E&Y on FII Taxation: Where is the Confusion?

The liberalisation of the Indian economy and the opening up of the capital markets to foreign investors in 1992 created a new class of investors "� foreign institutional investors (FIIs).

A special and concessional tax regime was introduced for the taxation of income earned by FIIs to make the markets lucrative for such investors.

With the increasing number of FIIs dominating the capital markets and a sizeable portion of foreign investment coming in through FIIs, their taxation in India has assumed considerable significance.

This article discusses the FII tax regime and some tax issues confronting FIIs.

Special Tax Regime

Gains made from investments in Indian securities are the primary and most significant item of income for FIIs.

Historically, FIIs have offered their income from transactions in Indian securities to tax as capital gains under the tax regime prescribed for FIIs under section 115AD of the Income-tax Act, 1961 (Act). Under the special tax regime, capital gains made by FIIs were taxed at the base tax rates mentioned below:

Long-term capital gains - 10%

Short-term capital gains - 30%

Gains characterised as business profits - 40% for corporate entities (30% for non-corporate entities)

Current tax regime

A new regime of taxing capital gains was introduced in October 2004. Under this regime, transactions in equity shares and derivatives (both stock and index-linked) effected on a recognised stock exchange and redemption of units of equity-oriented mutual funds are subject to a securities transaction tax (STT) at prescribed rates.

Under the new tax regime, capital gains earned from transactions in equity shares and units of equity- oriented funds chargeable to STT are taxed as under:

Long-term capital gains - Exempt (earlier taxed at 10% for FIIs)

Short-term capital gains - 10 % (earlier taxed at 30% for FIIs)

Gains, if any, in respect of transactions in equity shares (which are not effected on a recognised stock exchange), debt securities, non-equity oriented funds and derivatives (though transactions in derivatives are subject to STT) continue to be subject to tax at the rates mentioned in the Special tax regime (see above).

The above capital gains tax rates are subject to relief that may be available to an FII under tax treaties that India has entered into with other countries where the FII is a tax resident.

Characterisation of gains earned from investments

There has always been ambiguity in respect of characterisation of income earned by FIIs on transfer of securities as capital gains or business income.

The Central Board of Direct Taxes (CBDT), in an instruction issued in 1989, laid down certain tests to distinguish between shares held as stock-in-trade and shares held as investment. CBDT now proposes to issue supplementary instructions (though not specifically in the context of FIIs) to provide further guidelines to assist the revenue authorities determine whether a tax-payer is a trader in shares or an investor in shares. The instructions reiterate the principles laid down in several judicial cases dealing with the characterisation of income.

The instructions, which apply to all categories of tax-payers (including FIIs unless specifically excluded by the CBDT while issuing the final instructions), could have far reaching implications.

Historically, most FIIs have been offering gains from transfer of securities to tax as capital gains - a position that has also been accepted by the revenue authorities. However, several rulings by the Indian Authority for Advance Ruling (AAR) examined the characterisation of income arising on transfer of securities in the case of FIIs.

Based on the facts of specific cases, AAR ruled that the securities held by FIIs constituted their business assets and the resultant gains constituted business profits. In arriving at the said conclusion, the AAR was guided, inter alia, by:

the enormity and frequency of transactions

the motive of the FII to earn profits (rather than earn dividend income) from purchase and sale of shares.

Further, on the basis that FIIs did not have a permanent establishment (PE) in India, the income of FIIs were held to be not taxable in India under the provisions of the applicable tax treaty.

A similar issue would arise in case of gains from transactions in derivatives in India given that there has always been an ambiguity on whether the income from derivatives would constitute business income or capital gains in the absence of a specific code of taxation.

In a recent ruling, AAR held in the case of a UK-based FII that income from purchase and sale of derivative contracts constitutes business income and is not taxable in India in the absence of a PE in India.

It is possible that the revenue authorities, relying on the principles laid out in the proposed CBDT instructions and the judicial precedents, may seek to treat income earned from the sale of securities as business profits.

While this would have a positive impact for FIIs investing from a jurisdiction with which India has a tax treaty (since gains would be exempt from tax in the absence of a PE), it would have a significant negative impact for FIIs that do not have recourse to tax treaty protection.

This is due to the fact that under domestic tax law, business profits earned by a non-resident are presently taxable at a rate of 40% (30% in case of non-corporate entities) on net profits (revenues less permissible expenses).

However, the above basis of taxation could particularly trigger a host of compliance and documentation-related issues for FIIs (such as tax withholding, maintenance of books of accounts, requirement to furnish a tax audit report to name a few), resulting in increased cost of investment for the FIIs.

Developments under the India-Mauritius tax treaty

Given the beneficial provisions for taxation of capital gains under the India-Mauritius tax treaty and the favourable regime for regulation and taxation of offshore funds in Mauritius, many FIIs investing in India have structured their investments into India involving an investment vehicle domiciled in Mauritius.

For many years, the revenue authorities accepted the tax return filings made by such FIIs without examining the substance of the formation of such investment vehicles.

However, the revenue authorities, while auditing tax returns filed by various Mauritius-based FIIs in 2000, denied some FIIs the benefits gained under the India-Mauritius tax treaty on the basis that such FIIs were neither tax residents of Mauritius nor the beneficial owner of the income earned from Indian investments.

Subsequently, CBDT (the apex Indian tax administrative body), issued a notice clarifying that FIIs holding a tax residence certificate issued by the Mauritius revenue authorities would be regarded as tax residents of Mauritius and the beneficial owner of income earned from India.

A non-governmental organisation (Azadi Bachao Andolan) filed a public interest litigation petition in the Delhi High Court challenging the validity of the above notice. The Delhi HC quashed the notice, holding, inter alia, that the notice breached the powers conferred on the revenue authorities by the domestic tax law.

The central government appealed against the decision of the Delhi HC before the Supreme Court (SC). The SC, in October 2003, passed an order setting aside the decision of the Delhi HC and declared the notice to be valid and efficacious.

Thus, based on the current tax provisions, FIIs that are tax residents in Mauritius are entitled to the beneficial provisions of the India-Mauritius tax treaty where a tax residence certificate is issued by the Mauritius revenue authorities.

With the reduction in tax rates of capital gains (see Current tax regime), the efficacy of structuring investments in India by involving an investment vehicle domiciled in Mauritius has significantly reduced though it continues to be employed by several foreign investors investing in the Indian capital markets.

Manner of set-off of capital losses

Another issue faced by FIIs is the manner of set-off of capital losses incurred prior to April 1, 2002.

Up to (and including) financial year ended March 31, 2002, the Act permitted a tax payer to set-off losses from one source against income from another source under the same head of income (the Act was amended effective April 1, 2002 restricting the manner of set-off of long-term capital losses).

Therefore, a tax payer was required to set-off the capital losses incurred during the year (on transfer of short-term and long-term capital assets) against capital gains earned during the year in the manner prescribed under the Act.

Where the net result of the above set-off was a capital loss, the tax payer was permitted to carry forward this loss to be set-off against capital gains earned in eight subsequent years.

However, where the net result of the set-off resulted in a capital gain, the tax payer could utilise the capital losses for past years brought forward, if any, to set-off the net capital gains of that year.

The above manner of set-off was not accepted by the revenue authorities. It was the revenue authorities' contention that since the short-term and long-term capital gains were taxed at differential tax rates (30% and 10%, respectively), they are to be regarded as distinct sources of income.

Having concluded in the said manner, the revenue authorities, in accordance with the provisions of the Act, held that short-term and long-term gains and losses need to be determined separately before netting-off the net gains / losses inter se.

When the matter came up for hearing before the special bench of the Income Tax Appellate Tribunal, Mumbai (ITAT) [a 3-member bench constituted to decide on the matter], the bench held that since the Act had not prescribed any order of precedence according to which the loss arising from one source has to be set-off against income from any other source, it is the legitimate right of the tax payer to choose the option that is more favourable to it so that it could avail the benefit of the concessional rate of tax on long-term capital gains.

The above judgment comes as a great relief to FIIs that have been keenly awaiting the outcome of this case before the special bench. With the matter now having been settled, a number of cases pending with ITAT and at lower levels with taxes running into millions of rupees locked in as a result of the litigation on this issue are expected to be favourably decided.

The reduction in tax rates, coupled with the India growth story, has given the much-needed impetus to FII investments in the Indian capital markets.

However, certainty and clarity in tax matters is critical to retain the attractiveness of India as an investment destination. Proactive clarifications in the future from CBDT on contentious issues, including characterisation of income, would certainly be very welcome.

(Courtesy: Ernst & Young)