India Budget 2014: New beginnings and new direction
The Indian Finance Minister has just announced the Budget for the year 2014-15. A number of reforms have been proposed including liberalization of foreign direct investment in defence and insurance upto 49%, a pass-through regime for real estate and infrastructure investment trusts, some certainty for foreign institutional investors (FIIs) and foreign portfolio investors (FPIs), boost to debt markets, and a clear commitment towards a stable and predictable tax system. It seems that the focus of the 2014 Budget is on long term structural reforms rather than short term palliatives. However, some of the low hanging fruits have been missed out, including clarity on the retroactive tax, general anti-avoidance rules (GAAR) and a pass-through status for all categories of alternative investment funds. Hopefully these will be addressed in Budget 2015.
In recent years, India has witnessed low growth rates, high inflation and a widening fiscal deficit. MNCs, funds and global investors were increasingly resentful of the policy paralysis and aggressive tax regime prevailing in India. The mood was uplifted when the new Government led by Prime Minister Modi won a landslide victory in the recent May 2014 elections. While the 2014 Budget introduces some reforms, there is definitely scope for more.
Corporate tax rates remain constant at around 30% for residents and 40% for non-residents, with a few additional incentives and allowances provided to individual taxpayers. Dividends distributed by Indian companies continue to be subject to a dividend distribution tax of around 15%, albeit one that is now computed on a grossed up basis.
The Government has decided not to revoke the 2012 retroactive amendment to tax indirect share transfers which was introduced to counter the Supreme Court’s decision in the Vodafone case. The Finance Minister did recognize the damage caused by these amendments including uncertainty and loss of investor confidence, and assured that the new Government would not introduce a similar retroactive tax. Fresh cases on the indirect transfer issue will be scrutinized by a high level government committee. However, there is still ambiguity on the scope and application of the indirect transfer tax and how it will be considered in the context of the existing cases.
There was also hope that GAAR would be further deferred for at least another year. GAAR now continues to be effective starting April 1, 2015 and applies to all investments post August 2010. It provides extensive powers to the tax authorities to disregard tax driven structures that are abusive, non-arm’s length or lack commercial substance. Due to the ambiguity in the GAAR provisions, it was expected that detailed guidelines would be released. Unless the Government provides more certainty on the application of GAAR, it will result in significant litigation and negatively impact investor sentiments.
As a positive step, the Government has announced a partial tax pass-through regime for real estate investment trusts (REITs) and infrastructure investment trusts (InvITs). The much awaited draft framework for REITS was announced last year and thanks to clarity in tax treatment, global investors can soon participate in core real estate assets in India. The regime for InvIts would provide a massive boost to infrastructure growth and development in India. Long term capital gains on sale of units as well as dividends received by the REIT and distributed to the investor shall be tax exempt. Interest income received by the REIT is tax exempt and foreign investors shall be subject to a low withholding tax of 5% on interest payouts.
To provide certainty to FIIs and FPIs, income earned from sale of securities shall be deemed to be capital gains income. This would eliminate litigation on the issue of income characterization. While long term capital gains on sale of listed shares are exempt, FIIs and FPIs are likely to continue investing from jurisdictions such as Mauritius or Singapore to secure relief against short term capital gains tax. The Budget proposal however does not address issues such as the availability of tax treaty relief for such funds. Further, issues such as commercial substance as well as the potential impact of GAAR continue to cast a shadow over treaty relief.
Fund managers may also be disappointed with the continued absence of specific pass through treatment for domestic alternate investments funds, which has been a long-standing demand of the industry. Such funds, therefore, have to be carefully structured to ensure tax efficient pass through status.
As a welcome move, concessional withholding tax rate of 5% has been provided up to 2017 for interest on long term foreign currency denominated bonds. This will provide a boost to India’s debt markets. However, the 5% rate applicable to rupee denominated debt instruments including non-convertible debentures will lapse in June 2015, unless extended in next year's budget. If extended, it would provide further incentive for FIIs and FPIs to invest in such instruments which have become a standard in sectors such as real estate.
The Budget proposes to indefinitely continue the lower 15% tax rate on dividends received by Indian companies from overseas subsidiaries. While the object of this proposal is to encourage repatriation of funds, it would provide relief to Indian MNCs as they globalize and expand overseas.
To address the concerns of MNCs on transfer pricing matters, the Budget seeks to provide a roll back for advance pricing agreements (APAs) for a period up to 4 years. Transfer pricing has become one of the most litigated areas and APAs are expected to provide significant relief to MNCs. To promote certainty in taxation, the Government also proposes to expand the advance ruling machinery to domestic transactions and increase the number of benches for speedy disposal of applications. Over the years, advance rulings have provided considerable certainty to investors and MNCs doing business in India. The new Government is also committed towards reducing litigation and making the tax administration less adversarial.
A number of incentives have also been provided to specific industries. The tax holiday for the power sector has been extended to 2017 and the range of investment linked allowances has been widened. Notable customs and excise duty reliefs are proposed in relation to electronic products as well as renewable energy equipment. The Government will also closely work with the states to roll out the proposed goods and services tax regime that will simplify and consolidate all indirect taxes.
When the new Government was elected, investors expected a slew of radical reforms. Although the 2014 Budget does not propose any far reaching changes, considering the Government had only 45 days since being elected to present the budget, it does represent a conscious attempt to reverse the sluggish macro-economic trends prevailing in India. The Government plans to embrace the daunting task of overhauling India’s subsidy regime which is a major contributor to the fiscal deficit. Overall, the Budget seeks to ensure balanced regional development across the country by promoting infrastructure, job creation and sustainable growth.
Today, while many reforms do require legislative amendment, the critical ones envisage a fundamental shift in the attitude of the Government (including the tax authorities) towards a business and an investor friendly ecosystem. With the overwhelming majority enjoyed by the present administration, it is well positioned to address both aspects of reform and bring India’s growth story back on track.
We have provided below a more comprehensive analysis and further insights on the 2014 Budget proposals. Hope you enjoy reading it.
INDIRECT TAX TRANSFER: SOME RELIEF? DIRECT OR INDIRECT?
NEW TAX REGIME FOR REITS: PASS THROUGH BUT ONLY PARTIAL!
LIBERALIZATION OF FDI: CHEERS FOR INSURANCE, DEFENSE & REAL ESTATE; BABY STEPS FOR RETAIL?
FINANCIAL SECTOR REFORMS: STREAMLINING AND EASING NORMS
CAPITAL MARKET REFORMS: REFORMING THE IDR AND ADR FRAMEWORK
INCREASE OF HOLDING PERIOD FOR UNLISTED SHARES ON CAPITAL GAINS: NEGATIVE IMPACT FOR PRIVATE EQUITY AND M&A
CERTAINTY TO FPIS ON CHARACTERIZATION OF INCOME; FINE TUNING STILL NEEDED
GAAR/ANTI-AVOIDANCE PROVISIONS: LACK OF CLARITY CONTINUES
FOREIGN BORROWINGS: MIXED BAG OF BENEFITS
TAX DISPUTE RESOLUTION – ADVANCE RULINGS AND SETTLEMENT PROCESSES TO PROVIDE RELIEF
RESOLVING TRANSFER PRICING DISPUTES: SOME MORE PROGRESS
FOREIGN DIVIDENDS: INCENTIVE TO BRING BACK FUNDS CONTINUED IN PERPETUITY!
INDIRECT TAX TRANSFER: SOME RELIEF? DIRECT OR INDIRECT?
In spite of this Budget being generally in sync with the Finance Minister’s commitment to “provide a stable and predictable taxation regime that would be investor friendly and spur growth”, the Finance Bill, 2014 (Bill) provides little relief in respect of the real elephant in the room i.e. the retrospective indirect transfer tax provisions. To rewind to the origins of the provisions, Indian revenue authorities initiated high profile litigation against Vodafone International Holdings BV (Vodafone) in relation to the purchase by Vodafone of an offshore company which indirectly held assets in India. Claims were initiated on the basis that Vodafone had failed to withhold Indian taxes on payments made to selling entity, Hutchison Telecommunications International Limited and the matter was litigated up to the Supreme Court of India, which ruled in favour of Vodafone. The Supreme Court held, inter alia, that there was no Indian tax chargeable in respect of a transfer of offshore assets between the two non-residents. Shortly after the judgment was delivered by the Supreme Court, the Government introduced these provisions which became retroactively applicable.
The constitutional validity of these amendments is currently under challenge in more than one High Court, on account of important issues such as the applicability of indirect transfer provisions to listed companies, issues on the attribution of value, adjustment of cost of acquisition, territorial nexus etc. An expert committee was also set up under the leadership of Dr. Shome, which made several recommendations which are yet to find their way into the law.
Since their introduction in 2012, with retroactive applicability from 1961, the provisions have single-handedly been responsible for significant deterioration in investor sentiment. They have also plagued cross-border M&A and restructuring-related activity on account of their widely worded and ambiguous scope. Considering the ruling Government’s public statements on “tax terrorism” during its election campaign, it was expected that some relief would be provided on this account in the Budget. However, aside from some lip service to the issue, stating that retrospective amendments would be used sparingly, no other changes have been made in the Bill. The Budget speech has indicated that existing litigations will be carried through to their logical end. However, the Finance Minister has indicated that transactions which would come under the purview of these provisions henceforth will be scrutinized by a High Level Committee which will be set up by the CBDT before any action is initiated in such cases, and it is expected that official communication may be released on this issue in the near future. The Finance Minister has clarified (in a post-Budget interview) that assessing officers will not issue notices in relation to these provisions and in case a notice has been issued, the taxpayer can approach the CBDT for relief. It would also need to be seen that if a differential approach is adopted for existing litigations and for new transactions that come within the purview of tax authorities, whether such differential treatment can withstand a constitutional challenge on the right to equality.
With a view to incentivizing the Indian real estate market, SEBI released the draft SEBI (Real Estate Investment Trusts) Regulations, 2013 on October 10, 2013 following which the framework for listed REITS has been put in place in India. REITs would serve as an asset-backed investment mechanism where an Indian trust is set up for the holding of real estate assets as investments, either directly or through an Indian company set up as a Special Purpose Vehicle (SPV). Please click here for our article where we previously discussed further details on this measure. However, till date, there was no clarity on the proposed tax regime, which is a key element for enabling a successful REIT regime.
The Bill proposes to add several amendments to the Income Tax Act (ITA) to clarify the income tax treatment of REITs and infrastructure investment trusts (collectively referred to as REITs in this piece). These provisions have been incorporated depending on the stream of income that the REIT is earning and distributing:
1. Income in the nature of interest
The Bill provides for a pass through treatment in respect of any interest income that is received by the REIT from an SPV. This will result in the REIT not being subject to any tax in respect of such interest income, whereas the investors will be subject to tax on the same. However, there would be a levy of withholding tax that would be imposed on distribution by the REIT to its unit holder. This withholding tax would be at the rate of 10% if paid to resident unit holders and 5% if paid to non-resident unit holders.1 In case of non-resident unit holders, the 5% tax would be the final tax payable by the non-resident, while in case of residents, they will be subject to tax as per the tax rate applicable to them. The pass-through treatment, along with the low rate of withholding tax for non-residents, will benefit non-residents to take exposure to REITs in India.
2. Income in the nature of dividend
Where dividends are distributed by the SPV to the REIT, the existing provision dealing with Dividend Distribution Tax (“DDT”) under Section 115-O of the ITA would apply and the SPV would face a 15% tax on distribution with no further liability on the REIT as a shareholder. Further, the Bill proposes that any income distributed by the REIT to its unit holder that is not in the nature of interest or capital gains is exempt from income tax. Therefore, distributions of dividends received from the SPV by the REIT to the unit holders would be exempt from tax in India.
3. Income in the nature of capital gains
Where the REIT earns income by way of capital gains by sale of shares of the SPV or by sale of the real estate assets held by it, the REIT would be taxed as per regular rates for capital gains under Section 112 i.e. 20% for long term capital gains (LTCG) and slab rates for short term capital gains (STCG). However, further distribution of such gains by the REIT to the unit holder is proposed to be exempt from tax liability. Separately, where a unit holder disposes of units of a REIT, LTCG (units held for more than 36 months) would be exempt from tax and STCG would be taxed at 15% since units would be treated as listed securities under the ITA.
4. Income in the nature of business profits/lease rentals/management fee
Chapter XII-FA is proposed to be added to the ITA by which Section 115UA is to be included for dealing with the taxation of income earned by a REIT that is not in the nature of capital gains or interest income. All such income is proposed to be taxed in the hands of the REIT at the maximum marginal rate i.e. 30%. This would apply in a situation where the REIT is holding the assets directly or in situations where they are charging fees to the SPV. Such income, while distributed by the REIT to the unit holders would be exempt in the hands of the unit holders.
5. Tax treatment of the sponsor
The Bill proposes to make the transfer of shares of the SPV into a REIT in exchange for issue of units of the REIT to the transferor (or the sponsor) exempt from capital gains tax under the ITA. However, although the units of a REIT would be listed on a recognized stock exchange, specific amendments are proposed to exclude units of REITs from the exemption of tax on LTCG and the reduced rate of 15% for STCG, if sold by the sponsor. Therefore, rates of 20% for LTCG and slab rates for STCG would be applicable for sale of units of REITs by the sponsor.
Moreover, amendments are proposed to exclude units of a REIT from the beneficial holding period of 12 months as well for LTCG to apply and a holding period of 36 months is proposed. However, it is proposed that the cost of acquisition of the shares of the SPV by the sponsor shall be deemed to be the cost of acquisition of the units of the REIT in his hands.
In addition to the above, the Bill has also proposed that Securities Transaction Tax is to be payable for listing of units of a REIT.
Although the SEBI regulations dealing with REITs allow them to hold real estate assets either directly or through an SPV, the tax benefit for a sponsor to set up a REIT has been extended only to cases where real estate assets are held by the REIT through an SPV. This creates an issue where a sponsor wants to transfer the assets directly into the REIT and not transfer of shares by the sponsor. While, an argument can be taken that such transfer should be subject to tax under the trust taxation regime, the industry was expecting that a specific provision would be provide to enable such transfers without any tax incidence. This can be a substantial dampener for investors looking to set up REITs to invest in the Indian real estate industry or to hold existing investments in India through REITs since the option of holding real estate assets directly through a REIT may involve a tax leakage. Further, the tax pass through available in respect of interest income can become limited use if the REIT can only acquire shares from sponsor's and not acquire assets without a tax incidence for the sponsor. An additional issue that is outstanding is in cases where assets are held in a LLP and on the tax treatment in order to transfer the partnership interest to the REIT.
Although the REIT regime is a step forward in establishing an investment friendly regime, it is hoped that the Finance Ministry would address the above issues going forward and possibly simply the REIT taxation regime. It should be noted that almost all countries provide for a complete pass through regime for REITs if the prescribed regulatory criteria is met and a move towards that will further increase interest in this space.
Leading up to the elections, the stance of the current government has been in support of foreign direct investment in sectors where growth and investment is required. The sole sector where reservations were expressed has been in multi-brand retail. Although no comments have been made in this regard, the Finance Minister made specific reference to boosting the India growth story, and from that perspective has proposed liberalization to the defense, insurance, real estate and manufacturing-retailing industries.
The Finance Minister noted the need to, (a) reduce dependency on foreign defense equipment; and (b) incentivize the nascent defense manufacturing industry in India. Towards this end, the Finance Minister has proposed to liberalize the sectoral cap on foreign investment in the defense sector. Previously, foreign investment in the defense sector was allowed up to 26% under the government route (i.e. with the approval of the Foreign Investment Promotion Board). For investment higher than 26%, specific approval of the Cabinet Committee on Security had to be sought which approval would be provided on a case by case basis in cases where it was “likely to result in access to modern and ‘state-of-art’ technology in the country”. The above mentioned limit of 26% is now sought to be been raised to 49% under the government route subject to full Indian management and control. Currently the FDI Policy prohibits portfolio investment by FIIs / FPIs in the defense sector. The Finance Minister while increasing the composite cap of foreign exchange from 26% to 49% has not clarified whether this prohibition will continue. For an economy that ranks in the top ten in terms of defense expenditure, the market for defense manufacturing (especially domestically) should be ripe. Institutional investors provide precisely the kind of capital the government would want to encourage i.e. pure economic interest with no expectations on control. It is therefore, hoped that in the fine print, this restriction will be removed.
A similar liberalization has also been proposed for the insurance sector which the Finance Minister has noted is “investment starved.” Currently, foreign investment in the insurance industry stands at 26% under the automatic route. It is now proposed to be allowed up to 49% under the government route, subject to Indian management and control. Although not expressly stated, it can be assumed reasonably that investment up to 26% will continue to be under the automatic route, and from 26% till 49% will require the specific approval of the Foreign Investment Promotion Board. This investment cap is likely to include investment by non-resident Indians and FII / FPI. The insurance sector in India was first opened up over a decade ago, since then more than INR 300 billion have been infused into the industry. Yet, insurance coverage in India is in single digits. Given the burgeoning middle class story and a market for expansion, an increased sectoral cap may just be what the insurance sector (wants and) needs.
What would be important to keep an eye on is the references to “Indian management and control” stated against both the defense and the insurance sector reforms. It is likely that management and control will be tested under the parameters set out by the Reserve Bank of India late last year. The definition of control was revised by the Reserve Bank of India last year2 wherein it had also moved towards the definition promulgated and accepted by the Securities and Exchange Board of India. By including the concept of ‘Indian management and control’, there is an emphasis on the definition of control which was introduced to ‘include the right to appoint a majority of the directors or to control the management or policy decisions including by virtue of their shareholding or management rights or shareholders agreements or voting agreements’. Hence, it would be interesting to see how the negative veto rights, etc. are perceived in these sensitive sectors. Therefore, it is important to note that control would mean: (a) effective control; and (b) will be a substance based test that will be determined by the facts and circumstances. The fine print in this regard would be important to understand the scope of this requirement.
Giving another edge to the Prime Minister’s vision of ‘one hundred Smart Cities’, the Finance Minister proposed key reforms to foreign investment in the real estate and development sector. Previously, in order to qualify for foreign direct investment (FDI), the project size had to be a minimum of 50,000 square metres and at least USD 10 million had to be infused for a wholly owned subsidiary. This was a major challenge since in Tier I cities which formed a bulk of the demand demography, finding such a large project was difficult, whereas in Tier II and III cities where such projects were available, the demand was not sufficient enough to warrant investor interest. Through this Budget, the Finance Minister proposes to reduce the requirement of 50,000 square metres to 20,000 square metres, and the capitalization requirement (for a wholly owned subsidiary) from USD 10 million to USD 5 million respectively. This has partially addressed the long standing demand of the industry, which was expecting a reduction to 10,000 square metres, since even 20,000 square metres could be difficult for some Tier I cities (ex –Mumbai). However, this relaxation should provide impetus in development of smart cities providing habitation for the neo-middle class, as is contemplated in the Budget.
In addition, to further encourage this segment, projects which commit at least 30% of the total project cost for low cost affordable housing will be exempted from minimum built-up area and capitalisation requirements under FDI. This could provide a major fillip to affordable housing projects where the size of the project is less than 20,000 square metres. Also, though the provision is yet to be introduced, the proposition of the Finance Minister to include slum development in the statutory list of corporate social responsibility activities is encouraging.
The Finance Minister has also stated in his speech that retail sale by manufacturing units including sale via electronic platform (i.e. e-commerce) would also be allowed under the automatic route. There always seemed to be a disconnect between the intention of the regulator with respect to its views on FDI in manufacturing and FDI in retail (single-brand and multi-brand) / e-commerce. Although the Finance Minister does not seem to have opened up the e-commerce sector to foreign participation, emphatically permitting manufacturing companies having FDI to use the electronic platform for retail sales will provide great relief to such entities who have otherwise had to depend on other sources to sell their products online.
The budget has laid emphasis on the banking and financial services sector through channelizing resources to key policy focus areas as well as concentrating on improving the fundamental ecosystem for the sector.
a. PSU banks likely to get more retail investments and see consolidation
Public sector banks in India have most of their shareholding held by the Government with minimal retail / institutional participation. Also, in order to meet the higher capital requirement that the Basel III norms prescribe, there is an eminent need to increase the capital base of PSU banks. Recognizing this need, the budget has recommended that additional capital can be brought in by tapping domestic retail investors, thereby increasing their stake in PSU banks. However, it was highlighted that majority Government ownership of these banks would be preserved though some extent of greater autonomy with accountability will be considered.
Additionally, the Government is in-principle considering proposals for consolidation of PSU banks. Such M&A activity should provide for efficient utilization of resources through improved economies of scale. However, the impact on consumer welfare would need to be carefully managed.
b. FSLRC initiatives and banking sector measures
Appreciating the initiatives of the Financial Services Legislative Reforms Commission (FSLRC), the Budget promises to expeditiously take the same forward. Some key measures proposed by the Budget include:
With the objective of furthering the development of Indian capital markets, the Finance Minister has stressed on developing a vibrant corporate bond market, currency derivatives market and depository market in India by eliminating unnecessary restrictions in the existing frame work.
a. Revamping the Indian Depositary Receipts (IDR) Regime
Since the introduction of the IDR Regime, India has only witnessed one IDR listing. The IDR Regime was expected to facilitate capital raising by foreign investors from the domestic market in India, and at the same time provide domestic investors an opportunity to make investments in securities of well-recognized multinational companies listed on developed markets. However the existing regime is fraught with shortcomings such as:
1. Limited two way fungibility: Initially the regulations for IDRs did not allow holders of underlying equity shares to convert such equity shares into IDRs. However, redemption of an IDR into underlying equity shares was permissible subject to the fulfillment of certain conditions. As an impetus for the issuance of IDRs, SEBI and RBI in August 2012 provided for a limited two-way fungibility. Despite this change, Indian stock exchanges have not seen a foreign company seeking to list its IDRs.
2. Uncertainty on taxation: At present tax implications at the time of redemption of IDRs into underlying equity shares are not provided under the ITA. Accordingly, any gains arising on redemptions of IDRs into the underlying equity shares, if not specifically exempt under the IT Act, would lead to the situation of the holder being subjected to tax in the absence of any realized gains, and hence making a redemption unattractive
The Finance Minister proposes to introduce a much more liberal and ambitious Bharat Depository Receipt which will hopefully overcome the shortcomings and achieve the desired objective of the increasing the exposure of foreign companies to Indian capital markets.
b. Expanding the ADR/GDR framework
At present, the depository receipts can be issued only against equity shares as underlying securities. The Finance Minister has proposed to allow issuance of depository receipts with all permissible securities as underlying securities. This is a welcome acknowledgement of the recommendations of the Report of the Committee to Review the FCCBs and Ordinary Shares (Through Depository Receipt Mechanism) Scheme, 1993 provided under the chairmanship of Shri M. S. Sahoo in November 2013. With this proposal expected to take effect though necessary legislations in the coming days, issuance of depository receipts against any underlying securities i.e. equity or debt; by any issuer, listed or unlisted, may be permissible.
c. Dampener for Mutual funds
Presently, for the units of mutual funds (other than equity oriented funds), the capital gains arising on transfer of units that are held for more than a year are taxed at a concessional rate of 10%. The Finance Bill seeks to increase the rate of tax on long term capital gains to 20% on transfer of units of such funds. Further the period of holding required to avail such long term capital gain has been increased from 12 months to 36 months for this purpose. The enhanced tax leakage will act as a dampener for the debt oriented Indian mutual fund industry in general and for Indian corporates in particular who park surplus cash in such funds. A short term holding for treasury operations may become less tax-efficient for them.
INCREASE OF HOLDING PERIOD FOR UNLISTED SHARES ON CAPITAL GAINS: NEGATIVE IMPACT FOR PRIVATE EQUITY AND M&A
‘Capital gains’ are classified as LTCG and STCG depending on the period for which the transferred asset was held by the transferor till the date of transfer (Holding Period). Accordingly, higher tax rates are also applicable to STCG. While the Holding Period applicable for LTCG is 36 months for all assets, an exception was drawn out under the ITA for shares of any company and other listed securities where the Holding Period applicable was 12 months.
The Bill, however, proposes to amend the definition of STCG to restrict the beneficial holding period of 12 months only to listed securities, thereby excluding unlisted shares (whether of a public limited company or a private company) from this benefit. This move would adversely impact most investors since they have been entitled to beneficial rates of 20% (or in some cases, 10%) for LTCG in India on exits from unlisted companies undertaken after a one year period. Owing to the STCG characterization that would be given to any exit undertaken prior to a 3 year holding of such shares, investors could face a substantially larger tax demand i.e. at progressive rates (between 10%-30%) for Indian/foreign individuals, 30% for Indian/foreign unincorporated entities, 30% for Indian corporate investors and 40% for foreign corporate investors.
Although private equity investors would generally have a longer Holding Period than just 3 years in respect of Indian investments, there may be instances of exit opportunities in a shorter span of time in which case there would be an additional tax burden.
While the Finance Minister has spoken of reviving the economy and promoting investment in his Budget speech, such additional tax burden goes against this spirit and would dampen the investment climate.
The Finance Minister, in his maiden Budget speech has provided much needed clarity on the characterization of income of FPI registered with and investing under the Securities and Exchange Board of India (SEBI) regulations.
Under these amendments, securities held by an FPI will be considered “capital assets”, and gains derived from their transfer will be considered capital gains. As a result of this amendment, gains arising on disposal / transfer of a range of listed securities including shares, debentures and eligible derivative instruments as may have been acquired under applicable laws, shall be taxed as capital gains (and not business income) under Indian domestic law.
The characterization has been a long standing point of contention under Indian tax law – this is because, under Indian tax treaties, the business income of a non-resident is not taxable in India unless the non-resident has a permanent establishment in India. In comparison, capital gains are generally taxable unless the non-resident invests through a favourable treaty jurisdiction such as Mauritius, Singapore or Cyprus. While revenue authorities have tended to treat the income of FII / FPI as capital gains on this account, the position has undergone much litigation in the past.
This move therefore provides certainty to FPIs, and comes as a relief to various categories of FPI investors, such as foreign individuals/companies and other broad-based funds that tend to have brokers and fund managers operating from India. Funds that have been taking the position that such income results in business income may need to re-visit their fund structure due to this development, especially if they are situated in jurisdictions such as the US and the UK which do not contain favourable capital gains provisions in their treaties.
Another issue with this characterisation will be that Indian tax jurisprudence has typically treated derivative transactions as resulting in business income. However, for FPIs, all investments will be considered to result in capital gains, irrespective of whether they are in derivatives. This will limit the ability of the FPI to claim and setoff losses from such investments, and will lead to an anomaly where non-FPI investors may get business income characterization on derivatives while FPIs would get capital gains characterization.
Another important issue will be the issue of treaty eligibility to FPIs and other foreign investors, particularly if their income is characterized as capital gains. With the general anti-avoidance rule looming around the corner, investors are likely to be apprehensive about whether Indian tax authorities will continue to respect treaty benefits to Mauritius and other jurisdictions on the basis of tests laid down in the past.
It was also suggested in the budget speech that, clarity may be provided that fund managers of FPIs who are present in India would not create a permanent establishment (PE) for the offshore funds in India. Management teams for India-focused offshore funds are typically based outside India as an onshore fund manager enhances the risk of the fund being perceived as having a PE in India.3Consequently, the profits of the offshore fund are taxable in India to the extent attributable to the PE. The measure by the Finance Minister is intended at providing an impetus to fund managers to operate from India.
The key anomaly here is that if FPI income is to be characterized as capital gains, it is unclear why the PE exclusion would be of benefit to FPIs. The constitution of a PE only exposes the business income of a non-resident to risk – FPIs who have capital gains would be subject to tax under Indian source rules if the asset transferred is situated in India, absent treaty benefits on capital gains. Also, the budget speech did not, unfortunately, discuss whether an exemption would be extended to the managers of private equity funds who are more likely to require an on ground presence in India in comparison to FPIs.
Another issue will be the exposure due on account of automated trading platforms installed on servers present in India. A particularly interesting case would be hedge funds that rely on co-location servers in Indian exchanges. There could be a case of potential tax exposure in India if the hedge fund trades are based on algorithms running on India based servers. The actual text of the circular covering this aspect would need to be seen to understand the coverage of the safe harbor. While we wait and watch for official communication on this front, it is hoped that these issues will be dealt with as well.
Owing to the wave of expectation that was generated by the new Government, investors were hoping for a relaxation of the multitude of anti-avoidance provisions, including the General Anti-Avoidance Rules (GAAR) which were added to the Income Tax Act, 1961 in the last 3 years. Moreover, there was also wide speculation in the media as to the deferment of the GAAR by a further 1 or 2 years to promote investment. As it stands today, the GAAR provisions will be effective from April 1, 2015.
The Budget is however silent on the GAAR and neither is there a change in the text of the GAAR provisions nor a positive observation from the Finance Minister on the issue. This is a dampener for foreign investors since it was hoped that the GAAR would either be deferred or rationalized so as to bring it more in line with global standards. Similarly, beneficial changes to several other anti-avoidance provisions such as broad amendments for taxing of capital receipts under Section 56 would have been desirable for promoting India as an investment destination. This is more so as the Finance Minister has stressed on creating an investment friendly climate in his Budget speech. Owing to the importance of this issue, it is hoped that the Government comes out with more guidance on these issues over the course of time.
Section 194LC provides for a lower tax withholding at the rate of 5% on interest payments made by an Indian company to non-residents on foreign currency denominated borrowings by it under a loan agreement (obtained under Foreign Exchange Management (Borrowing or Lending in Foreign exchange) Regulations 2000 or “ECB regulations”) or through the issuance of long-term infrastructure bonds provided that the interest is not more than State Bank of India’s prime lending rate (PLR) plus 500 basis points. However, the provision had a sunset clause till July 1, 2015. The Bill seeks to extend this benefit to cover any borrowings made from July 1, 2012 to July 1, 2017. The Bill also proposes to extend the coverage of section 194LC to any kind of long-term foreign currency bond issued on or after October 1, 2014 but before July 1, 2017.
However, the above benefit has not been extended in respect of any rupee-denominated bond issued to FIIs and FPIs. The Finance Act, 2013 had introduced section 194LD of the Income Tax Act, 1961 which provided for a lower withholding tax of 5% provided that such interest income was payable on or after June 1, 2013 but before June 1, 2015.
Most of the FII / FPI investments in the real estate sector are through subscription/purchase of into listed, rupee-denominated debt instruments issued by Indian companies or non-convertible debentures (NCDs). It was expected that the concessional withholding tax rate would be extended beyond the original sunset period of June 1, 2015. However, the Bill has left section 194LD unchanged. In the absence of such extension, interest payments to FIIs are otherwise subject to a withholding tax rate of 20% subject to benefits that may be available under the provisions of a tax treaty entered into between India and the jurisdiction in which the FII / FPI is resident.
Tax litigation has become a serious issue in India, with about INR 4 trillion under dispute and litigation before various Courts and Appellate authorities. The increasingly adversarial and fractious relationship between the taxpayer and revenue authorities has been recognized as being problematic, and some efforts have also been made over the last few months by the Tax Administration Reform Committee (TARC) under the leadership of Dr. Shome. The Finance Minister made further proposals to resolve the problem in his Budget speech - while these are yet to find place in the form of a proposal in the Bill, they will be important nevertheless if they are brought into force.
The first proposal is to allow resident taxpayers to file for advance rulings on their tax liability. Presently, under Section 245N of the ITA, only a non-resident; a resident having a transaction with a non-resident; or a notified public sector unit is eligible to apply for an advance ruling on its potential tax liability. Extending this facility to residents would relieve the overburdened Indian courts and also provide much needed certainty to resident taxpayers. Advance Rulings have, except in the recent past, been successful as the Chairman of the Authority for Advance Rulings (AAR) is a retired Supreme Court judge who is able to decide upon complex and emerging issues of taxation on which there is limited precedent, in an expeditious manner.
The standard assessment proceedings and appellate processes tend to take several years and are expensive, aside from requiring the taxpayer to deposit a certain portion of the tax to go on appeal. This is often not feasible for all taxpayers, and resident taxpayers are likely to benefit from the flexibility and certainty, particularly once the General Anti-Avoidance Rules become effective starting April 1, 2016.
The second proposal deals with the practical issue of a backlog at the AAR over the last few years. While the AAR is under a statutory obligation to pronounce a ruling within six months of the filing of an AAR application, some applications before the AAR have been pending for up to two-three years. This defeats the purpose of this system which was intended to be a speedy and efficient mechanism for ensuring tax certainty. Recognizing this problem, the Finance Minister has proposed the constitution of additional AAR benches, which will provide much relief.
Another significant proposal that the Finance Minister touched upon in his speech, but which did not find any mention in the Finance Bill is the enlargement of the scope of the Settlement Commission. Recommendations to this effect were reflected even in the first report of the TARC which was submitted to the Finance Minister in June. This mechanism is intended to make the settlement of tax disputes a more collaborative process aimed at strengthening taxpayer confidence in the revenue system as opposed to an adversarial one where the revenue authorities look at applying coercive measures to ensure compliance by the taxpayer.
This mechanism permits the referral of any assessment or reassessment proceedings or appeal or revision from the same (filed within the limitation period), which may be pending before any revenue authority, for settlement through this alternative dispute resolution (ADR) mechanism. However, it requires the taxpayer to disclose income that has not been disclosed to the tax department and mandatorily pay the full amount of tax and interest on such additional income before filing the application.
While out-of-court settlement of tax disputes is still in its nascent stage in India and there has been limited comment on this issue by the Finance Minister, other jurisdictions such as UK and Australia have been quite successful in implementing ADR in tax disputes; and we may have lessons to learn from them. The HMRC, for instance, has adopted a risk based approach in pursuing tax avoidance. So where there is a higher chance of a successful outcome for the HMRC, it will not seek to settle the dispute out of court for less than 100% of the tax.4 But “low risk” companies have been promised a “light touch”. By pursuing a risk based approach as opposed to targeting industries or jurisdictions, it has been able to target tax avoidance, while at the same time improving its relationship with large businesses and not pursuing frivolous litigation.
Measures such as suspending all or parts of the penalties pending against taxpayers, where “careless errors” have been made by the taxpayers, on the condition that they comply with the conditions imposed by the HMRC points towards a system that encourages behavioural change and long term investment in improving accountability and compliance with the law as opposed to mere revenue generation5. Introduction of similar measures in respect of the Settlement Commission would be welcome.
India has been overwhelmed by a large number of transfer pricing (TP) disputes over the last few years, with around 3,200 transactions taken for TP audits in 2012-13 alone and an aggregate adjustment of around INR 700 billion made. These cases have strained the resources of taxpayers, the tax administration and courts alike, and efforts have been on to introduce some degree of certainty into what is admittedly a very subjective space.
This process began in 2012 with the introduction of an Advance Pricing Agreement (APA) scheme, which allowed taxpayers and the revenue to enter into pricing arrangements relating to specified transactions. The scope of an APA could include specifying transactions covered by it, the agreed TP calculation methodology, a determined arm’s length price (ALP) and assumptions which must be true for the APA to remain binding.
In this year’s Budget speech, the Finance Minister stated that the APA authorities would be provided with additional resources to expeditiously clear APA applications (and possibly take on more applications). A ‘roll-back’ provision is also proposed, so that the price determined by an APA can be applied to international transactions undertaken by a tax payer in the previous four tax years from the date of the APA. This would allow assesses to not only avoid future disputes over transfer pricing but also provide clarity on past disputes, which would reduce some litigation.
Two important changes are proposed on the methodology for determining an appropriate price. While these were suggested by the Finance Minister in his speech and are yet to form part of the law, they would provide much relief to taxpayers if introduced. The first measure is to allow multiple year data for determining the arm’s length price – this will be very important, particularly to taxpayers who may have difficulty finding appropriate comparables in the same year or where sudden changes in market conditions have caused significant or atypical price variations. The second measure has been to allow for a range concept for determining arm’s length price. Currently Indian tax laws compute arm’s length on the basis of an arithmetic mean, whereas the OECD standard is to use an arm’s length range of prices, which allows more flexibility. For instance, an inter-quartile range could be helpful in periods during which there are fluctuating economic and market conditions. This measure is also much appreciated and will go a long way in clearing out TP related litigation.
A third substantive provision, has been that the existing TP provisions apply to certain ‘international transactions’ between associated enterprises (AEs), and in certain cases, between unrelated third parties. The requirement in all instances is that at least one of the AEs has to be a non-resident under Indian tax law. In cases where an unrelated party has a prior agreement with an AE of an enterprise in relation to a transaction between the unrelated party and the enterprise, this third party may be deemed to be an AE of the enterprise. The Bill proposes to amend Indian tax law to clarify that such a third party (deemed AE) could be either a resident or non-resident of India. This has an impact on transactions where an Indian entity is acting as a ‘warehousing entity’ or is entering into an arrangement at the behest of the AE’s. This will work towards plugging some anomalies in the scope of the TP provisions.
The Finance Act, 2011 had introduced a lower rate of 15% tax in respect of dividends received from outbound investments by domestic companies (where more than 26% of equity share capital is held by the domestic company). This benefit was available for financial year 2011-12 and was extended for one more year. The Bill proposes to extend this benefit indefinitely. This proposal aims to bring about long term certainty in this respect and will incentivize companies to repatriate funds into India, especially for those who have made successful investments outside of India and want to bring back capital into India for investment purposes.
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1 This provision would be effective only as of 1 October, 2014.
2 As per Circular A.P. (DIR Series) Circular No. 44 dated September 13, 2013
3 However, it is important to note that the presence of fund management entities outside India is not entirely a consequence of the PE risk. Typically, fund managers are located in the same jurisdiction in which the fund entity itself is domiciled with a view to demonstrating substance in that jurisdiction which in turn may be necessary for retaining benefits under a tax treaty as well as to prevent scrutiny under anti-avoidance provisions including GAAR.
4 Companies which may have a number of unresolved issues with significant amounts at stake HMRC; See The High Risk Corporates Programme, available at http://www.hmrc.gov.uk/large-businesses/prog-approach.htm.
5 Alan Mac Pherson et. al, ‘United Kingdom’, Anuschka Bakker and Sander Kloosterhof (eds.) Tax Risk Management—From Risk to Opportunity IBFD (2010) p. 414.