Foreign investors fret over India’s surprise capital gains tax

MUMBAI (Reuters): Minutes after India’s surprise announcement of a 10 percent long-term capital gains tax on equities, Rakshit Sethi’s inbox began filling with emails from worried foreign investors. Sethi, managing director at investment firm Fair Value Capital, could offer few words of comfort.

“There is no way to sugar coat it,” he said. “This will have a direct impact.”

Even before a sharp sell-off in global markets at the start of this week, foreign investors had responded with dismay after Finance Minister Arun Jaitley said on Thursday that India would tax capital gains for equity investments held more than a year starting on April 1, re-imposing a tax scrapped in 2004.

The tax, unveiled as part of the government’s annual budget presentation, is raising the spectre of reduced inflows into a country that has been a darling for foreign investors, who pumped in $2.2 billion so far this year after bringing in $75 billion over the previous six years.

India already taxes equity investments held for less than a year at 15 percent and has a securities transaction tax that can range from about 0.01 percent to 0.25 percent depending on the type of security.

Investors say the latest move would make India more expensive than the rest of Asia, where most countries do not impose a long-term capital gains tax for non-residents. South Korea on Tuesday scrapped a plan to increase the number of overseas funds that would pay taxes.

The timing could also not have been worse as global markets have tumbled amid worries of higher inflation. That is leading investors towards safer havens and raising concerns that outflows could hit emerging markets, at time when Indian valuations were already starting to look stretched.

After notching up a string of record highs, India’s broad NSE index was trading at nearly 19.6 times price to estimated earnings for the year ending December, higher than its five-year historic average of 17.2 times.

The NSE has slumped 4.8 percent since the government unveiled its budget on Thursday, with tax concerns dominating sentiment.

Vikas Gattani, chief executive of Progress India Opportunities Fund in Singapore, said he had not yet decided to reduce allocations to India, but he is worried.

“India was looking expensive even prior to this,” he said. “So to that extent, there was just too much over-optimism in India and it gives you reason to correct in the market.”

The government, in an FAQ document on Sunday, said it had imposed the tax to bolster revenues and to ensure fairness with manufacturers, which pay higher taxes.

But Amit Jain, managing director of private equity firm GTI Capital, said the action was inconsistent from a government that, under Prime Minister Narendra Modi, has avidly courted foreign investors.

“I think this whole idea of attracting foreign capital and then penalising it in this form will send confusing signals and discourage foreign investment,” he said.

Yet any decision to reduce allocation may not be so clear cut.

Growth in India’s economy is expected to recover to 7-7.5 percent in the year starting in April, making it again the world’s fastest-growing major economy. Meanwhile, earnings are also starting to rebound after years of sub-par performance, which could help boost equities and the rupee.

Some tax consultants believe foreign investors could be tempted to route investments through countries with favourable tax treaties with India, such as France or the Netherlands, or through offshore derivatives that track Indian equities.

But that could also be problematic, as India has been cracking down on so-called tax havens and trade in such derivatives, tax consultants said.