First, lets get some facts straight. As someone involved in the fund management business and advising a few Mauritius-based funds, my view is that the tax-man in India who gave a capital gains tax bill to a few fund managers has done the correct thing - legally.
At the time of setting up Mauritius-based vehicles, a legal opinion presented to me clearly stated (unless age has killed my memory beyond repair) that:
- it is okay to set up a Mauritius-based company to take advantage of the double taxation facilities,
- but beware how that Mauritius arm deals with its Indian affiliate or related Indian entity - because the treaty classifies who does, and who does not, enjoy the benefit of the preferential tax treatment.
And it was that "beware" which everyone ignored. The "beware" was this: If, for example, Fund ABC is set up in Mauritius and if Fund ABC has an Indian office called India ABC, then India ABC cannot make decisions on behalf of Fund ABC because then, under the terms of the treaty, Fund ABC will be assumed to be having an operation in India and would fall under Indian tax laws.
However, India ABC could give advice to Fund ABC by sending Fund ABC recommendations, suggestions but could not decide for Fund ABC. Therefore, India ABC cannot call a broker and buy/sell shares on behalf of Fund ABC. So, those who followed the law made sure that India ABC only sent a recommendation to Fund ABC that it was advisable to buy shares of ACC, Birla, or whatever and made sure that Fund ABC then called the broker and placed the order to buy/sell shares directly. But instead of following the law, most India ABCs began to call brokers directly and gave instructions as if they were Fund ABC.
If this distinction between an active and passive role is still one of the conditions of the treaty with Mauritius then, clearly, the tax man has done the right thing by serving notice on the India ABCs and the Fund ABCs to cough up a tax payment. I have not seen anything to suggest that this condition was waived in any amendments of the treaty since my last interaction with it in 1996.
Now, having laid the facts on the table and complimenting the tax man for doing the right thing, let's get to the larger broader issue: what is this capital gains tax all about? And that is not an issue with the tax man but, really, with the Ministry of Finance. For years the foreigners have been saying that paying a tax on capital gains is downright silly. India is competing for capital and in a world with over 60 stock markets, being one of the few that charges some sort of tax on capital gains is reason enough to dissuade foreign money flows into India.
But this "foreign" argument is not as solid as it sounds because:
- foreigners are no angels carrying money to give us for free, they want returns. Whether we have SEBI registrations, or no SEBI registrations, a US$ 10,000 charge for the registration or whether it is for free, if we have capital gains tax or not: if the foreign portfolio managers smell a chance to make money, they will invest in India. Zero capital gains tax will certainly make India a more attractive market but maintaining capital gains will not see the US$ 11.5 billion FII money declining to zero.
- foreigners pay capital gains tax in other countries: Australia, Poland, Spain and Thailand being some of them, though many foreign investors get exemptions or credits due to their status as a pension fund or due to a Double Taxation Agreement.
The Ministry of Finance should do away with capital gains taxation not because the foreigners want it removed but, rather, because we Indians are fed up of capital gains tax and the material loss to the Ministry of Finance is, well, immaterial. By the time you add indexation and offsetting opportunities, the capital gains tax that the Ministry gets must be less than 1% of all tax revenues.
But there is another reason to knock of capital gains tax: Create more business in India. At present, the Indo-Mauritius tax treaty probably supports about Rs 1 billion (US$ 23 million) of annual expenses on salaries, hotel expenses, and airline costs as every foreign company like Fund ABC has to have Mauritius-based accountants, lawyers, and board meetings! Let the foreign funds spend that money at the hotels in India (psst…buy Indian Hotels!) and on airlines, lawyers, and accountants in India (pssst…forget computer scientists, marry your daughter off to a CA.) And then there is the scandalous trading in GDRs that generates over Rs. 11 billion (US$ 250 million) in profits for foreign brokerage groups without giving a chance to the Indian brokers to compete for that GDR business. If capital gains tax is removed, then foreigners will be happy to buy local stocks and that will push that entire revenue stream into India.
So, here is some advice for the Ministry of Finance: if Fund ABC and India ABC did something incorrect, punish them and collect a tax.
Meanwhile, bite the bullet, and make all investments and transactions in shares of listed companies exempt from capital gains tax for resident Indians - and by the way, extend that facility to the foreign investors, too.