The finance ministry said it had agreed to clarify that backdated MAT was not applicable to FIIs or FPIs without a permanent base in India "and has decided that an appropriate amendment to the income tax act will be carried out".
Tax experts welcomed the decision. Most had condemned the proposed tax change as both out of line with international norms and damaging to India's investment reputation.
"It is a relief the government has acted on this matter and hopefully finally put it to rest, although one must remember this whole episode need not have happened in the first place," said Ketan Dalal, head of tax and regulatory services at PwC India.
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Despite Tuesday's decision, a number of other prominent tax cases involving individual foreign companies in India remain unsolved, including those affecting British telecoms group Vodafone and oil explorer Cairn Energy.
Tax demands for MAT from foreign investors earlier this year led to an outflow of capital that weakened the rupee, and prompted moves to take legal action by fund managers such as Aberdeen Asset Management.
The demands also added to the list of grievances among investors in India over the difficulty of doing business in the country and particularly over what prime minister Narendra Modi once described as "tax terrorism" against business.
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"In the 19 years since MAT was introduced [in 1996], it had never been levied on FIIs/FPIs," the A.P. Shah report concluded. "A change in this settled position in August 2014 is extremely late in the day . . . None of the other Brics countries, namely Brazil, Russia, China and South Africa, levy MAT."
Mr Jaitley's decision is likely to end a damaging back-and-forth row, in which the government initially defended moves by revenue authorities to target foreign funds, before starting to defuse the situation by appointing the independent review.
Mr Jaitley's move to reassure investors over tax comes as international fund managers pulled nearly Rs170 billion ($2.6 billion) out of Indian equity markets in August on worries about the weakening of China's economy, the largest outflow ever.