By Henry Jamieson From Seeking Alpha
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. Summary

Summary
20% tax on book profits.
Potential to apply to the previous 7 years.
Demands for £4,160,000,000 to be paid.

What is it?

India, unlike the majority of other countries, operates a Minimum Alternate Tax (“MAT”) regime. At a high level, this means that if the effective tax rate a corporation pays in India is below 18.5%, then the MAT will apply and the corporation will have to pay tax at 18.5% on their ‘book’ profits as per their profit and loss account. With surcharges taken into account, this rises to just over 20%.

Historically, foreign institutional investors (“FIIs”) benefited from a special provision under Indian law designed to encourage investment in India’s capital market. Under this provision, any gains on equities held for more than one year are subject to tax at 0%, and equities held for less than one year are broadly subject to tax at 15%.

As a result of this, funds have not been applying this tax and have not accounted for the possibility of paying it at all. However, recently the Indian tax authorities have realized that a regulatory ruling from 2012 could apply to foreign investors.

On the back of this, a number of funds operating in India have been receiving notices from tax authorities to pay this MAT on previous year’s book profits. Unsurprisingly, a number of funds appealed this and the Indian government passed a law exempting foreign funds from this tax for future years.

Unfortunately, they did not provide any clarification on the issue of MAT applying to previous year’s profits, and the tax authorities argue that if the funds are now exempt, they must not have been exempt before. As a result of this, funds are continuing to receive demands from Indian tax authorities to pay this MAT.

Whilst not all funds have yet received notices from Indian tax authorities, it is a reasonable assumption that if the courts rule in favor of the tax authorities that every fund at risk will receive a notice from Indian tax authorities.

How big a problem could it be?

The length of time the tax authorities can apply MAT to is 5 years, with the possibility to extend this to 7 years in certain circumstances. Therefore, there is the potential for funds to receive demands for MAT on profits earned as far back as the 2007/08 financial year. However, in practice, most funds have only received notices for unpaid MAT for the previous 5 years, so going back as far as FY 2010/11.

The amount of money at stake for foreign investors is truly phenomenal. The Indian finance minister Arun Jaitley has publicly stated that the demands add up to Rs. 40,000 crore, equivalent to roughly £4,160,000,000 ($6,290,000,000).

To put that in context, this is equivalent to nearly half the entire GDP of Iceland.

Who will be affected?

A number of funds will not be affected by the decision to apply MAT retrospectively. This is because the Indian tax authorities and Indian government have publicly stated that they will not seek to override tax treaties (the agreements countries make to decide who pays what tax in each other’s country). The result of this is that funds domiciled in a number of countries such as the Mauritius, Singapore, France, the Netherlands and a few others will not be affected as they are protected by their treaties.

Crucially, however, the Cayman Islands treaty with India does not offer such protection from MAT rules, and as the majority of funds are set up in the Cayman Islands, a large number of funds will not benefit from this exemption.

In addition to this, whilst the majority of the press is focused on the issue of MAT applying to FIIs, the amendment to the law protecting FIIs from future MAT charges made clear that investors investing as venture capitalists would not be protected. It is plain to see that this has the potential to sharply reduce the amount of capital inflows to India and damage the Indian capital markets.

When will this be decided?

The ruling on the applicability of MAT to the funds that have received notices is expected to be largely dependent on the precedent set by a similar case (Castleton Investments Limited) currently being heard in Indian courts.

Castleton is a holding company based in Mauritius that owns shares in an Indian listed company. They sought an advance ruling from the authorities that gains on the sale of these shares would be exempt from capital gains taxes under the Mauritius treaty. Whilst the authorities ruled in their favour on this point, they argued that MAT would still have applied to them if they had not benefited from the Mauritius treaty.

It is this point that is currently being heard in the high court and one which will decide the fate of an enormous number of other funds. Originally, it was expected that this case would not be concluded until 2016; however, the Indian government has recently agreed to an expedited hearing in order to attempt to resolve this case and deliver a clear answer to investors as soon as possible.

In addition to this, the Financial Times recently reported how Aberdeen Asset Management has filed a legal challenge at the High Court of Bombay which will no doubt be closely watched by many other funds.

Uncertainty

As could be expected, this uncertainty has begun to affect the markets and the chart below shows the value of the S&P Sensex index made up of 30 financially sound companies listed on the Bombay stock exchange. As the chart shows, there has been a decline in the value of the Sensex from the beginning of April when funds began receiving notices, and this fall accelerated dramatically after the 13th of April when the Financial Times published an article on the issue.

(click to enlarge)S&P BSE Sensex Index April 2015

Opportunities

By now you know more than you ever wanted to know about Indian tax laws. However, this is all irrelevant if there is no opportunity to make money from this new knowledge.

There are two main opportunities to make money from the MAT ruling going through.

1. Short the index

The simplest and easiest way to make money from the MAT ruling is to simply short the S&P Sensex index. There are two reasons why the value of the S&P Sensex will fall.

Firstly, if this ruling passes and changes what has been historically accepted for many years, it is likely that investors will leave India for markets where they can be more certain that any gains they make will not be subject to a 20% cut in 5 years time.

Secondly, if it is ruled that the funds will have to pay the Rs 40,000 crore that the Indian government is demanding they pay, it is likely they will be forced to sell the assets they hold to pay this tax.

By virtue of they being subject to the tax, these funds must be invested heavily in India and it is likely that a significant proportion of their assets will be made up of Indian equities. This widespread selloff of Indian equities will lead to a significant fall in the value of the S&P Sensex.

2. Short the funds

Another simple method to profit from the introduction of MAT applying to foreign funds is to short the funds themselves.

Whilst many of the funds invested in the Indian stock market are private funds, such as hedge funds and pension funds, there are a number of public funds such as the WisdomTree India Earnings ETF (NYSEARCA:EPI).

Conclusion

Whilst no ruling has currently been made, and it is conceivable that the courts could either rule in favor of the fund industry or the tax authorities, it is clear that this one tax law could have the potential to do some very serious damage to the value of a number of funds that have invested heavily in India.

This is an area that I will be paying very close attention to in the coming months and ensure that I am one of the first to benefit from the rising uncertainty when the wider market finds out about this law, and also one of the first to benefit if the rules do go through and publicly traded funds find a large proportion of their NAVs have been wiped out overnight.

For more on this story go to: http://seekingalpha.com/article/3224676-why-this-weird-indian-tax-rule-is-scaring-fund-managers-across-the-globe

IMAGE: www.indiacaclub.com