India: Trigger Happy on the Sensex

There is no change in my long term fundamental outlook which can be read here. On technical outlook, you can look here. The developments in technical outlook are largely negative. Since the budget disappointed, it is likely that the gap caused by election euphoria will be filled; thus the chances of 12,100 on the downside have risen.

There are also several events such as the monsoon, the policy on foreign direct investment, the risk of a rising fiscal deficit and a country downgrade, the disinvestment policy and the new tax code, which could take the market to closer to 9,700 if the event is viewed negatively.

Long term investors who are at their standard allocation levels, who wish to go over-weight emerging markets, can afford to wait for better entry points for deployment of their incremental investments. Those who are underweight and wish to reach a standard allocation should probably buy at current levels, and consider going over-weight if the market falls lower.

The event risks are considered below:

Monsoon

So far the monsoon has disappointed. With rising El-Nino conditions it is likely that the monsoons will be a disappointment this year. The US Department of Agriculture has highlighted the possibility of drought like conditions in India if the rains do not arrive by mid July; we are now in mid July. Overall, this is a negative trigger for the following reasons:

• El Nino conditions persisting are indicative of a below average hurricane season in the Gulf of Mexico. This removes an upward momentum trigger from oil prices, which is very important for India. On the one hand it is positive as lower commodity prices are a positive for growth. But on the downside, Reliance, India’s largest Sensex entity traditionally gains as oil prices rise.
• A drought or substandard monsoon will mean a weak agricultural economy. Higher food prices and rising CPI is one consequence; and not a pleasant one because CPI is in excess of 10% today. Rising CPI levels give rise to an expectation of rising interest rates, which is a negative trigger.
• With high food intensity (household budgets spend a very significant proportion on food) the rising food prices will leave lesser amounts for discretionary spending. Because over 60% of the population is agrarian based, the implications for domestic demand are grim. I believe the recently presented budget caters for a weak monsoon; what remains to be seen is whether market expectations will move towards an anticipated further increase in the fiscal deficit to support this sector. Such a move in expectations will be a negative trigger for the economy.

Policy on Foreign Direct Investment

I do not see cause for concern in this area. India has made clear its desire to attract foreign capital. I expect evolution of policy in this area to be a positive trigger.

The Disinvestment Policy

I do not see a cause for concern in this area. Disinvestment is high on the priority list, if for no other reason than to reduce the fiscal deficit. I expect evolution of policy in this area to be a positive trigger.

There is a possible negative trigger too. It is unlikely that the government will reduce itself to a minority shareholder in the banking sector. While this was a possibility pre financial crisis, going ahead I believe the government will not give up its control in this area; it is also why I personally never invest in a public sector undertaking.

The other possible negative trigger is that such disinvestment will mop up liquidity. Lower liquidity levels could lead to a sluggish wider market. This is unlikely to have a significant impact because as animal spirits return, so too shall liquidity.

The Fiscal Deficit

The markets have started pricing in the risk of an unsustainably high fiscal deficit. The deficit when viewed at central, state and subsidy levels is well in excess of 10%; this is unhealthy, but unfortunately, in this economy it is also necessary. The risk of a further rising deficit caused by a failed monsoon is also a negative.

The high fiscal deficit points towards lower liquidity levels and higher interest rates because of the governments need to borrow. This is a negative.

The risk of a country downgrade by SP and Moody remain elevated. A downgrade would make borrowing more difficult and more expensive. These are negative triggers; given the constraints on global liquidity, it is even more negative.

Despite concerns in this area, I expect the concerns to first act as a negative trigger and then expect the policy communication (expected in October) to be a net positive trigger. A return to fiscally responsible policy will act as a massive upgrade for the markets; the markets are pricing in a credit rating downgrade, as this risk recedes, the positive impact will be significant.

There are several factors which can lead to positive surprises on the fiscal deficit. These include:

• Reduced need for stimulus as private spending increases.
• Removal of oil subsidy
• Disinvestment proceeds
• Improved tax compliance and enforcement through the recently initiated Unique Identification Project.
• Impact of the proposed direct tax code.

The New Tax Code

A draft of the New Tax Code is expected to hit the public domain by late August. It is expected that this code will greatly simplify the tax laws and will result in better compliance and enforcement and a broader tax base. The resulting incremental tax revenues will first reduce the fiscal deficit. This is a net positive. India has also committed to reduce tax rates as the tax base widens; an expectation of lower tax rates is also a positive trigger.

For companies, we can look forward to lower tax rates; as a minimum we will see the surcharge go. We can also look for lower compliance costs and lower costs associated with dispute resolution. These are potential positive triggers.

We might see the dividend distribution tax (DDT) go; however this will be neutral as it is likely that dividend income will be taxed in the hands of investors in lieu of the removal of the DDT.

The impact on investors is less clear. My own view is that we shall see a removal of the Security Transaction Tax and a return of short and long term capital gains tax. This could be a negative trigger because the post tax return expectation will fall below where it stands today. It may lead to debt as an asset class gaining attractiveness relative to equity.

For foreign portfolio investors operating with no treaty privilege, the attractiveness of the Indian market versus other emerging markets will reduce as a result of a change in long term post tax return expectations.

For portfolio investors operating with treaty privilege, the introduction of capital gains tax will be neutral. However, anti avoidance rules will certainly result in elevated disputes. At a minimum, foreign portfolio investors will need to substantially increase the substance of their inbound investing vehicles in order to qualify for treaty privilege.

Because the cost of substance will be well below the tax savings, I expect a massive shift in the structures used to deploy capital. To be honest, any portfolio investor operating with treaty privilege, who operates through an inbound investment vehicle lacking in substance is either foolish or ill advised!

I expect the end result to be market neutral (with a moderately negative bias) in the long term because increased post tax earnings of will offset lower post tax post tax shareholder returns. However, with equity losing attractiveness versus debt and other emerging markets, the multiple achieved is likely to remain somewhat below the prior economic expansion.

The impact on investors is less clear. My own view is that we shall see a removal of the Security Transaction Tax and a return of short and long term capital gains tax. This could be a negative trigger because the post tax return expectation will fall below where it stands today. It may lead to debt as an asset class gaining attractiveness relative to equity. In the short term it may lead to a run on the market as people try to book tax free gains during the year end 31/3/2009 and look to reinvest with a higher cost basis for the future.

Comments

[Seth Freeman:]

There already is a 15+% short-term capital gains tax on Indian securities. There is no long-term gains tax at present.

Shiv refers to the use of Mauritius or Singapore structures to enter the Indian market and take advantage of India's anti-double taxation treaties with those countries. We have two of them. Trading through these structures avoids double-tax (as the result of withholdings in India) for US tax-payers. as there is no such treaty between the US and India. However, US taxpayers do pay tax in the US on their Indian profits. I think most foreign investors with Mauritius structures, their company administrators, custodian banks and tax advisors do a proper job in maintaining the substance of these entities. Besides, the Certificate of Residency issued by the local authorities provides a prima facie protection. I don't think the new budget policies have any form over substance implications for these entities.

Given the significant participation of foreign investors as a % of total investment in the Indian securities market, I do not believe the government will impose higher short-term gains taxes or any long-term capital gains tax on portfolio gains.

One of the big risks as illustrated last week is the ill-timed and ill-conceived policy statements from Indian government officials that precipitate large declines in the market. SEBI did this over a year ago when they issued their policy P-Notes. Both times the market abruptly sank. Its this kind of volatility that dissuades foriegn investors and distracts them from the outstanding long-term investment opportunity. seth.freeman@emcapital...

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The impact on investors is less clear. My own view is that we shall see a removal of the Security Transaction Tax and a return of short and long term capital gains tax. This could be a negative trigger because the post tax return expectation will fall below where it stands today. It may lead to debt as an asset class gaining attractiveness relative to equity.

For foreign portfolio investors operating with no treaty privilege, the attractiveness of the Indian market versus other emerging markets will reduce as a result of a change in long term post tax return expectations.

For portfolio investors operating with treaty privilege, the introduction of capital gains tax will be neutral. However, anti avoidance rules will certainly result in elevated disputes. At a minimum, foreign portfolio investors will need to substantially increase the substance of their inbound investing vehicles in order to qualify for treaty privilege.

Because the cost of substance will be well below the tax savings, I expect a massive shift in the structures used to deploy capital. To be honest, any portfolio investor operating with treaty privilege, who operates through an inbound investment vehicle lacking in substance is either foolish or ill advised!

Jul 13 08:51 AM

[Shiv Kapoor:]

Seth

A couple of points.
1. If STCG and LTCG return, it is likely that STCG will be taxed as the top slice of income (mostly 30%) and LTCG at 20%.

2. As regards your comment "their company administrators, custodian banks and tax advisors do a proper job in maintaining the substance of these entities. Besides, the Certificate of Residency issued by the local authorities provides a prima facie protection.". For now it holds. However it is likely that the Mauritius/India treaty will be re-negotiated/amended to include a limitation of benefits clause (this is already in an advanced stage of discussion). You need to look at the Singapore treaty to understand what is likely to be necessary for treaty qualification subject to a limitation of benefit clause. I would also add that no tax advisor worth his salt would advise you to rely exclusively on "their company administrators, custodian banks and tax advisors do a proper job in maintaining the substance of these entities. Besides, the Certificate of Residency issued by the local authorities provides a prima facie protection." to maintain substance. Today in India this is a safe (not necessarily sensible though) position because of the Aazadi Bachao precedent; it is merely abusive not evasive so you should be fine. But tomorrow, a change in law or a treaty amendment could help. My view - you must have substance in Mauritius to be safe - direct employees and an office in Mauritius will help create it.

3. Some US taxpayers do pay taxes in US and in those situations, it is likely that any taxes paid in India will be creditable in US. But keep in mind several tax deferred vehicles invest in US via pension funds/401K accounts etc. These people do not pay tax in US. The Indian tax will end up being a cost for such investors.

On Jul 13 08:51 AM Seth Freeman wrote:

> There already is a 15+% short-term capital gains tax on Indian securities.
> There is no long-term gains tax at present.
>
> Shiv refers to the use of Mauritius or Singapore structures to enter
> the Indian market and take advantage of India's anti-double taxation
> treaties with those countries. We have two of them. Trading through
> these structures avoids double-tax (as the result of withholdings
> in India) for US tax-payers. as there is no such treaty between the
> US and India. However, US taxpayers do pay tax in the US on their
> Indian profits. I think most foreign investors with Mauritius structures,
> their company administrators, custodian banks and tax advisors do
> a proper job in maintaining the substance of these entities. Besides,
> the Certificate of Residency issued by the local authorities provides
> a prima facie protection. I don't think the new budget policies have
> any form over substance implications for these entities.
>
> Given the significant participation of foreign investors as a % of
> total investment in the Indian securities market, I do not believe
> the government will impose higher short-term gains taxes or any long-term
> capital gains tax on portfolio gains.
>
> One of the big risks as illustrated last week is the ill-timed and
> ill-conceived policy statements from Indian government officials
> that precipitate large declines in the market. SEBI did this over
> a year ago when they issued their policy P-Notes. Both times the
> market abruptly sank. Its this kind of volatility that dissuades
> foriegn investors and distracts them from the outstanding long-term
> investment opportunity. seth.freeman@emcapital...
>
> ----------------
> The impact on investors is less clear. My own view is that we shall
> see a removal of the Security Transaction Tax and a return of short
> and long term capital gains tax. This could be a negative trigger
> because the post tax return expectation will fall below where it
> stands today. It may lead to debt as an asset class gaining attractiveness
> relative to equity.
>
> For foreign portfolio investors operating with no treaty privilege,
> the attractiveness of the Indian market versus other emerging markets
> will reduce as a result of a change in long term post tax return
> expectations.
>
> For portfolio investors operating with treaty privilege, the introduction
> of capital gains tax will be neutral. However, anti avoidance rules
> will certainly result in elevated disputes. At a minimum, foreign
> portfolio investors will need to substantially increase the substance
> of their inbound investing vehicles in order to qualify for treaty
> privilege.
>
> Because the cost of substance will be well below the tax savings,
> I expect a massive shift in the structures used to deploy capital.
> To be honest, any portfolio investor operating with treaty privilege,
> who operates through an inbound investment vehicle lacking in substance
> is either foolish or ill advised!

Jul 13 09:06 AM

[Shiv Kapoor:]

Just wanted to add a note on India's CGT rules.

For equity =< 1 yr is short term; > 1 yr = long term. For all other assets =< 3 yr is short term; > 3 yr = long term. .

For transactions on an exchange where the negligible securities transaction tax has been paid, LTCG is 0%; STCG is 15% plus surcharge and cess.

For off exchange transactions where no securities transaction tax is paid; STCG is 30% plus surcharge and cess while LTCG is 20% of the indexed gain (foreign investors can opt for 10% wihout indexation). I expect the new code to eliminate STT and have STCG/LTCG at these rates.
It gets more complex for trades in the futures and option market; or if a high churn leads to a re-classification of the nature of gains from capital gains to business income.

Jul 13 12:07 PM