Vol.

1 Issue 2 May 12, 2011

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Capital Gains – An all new classification

As part of BMR’s thought leadership initiatives, this bulletin, which is the second in a series
leading up to the legislation of the Direct Taxes Code Bill, 2010 (‘DTC’), aims at
Taxand conducted Global Survey
deconstructing and understanding the new legislation and to debate some of the issues 2011 – Taxand the CFO. Click
surrounding its introduction. This bulletin specifically looks at the capital gains tax provisions here to view full research findings.

in the DTC. PERE together with Taxand

produced the 2011 global guide to
Under the Income-tax Act, 1961 (‘Act’), capital gains/losses arises on a transfer of a “capital tax, advising on real estate
asset”. A capital asset has been defined to mean any property of the taxpayer, whether or not investment opportunities. Click
here to view guide.
such property is connected with the business of the taxpayer, but excludes stock in trade,
consumables and raw materials held for the purpose of the business of the taxpayer. BMR Advisors, in association
with, IPPAI, has produced a
survey report "Impact of Taxation
The provisions of the DTC propose a paradigm shift with regards to the scope of capital gains
on the Energy Value Chain &
taxation. Under the DTC, capital gains/losses arise only on the transfer of “investment Electricity Prices in India",
assets”. analyzing the present regulatory
and policy framework for the
energy sector . Click here to view
What are investment assets?
report.

From the manner in which the term “investment assets” has been defined in the DTC, it
appears that the category of investment assets is significantly narrower as compared to the
current category of capital assets under the Act. Click here to view archived
webinar – “Insights into the India
The DTC defines investment assets to mean – Budget 2011”

Securities held by Foreign Institutional Investors (‘FII’);

A business undertaking/division of the taxpayer; and

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All capital assets which are not business capital assets.
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Therefore, transfer of capital assets connected with the business of the tax payer, which are (Private Equity) according to the
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currently covered under the capital gains provisions of the Act are specifically kept out of the
for the first quarter of 2011
scope of capital gains tax under the DTC. Hence, it appears that any gain/loss made from the
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transfer of business related capital assets would now get covered under the head “income
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from business” and not capital gains. The meaning of “business capital assets” would awards at 5th International Tax
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The term “business capital asset” has been defined under the DTC to mean any capital asset
“World Tax 2011” guide, to the
self generated in the course of business, any intangible asset related to the business World’s leading tax firms.
(goodwill, trade mark/brand name, right to manufacture/carry on business, tenancy rights,
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capital asset, not being land, connected with or used for the purposes of

any business of the taxpayer.

Kalpesh Maroo
This definition of business capital asset and particularly the residuary clause highlighted
Sharath Rao
above is wide and can potentially have large ramifications.

Classification issue

This discussion leads us to the issue whether all the capital assets of a business concern
would be regarded as business capital assets under the DTC?
As the term “connected with” can bring within its ambit any capital asset that has some Mukesh Butani, New Delhi
+91 124 339 5010
connection with the business of the tax payer, the definition of business capital assets seems
mukesh.butani@bmradvisors.
to be an all encompassing one. Adding to this issue is that the term “business” has also been com

widely defined to include ‘any trade, commerce or manufacture; or any adventure or concern
Rajeev Dimri, New Delhi
of that nature or any profession or vocation’. +91 124 339 5050
rajeev.dimri@bmradvisors.com
A question which arises is if a commercial concern (say a Company) is seen as always being
Bobby Parikh, Mumbai
set up with some commercial intent (primary or incidental), would all the assets of such a +91 22 3021 7010
bobby.parikh@bmradvisors.
concern then be regarded as business capital assets, irrespective of how connected they are
com
with the main business of the tax payer?
Abhishek Goenka, Bangalore
In deciding this question, one could argue that the aspect of proximity of the asset with the +91 80 4032 0100
abhishek.goenka@bmradvisors.
main business of the tax payer has to be checked before concluding on whether the asset is a com
business capital asset or otherwise. Conversely, one could also argue that the definition of
Sriram Seshadri, Chennai
business is very wide and all activities of a concern (barring probably one-off activities) could +91 44 4298 7000
sriram.seshadri@bmradvisors.
potentially be classified as a business and by implication all assets used or connected with
com
such activities could be classified as business capital assets.
Amod Khare, Singapore
Clearly, the classification of assets into business capital assets and investment assets is, +65 6408 8004
amod.khare@bmradvisors.com
potentially, going to be an area of significant dispute going forward.

Impact

The classification of income from the sale of assets into income from sale of business capital

assets and income from sale of investment assets is important since under the DTC, as is the
case of the Act, income is classified under different heads (such as capital gains, income from
business, etc) and the computation machinery, exemptions available, etc are separately
provided for each head of income. Discussed below are some of the potential consequences

arising on account of the classification issue -

a) Tax neutral transactions

In case of tax neutral transactions like corporate restructuring involving amalgamations,

de mergers, etc, the capital gains tax exemption applies to only “investment assets”.

Hence, while the assets being transferred by the transferor companies may qualify for
the exemption (since an undertaking or a division of a business is treated as an
investment asset), the shareholders of such companies receiving shares in the
transferee company may not qualify for the exemption unless the shares held by them
qualify as investment assets. Similar question arises when assets are transferred

between a holding company and its wholly owned subsidiaries or when assets are
distributed by a liquidating company to its shareholders. Assets involved in a gift or
inherited under a will also have similar implications.

b) Shares and investments held by investment companies, holding companies and FIIs

For an investment company or a group holding company whose assets consist primarily

of shares and securities of other companies, there is high likelihood of such assets not
being regarded as “investment assets” as the principal business activity of such entities
would be to hold shares in various companies.

For offshore holding companies, this would raise interesting issues regarding the
eligibility of such companies to rely on the capital gains tax relief under certain Tax
Treaties (“Treaty”). As a general principle, if the relevant article in the Treaty dealing with
capital gains, specially deals with the treatment of income on the transfer of an asset

(such as shares), then the taxability would be on the basis of such an article as against
examining taxability under a more general head such as business income,
notwithstanding the fact that under the DTC, the income of such a non resident may be
taxable as business income. Needless to say that the ultimate eligibility in each instance
 would need to be determined based on specific language of the Treaty and the facts on
hand.

Curiously, securities held by FIIs are specifically defined to be an investment asset. Such
a specific classification would add an interesting angle to the current debate of
classification of the income earned by FIIs into business income or capital gains. Several

FIIs operating out of countries such as US, UK currently claim shelter under the business
income article on the basis that they don’t have a permanent establishment in India.
Given the specific classification of their income as capital gains under the DTC, the
eligibility of such FIIs to rely on the business income article under the DTAA going
forward would be a significant challenge for many of these FIIs.

c) No indexation of the cost of acquisition/improvement

If an asset is not classified as an investment asset it would mean that the cost of
acquisition of such assets will not be indexed (an adjustment for inflation), which
otherwise is available for certain investment assets under the DTC. This could have far

reaching consequences for assets which are currently held as capital assets and which
have assumed significant value over their holding period. The issue is accentuated in

these cases as there is no transitionary provision that applies to assets that get the
capital gains treatment under the current Act but could become “business capital assets”
under the DTC.

d) No beneficial treatment for shares and securities sold on which Securities Transaction

Tax applies

Under the DTC, for shares and securities (held as investment assets) which are sold on
a recognized stock exchange in India on which Securities Transaction Tax (‘STT’)
applies, there is standard deduction of 100% (if the securities are held for more than a

year) or 50% (if the securities are held for less than a year). Therefore, if as per the
classification rule, shares and securities are not categorized as investment assets, but as
‘business capital assets’, the standard deduction will not be available.

Conclusion
The classification issue seems to have the potential of creating a substantial shift in the
treatment of gains/losses arising from the transfer of capital assets. While there are

other issues within the capital gains taxing provisions (which we will discuss in our
forthcoming bulletins), all these recede to the background in comparison with the

classification issue. While the legislative change in the asset classification seems to be
a conscious decision, it is hoped that the fallout of such a change in classification,
including on the tax neutrality of certain transactions and Treaty characterization are
thought through and considered before the final draft of the DTC is released.

Disclaimer:

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express views or expert opinions of BMR Advisors. The newsletter is meant for general guidance and no responsibility for loss arising to any person acting or
refraining from acting as a result of any material contained in this newsletter will be accepted by BMR Advisors. It is recommended that professional advice
be sought based on the specific facts and circumstances. This newsletter does not substitute the need to refer to the original pronouncements.

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