The Taxation proposals contained in the Union Budget 2014, read in light of the General Anti-avoidance Rules (GAAR) which were notified September last year seem to carry a simple message to FIIs – avail the tax certainty and concessional tax treatment afforded under the Domestic Tax law provisions, forget Tax Treaty benefits and thereby spare yourself of GAAR worries.

The real concern as regards applicability of GAAR provisions to FIIs was that Tax Treaty benefits could potentially be denied by invoking the GAAR provisions, particularly where “Treaty Shopping”  is suspected (read Mauritius-resident FIIs), and consequently income of such FIIs would be taxed in India. The GAAR rules which were notified last year contained a useless exemption to the applicability of GAAR to FIIs – the rules provided for exclusion of FIIs from the purview of GAAR provisions, subject to the condition that they don’t claim Tax Treaty benefit!

The Budget proposals now guarantee “income characterization” to FIIs. All incomes from securities transactions would now only be subjected to capital gains taxation in the case of FIIs. India has a favorable tax regime for capital gains in listed securities – gains which are of short-term nature (ie those arising from securities held for 12 months or less) are taxed at a concessional rate of 15% while long term gains (those arising from holding period of greater than 12 months) are exempt from tax. Such transactions are however subjected to a small Transaction-level tax called the Securities Transaction Tax.

Characterization of income from securities transaction has been a bone of contention between Revenue authorities and Tax payers in general – and not just FIIs. The “certainty” in income characterization guaranteed to FIIs actually creates a situation where “active” FIIs would enjoy a favorable tax treatment vis-à-vis similarly placed domestic stock traders.

Active FIIs are generally proprietary accounts or Funds which follow an active investment strategy involving frequent entry and exit to catch “market momentum” moves and are therefore at high risk of their income being characterized as “Business income” which is taxed at steeper rates. All such FIIs would be the real beneficiaries of the tax proposal, as their income can now only be taxed under the head “Capital Gains”. The favorable characterization to FIIs would apply even to income from derivatives – a significant benefit given that the derivative segment now accounts for a lion’s share of capital market volumes. By contrast, the domestic traders under similar circumstances would very likely be taxed on their income from stock and derivative trades at a higher rate under the categorization as “Business income”.

Investment Management Activity

While alluding to the above proposal in his Budget speech, the Honorable Finance Minister had remarked that Investment Managers of FIIs are often stationed outside India on account of the fear that their presence in India would have adverse tax consequences to the Funds which are managed by them.

From the perspective of Investment Managers, the above reference had the potential to be wrongly construed as granting of special tax benefit to the activity of Investment Management itself. However, no such special benefits have been proposed and Investment management outfits would face normal tax consequences (as business income) on their advisory fees, should they be based in India.