The Direct Taxes Code, which was recently tabled in the Parliament has as one of its noble objectives, reducing the uncertainty and litigation for the foreign investors. However, the recent version of the Bill may have just done the opposite for the Foreign Institutional Investors (FIIs). One hopes that some of these proposals are unintended and when the Standing Committee reviews the Bill, they will be suitably amended.
The Bill has largely restored the existing tax framework for taxation of capital gains. While long term capital gains will continue to be tax exempt, transactions outside the exchange, which are not subject to securities transaction tax, will be taxed at the rate of 30% as against 10%/20% under the existing regime. However, indexation benefit will be available on such gains.
Also, the FIIs will not be permitted to set off or carry forward losses arising from sale of long term investments. Short term gains will be taxed at ordinary rates with a 50% deduction. Thus, most FIIs will pay the short term capital gains tax at the effective rate of 15%. Further, only 50% of short term losses will be permitted to be set off and carried forward.
The Bill provides that the income earned by FIIs will be deemed as capital gains. This would not have much impact on the FIIs as most FIIs at present offer their income to tax as capital gains. The deemed characterisation under the Bill implies that income from derivative transactions, which are currently treated as business income, will now be taxed as capital gains. Considering that most derivative contracts have a maturity period of between 30-90 days, the income from the derivative transactions will be subject to tax at 15%.
Given that the Bill permits all non-resident taxpayers, including FIIs, to opt to be governed by the treaty if it is more beneficial, it will be interesting to see if investors who have access to a tax treaty can take a view that their income from derivative transactions should be treated as business income under the treaty and not taxable in India, in the absence of a Permanent Establishment. However, the intent under the Bill clearly seems to be to treat all income of FIIs as capital gains.
For FIIs investing from favourable treaty jurisdictions, all capital gains will be tax exempt. Though, structures without much commercial substance are likely to face challenges with the advent of general anti-avoidance rule ('GAAR').
As per the proposed GAAR, if the structure has been set up to obtain an unintended 'tax benefit' or involves treaty shopping, the Indian tax authorities will have the ability to lift the corporate veil or deny the treaty benefits.
While the detailed rules and safe harbours are still to be announced, it is apprehended that holding structures set up in tax favourable jurisdictions such as Mauritius and Cyprus will be presumed to be set up for tax avoidance and the onus to prove otherwise will be on the taxpayers.
This uncertainty might tilt the balance in favour of certain well established jurisdictions such as Singapore, which already have an objective substance test built into their tax treaty with India. For those FIIs who have traders based in jurisdictions from where they invest, it may be easier to meet the commercial substance test.
The significant impact on the FIIs will be as regards the taxation of their investors. The Bill deviates from the current law and has sought to tax offshore transfer of shares in companies which hold at least 50% or more investment in the form of Indian assets.
As a consequence, non-residents investing in an open-ended offshore fund set up as a company may be subject to Indian tax upon redemption of offshore shares. This might create unintended cascading tax burden on the investors in the offshore funds set up as collective investment vehicles, and which have more than 50% asset allocation to India.
However, the offshore derivative instruments may not be caught in the tax net as generally participatory notes issued by FIIs are neither shares nor considered as 'interest' in the issuer. Therefore it may be possible to contend that income from participatory notes continues to remain outside the purview of the Code and hence not taxable in India.
The overall impact of the Bill on FIIs seems to be positive and restoring the current capital gains tax regime is certainly a welcome move. The potential taxation of investors and the uncertainty on tax treaty availability due to GAAR are dampeners. Detailed rules and safe harbours will need to be reviewed to assess the potential impact.