What happens when sub-accounts convert to FII status
November, 03rd 2007
If the conversion of a sub-account to an FII causes a transfer of securities from the sub-account to the FII, it would trigger a taxable event.
Conversion of a sub-account to FII (foreign institutional investor) could potentially trigger tax consequences, which may well be significant, cautions Mr Vipul R. Jhaveri, Partner, Deloitte Haskins & Sells, Mumbai.
Unless FIIs get to evaluate the same, they may expose themselves to a tax burden that they may neither have anticipated nor bargained for, he adds, during an e-mail interaction with Business Line.
As per the market regulators draft proposal on participatory notes (PNs), FII sub-accounts will not be allowed to issue PNs; and an 18-month-period has been stipulated for winding up derivatives positions taken through the PN route.
From the income-tax perspective, it would be very important to see the conversion process that SEBI (Securities and Exchange Board of India) prescribes and, in particular, whether it will involve a transfer of securities under the Income-Tax Act, 1961 (the Act), explains Mr Jhaveri.
Under the Act, a sub-account of an FII is treated as a separate taxable entity, he reasons. If the conversion of sub-account to FII causes a transfer (as defined under the Act) of securities from the sub-account to the FII, it would trigger a taxable event. On the other hand, should the conversion process not result in any transfer, there is no cause for worry. The process of conversion thus holds the key to determining whether there will be any income-tax implications.
Further, if the conversion involves migration from a tax-friendly jurisdiction to another jurisdiction that does not exempt capital gain from being taxed, due to SEBI registration requirements, it may lead to a continuing tax burden for the converted FII, observes Mr Jhaveri.
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Business income or capital gains
Time is ticking fast for the sub-accounts of FIIs (foreign institutional investors). On October 22, SEBI announced a 24-hour deadline for letter of intent from proprietary sub-accounts wishing to apply for FII status. And a weeks time was given for submitting the application. Sub-accounts, for starters, are the mechanism through which FIIs handle PNs.
Does the recent SEBI move, aimed at greater transparency of FII sub-accounts and PNs, have any tax implications for sub-accounts? As per the provisions of SEBI, a registered sub-account shall be deemed to be registered as a FII for the limited purpose of availing of the benefits available under Section 115AD of the Income-Tax Act, 1961, answers Dr Suresh Surana, a Mumbai-based chartered accountant and founder of RSM-Astute Consulting Group, over the e-mail.
Excerpts from the interview:
How is the income of an FII taxed?
Taxability of an FIIs income depends on the classification of its income, either as business income or capital gains. The determination of the character of income depends upon the facts and circumstances of each case and there cannot be a fixed parameter for characterising certain income as business income or capital gains. The matter has been under severe litigation in the recent past, and the Indian tax authorities have been following an aggressive approach for the collection of taxes.
Is there any finality to the issue?
A recent circular, issued by the tax authorities, prescribes certain distinctions for the shares held as stock-in-trade vis--vis shares held in as an investment. It can provide certain guiding principles.
Some of the principles laid down in the circular to determine the character of income are:
The entry in the books of account. The manner in which the shares are valued/held in the books of account, that is, whether they are valued as stock-in-trade at the end of the financial year for the purpose of arriving at business income or held as investment in capital assets.
The volume of transactions, the magnitude, ratio of purchase and sales, etc.
The objective/motive of making of purchase/investment. If the same is purchased to earn profit, it can be treated as business income; in case the same is held for earning dividend income, the same should be treated as capital asset.
What does Section 115AD say?
Section 115AD of the I-T Act prescribes special rates of tax for notified FII in respect of its income from investment in securities and capital gains on transfer of such securities. The taxability of the gains arising out of sale of shares in the hands of FII (also applicable to sub-accounts), under the provisions of the IT Act is summarised below (for corporate entities):
For listed shares/securities/units, through recognised stock exchange and STT (security transaction tax) being paid, long-term capital gains tax is nil, and the short-term one is 10.558 per cent.
For other cases, long-term capital gains tax is 10.558 per cent; and, short-term, 42.23 per cent.
In both the instances, business income is taxed at 42.23 per cent. However, it is nil, in the first case, if the income of an FII is not taxable in India under a tax treaty and if that FII does not have a permanent establishment (PE) in India.
How is tax treatment different for FIIs coming through the Mauritius route?
Most of the FIIs are tax residents of Mauritius and are eligible for double tax avoidance agreement (DTAA) benefits available due to the Indo-Mauritius treaty. Tax rates applicable to such cases are: Nil capital gains tax, both long-term and short-term; and business income taxed at 42.23 per cent, except where the FII does not have a PE in India, in which case the business income tax is nil.
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On offshore derivative instruments
Will the proposed review of FII regulations about issuance of ODIs (offshore derivative instruments) have any income-tax implications in India for foreign investors? The answer appears to be in the affirmative.
The proposals may lead to tax cost for the overseas investors and these investors will have to take a re-look at their India investment strategy, cautions Mr Naresh Makhijani, Executive Director, KPMG.
As you may be aware, the market regulator SEBI recently clarified that it will allow only proprietary sub-accounts of FIIs to issue participatory notes (PNs) till such time these sub-accounts get themselves registered as full-fledged FIIs.
The regulator is also set to undertake a full review of regulations relating to the foreign portfolio investors with the ultimate objective to have a cleaner market where everyone knows the identity of all investors, reminds Mr Makhijani. As per the latest press reports, SEBI is expected to issue a notification to allow foreign nationals with a minimum net worth of $50 million to invest through sub-accounts.
Excerpts from the e-mail interview:
Why control ODIs?
The potential exponential returns from investments in Indian stocks have led to considerable interest by overseas investors, particularly FIIs. To regulate the same, SEBI has issued a draft discussion paper on the issue of ODIs. These proposals, if carried out, may cause restructuring of investments by FIIs with the resultant tax consequences.
How do these ODIs work?
Simply stated, overseas investors subscribe to ODIs such as PNs for an exposure in Indian equities or equity derivatives. These investors are unregistered with SEBI. These ODIs are issued by a FII (or its sub-account) registered with SEBI.
What are the tax implications of the proposed regulation?
SEBI has proposed that there should be no further issuance of ODIs by sub-accounts of FlIs. So, investment in Indian securities that underlie the ODIs will now have to be traded by the FII itself and may cause a taxable event in India.
For instance, a corporate FII in Luxembourg may have a sub-account in Mauritius, a country with which India has a tax treaty, whilst Luxembourg has yet to have a tax treaty. If the Mauritius sub-account is barred from issuing ODIs, the only option before the FII is to issue the ODIs from Luxembourg to the investors.
This would hurt the FII in Luxembourg by way of income-tax, as the gain realised from sale of securities would suffer income-tax as per the domestic tax law, that is, the rate of 10.56 per cent or 42.23 per cent including surcharge and education cess (for short-term capital gains from sale of listed and unlisted shares respectively) or at the rate of 21.12 per cent including surcharge and education cess (for long-term capital gains from sale of unlisted shares) against total capital gains tax exemption in Mauritius. This could eventually force the FII in Luxembourg to stop issuing ODIs.