Are foreign institutional investors (FIIs) welcome on Dalal Street? Going by the over $48 billion that has flowed into the Indian markets since 1995, the answer would be a resounding yes. But then there's the Central Board of Direct Taxes (CBDT), which may not be too popular amongst overseas portfolio investors. Unsurprisingly, for the CBDT, its revenue kitty is more important than FII inflows. Consider: Last fortnight, the CBDT issued a "clarificatory" circular that lays down the principles for tax assessing officers to determine whether money made from the sale and purchase of shares should be classified under the head of capital gains or business income. Such an apparently simple issue has become a cause for much vexation thanks to the difference in tax rates applicable under the two heads.
Since 2004, when the capital gains tax regime was tweaked in tandem with the introduction of the securities transaction tax, there is no tax on sale of listed securities if they are held for longer than a year. If they're held for a shorter duration, the tax is a uniform 10 per cent. Business income, on the other hand, is taxed at the highest rate of over 33 per cent. For FIIs, the tax rate rises to nearly 42 per cent. However, additional provisions for FIIs allow them to remain exempt of tax even on business income if they do not have a permanent establishment (PE) in India. And quite a few FIIs invest in the country via Mauritius, making them tax-exempt under the Double Taxation Avoidance Agreement with that country.
In the past there has been litigation on both counts: Capital gains versus business income and whether the FII has a PE in India. The recent CBDT circular comes on the heels of a couple of judicial decisions that have debated the differences in shares held for trading (business income) and those held for investment purposes (capital gains). Earlier this year, in a case involving Fidelity Northstar Fund, the Authority of Advance Rulings (aar) had culled out three principles to make this distinction. One, the investor can show if the shares are held as trading assets. Two, the nature of the transaction can be determined by the books of accounts, the magnitude and the ratio between the purchase, sale and holding of shares. And three, where the aim of the transaction is to derive dividend income, those transactions will yield capital gains. Enunciating these principles, the revision will reduce the number of claims and there will be fewer contentious cases to fight in the courts, believe Finance Ministry officials. "The assessing officer can look at the issue on a case by case basis," says a Department official.
Not all agree, however. Ample motivation would exist for the assessing officer to try and classify the gains made from sale and purchase of shares as business income. Meanwhile, the aggressive FIIs could well take recourse to the argument that lack of a permanent establishment in India means that they do not pay any tax.
"It (CBDT circular) merely reiterates the tests for determining the nature of the shares held, and those tests are quite subjective. So, it is as unclear as before for the FIIs," says Sudhir Kapadia, partner with auditing firm BSR & Co. Kapadia insists that a simpler and more efficient way of dealing with the issue both from the revenue and the investor point of view is to follow practices that prevail in other emerging markets such as Taiwan, Hong Kong and Singapore. In these markets, income of offshore funds earned from transfer of local securities is tax-free. As a Delhi-based economist put it: "Investors can live with rules, even unpleasant ones, but nobody likes uncertainty."