Taxation of Foreign Institutional Investors in India: The Hanging Fire

Abstract

Foreign Institutional Investors (FIIs) have always remained influential players in India's investment market. However, India's tax regime in respect of FIIs has constantly undergone turbulent phases. To start with, the controversy pertained to classification of FII income under the income heads of business income versus capital gains, which classification was critical considering its tax chargeability and tax rate implications under India's direct tax laws. While this debate appears to have been put at rest by the 2008 ruling in LG Asian Plus Ltd. v. ACIT, uncertainties for FIIs in the context of non-resident taxation in India followed. The first limb of this uncertainty is found in the proposed General Anti-Avoidance Rules (GAAR) which seeks to implement the 'commercial substance' test if the Indian tax authorities believe that the transaction was undertaken only to avoid taxes or lacked commercial substance. This is proposed to apply notwithstanding that the transaction was routed through a tax friendly jurisdiction, and as per India's tax treaty with such jurisdiction, no tax liability arises in India. While effectuating of GAAR has been pushed back to 2016, the retrospective amendments of 2012 undertaken in India's Income Tax Act, 1961, pursuant to the Vodafone ruling by India's apex court, has brought FII taxation under radar. The amendment, which adopted the 'look through' approach against the 'look at' approach, may expose investors/P-Note Holders behind the FIIs to taxation in India, notwithstanding that the FII may be located in jurisdiction like Mauritius, with whom India has a favourable tax treaty. Also, as no time limit is prescribed for retrospective application of the amendment, the whip will keep hanging on FII investments time immemorial. Expert committees have been set up to scrutinize and settle these tax controversies and to create conducive tax environment for foreign investors in India, which is of utmost significance both, from an investment and economic standpoint. However, with the foregoing retrospective amendment in effect, it is to be seen how Indian authorities pacify FIIs from drawing out their investments from India amidst the tax qualms and mitigate the uncertainties and associated risks. This article discusses India's FII tax regime in light of the foregoing controversies, the prevailing uncertainties and challenges, their impact on FII investments in India, and India's consequent exposure to potential actions under bilateral investment treaties.