Capital gains vs. interest

Open offers and buybacks have been an integral part of capital market activity. Often, there are delays in the completion of open offer formalities, resulting in payment of additional consideration, which is computed as ‘interest’ under Securities and Exchange Board of India regulations.

Should the additional compensation be treated similar to the original consideration (that is, capital gains/ business income, depending on whether the security is held as investment/ business asset), or should it be treated as interest and taxed accordingly?

Interest income is typically taxed at a base rate of 30 per cent for Indians and 40 per cent for foreign companies, whereas long-term capital gains are taxed at 10 per cent or 20 per cent depending on the class of investors and the type of transaction, that is, off-market transaction. For foreign investors, capital gains on sale of Indian securities may be exempt from tax in India under the relevant tax treaty.

Recently, the Mumbai Income Tax Appellate Tribunal, in the case of Genesis Indian Investment Co Ltd, dealt with this issue. The SEBI-registered foreign institutional investor had made portfolio investments in Indian capital markets. It, inter alia , held shares of Castrol India Ltd.

Following British Petroleum’s announcement to acquire Burmah Castrol Plc (which held shares in Castrol UK), under Indian regulations BP had to make an open offer to acquire 20 per cent of Castrol India’s share capital. BP sought exemption from SEBI, but subsequently withdrew its application. Due to this, and other litigation, the public offer to buy back Castrol India’s share capital was delayed. Eventually, Castrol UK was held liable to pay 15 per cent interest on the offer price, from the date on which the offer was made to the date of actual payment to shareholders.

Genesis Indian Investment tendered its shareholding in Castrol India under the open offer and received additional compensation (above the offer price/ sale consideration). Indian revenue authorities characterised this compensation as ‘interest’ and taxed it accordingly.

The Mumbai tribunal observed that the compensation was a part of the sale consideration and, relying on the Supreme Court’s decision in the case of Govinda Choudhary, held that it should be taxed as capital gains. The tribunal further observed that the key differentiating factor is whether the interest is paid for delayed payment after the debt has crystallised, or for the period before that.

Genesis Indian Investment received additional compensation for the delay in completing the open offer formalities prior to the date of tender/ acceptance of shares. As it was not for paying the determined consideration after the purchase/ sale transaction, it constituted a part of the sale consideration.

The characterisation of additional payments received as interest or capital gains has been a vexed issue, with divergent judicial decisions. The Mumbai tribunal’s decision is a welcome one — it is driven by the facts of the case, and analyses the issue in the correct perspective, without merely looking at the nomenclature of the payment.

(The article uses base tax rates; surcharge and education cess apply)

Jesal Mody, senior tax professional contributed to the article.

(The author is Associate Director – Tax and Regulatory Services, EY)

COMMENT NOW