WHEN markets crash, excuses often masquerade as explanations. An apparently innocuous circular issued by the Central Board of Direct Taxes (CBDT), containing instructions given to its assessing officers, in early May has been cited as a reason why Foreign Institutional Investors (FII) withdrew from the markets. The issue became so critical that Finance Minister P. Chidambaram had to reassure FIIs that they were not the target of the Income Tax Department's proposed guidelines.
The "draft instructions", which were posted on the Internet by the CBDT, would have been perceived as an arcane issue best left to tax experts. Moreover, the very fact that the CBDT sought views from the public would have been commended as a venture in transparency. So, why did it create such a furore?
The answer lies in where FIIs come from and how they are taxed, if at all they are. A tax on capital gains, arising out of an appreciation in the value of an asset, has always been regarded not only as a tool to curb speculation but as a means of upholding the principle of equity. One of the most controversial aspects of FIIs' operations in India has been their use of the dubious provisions of the Indo-Mauritius Double Taxation Avoidance Convention (DTAC). Claiming to be residents of Mauritius, a quasi tax haven, these entities pay taxes neither in India nor in Mauritius. Generally, they charge their incomes under the capital gains head and then seek refuge under the provisions of the DTAC (Frontline, November 21, 2003).
Other FIIs, particularly those based in the U.S., have been seeking a level playing field vis--vis competitors from Mauritius-based FIIs. In order to avoid paying capital gains tax, which they would be liable to pay despite a double taxation avoidance treaty with the U.S., they have generally preferred to be taxed under the head `business income' instead of capital gains.
S.K. Jha, a former Commissioner of Income Tax and a severe critic of the Indo-Mauritius DTAC, said: "The non-Mauritius-based FIIs claim that they are mere traders, only that their business is buying and selling shares." The loophole that enables them to avoid paying tax under the business-income head is based on their claim that since they do not have a "permanent establishment" in India, they are not liable to be taxed in India.
When the markets crashed on May 19, Chidambaram said "misinformed" reporting by the media had caused confusion. He said no FII had been assessed as a trader. They were treated only as investors because they did not have permanent offices in India, he said.
S.K. Jha avers that the concept of "permanent establishment" is "foreign to the Indian Income Tax Act. "Any tax," he pointed out, "should be transaction-based, irrespective of where they come from - Mauritius or anywhere else." He also said that the FIIs' clout has been demonstrated by their ability to decide the terms on which they should be taxed. Chidambaram's assurance, he said, only demonstrated "the clout they enjoyed in the corridors of power".
The "draft instructions" are based on relevant court judgments and, according to Jha, a routine matter in the Income Tax Department.
In October 2004, after the UPA government assumed office, it slashed the rates of short-term (holdings bought and sold within a year) capital gains tax applicable on securities transactions to 10 per cent from 30. The long-term capital gains tax was reduced to zero from 10 per cent. This was widely seen as an appeasement of the FII lobby, particularly after the May 2004 crash, which happened soon after the last round of the Lok Sabha elections and the formation of the UPA government.
On May 19 Sitaram Yechury, Communist Party of India (Marxist) Polit Bureau member, demanded the reintroduction of long-term capital gains tax and a review of the Indo-Mauritius DTAC. He said that only a "minuscule minority" had gained from the "stock price bubble". He argued that untaxed capital gains were fundamentally iniquitous because it allowed the rich to escape without paying any taxes at all.
On May 22, even as the markets crashed, the CBDT issued a statement to counter rumours in the markets that its circular had caused the panic. In an apparently placatory note, it stated that its assessing officers would take the "totality of the facts and circumstances before reaching a conclusion". It pointed out that the draft did not refer to FIIs at all and that it was only meant to "provide greater clarity" to its officers.
V. SRIDHAR
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