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Economic Insight Foreign investor tax grab shatters faith in Modi's pledge to open up India

Indian Prime Minister Narendra Modi promised a war on the "tax terrorism" practiced under the previous government. After a year in power, some investors are wondering if Mr. Modi has acquired a case of Stockholm Syndrome. That's because the Prime Minister appears to have grown sympathetic to India's notoriously capricious tax collectors.

Foreign portfolio investors were doing well with Mr. Modi in power. They bet his landslide victory last May heralded faster economic growth. The managers of mutual funds and other institutional investors rushed to India's stock exchanges. The gamble paid handsomely, as the value of Indian equities soared by 30 per cent in 2014.

Then the taxman showed up. Earlier this year, the income-tax department sent letters to dozens of international fund managers, telling them their profits were subject to the minimum alternate tax, or MAT. The levy is meant to squeeze at least some revenue out of profitable companies that are adept at exploiting loopholes and tax breaks. The Indian business press puts the total claim foreign portfolio investors owe at more than $6-billion (U.S.).

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International investors appear to have misread a promise Finance Minister Arun Jaitley made in his budget in February. He said he would ensure the capital gains of foreign investors would be protected from the MAT. But Mr. Jaitley was speaking prospectively. Indian tax authorities operate with a degree of independence from the government and they decided profits earned to date were fair game. Investors appealed to New Delhi to intervene. The Finance Minister's response was to point out that India wasn't a "tax haven." In other words, pay your taxes.

The episode is the latest example of the more enthusiastic members of the global business community misjudging Mr. Modi. The Prime Minister is undeniably pro-business. His priority is generating investment to generate double-digit economic growth. But Mr. Modi isn't doctrinaire. He has been cautious, behaving more like a politician who wants to win a second term than a reformer bent on blowing his considerable political capital.

Mr. Modi hasn't had to do much because he has had momentum on his side. India this year likely will overtake China as the world's fastest growing major economy. The country's gross domestic product is expected to advance at an annual rate of around 7 per cent. "There is newfound confidence in India," Mr. Jaitley told an audience in Washington last week.

That's true. But confidence is a fragile thing and the faith of some investors in India has been shattered by the MAT. The country's two main equity markets this week slumped to their lowest levels in three months, in part because of uncertainty over the Indian tax regime. The surprise tax claim has reminded investors of India's history of retrospective taxation. Mr. Jaitley has promised never to exercise that authority. But he also declined to repeal the law. The multibillion-dollar MAT claim has opened to the door to questions about the Modi government's commitment to making India a more comfortable place for foreigners to do business.

The government appears to understand that it has a public relations issue on its hands. Mr. Jaitley took time out of his schedule at the semi-annual meetings of the International Monetary Fund in Washington last week to speak for an hour on his approach to taxation at an event hosted by the Peterson Institute for International Economics. This week, senior Indian officials held conference calls with global investors on the MAT. They clarified that investors from countries that have tax treaties with India that guard against the double taxation of capital gains would not have to pay the MAT in India.

But if this last point was meant to cause comfort, it likely backfired. It took the business press little time to figure out that most investors lack such treaty protection. The Business Standard reported that India has such agreements with Mauritius, Singapore, Cyprus, France and the Netherlands. Mauritius and Singapore long have been backdoors into India and are the second and third-biggest source of foreign funds, respectively. But India is free to tax the capital gains of U.S.-based investors, who account for about 32 per cent of foreign institutional investment in India. That is more than the combined share of Mauritius and Singapore, according to Mint, a business newspaper. Luxembourg, Britain and Norway also are among the big investors in India that lack protection from the taxation of capital gains. Same for Canada, which accounts for about 2 per cent of international portfolio flows, according to Mint.

In Washington, Mr. Jaitley said he would be setting a terrible precedent if he interfered with an independent institution's application of the law. If investors believe the MAT has been misapplied, they can take the matter to court, the Finance Minister said.

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That will be a less-than-enticing offer for many investors. Indian courts are slow and unpredictable. But the Modi government probably deserves the benefit of the doubt on the MAT. Mr. Jaitley noted that India's economy is growing at a decent clip despite its messy tax system. Imagine what would happen if taxes were more predictable? That's a strong incentive for Mr. Jaitley to follow through on his tax promises.

It just is going to take him a little longer to do it than some would like.

Kevin Carmichael is a senior fellow at the Centre for International Governance Innovation, based in Mumbai.

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