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All these years no short term capital gains tax has been levied on FII money coming in via Mauritius, because of the Double Taxation Avoidance Agreement (DTAA) between India and Mauritius.
As a result, this income has been escaping tax both in Mauritius (which does not tax capital gains) and in India (which exempts only long term capital gains, short term gains being currently taxed at 15 per cent with a 3 per cent cess).
This was not an oversight. Everyone knew that, in the name of avoiding “double taxation,” the money was not being taxed at all.
But at the time the point was first raised, the Government felt that this was a cost we had to pay if we wanted FII flows. The Supreme Court, in effect, accepted this reasoning in its 2003 judgment in the Azadi Bachao Andolan case.
From trickle to flood
Things have changed a great deal since then, and with exceptions like 2008 and 2011, FII flows have gone from a trickle to a flood. As the Government keeps widening the tax net (to meet burgeoning expenses while keeping tax rates low), some in the Government believe that there is no reason to leave FIIs out.
The revised June 2010 discussion paper on the Direct Taxes Code had a chapter specifically directed at cases in which, under the name of avoiding double taxation, certain kinds of income end up not getting taxed at all.
Even under the ‘ideal' case that Deloitte's International Taxation people believe India should model its General Anti-Avoidance Rules (GAARs) on, Mauritius-based FIIs would be left without a leg to stand. It is hard to think of any ‘commercial substance', other than tax avoidance, that FIIs can come up with for the Mauritius leg of the transaction.
Retrospective changes
Participatory notes, the Finance Minister has promised not to touch. And a Finance Ministry official has specifically stated that FIIs will not be targeted by retrospective changes in Section 9. But that still leaves one question: If the cash-strapped Finance Minister had specific anti-avoidance measures in mind, why did he stir up a hornet's nest with his Budget Speech one liner about General Anti-Avoidance Rules.
Will FIIs be brought into the tax net? Eventually, yes, but here and now the Finance Minister might drag his feet, as in the case of fuel and fertiliser subsidies. A tax on short-term FII gains would reduce market volatility, but leaving the whole thing hanging in the air could aggravate it.
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