The revised discussion paper (RDP) on Direct Tax Code seeks to settle the current ambiguity by clarifying the character of income earned by foreign institutional investors (FIIs) from transactions in capital markets. This, apparently, also closes one of the avenues availed of by certain FIIs for claiming tax exemption in India.

Scheme of taxation of capital gains: The RDP proposes a revised scheme of taxation of capital gains. Under the revised scheme, capital gains would be considered as income from ordinary sources and taxed at applicable rates. While no indexation would be available for listed equity shares and units of an equity-oriented fund (specified securities), held for more than one year, a deduction at a prescribed percentage of capital gains would be available in computing the adjusted capital gains.

Capital gains earned on non-specified securities held for more than one year would be eligible for indexation benefit. Securities Transaction Tax is proposed to be calibrated based on the revised tax regime for capital gains and flow of funds to the capital market.

Characterisation of income: The characterisation of income earned by FIIs from transactions in the capital market has been a vexed issue. Historically, most FIIs have offered the income earned on sale of shares under the head capital gains. The revenue authorities have till date, in most of the cases, accepted this position. However, some FIIs have claimed the above income as business profits and consequently in the absence of a permanent establishment (PE) in India, treated the same as exempt from tax in India under the applicable double tax avoidance agreement (DTAA).

There have been a few rulings by the Authority of Advance Rulings (AAR) on the subject. A ruling of the AAR in 2007, has distinguished its earlier ruling in the context of characterisation of income earned on transactions in equity shares by FIIs. The AAR in that ruling held that income on sale of shares earned by FIIs is taxable under the head capital gains.

Further, the AAR has, in a couple of other rulings, held that income earned by FIIs from trading in futures and options (exchange traded derivatives) is business profits and not taxable in India in the absence of a PE in India under the relevant DTAA.

It appears that the underlying intention of the government is to close, as far as possible, all windows available to FIIs to claim exemption from tax in India on transactions in securities, to a ensure level-playing field with the domestic investors.

In a step towards this direction and also to end the controversy surrounding the characterisation of income of FIIs, the RDP provides that the income of FIIs from purchase and sale of securities shall be treated as capital gains. It appears that this treatment is also sought to be extended to investment by FIIs in exchange traded derivatives.

Having said that, it would be interesting to examine the precise language of the amendment to evaluate if it provides any scope of taking a different position as regards characterisation of income under the DTAA (although this is precisely what the RDP intends to cover).

The DTC had proposed that between domestic law and the DTAA, the latter provision will prevail. This had raised apprehensions regarding the eligibility to beneficial provisions of DTAA upon enactment of the DTC. The RDP proposes to revert to the existing tax provisions whereby the domestic tax law or the DTAA, whichever is more beneficial to the taxpayer shall apply. However, it is clarified that the DTAA will not have preferential status over domestic law, inter alia, when the General Anti-Avoidance Rule (GAAR) is invoked.

While the above clarification on characterisation of income should not by itself impact the FIIs which are tax residents of Mauritius, Cyprus and other jurisdictions having DTAAs with India which exempt capital gains from taxation in India, it would be important to see the approach of the government in invoking the GAAR provisions to investments made through existing structures from these countries.

Thus, the income earned by such FIIs would continue to be exempt from tax in India unless the GAAR provisions are invoked or until such DTAAs are amended to remove the exemption.