The major talking point arising from the Budget 2018 proposals has been the reintroduction – after a hiatus of over a decade – of tax on long-term capital gains arising from listed equity shares or units. While this reintroduction was widely expected and predicted, the manner in which the government has softened the blow for the investor community is noteworthy, with gains up to 31 January 2018 (for shares acquired before 1 February 2018) being grandfathered from taxation. This has ensured that investors will in effect only pay tax on the gains earned on or after 1 February 2018.
In summary, Budget 2018 has proposed to tax long-term (period of holding more than 1 year) gains arising from the transfer of listed equity shares of a company/equity oriented fund/units of business trust on or after 1 April 2018, exceeding Rs 1 lakh (approximately $1,500). The tax rate would be 10 percent plus the applicable surcharge and a 4 percent cess. Gains accrued up to 31 January 2018, in respect of shares acquired on or before 31 January 2018, would not be taxable. In other words, the cost of acquisition would be considered higher of:
a) Actual cost of acquisition, and
b) Lower of
- fair market value (i.e. the highest price quoted on a recognised stock exchange on or near 31 January 2018, in case of a listed asset or the net asset value in case of unlisted units); and
- full value of the consideration received or accruing as a result of the transfer.
This is applicable to both Indian resident taxpayers as well as non-residents and foreign investors. Non-resident taxpayers can, however, avail tax treaty benefits subject to furnishing a valid Tax Residency Certificate (TRC), provisions of the General Anti-Avoidance Rule and also, provisions of the Multilateral Instrument (MLI) signed under OECD’s Base Erosion and Profit Shifting project, as applicable once implemented.
Impact On Foreign Portfolio Investors
Considering that many foreign portfolio investors have historically used the Mauritius or Singapore route for investing in listed Indian equity shares, they had only started paying taxes in India from 1 April 2017, on the short-term capital gains from such securities due to the amendment in India’s tax treaties with Mauritius and Singapore. The only avenue which was available to them for not paying taxes in India was to claim the tax exemption available for long-term capital gains under the Indian tax law itself. Having made peace with this tax situation, many had contemplated investing directly from the United States or the United Kingdom instead of routing money through a country with which India has a favourable tax treaty.
However, with the tax exemption for long-term gains also being proposed to be withdrawn from 1 April 2018, FPIs are required to brace for certain additional tax costs in India.
Considering this additional cost and compliance burden, FPIs appear to have started exploring the feasibility of migrating operations to Netherlands or France considering India’s tax treaties with these two countries.
As can be observed, the use of the Netherlands or France route into India has obvious tax benefits for FPIs, especially given that after 2019 even the Mauritius or Singapore routes will have no tax benefits in India. Considering that Netherlands and France are matured economies with stable political and attractive tax regimes (including participation exemptions, etc.), the case for moving to the Netherlands or France route after 2019 becomes more compelling.
This is because, on account of the recent change in the US tax laws (whereby foreign income will not be taxed in the US), the taxes paid on gains from direct investment into India will not be creditable in the US, thereby becoming a cost. On the contrary, once no taxes are paid in India under the India-Netherlands/France tax treaty, it may be possible to arrange the upward repatriation of income back to the US from these countries in a tax efficient manner.
In essence, a US-based investor investing from the Netherlands would have no capital gains tax costs at all.
However, before deciding to implement the Netherlands or France route, FPIs need to not only consider the provisions of India GAAR but also the provisions of the MLI which covers the India-Netherlands and India-France tax treaties (although yet to be effective or implemented). For instance, one of the important provisions arising from the MLI is the Principal Purpose Test (PPT) which effectively empowers the Indian tax authorities to deny tax treaty benefits in India if one of the principal purposes of undertaking a transaction or structure was to obtain tax treaty benefits in India. Given the evident rationale of FPIs for using the Netherlands or France route for investing in India, this may not be difficult for the Indian tax officer to charge, if not prove.
The fact that the PPT can be invoked without the checks and balances provided under the Indian GAAR is scary and would tantamount to providing the tax officer the power to unilaterally deny a bilateral tax treaty’s benefit.
Accordingly, the risk of litigation with tax authorities cannot be ruled out.
Conclusion
While the Netherlands or France route is tempting for FPIs, given the introduction of the long-term capital gains tax, they must ensure that the robustness and commercial rationale of their structures are adequately verified and documented so that the same can be substantiated before the Indian tax authorities at the time of assessment proceedings.
This article has been published in an arrangement with the BloombergQuint.
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