Direct Taxes Code - Impact on FIIs

Foreign institutional investors (FIIs) play a significant role in the Indian equity market, both as long-term investors and as short-term traders. It is therefore not surprising that the Revised Discussion Paper on the Direct Taxes Code (DTC) dwells at length on the issues pertaining to the taxation of these investors.



While the draft DTC released in August 2009 had threatened to bring all foreign investors under the tax net by overruling bilateral tax treaties signed with other countries, the Discussion Paper recognises that this is not feasible.

Clarifications have also been issued on a number of ambiguous aspects such as determining if income was capital gains or business income, test of residence, and so on.

DTAA

The initial draft had proposed that neither the tax code nor double taxation avoidance agreements (DTAAs) shall have preferential status if litigation arose. It had further provided that the one that is later in point of time shall prevail. This had led to fears that bilateral treaties could be overruled and large number of FIIs which were not paying any tax in India, as they were purported to be paying tax in their country of incorporation, could now be brought into the tax net.

This proposal was not feasible since no country could unilaterally negate a treaty that was entered in to by two countries bilaterally. The Discussion Paper therefore proposes that in case of litigation, the law that is more beneficial to the taxpayer — between domestic law and DTAA — shall prevail.

India has bilateral tax treaties for double taxation avoidance with more than 60 countries and a significant chunk of the FII funds flowing into the stock market are estimated to be routed through tax havens, such as Mauritius, that are covered by the DTAA.

FIIs covered by DTAA

According to the Discussion Paper, foreign investors utilising the double taxation avoidance rule to avoid paying capital gains tax in India can now continue to enjoy this benefit. They would neither have to pay short-term nor long-term capital gains tax under the revised proposal as the tax rate on capital gains in countries of their incorporation is mostly zero.

However, the tax authorities have the power to invoke GAAR (general anti-avoidance rule) where they think that the DTAA provisions are being misused. In such instances, the Discussion Paper states that domestic laws will prevail over DTAA and the FII can be made to pay taxes it was avoiding.

Since SEBI is already attempting to plug the inflow of money from unwanted sources into the Indian stock market, through various measures such as asking for greater compliance with disclosure norms in participatory notes and banning FIIs with multi-layered opaque structures, it would not be surprising if the tax authorities also follow suit and invoke GAAR where the source of funds is not apparent.

FIIs not covered by DTAA

Foreign investors not covered by any DTAA will face higher capital gains tax outgo if the proposals in the revised DTC are implemented. They are now only paying short-term capital gains tax at the rate of 15 per cent and no long-term capital gains tax.

According to the changes proposed, short-term capital gain will be added to the income of the taxpayer and taxed accordingly.

Capital gains on assets held for more than one year from the end of the financial year in which the investment is made, will now be added to the income and taxed albeit after deducting a specified percentage of the capital gains that will vary according to the taxpayer's tax slab.

This can have the negative effect of removing the incentive to hold stocks for longer periods, maybe resulting in greater churn in FII portfolios. Some external investors who are contemplating booking profit on investments held over many years might now rush to do so prior to implementation of the DTC on April 1, 2011. This factor could contribute to volatility in the first quarter of next year.

The Discussion Paper however mentions an ‘appropriate transition regime' if required. Such a window can help avert undue volatility caused by these changes.

Business income or capital gain

The Code has now clarified that income that FIIs make from buying or selling shares will be treated as capital gains and not business income.

While majority of foreign investors prefer to pay short-term capital gains tax at 15 per cent, there are some who claim that it is business income and avoid paying tax in the absence of a permanent establishment in India. This has led to long-drawn litigations with tax authorities for proving the place of residence. Taxing all FIIs' income from stocks has simplified the issue.

The exchequer is not losing any money by asking all FIIs to declare their income as capital gains, as short-term capital gains is anyway taxed as part of income. Thus FIIs who are predominantly trading in cash or derivatives will anyway pay tax at a higher rate. The need to distinguish between trading and investment gains of FIIs is no more relevant.

Test of Residence

The revised DTC has also made the determination of the residence of a company that is incorporated outside India easier. It proposes that a company will now be considered resident in India for taxation purpose if its board of directors or executive directors make or approve decisions in India.

This means that irrespective of where the executive board meet or the number of times they meet, the place out of which they function would now be considered the country of residence.

General anti-avoidance rule

In addition to clarifying on test of residence, the modified GAAR lays down that income-tax officers can determine the tax consequence for the assessee by disregarding the arrangement (such as DTAA) where the transaction lacks “commercial substance or is carried on in a manner not normally employed for bona fide business purpose.”

This means that tax authorities can now invoke GAAR with respect to the shell companies formed for routing money from tax havens into Indian equities and make them pay capital gains tax as per Indian laws. Such companies would have to prove that they had commercial substance.

It might not be possible for such offshore companies to take refuge under the tax treaties as the revised Code lays down that domestic law will take precedence over bi-lateral tax treaties when GAAR is invoked.

via BL