Foreign institutional investors in India have been given yet another reason for taking care with their capital – last week’s budget tax provisions.

With international banks issuing a letter speculating that it could lead to a complete pullout of the more than $200bn foreigners have invested in India, investors are pressing finance minister Pranab Mukherjee explain his intentions before the tax bill goes into effect on April 1.

So far foreign portfolio investments have slowed: since March 19, the first full trading day after the proposals were revealed in the annual budget, until Wednesday, foreign inflows hit $452.25m, with just one day of outflows – Tuesday, March 27 – of the seven trading days.

In the previous seven trading days, foreign inflows reached $1.09bn, so there’s been a significant drop off, but hardly the great sell-off some had predicted. The Bombay Stock Exchange has lost 2.3 per cent since March 19, but analysts said the contentious provisions were but one of many factors that fuelled the decline.

Instead, analysts said, investors are now waiting to see what Mukherjee will do before the bill goes into effect. Investor concern is centered on two provisions, one which will change the country’s tax laws to allow cross-border deals similar to Vodafone’s purchase of Hutchison Essar to be taxed retrospectively.

The other targets tax evaders, using the General Anti-Avoidance Rule, to force investors to prove that registrations in tax-haven countries are not intended solely to avoid tax. This provision, analysts said, is the government’s attempt to crack down on tax avoidance through Mauritius, the tiny island nation through which 40-60 per cent of foreign investment is routed.

“The government wants to plug as many holes as possible,” said Jagannadham Thunuguntla, head of research at SMC Global. “If your fund actually belongs to the US and just to get a tax advantage, you’ve created an artificial company in Mauritius…Mauritius is not being used as a residence, just as a tax shelter. [The government’s point is that] the tax-avoidance agreement with Mauritius should not be made a mockery of.”

Foreign investment makes up 17 per cent of the capitalisation of Indian markets, according to the Asian Securities Industry and Financial Markets Association. The bulk of that investment is made indirectly, via funds or instruments known as participatory notes, which are derivatives that mimic an underlying security.

The uncertainty surrounding the finance bill’s provisions prompted CSLA to cease selling so-called P-notes, which make up about 16 per cent of foreign investment in India and allow investors to avoid Indian taxes on direct investments, which can be as high as 40 per cent, according to Reuters.

One reason the government may choose to tax such notes is that they can be used by corrupt Indian politicians or businessmen to turn so-called “black money” into white. One analyst, who did not wish to be named, gave the example of a politician routing money from a Swiss bank through a P-note via Mauritius in order to launder it, and turn it into white money eligible to be invested in Indian equities.

That may be one reason the government won’t change its mind, despite Mukherjee having said on Tuesday that aspects of the provision may be modified. Another, Thunuguntla said, is simply that the government would lose even more authority if it rolled back yet another policy after the debacles surrounding FDI in multi-brand retail and proposed railway fare hikes.

“I think if they go back again, the credibility of the policymaking will come under question,” he said. “Reversing over and over can send the wrong signals about the policymaking.”

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