India: India sustains capital markets development

The changing landscape of financial markets brought about by evolving regulations, a shift in consumer demand and changing demographics is redefining the financial services industry. Complexities in financial markets are increasing, given the steady rise in the volume of products.

Capital markets in India are characterised by their vibrant equity and debt markets assuming a fast-paced growth. With domestic savings and investments pegged at a higher rate every year, capital markets strive to put the maximum savings into the right channels in the financial system, so increasing the depth of the markets.

Some of the other factors which are adding to the pressure for domestic players are high customer expectations, intricate business models and continuously changing technology, which span various products, infrastructure and channels. Cross-border transactions and investments are on the rise due to newer technology platforms.

The impact of taxation and allied exposures need to be recognised in this situation of new products and continuously changing technology in capital markets.

Mauritius is popularly used for routing investments into India. India's Double Tax Avoidance Agreement with Mauritius provides for exemption for a tax resident of Mauritius from capital gains tax on the sale of shares of an Indian company. Any person who under the laws of Mauritius is liable to taxation by reason of his domicile, residence or place of management is regarded as a tax resident of Mauritius.

This tax treaty was signed almost three decades ago during a period when India acutely required foreign capital. Given the concession under the tax treaty, many non-resident investors across the globe started investing into India through Mauritius. This is evident from the fact that about 40% of the foreign inflows into India are from Mauritius. These inflows are largely in the nature of foreign direct investments or portfolio investments in the secondary markets.

The Indian tax authorities have clarified that a tax residency certificate (TRC) issued by the tax authorities of Mauritius would be regarded as conclusive evidence regarding residential status and beneficial ownership of Mauritian entities for applicability of the tax treaty. Furthermore, the Supreme Court in India in its landmark decision in Azadi Bachao Andolan, upheld the applicability of these clarifications.

Even so, the tax authorities have attempted to lift the corporate veil in certain circumstances, disregarding the investing entity by looking through the ultimate holding entity/investee entity. One of the key reasons for lifting the corporate veil was that there was no commercial substance in the country of residence of an intermediate holding company. Thus the subject of ensuring substance gets immensely important to ensure that the corporate form of the intermediate holding entity is respected.

Where a taxpayer has approached the Authority for Advance Rulings (AAR) which issues binding advance rulings on the applicant, either the tax authorities or the taxpayer, who has sought it, the AAR relying on the Supreme Court's decision in Azadi Bachao Andolan is still upholding sanctity of the treaty. More recently in the case of DB Zwirn Mauritius, it reiterated that capital gains earned by Mauritius entities are not taxable in India, in light of the tax treaty between the two jurisdictions.

Earlier, AAR relying on the Supreme Court's decision in Azadi Bachao had granted India-Mauritius treaty benefit to E*Trade Mauritius which was a subsidiary of a US parent. However, recently, the tax authorities have filed a petition with the Supreme Court against this ruling on the grounds that the US parent was controlling activities of its subsidiary, the corporate veil must be pierced and that the treaty eligibility should once again be evaluated by the Supreme Court.

For the last few years it has been the stated position of the Indian government that it is in discussions with the Mauritius government to renegotiate the tax treaty. The recent accouchement by the chairman of Central Board of Direct Taxes that the Mauritius government has agreed to revise the treaty created the fear of withdrawal of the capital gains tax concession, leading to a significant fall in the stock markets.

Since withdrawal of the concession under the tax treaty is a political and economic issue, it is possible that during its treaty renegotiations, the Indian government may push for incorporation of anti-abuse rules or conditions in the treaty prospectively as against a complete withdrawal of the concession retrospectively.

Also, the Indian tax regime is likely to be replaced by a new Direct Taxes Code in the near future and general anti-avoidance rules could come into effect which could also be used by the tax authorities to discourage treaty shopping.

The Indian regulator permitted direct market access (DMA) to institutional investors few years ago.

Furthermore, certain investors also like to trade on the Indian stock markets using algorithm software. This software processes market information to identify the best available trading opportunity that meets all parameters. An order is generated when the algorithm software detects certain trigger conditions based on the parameters set. Typically, the broker would hire a rack at the stock exchange premises where both the servers and software would be installed. The co-location server facility allows brokers to place their servers in the same place as a stock exchange's trading engine, giving them faster access to order book data streamed from the exchange. Such a co-location server facility could give rise to the exposure of creating a taxable presence in India depending on who controls and owns the servers or software.

Most foreign institutional investors (FIIs) characterise their income from trading in Indian securities as capital gains, while some treat them as business profits. Under Indian domestic law both capital gains and the business profits are taxable whereas under tax treaties capital gains are exempt in case of some countries and the business profits are taxed only if the FII has a permanent establishment (PE) in India. Furthermore, in the case of treaties providing for a capital gains exemption, such are taxed in India if the securities form part of the business property of the PE in India. As such, the issue of PE is more relevant for the FIIs characterising their income as business profits and less important to other FIIs.

Keeping this in mind, investors have to trade carefully and structure their technology platform and the investing vehicles in an appropriate manner.

In India capital gains and business profits are taxed differently. In the last couple of years there has been a lot of debate on the issue of whether income earned by FIIs is capital gains or business profits. There have been some contradictory rulings in the past. In a recent ruling, in the case of LG Asian Plus Ltd, the Income-tax Appellate Tribunal (the tribunal) had held that gain/loss incurred by FIIs from derivative transactions would be treated as capital gain/loss. This ruling is of importance to all FIIs since it analysed in depth the rationale for characterising the income of FIIs in India by considering the relevant capital market regulations and clarifications issued by the tax authorities.

The past rulings on characterisation of income of an FII have been pronounced by the AAR, which are binding only on the applicant who has sought it. The recent decision is likely to have an impact the litigation on the issue of characterisation pending before the appellate authorities.

Incidentally, this ruling is also in line with the provisions of the proposed Direct Taxes Code, likely to be introduced from the next year or the following, in which it has been explicitly provided that such income would mandatorily taxed as capital gains.

Similar views were also expressed by the courts in the case of Gopal Purohit. In this case, the individual was both a trader and an investor. He maintained separate records for both the types of transactions and offered the income earned from investment as capital gains/loss and the income earned from investment as business profit/loss. The ruling by the Tribunal was in favour of Gopal Purohit and was upheld by the High Court. Recently, the tax department's appeal to the Supreme Court was dismissed.

FIIs often use forward covers to hedge their currency exposure on account of investments held in Indian currency. Cancellation of such contracts could result in gains or losses. Tax treatment of such gains/losses again has been a vexed issue. In the case of Citicorp Banking Corporation it has been held by the tribunal that losses arising on cancellation of foreign exchange forward contracts entered into by a FII for protecting it against the risk of currency fluctuation would be characterised as capital loss.

Furthermore, the tribunal also held that the special tax regime under the Act provides for tax rates on an FII's income from securities or capital gains and it has nothing to do with determination of the nature of gain or loss, that is, capital or revenue.

This is an important decision, the first of its kind concerning an FII on characterisation of loss arising on cancellation of foreign exchange forward contract. This decision will be useful for several FIIs in similar situations. One would, of course, need to consider the treaty provisions in the case of FIIs where the tax treaty provides for exemption from capital gains.

Recently, on application by VNU International, a non resident, the AAR pronounced in this important ruling that a foreign company is liable to file its return of income, despite no tax payable by it under a tax treaty.

This ruling is important to all non-resident taxpayers who are not liable to pay tax in India by virtue of benefits provided by a tax treaty. By holding that foreign companies are required to file return of income even if there is no liability to tax, the AAR has differed from the opinion given in its earlier ruling in Vanenburg Group BV, that there is no requirement to file the return of income if there is no liability to pay tax. This ruling is likely to increase the compliance costs of investors from countries with which India has a favourable tax treaty.

Indian laws provide for deduction of inflation-adjusted cost for computing capital gains. This benefit is provided mainly for Indian residents and certain non-residents who have invested in Indian securities in Indian currency. Recently, Transworld Garnet a Canadian company, raised the question of its eligibility for this benefit, though it had invested in Indian securities using foreign currency. The company wanted to invoke the non-discrimination clause in the India-Canada Double Tax Avoidance Agreement. The AAR in its ruling after considering the various provisions of the Act and article 24 of the tax treaty held that the denial of indexation benefits to the applicant does not amount to discriminatory treatment under the India-Canada treaty.

The AAR reiterated that the State is not obliged to extend the same privileges offered to its own residents to non-residents and that mere differentiation in tax treatment because of the residential status of the assessee would not amount to discrimination, as set out in the India-Canada tax treaty.

In the past in the case of Devendra Motilal Kothari it was held by the tribunal that fees for portfolio management services (PMS) are not inextricably linked with the particular instance of purchase and sale of shares and hence cannot be allowed as a deduction while computing capital gains. However, in its recent ruling of KRA Holding & Trading Pvt Ltd, the tribunal, distinguishing its earlier decision, held that fees paid to the portfolio manager for rendering PMS can be considered as expenditure directly connected to the asset and its transfer, and hence, are allowable as a deduction in computing capital gains.

The tribunal considering that the amended SEBI (Securities and Exchange Board of India) Regulations allow payment of PMS fees on a return based model, held that the expenses would be allowable as a deduction since they are directly connected to the asset and its transfer, bona fide payments made as per the norms of the arm's-length principle, since the portfolio manager and the client were unrelated, and incurred imminently and in the normal course of the investment activity.

The tribunal's decision is likely to have a significant impact on investors investing through asset managers. The tribunal held that fees paid to a portfolio manager are deductible when computing capital gains. It would be worthwhile exploring the relevance of this decision to other forms of asset management such as mutual funds, and to other related expenses such as distribution commission.

Biography
		Sunil Gidwani Executive Director PwC PwC House, 1st Floor, Plot 18A, Gurunanak Road (Station Road) Bandra (West), Mumbai, India – 400 050 Tel: +91 (22) 6689 1177 Mobile: +91 98211 31945 Email: sunil.gidwani@in.pwc.com Sunil Gidwani has been advising clients on tax and regulatory matters from the perspective of domestic and international taxation as well as India’s foreign investment policy, exchange control regulations, licensing requirements, corporate law and allied matters. His areas or industries of specialisation are banking and capital markets, foreign institutional investors and asset management. He has assisted leading banks, overseas hedge funds, private equity and real estate funds in setting up business presence in India and advised on several business transactions and financial service products from tax and regulatory perspective. Gidwani has written papers and presented at conferences and workshops under the aegis of various professional bodies including Dun & Bradstreet, the Institute of Chartered Accountants of India, the Institute of Company Secretaries of India and the Indian Institute of Capital Markets. Gidwani is a chartered accountant, company secretary and a law graduate. He passed CS examinations with 12th rank, and topped Mumbai University in the subject of taxation during LLB examinations.