Legal Mechanisms for Foreign Institutional

Abstract The paper seeks to lay down the existing legal mechanism for the foreign institutional ( portfolio ) investors in India and draws out its merit and demerit. I then seeks to draw outline to the current response of the Indian state both, legislature and judiciary to the foreign institutional investors. It then seeks to draw out the existing dichotomy between the income tax department and the government policies about the FPIs. Introduction Foreign institutional investors have not been defined in the income tax. The term in economic sense means an investment that is made into a country without a permanent establishment. Whether or not the investor has a permanent establishment in India is an important factor to determine before giving them tax benefit. There can be many definitions of the same, one of the standard definition that is used is given in the Article 7 of the DTAA between India and UK. It defines that a person has a permanent establishment if he maintains a stock is goods or merchandise from where he actually delivers goods or merchandise for or on behalf of the enterprise.[1] Simply because one carries out a business in another country through a middle man does not mean that one has a PE in another country. One company has to exercise effective control on the portfolio company for it to be considered as their company. [2] The power to define and name an investor as FIIs has been given to the Central Government under section 115 AD (3) (a). In 1995 Government of India listed 65 FIIs and they were treated to be foreign institutional investors (hereinafter referred to as FIIs).[3] The Foreign portfolio in investors (FPIs) registered with the SEBI are also be referred to as FIIs for the purpose of section 115 AD.[4] They have an advanced tax liability as per the provisions of Part C of Chapter XVII of the Income Tax Act 1961. They can claim Tax deduction at source (TDS) or avoid tax as per the DTAA. Section 115 AD elaborates what would constitute total income for a FII and it includes: (1) income received in respect of securities other than the income received from dividends. [5] Or units referred to in section 115 AB, i.e. income received in respect of units purchased in foreign currency or long term income arising from the transfer of foreign currency. (2) Income by the way of short term capital gain arising from the transfer of such securities. The amount of income tax is to be calculated in the following manner: (1) For securities, it is to be calculated at the rate of 20 percent with an exception mentioned in section 194 LD. [6](2) For short term capital gain, it is to be calculated at 30 percent except for the income in section 111 A which is to be calculated at the rate of 15 percent[7]. (3) For long term capital gain , it is to be calculated at the rate of 10 percent[8] (4) the amount taxed had the income been reduced by the amount of income for which the FIIs are charged.[9] This difference in tax rate for the short term capital gain and long term capital gain exists as the latter contributes more to the economics of the state. No deduction are offered to the gross income of the FIIs in respect of securities under section 28 to 44C or in clause (i) and (iii) of section 57 or under section 57 or under Chapter VI-A.[10] the first and the second g provisos of section 47 relating to the computation of charges will not apply in case of a transfer of the aforesaid securities by the FIIs. Any capital gains arising from transfer of long-term capital asset which is either equity shares or units of equity oriented shares shall be exempt from income-tax[11]. This is subject to any transaction relating to the sale of securities on which the securities transaction tax (hereinafter referred as STT) is applicable.[12] As per new STT the short-term capital gains is taxable at the rate of 10%.[13]. It also envisages that neither deduction under Chapter VI can be claimed nor the rebate under section 88 be claimed. Thus after 2005 for short term transaction of securities 10% tax is charged either under section 111 – A or 115 AD. Section 196 D elaborates that where an income in respect of securities referred to in section 115 is payable to a Foreign institutional investors, the person responsible for making the payment shall deduce income tax at the rate of 20 percent at the time of credit of such income to the account of the payee or at the time of the payment thereof in cash or y issue of a cheque or draft or any other mode. FIIs can enter into transactions relating to the securities or by entering in to derivate contracts. Derivative contracts are bilateral contracts which determine the content of obligation from a reference value. The performance of the contract is done in future. The reference value of the derivate contract can be anything starting from a real economy to any future event. In Indian the extent of these derivates contracts are regulated by SEBI and RBI and take place through a registered intermediary, like stock exchange board of India.[14] Thus this is a very important financial tool which is used by the FIIs to invest into a country. As the obligation is based on a reference value the fluctuates in a very short interval of time and thus the income is only generated In respect of the purchase and sale of the derivate and not on dividend as is the case with the securities. Section 10 (38) exempts any income that arise out of the transfer of long term capital asset being an equity share in a company or unit of an equity oriented fund and section 115 AD charges 10 percent tax from the long term capital gain arising out of the transfer of securities. This give rise to two peculiar questions. Firstly, whether the securities are held as stock in trade or as capital assets of the FIIs and Secondly, whether they would attract the provision of section 115 AD or Section 10(38), or 111 A. This a determinative factor as the investor has various rate benefits and rates under various heads. In the case of 115 AD the FIIs would be taxed at the statutory rate in 10(38), full tax exemption and in 111 A partial exemption. The first question is important because it uses the term capital asset and thus creating a doubt on whether such exemption is applicable to securities as capital asset only or does it extent to securities held as stock in trade. The legislative intent behind section 115 AD would through light on the purpose for which such specific section for FIIs was enacted. This was to encourage more and more foreign investors to invest in India, to fix the tax rate and to establish certainty regarding the tax rates and thus allowing the investors to assess all possible variables before designing their investment strategy in India. The purpose of section 115 AD is to provide for special concessional rate of taxation in relation to securities received from or arising from the income of FIIs. There was no particular reason why the income on account of trading in securities was excluded from the purview of section 115 AD. The fact that the transfer of securities gave rise to capital gains was dealt with clause (b) was not a valid reason to hold that the transfer of securities in the course of trading in them was outside the ambit of section 115 AD.[15] Even though it cannot be denied that the securities held by the FIIs are held in nature of Stock in trade and thus should come under the head of profit and gain from business and profession but is such proposition is accepted than the purpose for which a special section was in acted would be defeated. Also it is a general principal of law that specific provision (Section 115 AD) are considered over the general provisions ( 10 (38) and 111 A) Thus securities held by the FIIs have to be considered not as stock in trade but as capital asset for them to fall under the ambit of section 115 AD and both long term and short term capital gain by the FIIs will be taxed under section 115 AD. In India a lot of investment is done by the FIIs from the countries that India has signed a Double Tax Avoidance treaty (DTAA) with. Generally there is always clause which provides that such investors will pay tax only in the country where they have a permanent establishment. Thus the provisions of section 115 AD will not be applicable with such investors. In XYZ/ABC Equity Fund,[16], there was a holding company in Mauritius. Its main business was to hold securities and selling them at profit. The capital had been raised from obtaining money by acquiring large block of shares in Indian companies (portfolio companies). The investment strategy was through investment advisors who were acting as the nominee directors in this portfolio companies .Thus the assessing officer charged income tax on the profit and gain from business and profession. It was contended that the sales from the proceeds resulted in the business receipt and not capital gains. It was argued that the presence of the nominee director in the portfolio company made those portfolio companies the PE of the holding company in India. The question was whether the capital gain arising from the transfer of securities held in an Indian company (the portfolio company) be taxable in India? and whether the FII have a PE in India ? The court held that the presence of the nominee director did not make those portfolio companies as PE of the holding company in India. Hence not taxable under the head of business and gain and under Article 5 of DTAA (double tax avoidance agreement) of India Mauritius , the provision of section 115 AD and 10 (38) will not be attracted. The reason why DTAA is given preference over 115 AD or 10 (38) is because of section 90 (2), which says that the provisions shall apply to the extent they are more beneficial to the tax payer. Hence when a situation arise where the applicability of one of the two is in question. DTAA will prevail as it is more beneficial to the taxpayer. There is no provision in the Income tax Act which taxes the income generated in derivative contracts. Derivative has been recognized as a security under Securities Contract (Regulation)Act Now the same question arises whether the income from derivative contract is taxed under Income from business and profession or under capital asset. There are two views in this regards:

  1. First was given in the Morgan Stanley international limited [17] case where it was pointed that in order to determine this it is imperative to determine the extent of trade that is undergone with respect to the asset. At times it is important to determine the intension of the party to put them under of the income heads. The intension is determined from their action,. i.e. the substantial nature of their transactions and the quantum of purchase and sale. Thus there is no set rule of whether transaction in derivative contracts will be taxed under capital gain or profit from business and profession. It has to be determined on case to case basis
  2. Second view was taken recently in the case of Platinum Investment management A.c Platinum International Fund v DDIT [18]where the tribunal taxed the income from transaction of derivatives as capital gain. It scrutinized the SEBI regulations 1995 with section 115 AD and laid that in light of the Memorandum explaining the provisions of the Finance Bill, 1993, a FII is allowed to invest only in securities and thus the income from securities as to taxed only under section 115 AD. It said that as derivative has been made part of the securities and the marginal note of Chapter XII in which section 115 AD falls reads determination of tax in special cases. Thus a special provision overrides the general provision. I further went on state that speculative transaction, under section 43 (5) does not have an application to the FIIs in regards to the securities mentioned in section 115 AD. It said that the variable of the speculation and non speculation does not play any role and the income for all the aforementioned reason.

Both the views are important, they are not contradictory, one leaves it on the fact so each case, and other instills certainty in the regards to the taxation of the derivative contracts. The second view favors the investor more as it categorizes all transactions of FIIs securities as investment transactions and not as business transactions which allows them to invest more in India as they have to pay less tax. Further whenever there is a question in regards of the applicable law, DTAA will prevail and FIIs will not be taxed in respect to the Derivatives contracts but where there is no DTAA signed with the Country to which the FII belong then it will be taxed under section 115 AD. European financial transaction tax A lesson can be learned from the EU which has come up with an extensive policy regarding the taxation of Financial transaction. This tax was brought to ensure that the financial institutions make a fair contribution to covering the cost of the recent crisis and to ensure a level playing field with other sectors from taxation point of view. Under this tax the insurance contracts, mortgage lending, consumer credit and primary market transactions are excluded. Also currency transactions on spot markets are outside the scope of FTT, which preserves the free movement of capital. The scope of this tax is wide enough to incorporate instruments which are negotiable on the capital market, money market instruments, units and share in collective investment undertaking (including UCITS and alternative investment funds) and derivate agreements. It covers the over the counter trade. It is not only limited to the transfer of ownership but rather represents the obligation entered into. The definitions of financial instruments is wide and includes investment firms, organized markets, credit institutions, insurance and reinsurance undertaking and their managers, pension funds and their managers, holding companies financial leasing companies, special purpose entities, and where possible refers to the definitions provided by the relevant EU legislation adopted for regulatory purpose. [19] Additionally other persons carrying out certain financial activities on a significant basis are considered to be financial institutions. [20] The principal of taxation in this residential principal, in order for the financial transaction to be taxable in the EU, one of the parties to the transaction needs to be established in the territory of the member state. Moment of chargeability is defined as the moment when the transaction occurs.[21] FTT is payable by each financial transaction institutions which fulfill any of the following conditions: It is a party to the transaction, acting either for its own account or for the account of another person It is acting in the mane of the party to the transaction The transaction has been carried out on its account. When one FI act s on the behalf of the account of another FI only that other financial institutions shall e liable to pay FTT. In case the transaction is carried out by electronic means the tax is due immediately at the time of chargeability.[22] Thus now when India looks at reforming it tax policies it is imperative that he lessons are drawn for the EU which ensures that tax is levied on the investors but the investors but they are not overburdened. There is some line that has to be drawn and it should be visible so that there is certainty in the market and the investors can access the market and its regulatory framework before they are investing into a country. In the globalized world today the importance of the FPIs cannot be undermined and if they decide to invest in India , it is symbiotic relationship that both share and till it can remain that not turn parasitic from either side, a healthy marker will flourish. The regulatory mechanism in our country screens a lot of investment strategy and the tax regime make is even worse. The tax regime as we have understood does provide with incentive to the FIIs but there has always been confusion on what head they would taxed. That fosters uncertainty in the minds of the investors. Recently due to the change in government there was a lot a hope that India will be opening itself to the foreign investment and the unfriendly ground created by the Vodafone case will be cleared but the tax department has recently issued a notice to the portfolio companies that a minimum alternative tax shall be levied on them. Minimum alternative tax (MAT )is a tax that was levied on the companies and the firms who were earning a lot of profit but due to the various deductions and incentive were not paying proportionate tax. It is charges to some fixed rate on the books of account and it varies from companies to LLPs. The FPIs will be charges at the rate fo 20 % on ling term capital gain. India is one of the few countries in the world that levies tax on the non residents. This additional tax on the long term capital gain will disinterest the investors from investing into India.[23] FPIs before this notice pay zero tax for long capital gains but now it will change to 20 %, such an addition will surely hamper the already deteriorating investment attractiveness of India. As per the reports FPIs have been net buyers of 84, 988. 54 Crore in Indian equity market.[24] This projects the existing dichotomy within the government itself and reminds us that there is dire need to reform the tax system in India especially with respect to the FPIs. A


[1] Article 7 [2] Morgan Stanley & Co International Limited, 272 ITR 416. [3] Notification No. SO 282 (E)/ 31-3-95.Available at : // https://www.incometaxindia.gov.in/Pages/communications/notifications.aspx [4] Notification No: SO 199(E) / 22-1-2014. Available At : https://www.incometaxindia.gov.in/communications/notification/920110000000000014.pdf [5] Section 115 (O), Income tax Act, 1961. [6] Section 115AD (i) [7] Section 115AD(ii) [8] Section 115 AD (iii) [9] Section 115AD (iv) [10] Section 115 AD (2) (b) [11] Section 10 (38), Finance (No. 2) Act, 2004. [12] Chapter VII, Finance (No. 2) Act, 2004. [13] Section 111A, Finance (No. 2) Act, 2004. [14] Section 2(a) (a ), Securities contract Regulation Act, 1956. [15] Royal Bank of Cannada, IN re, (2010) 323 ITR 380 (AAR). [16] XYZ/ABC Equity Fund, (2001) 250 ITR 194 [17] Morgan Stanley & Co. International Limited, (272 ITR 416). [18] Platinum Investment management A.C Platinum International Fund v DDIT ( ITA No 3598/ Mum / 2010 ). [19] Thornton Matheson, Taxing financial transactions: issues and evidence, 2011 IMF Working paer WP /11/54 . [20] Article 2(7), FTT [21] Article 4, FTT. [22] Article 10, FTT. [23] Bijal Ajinkya, partner Khaitan and Company, Business standard. ( 17 September 2014). Available At : https://www.business-standard.com/article/markets/fresh-tax-fears-loom-for-foreign-investors-114091601057_1.html [24] Business standard ( 17th September ) Available At : https://www.business-standard.com/article/markets/fresh-tax-fears-loom-for-foreign-investors-114091601057_1.html.

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Legal Mechanisms for Foreign Institutional. (2017, Jun 26). Retrieved June 23, 2021 , from
https://studydriver.com/legal-mechanisms-for-foreign-institutional-investors-in-india/

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