The general anti-avoidance rule (GAAR) under proposed new tax legislation in India risks triggering a huge, disorderly unwinding of securities by foreign institutional investors unless cross-border portfolio exposures are exempted, warns advocacy body Asifma.

In its second letter on the topic, the Asia Securities Industry & Financial Markets Association has urged the finance ministry to exempt “small investment” by international portfolio managers from the GAAR rules since this is not what the proposed tax law is designed to target.

Last month, UK mobile group Vodafone served the Indian government with a legal notice as the proposed tax rule would allow the government to charge tax retroactively, therein subjecting Vodafone to a bill of over US$2 billion related to its 2007 acquisition of a mobile phone firm from a Cayman Islands unit of Hutchison Whampoa. The proposed law would effectively override an earlier Supreme Court ruling in January saying that Vodafone did not have to pay tax on the deal.

The proposed new rules, slated for parliamentary debate on May 7 and potentially due to be signed into law a week later, are designed to combat tax evasion. While India is not alone in introducing GAAR, Asifma notes that no major economy has also chosen to collect taxes from cross-border portfolio investments in listed securities.

“We are concerned that negative and unintended consequences will result if India puts its capital markets at risk by establishing a tax regime inconsistent with globally accepted norms,” Asifma chief executive Nicholas de Boursac wrote in a letter to the India finance ministry.

Asifma’s warning has coincided with reports that Macquarie’s Asia hedge fund has exited its short positions in Indian single stock futures, switching to gain short exposure by trading the NSE Index Nifty futures contract on the Singapore Exchange. Newswires reported that the pull-out by Macquarie Asia Alpha Fund was caused by an interpretation that the proposed tax rule could make the fund liable for potential capital gains tax.

Currently, small investment is defined as anything up to a 10% stake in an Indian listed firm; and government and corporate bonds that FIIs need to observe prescribed limits set by the Securities Exchange Board of India (Sebi).

Without a reliable tax system, intermediaries such as fund managers may decide to avoid India's capital markets altogether as they need to be held accountable to investors. GAAR puts the onus on investors to prove that registration in tax-haven countries, such as Mauritius, are not being used for tax avoidance.

One industry source in contact with securities regulator Sebi over this issue, says: “Many funds -- such as some of the global hedge funds which route their transactions through Mauritius to benefit from zero capital gains tax there -- probably don’t have many traders or activities in Mauritius as the management decision and asset allocation is being done in another location where the fund managers who trade India securities are also investing in other markets globally. The managers provide services to a series or family of funds and they could be affected by the GAAR.”

Since the financial budget announcement on March 16, Asifma says net inflows from FIIs effectively saw a daily average drop of 95%. It notes that from the start of this year to March 16 net inflow was Rs437 billion ($8.2 billion), but from March 17 to April 16 it stood at just Rs8 billion.

As at March 16, FIIs had assets under custody of over Rs10 trillion, or 17% of the capitalisation of India's securities markets.