The government, over the past few years, has carried out a number of systemic reforms across sectors to reinvigorate the investment cycle and gross domestic product. Demonetisation is now behind us and hopefully the Union Budget 2017-18 can further the growth agenda by continuing the series of reforms.
India remains an attractive destination among emerging markets for long-term investment and is structurally well placed to attract long-term capital from institutional investors, sovereign wealth funds, venture capital and private equity funds. There is always scope to remove some impediments and improve the investment climate. We expect the government to address the following issues on the tax front, which can help boost investor confidence.
In 2016, the Central Board of Direct Taxes issued circulars to bring consistency and clarity in treatment of income earned by investors from transfer of listed shares and securities and unlisted shares whereby such income shall be characterised as capital gains. Alternative investment funds (AIFs) are one of the key forms used for pooling funds from investors for typically making long-term investment in shares and securities. Income earned from such funds is exempt in the hands of funds, except business income. Such exceptions carved out in the law leaves room for interpretation for characterisation of income. Clarity in this respect can avoid potential friction with the tax department.
A suitable amendment should be brought to carve out from the obligation of AIFs to withhold taxes in cases where income distributed is not taxable in the hands of resident investor, for example in the case of long-term capital gains from listed securities.
In order to truly make it as pass through on the basis of taxation for AIF I and II, all expenses, cost and losses incurred by such AIFs should be treated as expenses and losses of the investors. A clear provision in this regard can help avoid leakage for investors.
The AIF III currently does not enjoy pass-through status and, therefore, needs to rely on other avenues available under the tax laws which are prone to litigation. To avoid litigation and bring certainty in tax treatment, pass through can be accorded to AIF III. This should be revenue neutral for the government as applicable taxes will be collected from investors in the like manner and to the same extent.
In a significant move, foreign direct investment in AIF was permitted last year under the automatic route. This enhanced the attractiveness of setting up an AIF with a larger corpus on account of non-resident investor base. While non-resident investors are not averse to making investment in AIFs, they do not prefer increased tax compliances. To increase FDI in AIFs, foreign investors who make direct investments in AIFs and whose only source of income is from AIFs can be exempted from return filing obligation in India as taxes are discharged by way of withholding of taxes by AIF.
Guidelines to determine Place of Effective Management (POEM) are likely to play a significant role in determining taxability of offshore entities. The end of financial year 2016-17 is round the corner and the final POEM guidelines have just been announced. Hence, the applicability of POEM (currently assessment year 2017-18) should be deferred appropriately so as to provide adequate time to the taxpayers to analyse the final guidelines and the impact thereof.
The intent of introducing provisions to tax indirect transfers was to bring within ambit overseas transfers resulting in transfer of control of the underlying Indian entity. The lower threshold of 5% prescribed for exemption from applicability of indirect transfer unintentionally brings within its ambit several transactions despite no consequential changes in control or management of the Indian concern.
Also, many investments are made through a multi-layered structure for various commercial and operational reasons. The existing provisions result in double taxation of the same income in such structures on account of a cascading effect. Suitably enhancing the existing 5% threshold could help to attain the purpose for which the provisions were introduced.
The Safe Harbour Rules were announced with the intent to discourage offshore domiciliation of Indian fund managers. Some eligibility conditions prescribed are cumbersome and practically difficult to comply. Relaxations in these conditions relating to investor diversification, threshold of participation interest of a single investor in the fund, would encourage fund managers to relocate to India.
The sunset clause for concessional rate of withholding tax (5%) on interest income could be extended and such rate could also be extended for all foreign debts subject to suitable safeguards to attract long-term capital.
Section 56 of the Income-tax Act, 1961 is an anti-abuse provision intended to tax transactions which generally take place between connected parties at lower than fair value. AIFs, being governed by regulatory framework undertake investment/divestment at values in the interest of its investors and therefore their investment should not be restricted by pricing restrictions provided in Section 56. Therefore, acquisitions/divestments by and to AIFs could be specifically exempted from the applicability of Section 56.
The above expectations, if acceded to in the Union Budget 2017-18, can further the government’s agenda to reduce tax litigation, provide clarity in laws, stimulate investor confidence and regain the investment momentum during 2017.
Alok Mundra is partner and Hiten Ved is associate director for deal advisory (M&A and PE) tax at KPMG in India. Views are personal.
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