Another Twist In The Indian Tax Treaty Saga

by Lorys Charalambous, Tax-News.com, Cyprus

18 May 2005

In a report to Parliament, the Comptroller and Auditor-General of India, Vijayendra N Kaul, has proposed that the income of foreign institutional investors (FIIs) from stock market activities should be treated as business profit and taxed accordingly.

A CAG report tabled in Parliament on Friday said that the income of FIIs/sub-accounts was often being "erroneously categorised as capital gains and being exempted from tax by routinely invoking the Double Taxation Avoidance Agreements (DTAAs)." As the tax treatment has major revenue implications, the CAG has said the Central Board of Direct Taxes (CBDT) should clarify its position on the matter.

"The board (CBDT) may issue necessary clarifications to ensure correct and proper taxation of income arising to FIIs/sub-accounts," the CAG has suggested. It has also specifically sought clarification on whether sub-account arrangements would constitute a `permanent establishment' under tax treaties.

Further, the CAG has recommended that the CBDT should strengthen the mechanism of coordination with regulatory bodies such as the Securities and Exchange Board of India (SEBI) and the RBI so that vital information relating to the income of FIIs/sub-accounts is obtained regularly and acted upon promptly by assessing officers with a view to bringing the same to tax.

While highlighting that cost-benefit analysis of DTAAs had not been conducted, the CAG report recommended that DTAAs be examined critically through a phased and well-monitored programme so that the interests of the revenue are safeguarded and one-sided concessions are avoided.

The CAG (an officer created by the Constitution to see that all the government authorities act in regard to all financial matters in accordance with the Constitution and the laws and rules framed under the Constitution) suggested that the board may "assess the costs and benefits from each DTAA transparently and objectively, especially as DTAAs are not placed before Parliament."

The CAG's report has to be seen in the context of long-running in-fighting between various agencies of the Indian establishment, in which the government has defended the tax-privileged position of FII's against attacks from tax inspectors and other bodies.

The root cause of the problem is that many so-called 'FII's are in practice simply Indian organisations or individuals who have round-tripped through Mauritius and other offshore centres in order to invest tax-free back in India. The government's preferred route to deal with this problem is to improve transparency by including exchange of information clauses in the DTAAs, and incorporating the DTAAs into overall bilateral free trade agreements.

This forumula has been applied to Mauritius, and may come to be applied to Singapore, which has recently emerged as a competitor to Mauritius as a conduit country for Indian investment. The Mauritius business community is in fact seriously worried about the threat posed by Singapore, although it seems unlikely that the India/Singapore agreements will rival those already obtained by Mauritius. As currently proposed, the India/Singapore DTAA will not contain capital gains tax exemption for incoming Indian investment, plus Singapore is resisting the introduction of an exchange of information clause.

The attitude of the Indian Finance Ministry will be crucial to existing and future DTAAs. If the CAG's report is taken up in a big way, that could spell problems for Mauritius. But history says that the government is unlikely to act unless it is forced to by political pressure.

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