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Direct Tax Alert Direct Tax Code Bill -2010 Focus on Foreign Institutional Investors
Volume: DTX/ 18 /2010 31 August 2010
The Finance Minister tabled the Direct Taxes Code Bill, 2010 (DTC 2010) in the Parliament on 30 August 2010 which is proposed to come into force on 1 April 2012.
In this issue:
Why is it important for you? Scope of new code relevant to FIIs Contacts
Why is it important for you?
Presently, the Income-tax Act, 1961 („the Act‟) governs the taxation of income earned in or from or with India. The Direct Tax Code, 2010 is proposed to replace the Income-tax Act, 1961. It is proposed to come into force from the financial year beginning 1 April, 2012. The draft Direct Taxes Code (DTC) along with a Discussion Paper was released on 12 August 2009 for public comments to simplify the direct tax legislation in India. Subsequently, comments were solicited from the public and examined by the Government. A Revised Discussion Paper was issued on 15 June 2010 to respond to the major concerns and comments of stakeholders. On 30 August 2010, the DTC Bill 2010 was presented in the lower house of the Indian Parliament.
2. Scope of the new Code relevant to Foreign Institutional Investors
Neither Foreign Institutional Investor nor securities held by them is defined in the Code. So the definitions under the SEBI regulations are extracted hereunder for ready reference. As per SEBI (FII) Regulations, 1995, "Foreign Institutional Investor" means an institution established or incorporated outside India which proposes to make investment in India in securities. Under the regulations an FII may invest only in the following:(a) securities in the primary and secondary markets including shares, debentures and warrants of companies, and (b) units of schemes floated by domestic mutual funds including Unit Trust of India, units of scheme floated by a Collective Investment Scheme. (c) dated Government Securities; (d) derivatives traded on a recognised stock exchange; (e) commercial paper; (f) security receipts.
2.1 Scope of taxable income
In India, the scope of total taxable income depends on whether the person is a resident in India or a nonresident in India. A resident in India is taxed on its global income; whereas a non-resident is taxed only on income accruing or deemed to accrue or received or deemed to receive in India . A company incorporated outside India will be treated as resident in India if its place of effective management at any time in the year is in India. An unincorporated entity is resident in India if the place of control and management of its affairs at any time in the year is situated wholly or partly in India
2.2 The taxation of the income earned from securities:
Dividend on shares: Exempt from tax in the hands of the FII in India. However the Indian company distributing dividend is required to pay dividend distribution tax of 15%. Interest (including interest on debentures /debt securities etc): taxable @20%. Income from units: Income from units of equity oriented mutual funds is exempt from tax provided the equity oriented Indian Mutual Fund pays income-distribution tax of 5% Income from units of mutual fund other than equity oriented fund: 20%
Presently under the Act, interest on securities was chargeable to tax @ 20%. However, interest on income-tax refund, interest on delay in open offer etc was chargeable to tax at the rate of 30% / 40% for non-corporate /corporate FII. Now under the code, all interest earned by the FII in India should be taxable at 20%. Presently all income from units were exempt from tax. Equity oriented mutual funds did not pay income distribution tax while debt and liquid mutual funds (i.e. funds other than equity oriented funds) paid income distribution tax.
The taxation of income earned on transfer of securities:
It is now provided in the direct tax code that any security held by the FII would be investment asset only thus giving rise to capital gains or loss on transfer of such investment asset. Further since the profits arising on transfer of securities should be capital gains, the question of whether the brokers, custodians, fund managers etc in India constitute permanent establishment of the FII in India should now not be relevant. Income under the head “Capital Gains” will be considered as income from ordinary sources. It will be taxed at the rate applicable to the taxpayer. The rate of tax proposed on foreign companies is 30% whereas on non-corporate e.g. trust, association of persons, etc is also at 30%. Levy of Surcharge and education cess to be done away with. Securities transaction tax is proposed to be continued. The rates of STT have not been specified in the Code and should be provided by under the Finance Act.
Computation of capital gains:
The capital gains will be the difference between the full consideration from the transfer of the investment asset minus the cost of acquisition of the asset, cost of improvement thereof and transfer-related incidental expenses. Capital gains arising on transfer of equity shares and units of equity oriented mutual funds which are subject to securities transaction tax: which are held for a period of more than one year shall be computed after allowing a deduction of 100 percent of capital gains. The Capital loss arising on transfer of such asset held for more than one year will be scaled down by 100% in a similar manner. which are held for a period of one year or less shall be computed after allowing a deduction of 50 percent of such capital gains. The Capital loss arising on transfer of such asset will be scaled down by 50% in a similar manner.
So long-term capital gains exemption continues for equity shares and units of equity oriented mutual fund chargeable to STT while long-term capital loss arising on sale of such assets are to be ignored. Short-term capital gains on sale of such investment asset, continue to be taxable @15%. For the purpose of exemption of gains, it is presumed that the investment asset should be held for more than one year from the date of acquisition as the code is silent on the start date.
Capital gains arising on transfer of other investment asset: transferred at any time after one year from the end of financial year in which asset is acquired by the person shall be computed after considering the indexed cost of acquisition. transferred at any time before one year from the end of financial year in which asset is acquired, no specified deduction or indexation is available.
Presently, long-term capital gains on sale of securities not chargeable to STT are taxed at 10% while shortterm capital gains on sale of such securities are taxed at 30%. Under the Code, all capital gains arising on sale of such securities should be taxable at 30% with benefit of cost indexation available for long-term investment asset. the cost of acquisition and the period of holding of such securities shall be determined on the basis of firstin-first-out method. The capital gains from all investment assets will be aggregated to arrive at the total amount of current income from capital gains. This will, then, be aggregated with unabsorbed capital loss at the end of the immediate preceding financial year (unabsorbed preceding year capital loss) to arrive at the total amount of income under the head “Capital gains”. If the result of the aggregation is a loss, the total amount of capital gains will be treated as „nil‟ and the loss will be treated as unabsorbed current capital loss at the end of the financial year. Capital loss to be allowed to set off only against capital gains. The capital loss can be carried forward for indefinite period.
Short-term loss earlier ignored under the Income-tax Act, 1961 for the exempt dividend on shares and income on units of mutual fund, is not provided for under the Code.
Income from debt securities
Interest (for this purpose includes dividends) stripping provisions are specified in the Code whereby interest stripped by sale and buyback are to be included in the income of the seller and the loss arising from such transaction for the buyer should be ignored. The income accruing from debt instruments transferred by any „person‟ at any time during the financial year shall not be less than the amount of broken period income from the instrument. Broken period income shall be calculated as if the income from such securities had accrued from day to day and been apportioned accordingly for the broken period.
Presently in case of FIIs, based on judicial precedent, the broken period interest on purchase and sale of securities is considered as cost of acquisition or sale consideration respectively as the debt securities are held as investment. The profit / loss on transfer of security is considered as capital gains / loss. Further interest income is taken only on coupon dates and interest accrued but not due is not offered to tax. With the introduction of the above provision in the Code, taxation of debt securities will now need to be examined.
Withholding of tax
There is no withholding of tax where the payee is a non-resident, being a foreign institutional investor, on any payment made to it as a consideration for sale of securities listed on a recognized stock exchange.
Would withholding of tax be attracted on capital gains arising on sale through open offers, buy back of shares and transactions not through the recognized stock exchange.
Rate of Tax withholding on other income is as under: Nature of Income Interest profit distributed by a Fund on which income distribution tax has not been paid on any other sum chargeable to tax Rate of tax withholding 20% 20%
Tax treaty provisions
It has been proposed to revert to the provisions under the existing law, wherein the provisions of the Code shall apply in relation to an assessee to whom the agreement applies, to the extent they are more beneficial. However, the provisions relating to General Anti-Avoidance Rules („GAAR‟), Controlled Foreign Company („CFC‟) and Branch Profit tax would continue to apply irrespective of the beneficial provisions of the tax treaty.. It has also been proposed that a person shall be entitled to claim relief under the provisions of the agreement on production of a certificate in the prescribed form, from the tax authorities of the country that such person is a resident of the country.
Anti-abuse provisions General anti-avoidance rules
The characteristics of the originally proposed rules have been retained. Additionally it is proposed that an arrangement would be presumed for obtaining a tax benefit would include reduction in tax base including increase in losses. The provisions would be applicable as per the guidelines to be framed by the Central Government. Further the definition of lacking commercial substance has been amended to clarify that obtaining tax benefit cannot be the only criteria for applicability of GAAR.
Controlled foreign company (CFC) rules:
As indicated in the revised discussion draft, CFC rules have been incorporated to provide for the taxation of income attributable to a CFC to be taxed in the hands of the resident. A foreign company would be considered as a CFC which 1. for the purposes of tax is a resident of a country or territory with a lower rate of tax 2. the shares of the company are not traded on any stock exchange 3. one or more persons individually or collectively exercise control over the company 4. it is not engaged in any active trade or business 5. the specified income exceed INR 2.5 million. Rules pertaining to the computation of the income attributable to the CFC which would be required to be added to the income of the resident have been provided.
Securities are not specified assets on which wealth tax is payable and so FIIs should not be liable to wealth tax in India on investment assets held in India.
Minimum Alternate Tax (MAT)
The Code is silent on the applicability of MAT to foreign companies. Based on judicial precedents, MAT should not be applicable to foreign companies having no presence in India and earning capital gains and income from other sources in India.
2.9 Compliance Procedures:
Permanent Account Number (PAN) requirements are similar under the Code as that of the present Act and all FIIs will require to obtain PAN. The due dates and the amount of instalment of Advance tax are similar as that provided under the Act. Further, interest for shortfall in the advance income-tax payable shall not be attracted where such shortfall is on account of under estimation or failure to estimate the amount of capital gains and the tax on such capital gains is paid in the remaining instalments or where no instalment is due by 31 March of the financial year. The due date for filing the annual return of income is: (i) the 30th June following the financial year if the person is not a company and does not derive any income from business; or (ii) the 31st August following the financial year, in all other cases.
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