Taxation, a key issue that has vexed foreign portfolio investors for the most part of a decade and dampened participation in Indian equity markets, has now been addressed by policymakers in India. In fact, unfavourable tax policies have been a key determinant of the cost of investing in India. The current tax regime promotes inefficiency in tax collection and provides a great incentive for treaty shopping. In a recent bid to absolve India of its unfavourable tax policies, the finance minister has approved much-needed changes in offshore funds taxation in India. According to media reports, the residence of fund managers in India will no longer constitute a permanent establishment and the location of fund managers will not determine business income.
It has been our view that billions of dollars have been waiting on the sidelines to be invested in India and large institutions would allocate funds to the country if they could open offices in India and bring decision-making closer to the ground. The finance minister?s move brings India?s tax regime in line with global norms and would give a tremendous fillip to the industry.
Tax regime uncertainty
At the moment, India is losing both high-paying jobs and tax revenues at a critical time when economic growth is sputtering, the rupee is in a free-fall and global investors have lost confidence in the Indian economy. The other consequence of the current tax regime is that we have actually exported the market for offshore derivatives, with underlying assets in India, to financial centres in Singapore, Dubai and Hong Kong. Even our currency markets are getting exported along with this. There is an easy answer. FIIs invest through countries like Mauritius because their gains through sale of investments, both short-term and long-term in India, are exempt from tax. Long-term capital gains are exempt in India but short-term gains are taxable. By making offshore funds exempt from taxation, India will bring an estimated 20,000 high-paying jobs back to India?s shores from offshore financial centres and solve the Mauritius issue in one stroke, at least from an FII perspective! (Foreign investments account for roughly 20% or $200 billion of India?s $1 trillion market cap. A 2% management fee is charged on this. Assuming 1% is spent in India, it translates to $2 billion, out of which nearly 50% or $1 billion is distributed as compensation for employees. Assuming that the talent pool has an average salary of R25 lakh, we calculate that at least 20,000 jobs can be shifted back to India.)
By making the requisite changes to its tax laws, India is sending a clear signal to naysayers that India is on the reform track. Most countries do not tax offshore funds. Such measures will align Indian taxation along with global norms for taxation of offshore funds. This will also increase transparency and better enforcement of regulations. By instituting this key reform, India will also not lose any tax revenues as it gets no revenue on this currently due to treaty shopping. It is better to exempt offshore funds from tax by a specific provision in the Income Tax Act than to do this through a treaty with a few countries.
The unholy mix of poor tax policies and volatility has caused tremendous damage to India?s equity markets. Wealth destruction for the equity investor also raises the cost of capital for corporate India.
Stock market volatility
The Economic Survey of India 2012-13 has pointed to the doubling of volatility in the Indian stock markets since the 1990s?the coefficient of variation has increased from 33.2 to 60.1 during this period. What is remarkable is that this occurred post ?improved? regulations and post the launch of the National Stock Exchange in 1992! Erratic foreign portfolio flows are often blamed for volatility in the Indian stock markets. But volatility is not just globally induced. In fact, the recent collapse in the stock market is based on a mere $1.5 billion of foreign equity outflows.
Volatility also kills the investment appetite for the large and small investor. It is no mean coincidence that household investment in debentures and shares has meaningfully declined from its peak of 13% of financial savings in the 1990s to a negative in 2012! That the Indian retail investor has lost faith in equity markets can be seen by the continuous stream of redemptions of Indian mutual fund programmes.
India can stimulate a return of savings back into equities by taking a tough stance on volatility. Volatility can be significantly reduced if the market starts functioning smoothly and the stock exchanges act tough. Derivatives have been recognised the world over as weapons of mass destruction. Despite this, Indian regulators have not considered the implications of having equity futures and options contracts. It is now increasingly obvious to market participants that the negative effect of high volatility overshadows the positive effects of liquidity. If these contracts were to be settled in cash at expiration, there would be significantly lower speculation in the stock market. Isn?t that the need of the hour?
Measures must be introduced to protect the ?small investor? in the equity derivatives segment. Insider trading rules must be strengthened and enforced. Stricter vigilance will lead to greater transparency in the functioning of the market and thereby a reduction in volatility.
Nandita Agarwal Parker & Mohandas Pai
Nandita Agarwal Parker is managing partner, Karma Capital Management LLC, and founder, Asset Managers Roundtable of India. Mohandas Pai is chairman, Aarin Capital Partners
