A Lesson Learnt the Hard Way: Don’t Mess with Large Foreign Funds

Finance Minister Arun Jaitley. Credit: PTI

Finance Minister Arun Jaitley. Credit: PTI

Finance Minister Arun Jaitley is not a man known to make stupid mistakes; he is also particularly skillful in ensuring he appears consistent in all his pronouncements at all times. Given this past record of Jaitley’s, everyone was quite taken aback at the uncharacteristic flip-flop, almost coming across as bumbling, by the finance minister over the much publicised “legitimate claim” of Rs.40,000 crore Minimum Alternate Tax (MAT) on Foreign Institutional Investors (FIIs) which was all but withdrawn within a fortnight.

The sequence of events is baffling. Jaitley first stated, in the strongest possible words, that India was not a “tax haven in some banana republic” and therefore legitimate taxes will have to be paid by foreign investors. He then went a step further to send a strong political message saying he could use Rs.40,000 crore for critical investments in irrigation and infrastructure. This statement had a sharp political flavour as it came in the midst of a serious farm economy crises accompanied by a growing perception that BJP is not doing enough for farmers.

Political calculations by Jaitley

So it was obvious that Jaitley’s pronouncements were not off the cuff and had been made in a politically calculated manner. One would even assume that Jaitley would have discussed this with Prime Minister Modi who too is excessively concerned these days about not appearing to be overly pro-big business. It is too important an issue not to have been discussed with Modi whose candidature as PM was very vocally endorsed by the 1000 plus FII community, which has collectively about $300 billion (at market value) invested in Indian stocks. These FIIs had said in their research reports that Modi’s arrival could result in a multi-year bull run in India’s stock markets. It is another matter that many of them have started talking about the beginning of a bear phase in India and better prospects for markets like China, South Korea, Brazil and Taiwan this year.

So Jaitley’s (and possibly Modi’s) first instinct was to stick to the quasi-judicial pronouncement that MAT was applicable retrospectively for the years gone by. Then as the FIIs started selling shares in the market the government began a rapid climb down. The first sign came when Minister of State for Finance Jayant Sinha held a hurriedly convened video conference call organised by the omnipresent Wall Street biggie Goldman Sachs. Sinha and the Revenue Secretary implicitly assured the FIIs that those who are operating from jurisdictions with a double taxation avoidance treaties, such as Mauritius and Singapore, would not be sent tax demands. This assurance was extraordinary because the self same quasi-judicial advance ruling in 2012, had clearly specified that the imposition of MAT would in fact override all tax treaties. The Finance Ministry was thus was treading on judicially dangerous ground by assuring FIIs that no MAT would apply if they operated from jurisdictions with double taxation avoidance agreements. 

Additionally, the case which triggered the imposition of MAT on all FIIs is still under challenge in the Supreme Court. Realising that this was thin ice, legally speaking the Finance Minister sensibly chose another course by referring the entire matter to a committee headed by former Delhi High Court Chief Justice A.P.Shah. This is a more judicious course because the earlier decision by Arun Jaitley to exempt all FIIs from MAT if they invested from tax treaty jurisdictions had created another big problem.

FIIs upset

But this made some highly reputed long term foreign funds from the US and Europe, with about $60 billion cumulative investments in Indian market, very upset as they had not invested from any tax treaty jurisdiction. For them the MAT would still be applicable. They started selling their stocks, causing a sharp decline in the Sensex over the past week. One well-known fund from UK, Aberdeen, publicly announced it was cutting its exposure to India. 

The larger point is that the FII community, with its outstanding $300 billion invested in India, has given Modi and his ministers the jitters over the past fortnight. Finance Minister Arun Jaitley has become the whipping boy for this mismanagement of the tax issue. But Jaitley alone cannot be blamed. It appears his constantly shifting stance on the MAT also had political endorsement from the PMO. One can’t imagine a PMO, which has its finger in every pie, would have left this critical matter entirely to Jaitley. The whole episode actually signals the government’s tentative handling of Modi’s commitment to foreign capital and the way it inherently conflicts with the government’s claim of being pro-poor. This is quite pronounced at the level of perception. The current episode establishes one thing clearly: when FIIs threaten you, action follows swiftly. One cannot say the same about the demands coming from the economically oppressed domestic constituents like the farmers.

However, despite the government swiftly addressing the FII tax issues, the stock market is still in decline and some would argue, in the grip of the bears. Foreign capital starts playing games when the policy regime is riddled with contradictions.

Note: An earlier version of this story incorrectly described A.P. Shah has a former judge of the Supreme Court.