India ignored warnings on foreign investor tax row: Sources

One official's letter seen by Reuters, sent in November, asked for direction and warned that once tax notices were issued there could be "large ramifications".

"They were sitting on a powder keg waiting for it to explode," said a senior official at the tax department.

The finance ministry last week asked officials to stop issuing new MAT notices, but that is some eight months after the first letter and roughly six weeks after a storm sparked by the sending of almost 70 initial claims totalling 6 billion rupees (USD 95 million).

A spokeswoman for the Central Board of Direct Taxes said it was "totally incorrect to say that the Finance Ministry did not appear to realise the seriousness of the issue" and denied that the ministry's response was slow.

She said the issue was brought to the notice of the government as it prepared its annual budget for 2015-16, with Finance Minister Arun Jaitley announcing that MAT would no longer apply to foreign investors from April 2015.

But Jaitley, whom a senior government source said was aware of the issue from January, left open the question of liabilities for past years, citing an outstanding court ruling.

Last week, more than two months after the budget was announced, the government announced a temporary freeze on MAT notices pending a review.

"COMPLETE MESS"

Foreign investors have long been critical of India's tax bureaucracy, citing aggressive claims that have led to damaging rows with companies including Vodafone and, more recently, Cairn India .

Foreign funds are drawn to India in part because taxes on market investments can be lower than in Asian emerging market rivals.

Before the MAT dispute, funds paid 15 percent on short-term listed equity gains, 5 percent on gains from bonds, and nothing on long-term gains. Taxes can be even lower if the investor is based in countries with tax exemption treaties with India.

The MAT claims so far have been small - Aberdeen Asset Management has, for example, received a claim of less than USD 50,000 - but investors complain the unpredictability unsettles them and the market.

The current controversy stems from a 2012 ruling over Mauritius-based Castleton Investment Ltd, an affiliate of pharmaceutical giant GlaxoSmithKline plc .

Contradicting previous decisions that had restricted MAT to domestic companies, a tax court ruled on a theoretical question that Castleton would be liable to MAT if it transferred shares in GSK's India unit to a Singapore arm.

Tax officials were initially reluctant to pursue the ramifications of the ruling for other foreign companies, but were prompted to do so by India's Comptroller and Auditor General (CAG) in 2013.

"We were in a position where you're damned if you do and you're damned if you don't," said the senior tax official.

As the tax officials got no substantive response to their letters from the finance ministry, they sent notices to investors, then claims, in late March.

The issue will be decided by the Supreme Court in August.

"This is just one of those cases where the government and the bureaucracy have created a complete mess of what was not such a complicated issue," said a London-based fund manager.

"Now they are trying to pacify investors, but all of this just leaves a very bad after-taste."