STATISTICS given by the Ministry of Commerce and Industry shows a healthy picture. Since the onset of globalization and internationalization of the Indian economy in 1991, India has attracted foreign investment worth Rs 699 billion and is fast emerging as an important business destination for western capital ventures.

Recently, American Depository Receipts (ADRs) issued by Indian companies have also evoked considerable interest among US investors. ADRs can be listed and traded as any other dollar denominated security.

As we have seen, in the adjoining article, the provisions of the Issue of Foreign Currency Convertible Bonds and Ordinary Shares (through Depository Receipt Mechanism) Scheme, 1993 (the Scheme) governs the issue of ADRs and GDRs.

Recognising the strength of stock options as a tool for the Indian software companies to attract and retain highly skilled professionals, the Finance Minister, in his budget for 1998-99 announced a special stock option scheme for Indian software companies linked with ADR/GDR offerings.

Taxation of ADRs Taxation of income arising out of ADRs, the underlying shares and of ESOPs linked to ADRs is governed by the provisions of the Income Tax Act, 1961 (I-T Act), read with the provisions of the guidelines contained in the Issue of Foreign Currency Convertible Bonds and Ordinary Shares (Through Depositary Mechanism) Scheme, 1993 and Fresh Guidelines for Euro Issues, 1994 as amended from time to time.

Accordingly, there is no tax in India on transfer of ADRs between two non-residents outside India. Redemption of ADRs into underlying shares is exempt in India, dividend income received by ADR holder or the holder of underlying shares is not taxed in their hands.

Sections 115AC and 115CA of the I-T Act, specifically provide for taxation of long term capital gains on sale of underlying shares. However, as explained later, this aspect is fraught with ambiguity.

A resident employee would be liable to applicable surcharge. As companies line up for listing their ADRs on NASDAQ, they find that while explaining the Indian tax implications of investment in ADRs, there are several issues where there is a distinct lack of clarity in the provisions.

Transfer of ADRs by resident employee: Both the I-T Act and the Scheme provide that there is no capital gains tax implication in India when the ADRs are transferred between two non-residents.

However, in case a resident employee transfers ADRs to a non resident outside India, the tax consequences are not clear. In this case, although the transfer of ADR would be outside India and would admittedly be made to a non-resident, it may not be covered under section 47(viia). As a result, the resident employee could be taxed on the capital gains realised by him on the transfer of such ADRs. It is not clear if this indeed is the intention with respect to ADR linked ESOPs for the resident employees.

Determination of the cost of acquisition: Determination of the cost of acquisition is vital for computation of capital gains. The Scheme provides that at the time of sale of the shares acquired by the ADR holder upon redemption of the ADRs, the capital gains are computed with reference to the cost of acquisition of the underlying shares.

The Scheme provides that the cost of acquisition of these equity shares received in exchange for ADRs will be the market price of the underlying shares on the date that the depositary gives notice to the custodian of the delivery of the equity shares in exchange for the corresponding ADRs.

This can be described as `stepped up’ basis of cost of acquisition. Sections 48 to 50 of the I-T Act describe the relevant costs for computing capital gains. There is no corresponding provision in these sections for the `stepped up’ basis of cost of acquisition.

Therefore, this method of computing the cost of acquisition is without any statutory basis. In practice, however, the tax department has not questioned this basis. Lack of clear provision in the I-T Act can result in the tax department not recognising this basis for computing the cost of acquisition.

In such an event, one would be left with no option but to consider the original purchase price of the ADRs as the cost of acquisition. This is clearly not the intention while devising the Scheme.

The Scheme, section 115AC and section 115ACA do not provide mechanisms for determining the cost of acquisition for the purposes of computing capital gains tax where the shares of the Indian company are not listed on the Stock Exchange, Mumbai or the National Stock Exchange.

Therefore, in the case of a company, which is not listed on the Stock Exchange, Mumbai, or the National Stock Exchange, the determination of cost of acquisition of equity shares received upon redemption of ADRs is unclear. Would the cost of acquisition in such situation be the original cost of acquisition of the ADRs?

Period of holding: According to the Scheme, a non-resident holder’s holding period for the purposes of determining the applicable Indian capital gains tax rate in respect of equity shares received in exchange for ADRs commences on the date of the notice of redemption by the depositary to the custodian. However, the Scheme does not address this issue in the case of resident employees. Also, there is no corresponding provision in the I-T Act in this respect either in case of a non-resident or in case of a resident employee. The practice followed seems to be without a statutory basis.

Subsequent sale: The Scheme provides that if the equity shares are sold on a recognized stock exchange in India against payment in Indian rupees, they will no longer be eligible for the preferential tax treatment.

It is unclear as to whether the preferential treatment under section 115AC and the Scheme are applicable to a non-resident who acquires equity shares outside India from a non-resident holder of equity shares after the seller non resident receives the equity shares upon redemption of the ADRs.

If section 115AC and the Scheme are not applicable to a non-resident holder, long term capital gains realized on the sale of such equity shares which are listed in India would still be subject to tax at the rate of 10 per cent. However, if the shares are not listed in India, a tax rate of 20 per cent would apply.

It would seem that the non-resident holder would also be able to avail of the benefit of exchange rate fluctuations for the computation of capital gains tax that is otherwise not available to a non-resident holder under section 115AC and the Scheme. Taxation of capital gains outside the preferential provisions of section 115AC may be more beneficial!

Taxation of rights: A further lack of clarity exists in respect of capital gains derived from the sale of subscription rights or other rights. A non-resident holder not entitled to an exemption under a tax treaty will be subject to Indian capital gains tax.

If such subscription rights or other rights are deemed by the Indian tax authorities to be situated within India, the gains realized on the sale of such subscription rights or other rights will be subject to Indian taxation.

It would seem that the capital gains realized on the sale of such subscription rights or other rights, which will generally be in the nature of short term capital gains, will be subject to tax at variable rates with a maximum rate of 48 per cent in case of a foreign company, 30 per cent in case of non-resident individuals and 34.5 per cent in case of resident employees if their taxable income exceeds Rs 1.5 lakh.

Though Indian companies are increasingly resorting to the ADR route to tap US markets, the ADR tax regime leaves much to be desired in terms of clarity and certainty of tax obligations of the investors