.

The government meanwhile is trying desperately to limit the damage, by
talking to foreign investors at all levels, convincing them that this
retrospective law is not meant for genuine investors. But to no avail
yet. Finance minister Pranab Mukherjee and finance secretary R S
Gujral have both denied anything sinister behind the introduction of
GAAR. While GAAR will in all probability come into existence from
April 1, 2012,
I asked my friend senior Supreme Court Advocate Homi Ranina what the
implications of this law was. Ranina cut to the chase by saying, “The
guidelines will only be known when the Finance Bill is passed in the
third week of April. WE don’t know under what circumstances GAAR will
be applied. The plan is obviously to weed out tax avoidance in
offshore transactions, in the main the large cross border deals.”
On Thursday, finance secretary Gujral offered some inkling of the way
forward when he said that the law will cover those FIIS which are
investing through tax havens. Importantly, he said it could be
applicable from 1 April, but would not carry out the scrutiny of
earlier transactions. The underlying credo behind GAAR from what one
gathers in finmin is that it will counter aggressive tax avoidance
schemes and will target transactions or arrangements that do not have
any commercial substance or consideration other than achieving tax
benefit. Significantly, he indicated that private equity funds will
come under GAAR’s ambit.
This could be extremely worrying and annoying for if the entity cannot
prove substantive interest in say a offshore haven like Mauritius, its
tax residency status will be rejected. Complicated. Very much. Till
such time as the Finance Bill is passed, the GAAR overhang will be the
sole talking point amongst the foreign investor community – both
direct and portfolio. Many reckon that PEs that fail to demonstrate
substantial presence in Mauritius will have to pay tax on profits, as
per GAAR and this will override the Indian-Mauritius tax avoidance
treaty.
When FIIs met Finance Secretary R S Gujral recently, he articulated
that General Anti-Avoidance Rule (GAAR) provisions would be invoked
only in case of "impermissible arrangements". He had stated, “If they
are in a permissible arrangement, clearly they are governed by the
particular treaty and GAAR does not get invoked at all. If it is an
impermissible arrangement, then GAAR gets invoked and the treaty does
not help them."
What is interesting is that FIIs are allowed after many policy flip
flops to invest in India using an instrument called participatory
notes through sub accounts. These instruments mask the identity of
actual investors and speculation has persisted that it is used openly
for the purpose of to round tripping, essentially bringing back money
salted overseas by the rich and powerful into the country. The colour
of money in the stockmarket is all the same and P Notes allow
politicians and businessmen to bring back their black money, it is
said. When the govt banned P Notes the last time round, there was a
veritable panic as FII money dried up, then the floodgates opened and
all was well. Now GAAR is the new dragon slayer.

For now one waits for clarifications from the finance ministry which
dissipate the clouds that hang over investors’ minds. FIIs have assets
under custody of more than Rs 10 lakh crore, or 17 per cent, of the
market capitalisation of India's equity markets. FIIs are also big
investors in Indian government and corporate debt which too is seeing
capital outflows due to this GAAR bogey. India also needs to realise
that is not the only investment destination, investors have other fish
to fry. Already there is talk that Indonesia will replace India in
BRICS. India can be ignored at your own peril, but India too needs to
contribute if it wants to better itself. By looking at regressive and
retrograde policies which lack consistency, the purpose of moving
forward is defeated. A capital; deficit nation like ours satrved of
funds for economic development needs to be forward looking. Yes, we
need to be jingoistic too, but if we want to improve the lot of the
last man standing, we should be progressive. So should our policies
and attitude. Money is the fastest traveling thing in the world, here
today, gone tomorrow. Remember that.