Little to cheer for FIIs even in revised direct taxes code

The revised discussion paper (RDP) on the direct taxes code (DTC) has given foreign institutional investors (FIIs) some hope by acknowledging their concerns on the proposal to abolish concessional capital gains tax regime for all investors.

Recognising that the abolition could have a significant impact on the Indian capital market, the RDP seeks to grant some relief, although some new measures proposed, such as a revival of the securities transaction tax, which was done away with in the original draft, and the proposal to mandatorily characterise income as capital gain are points of concern.

The draft DTC Bill proposed to discontinue the concessional tax treatment available for listed securities by proposing a general tax rate of 30% on all capital gains earned by FIIs, but at the same time permitted an indexation benefit where the securities are held for more than one year from the end of the financial year of their acquisition.

However, as per the RDP, in case of listed equity shares and units
of equity oriented funds held for more than one year, instead of indexation, the benefit of graded deduction will be allowed from the gains and such reduced gains will be taxed at the rate applicable to ordinary income.

The rates of graded deduction are yet to be announced, but the illustrative rates provided in the RDP indicate that following the graded deduction the capital gains tax liability would be lower than in the case of indexation.

The RDP also proposes to insert a specific provision on characterisation of income of FIIs, which seems to be an exception to other concessional proposals in the paper and instead aims to remove any potential possibility of erosion of tax base in the case
of FIIs.

The RDP says FIIs are allowed to only invest in securities under
Sebi regulations. Hence, in order to obviate the possibility of FIIs characterising their profits as business income and claiming tax exemption in the absence of a permanent establishment in India under the applicable Double Tax Avoidance Treaty, it will be provided that income of FIIs from purchase and sale of securities will be deemed to be capital gains.

This proposal should not cause any concern for FIIs, which are tax residents of countries such as Mauritius, Cyprus, etc, since treaties with these countries exempt capital gains on Indian securities. However, FIIs from other jurisdictions, which are engaged in trading of listed securities, will find that a potential window for claiming tax exemption on their business income may be closed.

A few FIIs, based on their specific fact pattern, have claimed their
income as business profits in case of transactions in listed equity shares as well as derivative transactions. Some of them succeeded in obtaining a ruling confirming their position, especially in case of derivative transactions where the Authority for Advance Ruling has accepted that Sebi and Fema regulations permit FIIs to trade and earn business profits.

It appears that the government proposes to neutralise the impact of such rulings and also discourage any possible attempt to seek such rulings in future by deeming all income of FIIs from purchase and sale of securities as capital gains.

The writer is associate director, tax & regulatory services, Ernst & Young.  Views are personal.