The draft Direct Taxes Code (DTC) released in August 2009 (DTC 2009) was seen by capital market participants, including foreign institutional investors (FII), as a paradigm shift in India's tax policy of having an efficient and concessional tax regime that attracts capital market investment.
A shift in the tax rates from 0-15 per cent with a levy of securities transaction tax (STT) to 30 per cent without STT coupled with the removal of distinction between short-term and long-term capital gains and other structural changes was seen to be a regressive step that could derail the flow of foreign capital into India.
In this context, the Direct Taxes Code, 2010 (DTC 2010) presented in Parliament to become effective from April 2012 offers a mixed bag. Some of the key proposals in DTC 2010 vis-à-visthe provisions in DTC 2009 are discussed.
Capital gains tax rate
DTC 2010 continues to not make any distinction between short-term and long-term capital gains. Capital gains derived from transfer of listed equity shares and units of equity oriented mutual funds (specified securities) will now be eligible for a 100 per cent deduction where the specified security was held for more than one year and 50 per cent deduction for holding period of one year or less.
A similar scaling down will be applicable even in determining capital losses. These deductions will be available subject to the transfer being chargeable to STT, which the DTC 2010 has reintroduced.
Effectively, capital gains derived from transfer of specified securities should be subject to an effective tax rate of 0-15 per cent similar to that prevailing in the current tax law; this is a major relief for FIIs.
FIIs investing in other asset classes, for example, debt securities, units of non-equity-oriented mutual funds and exchange-traded derivatives will suffer higher tax even for long-term holdings; no change is proposed in this regard in DTC 2010. Gains shall be taxable uniformly at 30 per cent with the exception that capital gains from transfer of securities held for more than one year from the financial year end of acquisition will be determined after applying cost inflation indexation.
Characterisation of income
The elimination in DTC 2009 of a special provision for taxation of FIIs in the current tax law (Section 115AD) would have once again brought to fore the long standing debate on whether FII gains are in the nature of capital gains or trading income. DTC 2010 deems securities held by FIIs to be investment assets and taxes gains from transfer of such assets under the head capital gains.
This will finally put an end to the controversy that has seen several conflicting rulings of the Authority for Advance Rulings.
On the flip side, being a deeming provision, it may enhance the tax liability in India of FIIs, which have taken a view that gains from certain asset classes (for example, derivatives) is in the nature of trading income and consequently not taxable in India relying on favourable provisions of an applicable Double Taxation Avoidance Agreement (DTAA).
Under the current tax law, in determining the tax liability of a non-resident, the provision of the tax law or a DTAA, whichever is more beneficial, applies. The DTC 2009 eliminated the preferential status of a DTAA and provided that the law, which is later in time, shall prevail.
This was widely criticised as being a step by India to generally and unilaterally override a DTAA, which is against the spirit of the customary international law of treaties between countries.
DTC 2010 has restored the preferential status of a DTAA over the domestic tax law with some important exceptions; the pertinent exception is cases where the Indian Revenue authorities (IRA) invoke the General Anti-Avoidance Rule (GAAR).
In a first of its kind provision, GAAR was introduced in DTC 2009 with the intention of curbing sophisticated forms of impermissible tax avoidance arrangements. The Commissioner of Income Tax (CIT) was given an unbridled authority to make the determination. In DTC 2010, the GAAR provisions will be applicable only subject to satisfaction of conditions to be prescribed by CBDT.
The onus to prove that an arrangement is not an impressible arrangement continues under both drafts to be cast on the taxpayer. Several FIIs invest into India from jurisdictions whose DTAA's with India provide a tax exemption for capital gains (for example, Mauritius). The structures that have been implemented by FIIs may be scrutinised by the IRA to examine if conditions for invocation of GAAR are satisfied. If so, benefits under the DTAA may not be available and such FIIs may be subject to Indian tax on capital gains.
Additionally, provisions relating to withholding tax exemption on payment of sale proceeds of listed securities, continuity of unlimited period for set-off and utilisation of capital losses, clarifications on branch profits tax applicability are very positive for FIIs.
The DTC 2010 provisions are, by and large, in line with the provisions in the current tax law with the important exception of the GAAR.(The author is a senior tax professional with Ernst & Young.)