Government sources said there was no reason for FIIs to worry about their earnings from buying and selling Indian stocks to be treated as business income and taxed at 42%, the rate for foreign firms. If the relevant arrangement is found to be impermissible under GAAR, these could be taxed as capital gains.
The rate for short-term capital gains from listed stocks (whether futures and options or delivery-based) is 15% while there is no tax on long-term capital gains. Even in tax case of investments from Mauritius, the tax may have to be paid if the arrangement is impermissible.
For a foreign company to be taxed for business income in India, it needs to have a permanent establishment (PE a fixed place of business) in India. Since FIIs don't have PEs in India, they are not subjected to taxation of business income. There is a market buzz on FIIs fearing the Indian subsidiaries of Mauritius-based asset management companies (which are seen to be related to FIIs) whom they take advise from on Indian stocks, could be treated as the FIIs' PE in India. These fears, government sources say, are unfounded.
The government is likely to cede considerable ground as it finalises the proposed GAAR. It may define a threshold for GAAR to kick in, so small tax payers are not subjected to these rules meant to avoid aggressive tax planning. Besides, the onus of proving instances of impermissible arrangements would lie with the tax authorities, instead of the taxpayer. Also, FIIs will be given time to wind down existing commitments to their investors abroad, without being impacted by GAAR.
The ministry is also likely to reduce long-term capital gain tax from 20% to 10% on investments made by private equity funds in shares of unlisted companies. As per the provisions of the Finance Bill 2012, while FIIs pay a long-term capital gain tax of 10% for investment in unlisted securities, private equity (PE) investors pay 20%.
A key option is to extend the debut of the new regime, so that FIIs get time to wind down existing commitments to overseas investors. This would allow investors who have put their money with FIIs using the Mauritius or other tax haven route to factor in the tax impact while investing in Indian markets.
The government will also put in place a threshold to ensure that small tax payers dont face GAAR. Finance Minister Pranab Mukherjee recently said the government does not intend to tax the participatory note-holder; instead, the tax will be levied on FIIs. FIIs say it would be difficult to pass on the tax costs to PN holders. FIIs including JP Morgan, CLSA and Morgan Stanley have met finance ministry officials over the issue. GAAR rules will come into effect for assessment year 2013-14 onwards and the rules will be framed after passage of Finance Bill. Finance secretary RS Gujral had said that only impermissible arrangements would be subject to GAAR provisions, and the government does not plan to tax honest FIIs.
The government may also put primary onus on proving aggressive tax avoidance on the taxman, while the Finance Bill goes by the principle of guilty until proven innocent, unlike in criminal cases, where the accused is treated innocent until proven guilty. Ernst & Young tax leader Sudhir Kapadia said many concerns will be addressed if the onus is shifted to tax authorities.
The rethink came after FIIs met Gujral several times. The department of economic affairs is also working with the revenue department under Gujral to find a way out. FIIs have also approached the stock market regulator. Fearing GAAR, which could subject FIIs operating through tax havens such as Mauritius to short-term capital gains tax, foreign investors have started trimming their portfolios, both in equities and debt.
Overseas investors say most FIIs have stopped selling offshore derivative instruments (ODIs), popularly known as PNs. ODIs are sold by FIIs to overseas investors who cannot directly participate in the Indian equities market.