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FIIs Get Hit by Minimum Alternate Tax Demand of 40,000 Cr. for Thinking Capital Gains Were Tax-Free

Foreign institutional investors must be perplexed. After this government came about and said “No retrospective taxes”, it does the most astounding things ever. The latest in the kit is to hit FIIs with back-taxes.

The history

In 2012, a Mauritius entity called Castleton Investment Limited (CIL), a Mauritius entity, asked an interesting question of the Income Tax Authority for Advance Rulings (AAR, where you can say, Look I’m doing this thing, will you tax it?)

CIL owned shares of Glaxo Smithkline India, since 1993. But it wanted to transfer these shares to a Singaporean group entity. Since it owned shares for 20 years, it should technically have not paid any taxes in India (long term capital gains tax in India is zero). Plus, India has a double taxation treaty with Mauritius.

But the AAR said something weird:

  • Yes, there’s no tax for this transaction in India
  • But wait, transfer pricing rules apply (so it has to be proved to be an arm’s length transaction)
  • And hang on, CIL has to pay Minimum Alternate Tax (MAT) in India.

Whoa. Wait. MAT is now nearly 20%.

An investment company that’s held shares in India since 1993, now would think that because cap-gains taxes are zero, they needn’t pay anything! But with a 20% MAT, that effectively means that any company which sells Indian listed shares will have to pay 20% MAT on the profits.

That’s effectively a capital gains tax! In another ruling in 2012, AAR confirmed the same thing for another company, Smithkline Beecham Port Louis Ltd.

This impacts every single entity that made profits selling shares in Indian companies before April 2015. Even if they were based in Mauritius, it seems, at least from the above ruling.

No MAT since 2015 April

The Feb 2015 budget removed MAT from FIIs hands, but only going forward.

Which meant only one thing: that MAT applied earlier. Which means, FIIs who made profits must pay.

The Big Demand

Arun Jaitley recently affirmed that he would press on with a demand of Rs. 40,000 cr. This demand was made of FIIs who bought (and sold) Indian shares in the past, and considered their gains to be tax free – either as a result of a double taxation treaty (such as being based in Mauritius) or because Long Term Capital gains taxes are anyhow free.

This is no longer the case, considering the AAR rulings.

Meaning: Sure, no capital gains tax. But MAT applies, so give us your 20% please.

Impact: Hedge Funds, Foreign Funds, VCs?

Think of this: A big VC bought into a startup from its Mauritius entity. It got an “exit” by having that company go through an IPO. It sold the shares later on an exchange, and returned the profits to its investors.

Suddenly they get a tax demand saying give us 20% of that old money back. Why? Because MAT is applicable. How are they going to get that money back? Doesn’t sound feasible, does it? But it’s out there.

Hedge funds that invested directly in India for the “long term” too have gotten these demands (i.e. even non Mauritius entities). And this doesn’t end here – even if certain companies haven’t got a demand yet, they can get more demands later, since the tax department will simply work on this one entity at a time.

They had requested Jaitley to please go retrospective on this law which would have cleared past dues – but Jaitley refused. Which means many of them will have to pony up; even if it means taking the money off their own pockets. But will they just choose the other option: Exit India Altogether?

The Impact is also to Indian companies: if your company owns shares and sells them, even after one year of holding, MAT will apply. When you value a company saying it owns shares of THAT company, what you should do now is straightaway put a 20% discount for MAT. Even for long term capital gains on mutual funds or “arbitrage” funds, companies are likely to be hit with MAT, making their effective returns lesser.

You never know when this rule will suddenly begin to apply to LLPs and even Individuals; there is something called “AMT” but we haven’t seen a ruling that applies this to capital gains yet.

It’s not over – there will be a lot of push and pull from every side, but this adds another horrible layer of misunderstanding. We wouldn’t be surprised to see such tax aggression followed by investors just refusing to invest. Yes, India does have a point; but does it really need to say that something is tax free when it isn’t?

  • saba says:

    When mat announced first? Suddenly it came from heaven?

  • kumar says:

    this is going to be fun to watch, and this story has been enacted in the recent past.
    vodafone drama comes to mind.
    of course, it was a different government run by a different party, but at the crux of the problem, it is money that someone thinks they are owed, and plan to collect, now that they have made plans to spend that amount under various heads.
    good luck to all involved parties.

  • DJ says:

    Hilarious. All those people who were saying tax laws should not retrospective, now have to ask to make this retrospective. Ha Ha. No wonder the govt and tax dept were happily saying – don’t worry, we won’t make retrospective tax laws. Take that!! Really, our govts are so cheap and arbitrary, its ridiculous!
    I have tried reading tax laws for investors and there are a LOT of things like this. The laws are so many and complex that one could demand anything really if the govt feels like it… especially from rich people, the govt can claim anything and everything. No wonder people in India decided – lets not be rich, lets not be meritocratic, etc, etc.

    • It really sucks! But hey such is India today…I wonder if, when this money doesn’t come, will the tax dept go after them with something else…

      • DJ says:

        No, no, we are getting better than before…
        Yeah, it will be interesting how the tax dept goes about trying to get this money. I think most laws in India rely on the people being sheep and falling in line, without asking questions. If the FIIs are unlikely to do that (lets hope so for the sake of more fun), then it will be fun to watch what happens. Likely that babus will go crazy with ego issues when their nonsense is questioned (like in the Vodafone case).

  • DJ says:

    By the way, so this is about 0.5% of total market cap. So, if this causes a 0.5% drop in the market, since FIIs need to sell some of their corpus to pay the taxes , then it is simply a transfer of private wealth/investment to public revenue. So, it seems to be just another way of crowding out of investment by the govt sector.
    And, 0.5% is a very low bar, as total FII inflow in 2014 was about 100k crores, so this is about 40% of annual investment. Now, if FIIs take out 40% of 2014 inflows, what that does to the market and currency should be a lot more than 0.5%, which raises the question, is it a wise move to do this even if it is legal? Aren’t we going to destroy way more wealth than the measly $7B, even if the destruction might be temporary? At the very least, something like this should be eased into place so that adjustments can happen over a long period of time, rather than suddenly. Or, maybe, the govt would like to see some FII outflow and a weaker rupee to spur exports. Well, that would be about the only good outcome, I guess…

  • Anon says:

    This amendment seeks to mock the entire FII framework under which FIIs were eligible to pay tax at a concessional rate. The FII Regulations were introduced in the post liberalisation era with an intention to develop Indian markets. I hope this government hasn’t forgotten that. I deal with FIIs and they are simply aghast by the huge quantum of tax that is suddenly slapped on them now.

  • Vineet says:

    Hi Deepak,
    Check this out, not related to FII’s but about our beloved Income Tax Dept.
    “Now, you have to disclose foreign travel in IT returns”
    I bet that this won’t result in any extra revenue only extra harassment for law abiding tax paying upper middle class folks.

  • JustSaying says:

    AAR rulings are binding only on the tax payer to whom it is issued. Hence, everyone else is not covered by this ruling, unless Supreme Court confirms this matter. Though AAR rulings have persuasive value.
    In case of Castleton, if I remember correctly, it was a prospective transaction for the transfer of shares. Not sure if they went ahead and did the transfer.
    To someone who asked when was MAT introduced – it was introduced in FY 1996-97 – so it is an old evil. By the way FII industry was aware of this MAT exposure. When it comes to paying something, you become aghast. Even in 2012, when Castleton decision was issued, FIIs were sounded off that they could be subject to MAT.

  • Dinesh says:

    Govt refuses to the Demand, now see the market

  • Shalabh CA says:

    Capital Gains and regular business income are two completely different things. Capital Gains arise out of investments while business income arises from business activity. Hence, almost every country has different tax regimes for capital gains and business income. These two cannot be mixed, i.e. income tax cannot be levied on capital gains or vice versa. Now India’s long term capital gains tax is zero for everyone. If it wants to tax capital gains, it should first increase its long term capital gains rate. But it certainly cannot apply MAT (a form of business income tax) on something which is obviously capital gains. None of the funds can ever pay this tax because funds earn fees not capital gains (the gains belong to investors in their funds). The whole issue should not have risen in the first place. It is like a joke. India’s Income Tax officials are making a mockery of our country in the world. These babus urgently need to go through an accounting and economics 101 class.

  • Vineet says:

    This article has more details and as we all know devil is in the details