Is India a hub of tax officials who whip out their pens and fire tax notices like a bunch of Al Qaeda operatives with their AK-47s? Or is it a haven for foreign wealth that is sheltered from the reach of the long arm of global taxation? Foreign investors who have made portfolio investments in the Indian stock markets over the years contend that it is the former. But those in charge of the country’s tax administration, including the Finance Minister himself, have not only hotly contested such a description but have, in fact, gone on to caution foreign investors that India is not a tax haven where foreign investors can expect to operate with impunity.
As Finance Minister Arun Jaitley so eloquently put it, “legitimate tax demand is not tax terrorism”. He also said: “We are not a tax haven and we don’t intend to be one…” (See http://goo.gl/Dcmzm8)
Of course, the debate would never have arisen had foreign institutional investors (FIIs) not, in recent times, been slapped with belated tax demands on incomes they earned from 2009 to 2011.
Varying estimates
In some cases, these demands have been raised after the initial assessment of income had been made and taxable income has been determined to be either ‘nil’ or a sum clearly lower than what is sought to be imposed on them by way of Minimum Alternate Tax (MAT). Estimates vary. But these claims are believed to be in the range of $ 4-5 billion in back taxes and interest and penalty, and possibly closer to $10 billion.
How have things come to such a pass? The FIIs have operated on the assumption that their profits and gains from investment operations in India will stand on a different footing from incomes earned by local (Indian) investors. The department had initially tried its best to bring them under Indian tax laws by arguing that they are actually operating from India and not from Mauritius or some such country, with which India has a preferential tax arrangement.
After losing the battle in the Supreme Court, over the question of the exact location of management control (the SC had ruled that if the institution held a certificate issued by the Mauritian authority stating it was resident of that country, the same should be accepted prima facie as the location from where the entity managed its investment operations) the tax authorities had allowed the FII view to prevail in tax assessment proceedings. But the Department has had a rethink on this and is now saying it will still have to pay some tax under the provisions of the minimum alternate tax (MAT).
What is MAT?
What exactly is MAT? To understand this concept better, one needs to go into the structure of Indian law, particularly the tax on investment profits. There are two possible options for bringing investment profits to tax. They can be viewed as flowing from the routine buying and selling of assets (investment business) or, alternatively, as accruing from a series of casual transactions of such buying and selling. The former is business profits and is taxed according to provisions of income tax law on computing business incomes. In the latter case, it will be classified as ‘capital gains’.
It is hard to lay down a rigid yardstick by which a set of transactions can be classified as forming either part of an investment business or transactions of a casual nature. In any case, it is a settled principle of tax law that where there is more than one way of classifying a source of income that is liable to tax, a taxpayer can opt for a classification that is more beneficial to him.
Thus, if it suits an assessee (technical term for a tax-payer) to define a certain set of transactions as essentially casual in nature, and is therefore in the nature of ‘capital gains’, he is entitled to do so and the authorities would subject the income to taxation applicable on such gains.
The above distinction is important as tax rates have tended to be more favourable for incomes classified as ‘capital gains’ rather than when those are seen as forming part of a business activity. FIIs have routinely classified their investment transactions and the resulting profits as ‘capital gains’.
Preferential treatment
This was additionally advantageous to FIIs incorporated in countries (practically all) with whom India has a bilateral treaty of taxation (Double Taxation Avoidance Agreements). These agreements typically promise to extend preferential tax treatment to entities from the other country as a means of strengthening bilateral economic relations. The most common theme across such agreements is a clause declaring that investors can elect to submit their incomes earned in one country to taxation as per the laws of the other country.
Let us assume a foreign institutional investor incorporated in Mauritius has earned ‘capital gains’ from purchase and sale of equities of some Indian companies. Let us also assume that the Mauritian tax law allows for such gains to be taxed at ‘nil’ rate (as indeed is the case with the Mauritian tax law) while under the Indian tax law the rate is something higher than ‘zero’. The agreement that India has entered into with Mauritius allows an FII to submit its income from Indian investment operations to the applicable rates of tax under Mauritian law. Not surprisingly, the FIIs have done precisely that and all these years the Indian tax authorities have accepted these claims and completed the tax assessment accordingly.
But the Indian tax authorities now contend that while FIIs may not have a tax obligation by virtue of the provisions of DTAA with the country they are incorporated, they do have another kind of obligation: one under the Minimum Alternate Tax (MAT), a scheme of alternative structure of taxation. (It is a measure of the cultural dominance of all things American that even Indian tax law has adopted the word ‘Alternate’ when the corresponding word in British English would be ‘Alternative’. But that is a different matter altogether).
Book profits
The law on MAT stipulates that where the tax payable by a company on the income computed by applying the provisions of the income-tax law is less than 18 per cent of an alternative measure of profits, called the ‘book profits’, the company shall pay tax at 18 per cent of such ‘book profits’. The expression ‘book profits’ represents profits computed by applying general principles of accounting and also specific provisions of the company law that deal with preparation of financial statements such as Profit and Loss Account and the Balance Sheet.
The FIIs say that the law on MAT applies only to Indian companies. The tax authorities say that the language of the provision on MAT talks only about the tax obligation of companies, in general, and not just Indian companies. Under income-tax law, even a foreign company is a company for tax purposes.
The FIIs say that even if they, for purposes of argument, accept that MAT applies to foreign companies as well, they are on strong legal grounds to escape any tax liability. That is because the second part of the stipulation, namely that ‘book profits’ be computed as per the provisions of Indian company law for preparation of Profit and Loss Account would not apply to them. As foreign companies they are obliged to prepare financial statements such as the P&L and the balance sheet only as per the company law applicable in the country of their incorporation. So a computation of ‘book profit’ under Indian company law does not arise and consequently there is no ‘book profit’ for purposes of MAT.
Jury still out
But the tax authorities contend that while FIIs are legally obliged to prepare a set of accounts in conformity with the company law applicable in the country where they are incorporated, they can still prepare financial statements as per Indian law and arrive at ‘book profits’ as though the provisions of Indian company law are applicable to them.
In short, the tax authorities are saying that the law on MAT is applicable to foreign companies and that, further, there are no practical or legal impediments to their preparing financial statements under Indian company law.
So, is it game, set and match for the Indian tax authorities? Not quite. The FIIs too have mounted a credible defence against the tax demand. That contours of such a defence form the second part of this essay.