As a result of numerous amendments to the Income-tax Act, 1961 (“the Act”) from time to time, the basic structure of the Act is burdened and its language complex. The Government, therefore, decided to revise, consolidate and simplify the language and the structure of the direct tax laws.

A draft Direct Tax Code 2009 (‘DTC 2009’) along with a Discussion Paper was released in August 2009 for public comments. Based on the feedback received from the various stakeholders, DTC 2009 was revised in June 2010. The present Bill, the Direct Tax Code 2010 (‘DTC 2010’) was tabled in the Parliament on 30 August 2010. DTC 2010 is proposed to come into force on 1 April 2012.

The key changes as proposed by DTC 2010 that affect the taxation of Foreign Institutional Investors (FIIs) are as follows:-

At the outset, the DTC 2010 has put to rest the controversy surrounding the benefits available under the Double Taxation Avoidance Agreements (DTAA). It provides that between the Act and the relevant DTAA, the one which is more beneficial to the taxpayer shall apply. However, there would be limited treaty override in accordance with internationally accepted principles. Thus, DTAA will not have preferential status over the domestic law when GAAR is invoked; or, when CFC provisions are invoked; or, when Branch Profits Tax is levied.

Distinction between long-term capital gains and short-term capital gains eliminated

Under the DTC 2010, income from all sources has been proposed to be classified into two broad groups: income from ordinary sources and income from special sources.

Income from ordinary sources includes:

  • Income from Employment;
  • Income from House-Property;
  • Income from Business;
  • Income from Capital Gains; and
  • Income from Residuary Sources.

.

Income from special sources in the case of a non-resident shall include  income by way of:

Interest;

  • Dividends on which dividend distribution tax has not been paid;
  • Profit distributed by a fund on which tax on distributed income has not been paid;
  • Income by way of royalty or fees for technical services; and
  • Income by way of insurance including reinsurance.

Income of FIIs from transfer of investment assets is

Capital gain

The term ‘asset’ has been defined to mean a ‘business asset’ or an ‘investment asset’. Any security held by a FII is an investment asset. Income arising on transfer of investment asset shall be computed under the head “Capital Gains” and shall be considered as income from ordinary sources in case of all taxpayers including non-residents.

The term ‘securities’ includes derivative as defined in section 2(h) of the Securities Contract Regulation Act, 1956.

No Specific Code for FIIs

Section 115AD of the Act specifies the tax rates in respect of the income streams of FII investments in India. The DTC 2010, however, has no  specific provision which deals with the tax treatment of income of FIIs. The tax rates have been provided in the Schedules to the DTC 2010.

Taxpayer Tax Rate
Company 30 percent
Unincorporated body* 30 percent

*”Unincorporated body” means a firm, an Association of persons, or a body of individuals .

The general tax rate in the case of income of the FII is 30 percent in case of a company or an unincorporated body. This rate is applicable to all companies including corporate FIIs.

Tax Rate on Interest

Interest income will be taxed at the rate of 20 percent.

Taxability of listed equity shares and units of equity oriented Mutual Funds subject to Securities Transaction Tax (“STT”)

In case of an equity shares in a company or a unit of an equity oriented Fund, transferred at any time after one year from the date the asset is acquired and such transaction is chargeable to securities transaction tax, a deduction amounting to 100 percent of the income is to be allowed and if the income is negative, 100 percent of the income is to be reduced from such income.

The changes are tabulated below:

Description Current

(held for more than 12 months from the date of acquisition)

Proposed

(held for a period of  more than one year  from the date of

acquisition)**

Current

(held for less than 12 months from the date of acquisition)

Proposed

(held for a period  of less than one  year from the date of acquisition) **

(Amount in INR) (Amount in INR) (Amount in INR) (Amount in INR)
Date of Acquisition 1st April 2011 1st April 2011 1st April 2011 1st April 2011
Long-Term Asset if sold on or after 1 April 2012 Asset sold on or after 1 April 2012 Short-Term Asset if sold before 1 April 2012 Asset sold on or  before 1 April 2012
Sale Value 100 100 100 100
Less: Cost of acquisition and Cost of Improvement 50 50 50 50
Capital Gains 50 50 50 50
Less: Deduction at specified rates on  capital Gains* Not Applicable 50

(specified rate is 100 percent of capital gains)

Not Applicable 25

(specified rate is 50 percent of capital gains)

Taxable Capital Gains Fully Exempt Nil 50 25
Tax on Capital Gains Nil Nil 7.5

(tax @ 15 percent) plus applicable surcharge and education cess

7.5

(tax @ 30 percent plus additional income-tax)

Tax on Capital Gains Nil Nil 7.5

(tax @ 15 percent)  plus applicable surcharge and education cess

7.5

(tax @ 30 percent plus additional income-tax)

* In case there is a capital loss, the same is also to be reduced by the specified percentage.

** The statement of objects and reasons to DTC 2010 provides that in respect of equity share and equity-oriented mutual fund unit, such securities should be transferred after one year from the end of the financial year in which it is acquired. This is an apparent anomaly with the DTC 2010

It may be noted from above table that in effect the Lomg Term Capital Gain on sale of listed shares continue to tax exempt and short term capital gains on such shares will be taxed at half the applicable rates.

Aggregation of Income

The income (after providing for the deductions) from transfer of an investment asset during the financial year shall be aggregated and the net result shall be income from capital gains.

The income from capital gains shall be aggregated with the unabsorbed preceding year capital loss, and the net result shall be current income under capital gains.

The income under the head capital gains shall be NIL if the net result of  aggregation is negative and the absolute value of the net result shall be the amount of ‘unabsorbed current capital loss’ for the financial year.

Various scenarios are provided as under:

Particulars ROI filed by the due date ROI not filed by due date
Scenario 1 Scenario 2 Scenario 3 Scenario 4 Scenario 5 Scenario 6
income of the current year equity shares held less than one year A 5,000 5,000 (5,000) 0 (5,000) 5,000
deduction @ 50 percent B (2,500) (2,500) 2,500 0 2,500 (2,500)
current income under the head capital gains C=A-B 2,500 2,500 (2,500) 0 (2,500) 2,500
unabsorbed capital loss preceding  year # D (10,000) (10,000) (10,000) (10,000) (10,000)
unabsorbed capital loss current year to be c/f E=C+ D NIL (7,500) (12,500) (10,000) (10,000) (7,500)
income under the head capital gains F 2,500 NIL NIL NIL NIL NIL

#the earlier year returns of income have been filed by the due date.

Observations:-

a) If the return is filed by the due date, the unabsorbed capital loss of current year is allowed to be carried forward. This includes portion of  the unabsorbed capital loss of the preceding year

b) The loss is allowed to be indefinitely carried forward for set-off

c) Loss under any head within ordinary sources can be set-off against  income under the head capital gains.

d) In case of delayed filing of the returns of income for any particular year, losses pertaining to that year would not be allowed to be carried forward for set-off in future years.

Taxability of securities other than listed equity shares and units of equity oriented Mutual Funds

For the purpose of computation of income from transfer of investment assets other than listed equity shares and units of equity oriented Mutual Funds, deduction of indexed cost of acquisition, indexed cost of improvement, will be allowed if such asset is transferred after one year from the end of the financial year in which the asset is acquired.

If the asset is acquired before 1 April 2000, then the fair market value of such an asset as on 1 April 2000 shall be substituted at the option of the taxpayer.

Withholding tax on Capital Gains and Interest income

No tax is to be deducted at source from payments made to a FII, on any consideration for sale of securities listed on a recognized stock exchange.

Although payment made to FIIs for sale of shares on a listed exchange are free from any tax withholding, payment of interest income and unit income ( other then by a equity oriented mutual fund) is subject to tax withholding of 20 percent. Further, a FII which invests through the foreign direct investment (FDI) route and participates in an open offer faces a tax withholding of 30 percent on sales consideration.

Interest income of the non-resident is considered as income from special source and tax at the rate of 20 percent is to be deducted at source on the interest paid to non-resident.

Broken Period Interest

The DTC 2010 provides that the income accruing from a debt instrument,  transferred by a person at any time during a financial year, shall not be less than the amount of broken-period income from the instrument. The term “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.

Income not includible for purposes of arriving at taxable income of the taxpayer

Dividend declared, distributed or paid to a company or a non-resident, in respect of which dividend distribution tax (“DDT”) has been paid by the Indian company at the rate of 15 percent

  • Any income received from an equity oriented fund in respect of which tax on distribution has been paid by the Fund at the rate of 5 percent.

Computation of income from special sources

While computing income from special sources, any amount by way of accrual or receipt shall be taken and no deduction or allowance or set-off of any loss shall be allowed. Such income shall be presumed to have been computed after giving full effect to every loss, allowance or deduction.

Delayed filing of return of income

In case of delayed filing of return of income for any particular year, losses pertaining to that year would not be allowed to be carried forward for set off in future years.

Test of Residence

Companies

Currently, a foreign company is treated as resident in India if, at any time in the financial year, the control and management of its affairs is situated wholly in India

In line with the international practice, it is now proposed that a company incorporated outside India will be treated as resident in India if its “place of effective management is situated in India.

The term “place of effective management of the company” means:

(i)                 the place where the board of directors of the company or its  executive directors, as the case may be, make their decisions; or

(ii)              in a case where the board of directors routinely approve the commercial and strategic decisions made by the executive directors or officers of the company, the place where such executive directors or officers of the company perform their functions.

Other Person

Every other person shall be resident in India in any financial year, if the place of control and management of its affairs, at any time in the year, is situated wholly, or partly, in India.

General Anti Avoidance Rules (GAAR)

The DTC 2010 seeks to provide that any arrangement entered into by a person may be declared as an impermissible avoidance arrangement and the consequences, under this Code, of such arrangement may be determined by-

a) disregarding, combining or re-characterising any step in the arrangement;

b) treating the arrangement as if it had not been entered into or carried out or in such other manner as in the circumstances of the case, the Commissioner deems appropriate for the prevention or reduction of the relevant tax benefit;

c) disregarding any accommodating party or treating any accommodating party and any other party as one and the same person;

d) deeming persons who are connected persons in relation to each other to be one and the same person;

e) re-allocating, amongst the parties to the arrangement, any accrual, or receipt, of a capital or revenue nature, or any expenditure, deduction, relief or rebate; or

f) re-characterising any equity into debt or vice versa, any accrual, or receipt, of a capital or revenue nature, or any expenditure, deduction, relief or rebate.

It is further provided that the above provisions may be applied in the alternative for, or in addition to, any other basis for determination of tax liability and they shall apply with such guidelines as may be prescribed.

Presumptions:

  • An arrangement shall be presumed to have been entered into, or carried out, for the main purpose of obtaining a tax benefit, unless  the person obtaining the tax benefit proves that obtaining the tax benefit was not the purpose of the arrangement .
  • An arrangement shall be presumed to have been entered into, or carried out, for the main purpose of obtaining a tax benefit, if the main purpose of a step in, or part of, the arrangement is to obtain a tax benefit, notwithstanding the fact that the main purpose of the whole arrangement is not to obtain a tax benefit.

Benefits under the Double Taxation Avoidance Agreements

The DTC 2010 seeks to provide that the Central Government may enter  into an agreement with the Government of any country or specified territory for the granting of relief or avoidance of double taxation (‘DTAA’), for exchange of information for the prevention of evasion or avoidance of income-tax or wealth-tax, for tax recovery, etc.

It is further provided that where such an agreement has been entered into, then the provisions of this Code will apply to the taxpayer to whom the DTAA is applicable, if such provisions are more beneficial to him except for provisions regarding General Anti Avoidance Rule, levy of Branch Profit Tax and Control Foreign Company Rules which will apply, whether or not such provisions are beneficial to him.

A person shall not be entitled to claim relief under the provisions of the DTAA  unless a certificate of his being a resident in the other country or specified  territory is obtained by him from the tax authority of that country or specified  territory, in such form as may be prescribed.

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