Facing a critical situation made more vulnerable by market volatility, FM Pranab Mukherjee announced that the new General Anti-Avoidance Rules (GAAR) introduced in the budget will not apply to participatory note (P-note) holders – those anonymous foreign investors who invest indirectly through registered foreign institutional investors (FIIs). Few people doubt that at least some of the money being invested through P-notes is really Indian money held in tax havens.

The purpose of GAAR is to ensure that individuals and companies do not use double-tax avoidance treaties (DTAs) and other tax ruses to completely avoid Indian taxes. FIIs registered in tax havens like Mauritius don’t pay any short-term capital gains taxes on share sales because Mauritius does not tax them. Thus the DTA facilitates tax avoidance by FIIs – when every other investor in India has to pay 15 percent short-term capital gains tax. (Long-term capital gains are tax-free).

Since the purpose of GAAR is to ensure that FIIs do not use convenient tax loopholes to pay zero taxes, the big question is whether the finance minister would be right to tax FIIs and not P-notes.

Favouring P-note holders means giving non-transparent investors rights that registered FIIs do not have. Moreover, since some of the P-note money could really be Indian money round-tripping back for short-term gains, it means the finance minister is actually giving black money holders a nice tax incentive to use P-notes.

That, surely, could not have been the purpose of a budget which spelt out several anti-black money provisions?

However, if the FM opts for the easier option, and lets FIIs retain their existing tax advantage by exempting them too from GAAR, it would be gross discrimination against Indian investors. This situation already exists – and we have been living with it for a decade. But surely it is not a great idea to privilege foreign investors over domestic ones?

The standard argument used to retain the tax loophole for FIIs is that the markets will crash if they opt out now. Plus, we need the FII flows now when the rupee is declining and falling.

However, one should take a closer look at this argument.

The real reason why we are so over-dependent on FIIs flows to prop up our markets is that we don’t allow domestic savings – a portion of the funds held by the Employees’ PF Organisation (EPFO), for example – to flow into stocks. The EPFO, anyway, is not a great fund manager. With a corpus of over Rs 3,50,000 crore, even a 10 percent investment in stocks through professional fund managers, can raise returns for all PF subscribers over the long-term. It would also serve as a counter-weight (along with Life Insurance Corporation, and mutual funds)  to FIIs who now tend to throw their weight about.

The irony of it all is this: FII money often represents foreign pension funds or employee savings. What is the logic in allowing foreigners to benefit from Indian stocks but not Indians?

So we have a system where the tax system is skewed towards foreigner investors because their money is important, and we also have a ban on our EPFO investors benefiting from our markets, which again makes FIIs more important in our policy-making calculus.

Here’s a neat scheme: impose GAAR on FIIs and P-notes. As stock prices crash, allow EPFO to buy these stocks at reasonable prices. The short-term disruption in the stock market would be worth the gain. The FIIs will return after licking their wounds – once they see India as the place to be.