Investment through PNs set to rise with proposed DTC

Taxes on FIIs may rise with long-term capital gains in the net.

Investment in stock markets through participatory notes (PNs), the offshore derivative instruments, are set to rise if the direct tax code (DTC) is implemented in the revised form released yesterday.

PNs are notes issued to overseas investors by registered foreign institutional investors (FIIs). The instrument is not taxed in India but mainly in tax havens, such as Singapore and Mauritius, or countries which have a significantly lower tax rate than India. Investors who do not want to bring their money directly into India were using PNs.

The notional value of investments in equities through PNs was 13 per cent of the Rs 8.18 lakh crore of FII investment in the country as of February, show the latest available data. Experts said this could rise to 25-30 per cent by next year, as FIIs will now make more use of the instrument, since the revised DTC will make it difficult for them to avoid paying taxes in India.

The DTC has proposed that even long-term capital gains tax should be levied on income from securities, which is likely to be 10-15 per cent. Earlier, only short-term capital gains tax, which is income from securities generated in less than a year, was collected at the rate of 15 per cent. FIIs may feel that long-term capital gains tax may be a burden, as they were already paying securities transaction tax (STT) on purchase and sale of securities.

"Tax payers from countries with whom India's tax treaties provides for capital gains to be taxed as per Indian domestic laws would now be hit. Till now, they were taking the position that business profits are not taxable in India," said Sameer Gupta, partner with Ernst & Young.

"The tax for FIIs in India is set to rise and they will look for other options to minimise it," said Suresh Swamy, executive director of Price Waterhouse.

In the revised DTC proposal, the income of FIIs from purchase and sale of securities will be taxed under the head ‘capital gains’. Experts say while most FIIs paid capital gains tax in India, around 20-30 per cent, who showed their income from the securities market as business income, claimed exemption.

While income from equity derivatives was considered as business income, for certain FIIs’, income from any equity investment was business income if they did not have any permanent establishment in the country and provided a commercial justification for their investment income.

While FIIs investing from tax havens were completely exempt from capital gains tax, major US and UK-based pension and mutual funds claimed their gains were business income and were exempted from any tax. By the double taxation avoidance agreement (DTAA) with countries like the US and UK, business income of FIIs was exempted from tax in India, as it was paid in their home country.

While more FIIs may now take the tax haven route to invest in India, major pension funds and mutual funds will resort to PNs. Also, PNs would be a much safer bet: for some FIIs to prove they enjoyed the benefits of DTAA or claiming credit from the home country would be a tedious job.

The diluted version of the new DTC says that between the domestic law and the relevant DTAA, the one more beneficial to the taxpayer would apply. For this, the FII will have to provide a certificate that it enjoyed DTAA benefits form the home country. There are around 25 PN-issuing FIIs in India.