The recent discussion paper also introduced the concept of a 'Controlled Foreign Corporation' in India.

Foreign investors not covered by any double taxation avoidance agreements will face higher capital gains tax outgo if the proposals in the revised Direct Taxes Code are implemented. Ongoing budget pressures have led to governments continuing to consider various methods to increase tax revenues. In August 2009 the Indian Ministry of Finance (MoF) released a draft of the new Direct Tax Code (Draft Code) as a Discussion Paper. Last week the MOF released a Revised Discussion Paper which responds to issues raised in the initial Discussion Paper. Responses to the revised discussion paper will be considered while finalizing the bill for introduction to Parliament.
 
In particular, the Draft Code proposes to consider the income under capital gains as income derived from ordinary sources, thus eliminating the current advantage of the distinction between long term and short term capital gains tax.  The Draft Code also proposes to tax the income of the Financial Institutional Investors (the FIIs) as capital gains which could increase certain FIIs tax liability.  
 
In addition, clarifications have been made regarding criteria for considering whether a company incorporated outside of India is a tax resident of India.  The concept of Controlled Foreign Corporation has also been introduced. 
 
Finally, there is positive news in that the previous Discussion Paper proposal that domestic law superseded tax treaty provisions if the domestic law was later in time has been backtracked whichever is more beneficial to the taxpayer (tax treaty or domestic law provisions) will now prevail with exceptions for general anti-avoidance (treaty shopping or lacking in economic substance) and Controlled Foreign Corporations.
 
Business income or capital gain
Currently, there is a distinction between long term capital gains tax (tax on capital gains made from transfer or sale of capital assets held for more than a year) and short term capital gains tax (tax on capital gains made from transfer or sale of capital assets held for less than a year).  Short term capital gains made from the transfer or sale of capital assets (such as stocks, bonds, etc.) is presently taxed at a rate of 15 percent whereas there is a tax exemption on long term capital gains tax.  Therefore, long term investments are currently exempt from capital gains tax.
 
One of the most significant changes brought in by the Draft Code is the removal of the entire head of income from capital gains.  Any income received as capital gains earned by a domestic investor shall be considered income received from ordinary sources and shall be taxed according to the individuals tax slab.  However, some benefit has been given to long term capital gains, i.e., it has been suggested that capital gains arising from transfer of an investment asset which are held for more than one year from the end of financial year in which asset is acquired, shall be computed after allowing a deduction at a specified percentage of capital gains (the rate has not been specified yet).   This adjusted capital gain will be included in the total income of the taxpayer and will be taxed at the applicable rate.  However, no such concession has been made for short term capital gains and all of it will be taxed at the slab rate.

Another significant change proposed by the new code is with respect to Foreign Institutional Investors (FIIs) registered with the Securities and Exchange Board of India (SEBI).  FIIs are regulated by the SEBI (FII Regulations), 1995 which provide specified sectors in which an FII is permitted to make investments.  The Draft Code has proposed to classify all the income arising from the purchase and sale of Indian securities by an FII as capital gains. 
 
Long & Short On Capital Gains Currently, FIIs are by governed by section 115AD of the Income Tax Act, 1961 which refers to the taxation on income of FIIs from securities or capital gains arising from their transfer.  While some FIIs have been classifying their income from securities transactions as capital gains, others have also been classifying such income as business income, thus claiming total tax exemption by declaring an absence of a permanent establishment in India.  It is this loophole that is being closed.

On one hand, the change proposed by the Draft Code might discourage FIIs from investing in India by increasing their tax liability, the change has to be considered in light of the fact that most FIIs invest in India via Mauritius or through another country which has signed a Double Taxation Avoidance Agreement (DTAA) with India. 
 
The India-Mauritius DTAA provides that capital gains are taxable in the country of residence of the shareholder.  Thus, FIIs entering through the Mauritius route are taxable in Mauritius which imposes zero capital gains tax.   FIIs who were not routing their investment through a DTAA jurisdiction, may now do so.
 
Introducing Controlled Foreign Corporations
Clarifications have been made in the Revised Draft Paper regarding whether a company incorporated outside of India may be deemed to be a resident of India.   A company incorporated outside of India will be deemed to be a resident of India if the companys place of effective management is India.  Place of effective management has been defined as the place where the board of directors, executive directors and officers make their decisions or perform their functions.  This may impact offshore holding company structures if the effective place of management is in fact in India.
 
Another important concept that has been introduced is that of Controlled Foreign Corporations which provide that passive income generated by a foreign company controlled directly or indirectly by Indian tax residents and where such income has not been distributed for tax deferral reasons, shall be deemed to have been distributed, thus making the distribution taxable as a dividend distribution in the hands of the Indian tax resident.
 
Many important changes are being proposed which affect both domestic and international investors.  Some loopholes such as business income for FIIs have been closed and proposals such abolishing the distinction between long term/short term capital gains will affect domestic investors.   Holding company structures may be impacted by new criteria detailing when a foreign company is resident in India and new proposals regarding Controlled Foreign Corporations.   The clarification regarding the priority of treaty provisions versus domestic law was welcome news for investors.  Commentators are now anticipating which changes will make into the bill which will be forwarded to Parliament.