Singapore: How do you celebrate the fifth anniversary of a colossal mistake? For India’s tax department, the answer has to be: Make a new one that’s a thousand times worse, then sit back and enjoy the fun.

There can be no other explanation for the “clarifications" the authorities issued before Christmas, instructing fund managers to withhold and pay taxes when investors make a profit selling units in offshore vehicles, if half or more of the investment is in Indian securities.

Managers’ disbelief turned to horror after accounting firms assured them this wasn’t a practical joke. India was indeed serious about collecting as much as 30% to 40% tax, even if an Asia fund in Hong Kong or Singapore redeemed, say, units in an India sub-fund to which it had only a 10% allocation.

Counting just the publicly traded funds, there are more than 1,000 investment vehicles that have a higher exposure to India than that. Between them, they manage more than $480 billion, according to data compiled by Bloomberg. Particularly at risk may be the 181 publicly traded funds whose India exposure is more than half of total assets; they have almost $39 billion under management.

To complete the travesty, the new levy would be in addition to the securities-transaction taxes and capital-gains taxes already paid on Indian securities. The rules are so poorly drafted that India may end up slapping taxes on profits that fund investors actually earned in China.

Last week, the Asia Securities Industry & Financial Markets Association made a submission to the Indian authorities on behalf of an industry in uproar. This is what Patrick Pang, Asifma’s head of fixed income and compliance, told me:

It’s an alarming development. Multiple layers of taxation will mean that the total tax can be greater than the actual gain. Not only will it kill India-focused funds, the indirect transfer tax also flies in the face of everything the government is saying about making the country an easier place to do business. No other jurisdiction has anything like this.

The provenance of the tax can be traced to India’s dispute with Vodafone Group Plc. In 2007, the British mobile carrier bought a Cayman Islands-based investment firm from Li Ka-shing’s Hutchison Telecommunications International Ltd. But what the holding company in Cayman really controlled, through other offshore entities, was a 67% stake in Hutchison Essar Ltd, an Indian wireless service.

New Delhi wanted to tax Li’s capital gain, and went after the buyer for not withholding it from the purchase price. After losing its case in the top Indian court, the government in 2012 changed the law: Any financial interest outside India would be deemed to be Indian if it derived a substantial part of its value from assets in India. The retrospective amendment of the code reeked of vindictiveness and became a PR disaster for the government, which even now refuses to give up the demand.

Now the same dodgy principle is being extended to funds, even those that are traded on exchanges outside India.

The tax authorities say they’ll spare investors who own less than 5% of a fund. That might mitigate the industry’s headache, but it wouldn’t eliminate it. For example, the US state of Tennessee owned 17% of the iShares India 50 ETF in September. If it sells some of its shares on the Nasdaq, India will want a piece of the gains. But how can the manager, BlackRock Fund Advisors, keep track of whether any 5%-plus holder has made a profit on a stock exchange? The paperwork alone would be a nightmare.

The Indian government should scrap the tax on the basis of impracticality. Otherwise, this too could blow up, with more harmful consequences for the country’s reputation than even the Vodafone fiasco. Bloomberg

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