GLASS HALF-FULL? CBDT CLARIFIES SAFE HARBOUR RULES FOR ELIGIBLE FUNDS HAVING FUND MANAGERS IN INDIA
Recently, the Central Board of Direct Taxes (CBDT) issued a notification1 (Notification) to clarify the eligibility criteria for offshore funds being managed from India through their managers to the benefit extended by Section 9A of the Income Tax Act, 1961 (Act). The Finance Act, 2015 had vide Section 9A, introduced an exception to the concept of a 'business connection' whereby, subject to satisfying the eligibility criteria, an offshore fund could be managed from India without attracting Indian taxes. This (welcome) move was implemented to incentivise the migration of fund managers to India. However, the stringent eligibility conditions led to several representations being made by the funds industry to make the provision more inclusive and effective. The recent Finance Bill, 2016 (Bill), therefore relaxed two conditions (as captured below) in order to rationalise the regime and to address industry concerns.
Presently, under the Act, any non-resident who establishes a business connection2 in India shall be taxed in India at the rate of 40% (exclusive of surcharge and cess) on the profits attributed to such business connection. Certain eligible funds (as specified in Section 9A of the Act) despite having its fund management activity in India, shall not be considered as having a business connection in India.
In an attempt to make this exception more effective, the Notification (i) clarifies the scope of the said provision vis-à-vis determination of thresholds for investments made and investor type; (ii) provides for an administrative mechanism by which the offshore fund can ascertain beforehand whether it is eligible to this benefit or not; (iii) prescribes compliance requirements including a statement to be furnished by the fund annually and transfer pricing documentation and related compliance requirements; and also (iv) sets out limited circumstances in which leeway shall be granted to the fund, albeit not entirely from complying with the conditions specified in Section 9A of the Act.
Eligibility Criteria for Funds – Then & Now
Currently, the Act prescribes the following conditions that need to be satisfied in order to be considered as an 'eligible fund' whose activities shall not constitute a business connection in India:
- the fund is not an Indian resident;
- the fund is a resident of a country or territory with which India has a Double Taxation Avoidance Agreement (DTAA) or a Tax Information Exchange Agreement (TIEA) or a treaty has been signed between specified associations of the two jurisdictions;
- participation or investment made by Indian residents does not, directly or indirectly, on an aggregate basis, exceed five per cent of the fund corpus;
- the activities of the fund and the fund itself is subject to applicable investor protection regulations in its country of residence, establishment or incorporation;
- the fund has a minimum of twenty-five members who are not, directly or indirectly, 'connected persons';
- a member or investor of the fund along with connected persons does not have any participation interest, directly or indirectly, exceeding ten per cent in the fund;
- the aggregate participation interest, directly or indirectly, of ten or less members or investors along with their connected persons in the fund, is less than fifty per cent;
- the fund has not invested more than twenty per cent of its corpus in a single entity;
- the fund has not made any investment in its associate entity;
- the monthly average of the corpus of the fund is not less than INR one thousand million subject to certain conditions mentioned for newly created funds;
- the fund does not carry on or control and manage, directly or indirectly, any business in India or from India;
- other than the activities undertaken by the eligible fund manager on behalf of the fund, the fund is not engaged in any activity which constitutes a business connection in India nor has any person acting on its behalf whose activities constitute a business connection in India; and
- the remuneration to an eligible fund manager, paid by the fund in respect of fund management activity undertaken by the manager is on an arm's length basis.
The conditions stated in (e), (f) and (g) above do not apply to investment funds set up by the Government, Central Bank of a foreign State, sovereign fund or such other notified fund. In relation to conditions stated in (b) above, the Bill proposes that the funds which are registered or incorporated in countries to be notified by the Government shall also be covered and the 'residence' criterion shall not be applicable. Further, in relation to condition (k) above, the Bill also proposes that the condition relating to controlling business 'from India' would be deleted.
The Notification has introduced the following rules to clarify the applicability of the eligibility criteria described above. The changes are effective and have been included in the Income Tax Rules (vide the Income Tax (5th Amendment) Rules, 2016).
Fund of funds structure
- Where an investor in the fund is an
institutional investor - being a pooling vehicle, for the
applicability of conditions in relation to the number of
members and the participation interest in the fund, the same shall
be determined by 'looking through' the institutional
investor. Accordingly, the institutional investor shall:
- Independently satisfy conditions (c), (e), (f) and (g) specified above; and
- be a resident of a country with which India has a DTAA or TIEA or there is a treaty between specified associations.
Due diligence to ascertain indirect participation of residents and relaxation in case of regulated investors in a fund
- In relation to condition (c) mentioned above, for investors other than individuals, the fund must undertake appropriate due-diligence to ascertain the indirect participation of Indian residents. If the investor is the Government, Central bank, sovereign fund, multilateral agency or a regulated investor such as a pension fund, University fund, bank or collective investment vehicles such as mutual funds, then, the fund shall obtain a declaration in writing from such investor regarding the participation of an Indian resident (if any) and the indirect participation in the fund of any Indian resident may be determined by the fund on the basis of such declaration.
Leeway in case of non-fulfilment of certain eligibility conditions
- The Notification allows funds the
benefit of Section 9A of the Act, despite non-fulfilment of
conditions (c), (d) and (e) specified above where such
- is for reasons beyond its control and (such non-fulfilment) does not exceed a period of ninety days;
- does not exceed a period of eighteen months beginning from the date on which the fund is setup or is not beyond the final closing of the fund (whichever is earlier) and bona fide efforts are made by the fund to satisfy the said conditions;
- is because the fund is in the process of being wound up and (such non-fulfilment) does not exceed a period of one year beginning from the date on which the process of winding up has begun.
- As per Section 9A of the Act, eligible funds must furnish a statement (in the prescribed form) of their activities for the relevant financial year containing information relating to the fulfilment of the conditions specified above. Such statement must be furnished within ninety days from the end of the relevant financial year. In case of any delay in filing the statement, the Notification provides that the benefit of Section 9A of the Act shall not be denied, so long as the delay in filing does not exceed a period of ninety days. The Notification has specified the format for filing the statement (Form No. 3CEK).
- If the remuneration paid to the fund
manager is not in accordance with condition (m) specified above,
the Notification states that the fund shall still be eligible to
avail the benefits of Section 9A of the Act, so long such
non-compliance is not:
- For a period of three previous years in succession; or
- For any three out of four preceding years.
Clarity on control and management of business in India
In relation to condition (k) described above, the Notification specifies an objective threshold of 26% whereby if the fund, directly or indirectly holds such rights in an entity which results in the fund holding more than twenty six percent in the share capital or voting power or interest in the entity, it would be treated as the fund controlling or managing the business carried out by such an entity.
Fund manager's remuneration to attract transfer pricing rules
Since condition (m) requires the fund manager to be remunerated on an arm's length basis, the Notification states that:
- The transaction between the eligible investment fund and the eligible fund manager shall be treated as an 'international transaction' and the said parties shall be treated as 'associated enterprises';
- The eligible fund manager shall maintain information and documents as prescribed in Section 92D of the Act;
- In addition to the report required to be furnished under the transfer pricing regulations in the Act, as applicable, the eligible fund manager shall obtain an accountant's report in Form No. 3CEJ (format included in the Notification) in relation to the activity undertaken for the fund;
- In case the documents required from a transfer pricing perspective are not maintained, in furtherance of the principles of natural justice, the fund shall be provided an opportunity to produce the necessary information and documents to enable the tax authorities to compute the fund manager's remuneration on an arm's length basis.
Prior Approval Mechanism
The Notification provides for an optional mechanism whereby the fund may seek the prior approval of the CBDT in relation to its eligibility for the purposes of Section 9A of the Act. Towards this, the fund may make an application in writing along with supporting documents, three months before the beginning of the year for which the approval is sought. Based on the review of the fund's application, a committee headed by the Principal Chief Commissioner or Chief Commissioner, shall within sixty days from the end of the month in which the application has been made, approve or reject the application of the fund. Necessary reasons shall be provided in case of rejection of the application. The Notification includes greater details on the administrative procedure to obtain an approval on the fund's eligibility assessment to benefit from the provisions of Section 9A of the Act.
In tune with the Government's policy, the Notification does clarify some critical aspects, reduces the element of subjectivity, and also provides some leeway as regards the fulfilment of certain conditions for being eligible for the benefits provided in Section 9A of the Act. This indeed brings some relief to funds and fund managers, a growing sector of the Indian economy. However, the Notification stops short of relaxing the onerous investor and investment related conditions – wishful thinking, perhaps!
An important change brought about vide the Notification is the application of thresholds for the number of investors and investment on a 'look through' basis in case of a pooling vehicle being the investor in the fund. While the 'look through' approach is already there in Section 9A in relation to the respective conditions, the Notification could be seen as curtailing the scope thereof (the phrase 'directly or indirectly' contained in the Act). At the same time, it also introduces additional restrictions. For instance, the 'residence' criterion for the pooling vehicle investing in the fund. As per Section 9A, the 'residence' criterion, is only there in case of the fund and not for the investors in the fund. The Notification introduces the 'residence' criterion for an investor being a pooling vehicle in the fund. Further, there is an apparent discrepancy of standards applying vis-à-vis the fund and pooling vehicle investing therein. As regards the residency of the fund, while the Bill, in a big move towards facilitating the reverse migration of fund managers to India, has proposed to ease the threshold from being a 'resident' offshore to being established, incorporated or registered offshore, the Notification requires the pooling vehicle to be a 'resident' offshore. This requirement, perhaps an oversight, invites the very issues that the Bill sought to resolve. This change albeit desirable from an information exchange perspective, creates uncertainty in a scenario where the pooling vehicle is not considered as a 'resident' of the jurisdiction where it is located in view of the structure of the investing fund and the applicable domestic laws.
Further, the requirement to maintain transfer pricing documents and certification also adds to the compliance burden for funds and their fund managers.
Temporary reprieve for non-fulfilment of the conditions may prove useful. However, the effectiveness of the very reason for the introduction of Section 9A of the Act should then be closely analysed.
The other crucial aspect of the Notification, which is a step towards making the Indian tax regime less adversarial, is the prior approval mechanism. The CBDT has ensured that principles of natural justice shall be strictly adhered to by providing for rules to ensure reasoned orders for rejection, opportunity for being heard, produce documents etc.
Importantly, key players in the funds industry can view this Notification as the glass either being half full or half empty.
Make It Count: Debenture Holding Period To Be Included For Shares
- Presently, the law on the period of holding of a share that had been acquired pursuant to the conversion of a debenture or bond is ambiguous. While the Act clearly stipulated that if a capital asset, being a share of a company, became the property of a tax payer as a result of conversion of a debenture or bond, the cost of acquisition of the share to the tax payer would be the cost of acquisition of the debenture or bond, it was silent on what would be regarded as the period of holding of such a capital asset. Thus, there was lack of clarity on whether the period of holding would date back to the date of acquisition of the debenture or bond, or whether it would be computed from the date of conversion.
In a welcome move the CBDT has now clarified3 that in the case of a capital asset, being a share of a company, which becomes the property of the tax payer as a result of conversion of a debenture or bond, the period of holding of the asset would include the period for which the debenture or bond was also held by the tax payer prior to the conversion.
This amendment to the Rules by the CBDT has finally put to rest the controversy surrounding the determination of the period of holding when debentures are converted into equity shares by clarifying that the period of holding of the shares would date back to date of acquisition of the debentures or bonds by the tax payer. However, the notification is silent on the period of holding in case of conversion of preference shares into equity, which unfortunately, continues to be a grey area.
Good News For Investors...Have You Held Your Listed Securities For More Than 12 Months?
Over the years, there has been a constant tug of war between taxpayers and tax authorities on the classification of gains arising on the transfer of shares/securities as 'capital gains' or 'business income'. Due to the lower tax incidence on 'capital gains', taxpayers prefer a 'capital gains' classification, while tax authorities usually attempt to tax these gains as 'business income'.
The moot question involved in such disputes is whether the investments of taxpayer are in the nature of 'capital assets' or 'stock-in-trade'. While there is no thumb rule to answer this question, courts have laid down certain bright-line-tests such as (1) intention of the taxpayer; (2) period of holding; (3) the treatment of such investments by the taxpayer in its books of accounts; (4) the magnitude, volume, frequency of share dealings; (5) the source of funds used to make such investments etc., to determine the taxability of such gains. In line with these principles, the CBDT, the tax governing body has also issued instructions in the past to be followed by the tax authorities. Despite this, the uncertainty still continues due to the highly subjective nature of the factors governing this issue.
In a bid to reduce vexatious litigation in the matter, the CBDT has, vide its Circular No. 6/2016 dated 29 February 2016 (Circular), issued a new set of instructions to be followed by its tax officers while assessing whether the gains arising on the transfer of listed shares and securities should be treated as 'capital gains' or 'business income'. The contents of the new Circular are summarised below.
Key takeaway of the Circular
- Where the taxpayer itself opts to treat such listed shares and securities as 'stock-in-trade': Irrespective of the period of holding, the gains would be taxed as 'business income'.
- Where the taxpayer desires to treat such listed shares and securities as 'capital assets':
- If the period of holding is more than 12 months, the tax officer shall not dispute the tax treatment as 'capital gains'; and
- If the period of holding is 12 months or less, the taxability would continue to be governed by the aforesaid tests.
- Taxpayers shall not be allowed to adopt a different/contrary stand in this regard in subsequent assessment years.
- However, the Circular specifies that these instructions shall not apply in respect of such transactions in shares/securities where the genuineness of the transaction is itself questionable.
The Circular brings welcome clarity and should encourage investors to stay invested for a reasonable period (at least more than 12 months) in the securities market; and thus, may serve to provide the necessary impetus to the securities market. This Circular is applicable only in respect of the gains arising on the transfer of listed shares/securities.; The taxability of gains on the transfer of other shares/securities will continue to be governed by the other tests already laid down.
1 Notification No. 14/2016 [F. No. 142 / 15 / 2015 - TPL]
2 Concept akin to but wider than the concept of a permanent establishment under the tax treaties
3 Notification No. 18/2016
The content of this document do not necessarily reflect the views/position of Khaitan & Co but remain solely those of the author(s). For any further queries or follow up please contact Khaitan & Co at firstname.lastname@example.org