A PECULIAR conflict marks Finance Minister Arun Jaitley’s attitude to taxation of profits earned by foreign institutional investors (FIIs) in India. He has chosen not to submit to their clamour that a set of tax demands relating to the last few financial years that has been slapped on them be withdrawn. These demands (reportedly totalling a potential Rs.40,000 crore) have been made on the grounds that income in the form of capital gains earned by many of them, even though exempt from long-term capital gains tax, was not outside the ambit of the Minimum Alternate Tax (MAT). On the other hand, the Finance Bill for 2015-16 has exempted FIIs from MAT starting April 1, 2015. In fact, investors in India’s capital markets have now been legally exempted from MAT not only for investments in equity or equity-oriented funds but also for the gains they make and the interest they earn on investments in debt instruments. Jaitley has exempted income earned by foreign firms from securities transactions and by way of interest, royalties and fees for technical services from MAT. Clearly, Jaitley and the Modi government have taken this decision that applies prospectively because they fear that in its absence, FIIs with a substantial presence in the country’s equity and debt markets will exit. But having been critical of retrospective changes in the tax law and caught in a legal situation that does not allow such changes, they seem unable to retract on the tax demands relating to previous years.
Caught in this bind, the Finance Minister initially resorted to an aggressive defence of the MAT-based tax demands on FIIs for previous years. Besides stating that the close-to-Rs.40,000 crore tax demand was sub judice and not amenable to remedy by policy, he also said that he “can change the face of India’s irrigation with that Rs.40,000 crore”. However, he claimed that being reasonable, he had waived MAT demands for the future, adding that waiving demands for past years would amount to making India a tax haven. The argument seems to be that missing out on mobilising controversial past dues will make India a tax haven, but revising the clauses that did deliver such controversial revenues so as to “legally” exempt FIIs from the relevant tax payments will not. That is clearly a sticky wicket for a cricket administrator to bat on. Besides the revenue hunger of a Finance Minister whose tax aversion and self-imposed fiscal consolidation target have left him starved of resources, this contradictory stance is explained by the fact that these tax demands were triggered by a 2010 ruling of the Authority for Advance Ruling (AAR). The ruling came in response to an application filed by the Mauritius-registered Castleton Investment Limited, seeking an answer to the question (among many others) as to whether the provisions of Section 115JB of the Income Tax Act would apply to its proposed outside-of-stock exchange sale of its shareholding in GlaxoSmithKline Pharmaceuticals. Castleton claimed, among other things, that it had bought and held these shares with the aim of reaping capital gains and that MAT was not applicable since it was a foreign company engaged in that activity.
The AAR was established in 1993 with the objective of providing non-resident/foreign investors a forum through which they can obtain legal opinion on tax liabilities and be clear about the law and plan investments on that basis. Under Section 115JB of the Income Tax Act, a company is required as of April 2010 to pay a MAT on its book profit if the income tax payable on its total income in any financial year is less than that minimum. The subsection currently reads as follows: “Notwithstanding anything contained in any other provision of this Act, where in the case of an assessee, being a company, the income-tax, payable on the total income as computed under this Act in respect of any previous year relevant to the assessment year commencing on or after the 1st day of April, 2011, is less than eighteen per cent of its book profit, such book profit shall be deemed to be the total income of the assessee and the tax payable by the assessee on such total income shall be the amount of income-tax at the rate of eighteen per cent.”
Thus, in principle, MAT applies when a company’s tax payable is less than 18 per cent of its book profit. Introduced in 1991 and revised more than once, the MAT provision is expressly aimed at ensuring that companies recording large book profits and distributing handsome dividends do not use exemptions and benefits available under the tax law to pay little by way of taxes. The presence of cash-rich, zero-tax companies was seen as justifying MAT, which requires these firms to pay taxes and surcharges equal to around 20 per cent of their book profits.
This “confusion”, that those benefiting from tax exemptions on capital gains from investment in securities traded on the stock exchange (and subject to securities transaction tax) are not subject to MAT, partly arose because of the differential treatment these gains have received under the tax law. To start with, while in the case of all capital assets a distinction was being made between short-term and long-term capital gains, the period within which the gains made were identified as short-term was 12 months in the case of shares and securities as against 36 months in the case of other capital assets. Second, while in the case of other assets receipts in the form of short-term capital gains were added to the income of the assessee, under Section 111A these gains, if derived from the sales of securities or equity-oriented funds in a stock exchange and subject to securities transaction tax, had a separate status and were taxable at the rate of 10 per cent until assessment year 2008-09 and 15 per cent from assessment year 2009-10. This differential treatment conveys the impression that capital gains from a specific form of stock exchange-based equity transactions are different from “regular” capital gains on other assets.
The confusion resulting from this differential treatment was compounded when Budget 2003-04, in an attempt to stall and reverse a decline in FII inflows into the country, chose to make the Indian stock market a tax haven. The then Finance Minister declared in his Budget speech: “In order to give a further fillip to the capital markets, it is now proposed to exempt all listed equities that are acquired on or after March 1, 2003, and sold after the lapse of a year, or more, from the incidence of capital gains tax. Long-term capital gains tax will, therefore, not hereafter apply to such transactions. This proposal should facilitate investment in equities.” Thus, while prior to 2003-04, long-term capital gains from sales of shares (on which securities transaction tax is paid) on a stock exchange more than 12 months after their acquisition were taxable at the rate of 10 per cent, such receipts were exempt from taxation after 2003-04 under Section 10(38). An important, though ambiguous, caveat relating to these provisions was that if an assessee just does the business of selling or purchasing shares, the income earned by that entity cannot avail itself of these special rates, as it is treated as “business income” and not capital gains.
There are obviously many questions raised by this special treatment of capital gains (whether short- or long-term) derived from the sale of shares and equity-oriented funds in stock exchanges and which are subject to the securities transaction tax. To start with, since these earnings are being treated differently from capital gains derived from the sale of other assets or even from equity sold outside stock exchanges, should they at all be treated as similar to income or revenues in the conventional sense? If not, should the surplus in the form of the excess of such incomes over costs accruing to entities engaging in such transactions be treated as profit of a kind that would be subject to MAT, when applicable? Since most FIIs/FPIs are engaged in the business of selling or purchasing shares, should their income be treated as conventional business income?
Further, since the intent of the 2003-04 abolition of long-term capital gains was to discourage short-term speculative investments and attract foreign investors with a longer-term interest, it was clearly aimed at creating an enclave for foreign financial investors that was a virtual tax haven. Hence, subjecting their earnings to MAT amounts to the government going against its own intent. It is not surprising, therefore, that the government had not made any tax demands from FIIs under the Castleton ruling, even though there has been at least one earlier occasion—in a case in 1997—when the AAR had ruled that MAT did apply to all foreign companies present in India. So, clearly, by seeking to create a zero-tax haven for financial investors the government had rushed ahead of the law in 2003. Not surprisingly, in the Castleton case the AAR ruled that “a company has to pay tax as provided for in this sub-section if the tax payable by it as otherwise determined under the Act, is less than the minimum prescribed herein”, and that the wording of the subsection does not make any distinction between a resident company and a non-resident company. This ruling has been challenged in the Supreme Court, but until such time the court gives a verdict the law requires FIIs to pay a minimum alternate tax of 18 per cent plus surcharges on their book profits.
But, for a government fearful of FII exit, that may be too long to wait for. So, somebody’s advice or sudden self-realisation has forced the Finance Minister to go soft. He and his officers have assured FIIs that if they are located in countries with whom India has a double taxation avoidance agreement, the MAT ruling would not be applicable. Further, while originally the Finance Bill had proposed that a foreign company would be liable to pay tax in India if its effective place of management was in India during “any time” in the previous year, the phrase ‘‘at any time’’ has been dropped “so that no ambiguity remains”. According to the Finance Minister, “a foreign company will be treated as a company resident in India for a previous year if its place of effective management is in India in that previous year.” Finally, the government has in Finance Bill 2015-16 formally exempted FIIs from MAT.
The fact of the matter is that all of this fuss relates to a set of investors who operate in India’s secondary equity markets and contribute almost nothing to productive investment. Why their profits should be protected from minimal taxation, when those of productive investors is subject to such taxation, is obviously a question that Jaitley does not seem interested in raising. And he seems to have forgotten that with the revenues from MAT on FII profits, he could in the future change the face of India in more areas than just irrigation.