Finance Minister's Chidambaram eighth budget - India's 82nd - disappointed foreign investors on Thursday by failing to deliver a much anticipated cut in withholding taxes for debt investments and creating confusion with a proposal that appeared to target tax treaties.
Several measures for foreign investors were unveiled for the 2013/14 fiscal year starting in April, including simplifying a cumbersome registration process and allowing investments in corporate bonds and government securities to be used as collateral to meet margin requirements.
However, the measures on their own were seen as unlikely to significantly boost foreign inflows at a time when India needs capital flows to plug a current account deficit that hit a record high in the quarter ended in September.
Indian shares were hit in part by concerns about the impact of the budget on foreign investors, with the benchmark BSE index ending down 1.5 percent.
"Easing the registration process for foreign investors is a facilitator, but the game changer would have been a withholding tax cut across the board, which would have helped the current account deficit and the development of the onshore debt market," said Jayesh Mehta, Managing Director and Country Treasurer at Bank of America.
The main announcement for foreign investors was the simplification of the complicated "Know Your Customer" rules.
Chidambaram, who met foreign investors last month as part of a roadshow, said the country would consolidate the current system of mandating different registration rules for different types of investors.
However, the government did not announce a cut in the withholding tax imposed on income from government and corporate debt investments and deducted at source that can now reach up to 20 percent.
The government also created confusion with a proposal stating a tax residency certificate "shall be necessary but not a sufficient condition" to take advantage of double taxation avoidance agreements, according to the Finance Bill that was part of the 2013/14 budget.
Tax authorities had previously considered this tax residency as enough proof to allow foreign investors registered in countries with these treaties to avoid paying taxes in India.
The amendment, due to take effect in 2016, sparked fears tax authorities would have wider discretion to go after foreign investors.
It also comes about a year after poorly written rules to ensnare tax evaders, called the General Anti-Avoidance Rules (GAAR), had sparked an outcry among foreign investors, prompting the government to amend their provisions and delay implementation for two years.
Ketan Dalal, a joint tax leader at PwC India called the amendment "disturbing," adding that "this does create significant uncertainty".
Chidambaram addressed these concerns at a news conference, saying the amendment had sought to clarify that tax authorities would now look at not only the tax residency requirement, but also enforce rules mandating these foreign investors are the beneficiaries of any investments under double tax agreements.
Those rules already exist under certain double tax treaties the ministry said, and were thus reiterating existing policy.
But Homi Phiroze Ranina, an advocate at the Supreme Court of India and former director at the board of the country's central bank, said questions still remained, especially as to which investment gains would be taxed.
"He is not clarifying whether the issue of beneficial ownership is there for capital gains," he told Reuters.
"The way the law is worded, if capital gains issues are not clarified then FII capital gains may come under scrutiny," he said referring to foreign institutional investors.