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Bombay Stock Exchange Sensitive Index of 30 scrips, popularly known as Sensex came down from the dizzy heights of 12,671 odd touched on 11 May 06 to the low depths of below 10,000 on 22nd May 2006 tempting a frenchman at a five star swimming pool in Mumbai to comment that "there is no sense or sex in your sensex"!

Reams of paper have been consumed in past one week alone to carry expert views, opinions, suggestions, cautions, forecasts all for educating & explaining the cause for the steep, unprecedented & unexpected fall in Indian Stock markets. Mr. Chidambaram, the Finance Minister, through the week has occupied prime space in this entire exercise of commenting on the fall leading a columnist (ET 24.5.2006) to question FM's excessive involvement in the movement of the stock markets as unworthy & unbecoming obsession &; an editorial (TOI 25.5.06) advising him to let the stock markets alone to investors.

In the midst of all these views & counter views, yet one more comment from not so high profile a person like me can easily be accommodated if not pardoned. Here it goes.

(i) In my view, the cause in the whole drama of stock prices falling like nine pins is not the draft CBDT Circular of 16 May 2006, inviting comments on proposed guidelines on tax treatment of stock market transactions as business income chargeable at 30% tax & not as short term capital gains chargeable at 10%. The real culprit is the Notice issued by the Income tax Department to several US based mutual funds asking them that they should withhold & remit tax to Indian Tax Department in excess of 40% of the gross management fees paid to its manager with respect to Indian shares & securities of those US Mutual Funds. CBDT is stated to have contended that these management fees constitute "technical services" & hence taxable at rates applicable to such services. It must be remembered that FIIS have been the largest sellers since early May 2006.

(ii) It is reported that in early April of this year, a US based body ICI representing over 9500 US mutual funds & investment trusts managing over $9.25 trillion in assets—wrote to Mr. Arbind Modi, joint secretary in charge of tax policy & legislation at the Department of Revenue, questioning locus standi of tax notices many US fund managers had been served While contending that no tax liability in India should arise on fund managers' fees, the ICI wrote that even if these services are taxable in India they would still be exempt under the income tax treaty against double taxation between the US & India. The tax treaty provides for taxing fees for services that involve transfer of knowhow & skills, which a fund manager does not do & hence not covered as such. Apart from the time & legal costs of engaging in litigation with the Indian tax authorities, the ICI believes that even a successful appeal could mean fund managers may have to wait "seven years or more" for recovering such taxed fees. About the impact of this move on portfolio investments from US funds into Dalal Street, ICI wrote that it was aware of "US mutual fund managers that are delaying decisions to invest in India until this tax issue is resolved."

"Absent a strong government signal," the ICI wrote, "FIIs may wonder whether additional novel attempts to impose tax will be pursued in the months & years to come."

Indeed, the implications of this action go well beyond US fund managers facing these orders. "If these tax demands hold, despite the specialized language of the US-India tax treaty, none of India's tax treaties could protect fund managers. Moreover, this won't apply to mutual funds alone, but to all categories of investors: like pension funds, university endowments, hedge funds, insurance companies investing in Indian capital markets, commented an expert specializing in NRI taxation.

(iii) According to me, only one Newspaper (Indian Express) has reported on this issue on Friday 19th May & despite the selective strategic purchases by LIC & domestic mutual funds from 22nd inst onwards when the Sensex did go over 11,000 intra-day, but FIIS have been net sellers through the week Mr. Chidambaram keeps clarifying about CBDT Circular of 16th May but does not say a word about the Notices for TDS by managers of US based funds & CBDT's views on the same which is perhaps the reason for FIIs' discomfort.

(iv) Perhaps, CBDT has thought it fit not to inform FM about this too trivial a matter in the same way it chose not inform him, few months back, when it engaged one Advocate by the name of Ms. Nalini Chidambaram in a tax case for a High Court matter.

(v) No doubt, draft Circular of CBDT dated 16 May 2006 also contributed in the turmoil among FIIs in absence of categorical assertion that the proposed guidelines on tax treatment of transactions on stock market to determine the character of income as business income or capital gains, do not apply to FIIs at all. It was only subsequently that FM went on record to say that FIIs are governed by separate stand alone sections of the Income tax Act. Similarly, international events like hardening of US Interest rates, fall in commodities prices & uncertainty on oil front all have in some measure of the other also adversely affected the FII sentiment & hence massive sales of Indian equity.

Coming weeks will be interesting to watch FIIs actions.


VIA: E-Mail (Shweta)

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