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Indirect advantage: FIIs may come via tax havens
January, 10th 2007

A host of US-based pension funds, retirements funds and university endowments investing directly in Indian equities are set to be impacted by the Authority for Advance Ruling (AAR) ruling on Fidelity Group.

These funds will have to bear an extra 10% cost if they offload shares within a year and earn profits. The AAR, a quasi judicial authority, on Monday ruled that the income from sale of shares by the 38-odd off-shore funds managed by the US and Canada-based Fidelity group will be treated as capital gains and not as business income.

This implies that these funds will have to pay short-term capital gains tax of 10% on their profits from investments in securities.

Some of the US-based pension funds and educational trusts that invest in Indian equities do not pay tax in their home country by virtue of their status. If their income from sale of Indian shares is treated as capital gains, these funds will have to pay short-term capital gains tax here. This would mean an extra cost for them as they cannot claim credit in their home country for taxes paid in India, said Sudhir Kapadia, partner Direct Taxes, KPMG.

The AAR ruling comes as a blow to such funds as they are keen on enhancing their returns by investing in Indian stocks. The authoritys rulings are binding on the tax payer and the department. They also have a persuasive value in the case of other tax payers.

Some tax experts reckon that the ruling lends greater certainty to the tax treatment of FIIs routing their investments through Mauritius, Singapore and tax-friendly destinations such as the Cyprus and UAE. Mauritius does not tax capital gains and Mauritius-based FIIs are exempt from paying capital gains tax here.

Bulk of the portfolio investments coming into India is routed through Mauritius because of the beneficial tax treatment. This benefit has also been extended to Singapore-based FIIs, subject to certain conditions. If the gains from sale of shares were to be treated as business income, tax authorities could examine whether the FII has a business connection or a permanent establishment (PE) in India.

However, if treated as capital gains, there is no need to determine the existence of a business connection or PE, according to Samir Gandhi, Tax Partner, Deloitte Haskins and Sells. The AARs ruling is, in fact, expected to give a further impetus to FIIs to route their investments through Mauritius or Singapore to save on short-term capital gains tax, said Kapadia.
 
Investments in stocks, if held for a year or more, are exempt from long-term capital gains tax. The timing of AARs ruling is significant as the Central Board of Direct Taxes (CBDT) is expected to soon come out with the final guidelines on the tests to distinguish between an investor and a trader in stocks.

A domestic trader in stocks has to pay a tax of 30% on his business income, whereas an investor has to pay
only a 10% on short-term capital gains. CBDTs draft instructions laid down 15 parameters to differentiate between shares held as stock-in-trade and shares held as investment.

This included, among other things, the scale of activity, total number of stocks dealt in and so on. The draft circular applied to all class of assesses, including FIIs. Against the backdrop of AARs ruling, it remains to be seen whether the final instructions of the CBDT makes a distinction between FIIs and non-FIIs.

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