A tax on adventure

Written by Sudhir Kapadia | Sudhir Kapadia | Updated: Oct 30 2009, 04:00am hrs
Even a cursory snapshot of some key sectors of the Indian economy would provide a fair indication of the gigantic funding requirements for achieving the investment objectives set out by the government. The infrastructure sector alone would require $600 billion, of which 30% is predicted to come from the private sector. If one adds renewable energy, logistics, education, health care and telecommunication, the requirement for funds would multiply many-fold and there is a consensus among policymakers in India that despite the relatively larger domestic savings rate in India, domestic savings will simply be insufficient to fulfil all these funding requirements. It is also common knowledge that the key drivers for free flow of capital from foreign funds are increased government encouragement for private sector participation, predictable cash flows, strong growth potential and a suitable tax and regulatory environment. Further, in many cases, a major portion of investment in PE funds actually comes from entities like sovereign wealth funds, non-profit making investments (charity, education, etc), pension funds and the like, which by their very nature are typically tax exempt in their home countries. Experience in fund raising suggests that many times these institutional investors serve as anchor investors for other private investors to join in the investment in the PE funds.

It is against this backdrop that there is a serious concern among foreign PE funds investing in India that the proposals under the DTC would require a scaling down of tax adjusted returns from investments in Indian companies and hence a possible re-allocation to other comparable growth destinations.

However, there are certain key deterrent proposals in this regard. These include, first, the capital gains tax regime. Since 2004, after the introduction of the Securities Transaction Tax (STT), long-term capital gains in listed securities are exempt from tax. The DTC proposes to abolish the STT and do away with the distinction between capital gains and business income. Accordingly, all capital gains (whether short-term or long-term) will be considered on par with business income and will, therefore, be subject to tax at the rate of 30% in the hands of PE funds. Whilst there appears to be merit in not extending concessional rates of taxation to short-term capital gains and treating them on par with business income, the proposal to do away with concessional rates of taxation on long-term capital gains would adversely impact capital formation. This is because a higher tax would reduce after tax returns on capital and further push the timelines for recoupment of capital investment, especially in long gestation projects in infrastructure as well as early stage/start-up companies.

This proposal is also to be seen in the light of no capital gains tax levied by many countries around the world on investments by offshore funds in shares of their domestic companies. Thus, the non-resident investor of shares of a company in the US and the UK would typically not be subject to tax on capital gains arising out of sale of shares of domestic companies in those countries. Further, countries like Singapore, Hong Kong provide capital gains tax exemption on sale of shares for offshore investors.

It is interesting to note that the DTC proposes to continue with the Dividend Distribution Tax (DDT) at the rate of 15% in lieu of non imposition of withholding taxes on dividend income. Thus, companies would be encouraged to pay out their profits by way of dividends as an effective tax rate on the same would be lower at 15% rather than plough back their profits for capital investments. This may actually discourage companies from ploughing back money for long-term investment needs due to the arbitrage avail-able on dividend payments versus capital gains. One way to avoid this horizontal inequity would be to provide a similar rate of 15% at least on long-term capital gains so that a company is indifferent to paying profits out as dividends or retaining profits for capital investment needs. This would also ensure that the long-term capital gains tax rate in India remains fairly competitive compared to other countries competing for PE funds.

Secondly, there exist treaty override provisions. The DTC provides that neither the tax treaty nor domestic law shall have preferential status and the provision that is later in point of time shall prevail. This proposal has also created tremendous uncertainty for PE funds, many of whom have invested in India through holding company jurisdictions like Mauritius, Singapore, Cyprus and Netherlands. Tax treaty requires that all these countries provide for capital gains tax exemption (wholly or partially). However, if at a later point in time, this rule is legislated in the DTC, it would automatically mean an override treaty provision, thus causing anxiety to the investors as to whether the capital gains exemption would continue to prevail. It may be further noted that there already exists a limitation of benefit rule in tax treaties with Singapore, Luxembourg and the US, which essentially prescribe the conditions under which treaty protection is available to residents of those countries. Therefore, a much better alternative to treaty override provision would be to incorporate suitable limitation of benefit provisions in the existing tax treaties, with Mauritius and Cyprus as well, if the intention is to limit the capital gains exemption under these treaties to genuine investors from those countries.

And lastly, there is the General Anti Avoidance Rule (GAAR). The DTC proposes powers to the Commissioner for invalidating an arrangement that has been entered into by the taxpayer for the main purpose of obtaining a tax advantage. The power to invalidate would arise if the taxpayer is unable to satisfy the Commissioner about the genuine business purposes of the arrangement or that the arrangement does not result directly or indirectly in abuse or misuse of provision of the DTC. This indeed is a very onerous requirement and the onus of proving bona fides lies clearly on the taxpayer. GAAR should be made applicable only in special circumstances, which should be objectively defined. For example, objective tests should be laid down where the intent is to disallow excessive interest paid on borrowings from related parties. Further, the onus of substantiating the arrangement as a tax avoidance arrangement should be on the revenue (as is the case in common law countries) rather than on the taxpayer.

At a time when arguably there are more opportunities for PE funds to invest in undervalued assets around the world post the economic meltdown, India would do well to proactively encourage greater flow of funds to investments in India by removing some of the above concerns and uncertainties and specifically continuing to make long-term capital gains tax policy attractive for this class of investors in the Indian economy.

The author is partner, tax & regulatory services, Ernst & Young, India