27th December, 2012

FII Alert - Foreign Investments in India
CBDT Issues FAQs on Tax Matters Relating to QFIs — Will it be a case of Better Never Than Late?

In the Budget speech of 2011, the then Finance Minister had hinted at the formulation of a new investor regime called the Qualified Foreign Investor (QFI) route. In August, 2011, the first step was taken by the Govt. in terms of issuing a circular. Thereafter, several circulars have been issued by Reserve Bank of India and the Securities Exchange Board of India. The QFI route was thereafter marketed heavily by the Govt. However, it failed to gather momentum on account of lack of clarity on tax related matters. Despite repeated representations by the custodian lobby (or Qualified Depository Participants (QDP) as they are referred to in the QFI scheme), the Govt. did not bring out the promised clarifications on these tax related issues. As a result, the QDPs were very wary of starting to accept QFI investments. Finally, on 26th December, the Central Board of Direct Taxes (CBDT) has put up a document in public domain which seeks to clarify the tax issues. These clarifications have been issued in the form of FAQs which are now available on the web portal of the Income-tax department.

The FAQs have been issued with a view to address most of the concerns and doubts that the QDPs and prospective QFIs had on the tax related matters. The key features of the FAQs are as follows:

Permanent Account Number (PAN)

It has been reiterated that QFIs will need to obtain a PAN. The procedure for obtaining the PAN and the documentation required to be submitted along with the PAN application have been highlighted in the FAQs.

Responsibilities of QDPs

As mentioned in our earlier tax alerts, the QDPs have been assigned a very key role in the QFI scheme. The entire responsibility for ensuring payment of due taxes by QFIs has been thrust on the QDPs and unlike the FII regime where the FIIs/Sub Accounts have to pay advance tax, in case of QFIs, the QDP has to withhold tax at source (in the Indian context, this is referred to as tax deduction at source (TDS)). The FAQs have reiterated the following responsibilities of QDPs in the context of QFIs:

  • to act as a single point of contact for all purposes including tax;
  • to facilitate the QFI in obtaining a PAN Card;
  • to deduct tax at source u/s 195 of the Income-tax Act, 1961 (the Act) and to ensure that the broker engaged by it for undertaking QFI transactions deducts and deposits tax at source. A QDP may compute the same on it’s own or with professional help. However in case of complex situations, QDP should approach the AO for determination of tax to be deducted u/s 195(2);
  • to act as the representative assessee/agent of the QFI in India and to this effect, a QDP would be required to submit a declaration that it has no objection to being treated as a representative assessee;
  • to be responsible for withholding taxes against profits on mutual fund investments by QFIs;
  • in case of sale considerations received under an open offer or buy-back of shares, if the purchaser of shares “credits” or “pays” the amount to the QFI then the purchaser would be required to deduct tax otherwise, it would be the responsibility of the QDP;
  • to be responsible for both non-deduction and short deduction of tax if it is found at a later date that the treaty benefits have been incorrectly claimed or considered;
  • to be liable for any short deduction/non-deduction even if the QFI ceases to be a client of that QDP.

Categorisation of taxable income on sale of shares and securities & related issues:

  • As per the Act, whether profits from sale of Indian securities will be treated as capital gains or business income is dependent on facts of each case. The FAQs draw the attention of QDPs and QFIs to an old circular (No.4/2007 dated 15/06/2007) issued by CBDT where certain guidance was given for distinguishing between an investment activity and a business activity. The circular lays down several principles which would have a bearing on the decision to be taken in terms of categorisation. Some of the important and relevant ones are:
  • Substantial nature of transactions, manner of maintaining books of accounts, magnitude of purchase and sales, ratio between purchases and sales and length of holding period
  • Motive of the assessee i.e. profit motive would indicate transactions are in the nature of trade and motive to earn income by way of dividend would indicate investment transactions

As per this circular, it is possible for a tax payer to have two portfolios, i.e. an investment portfolio and a trading portfolio. Where QFI has two portfolios, the QFI may have income under both heads i.e. capital gains as well as business income.

  • The deductibility of expenses would depend on the categorisation of the income. In general, if the income is treated as capital gains only expenses like brokerage fees would be allowed as deductions.
  • If the profits arising on sale of shares are treated as Capital Gains, it shall be computed by converting the cost of acquisition, expenditure incurred and full value of consideration in the same currency, as was initially utilized for purchase of shares and the gains so computed shall be reconverted in Indian currency.

Manner of deduction of tax at source

As per section 195 of the Act, tax is to be deducted at the time of payment or credit, whichever is earlier. TDS/ withholding computation is required to be done on settlement basis as the net proceeds will be credited by the broker on this basis for each settlement period. The tax so deducted is to be deposited by the seventh day succeeding the end of each month.

Provisions regarding set off of losses and claim of refund

  • Losses from one security can be set off against profits from another provided Securities Transaction Tax (STT) is paid in both cases.
  • TDS shall be effected on a net basis. Hence, losses of the current year can be set off while computing the TDS amount if such losses are available at the time of credit/payment as the case may be. This is explained with the help of the following table:
Settlement No.
Situation 1
Situation 2
Amount of Profit/ (Loss) (INR)
Amount on which QDP will have to withhold tax (INR)
Amount of Profit/ (Loss) (INR)
Amount on which QDP will have to withhold tax (INR)
1,000 (profit remaining after setting off loss of Settlement No. 2 as reduced by profit of Settlement No. 3)

In the above example in Situation 1, the QFI has made a total gain of Rs. 3,000 and the QDP would have deducted tax at source from Rs. 3,000. Therefore, in such situations, there would not be a need to file a refund claim with the tax authorities. On the other hand, in Situation 2, the QFI has made a total loss of Rs. 3,500 but yet, the QDP would have deducted tax at source from Rs. 2,500. Therefore, in such situations, there would be a need for the QFI to file a refund claim with the tax authorities.

  • Thus, as per the FAQs, TDS once effected can not be reduced by the deductor even if there is loss in subsequent transaction.
  • Further, it has been clarified that losses of earlier year(s) cannot be set off in the current year by the QDP while deducting TDS.
  • However, in the annual tax return, QFIs can claim set off of losses incurred in earlier year(s) against profits of the current year and also claim refund of excess TDS subject to the satisfaction of the conditions laid down in the Act.

Applicability of the Act vs. Double Tax Avoidance Agreement (DTAA)

  • Significantly, it has been clarified that while deducting tax at source, the QDPs should apply rates as per domestic law or as per DTAA, whichever is beneficial to the QFI.
  • Thus, DTAA provisions can be taken into consideration by QDPs while deducting tax at source. This was a very strong demand put forth by the QDPs and the Govt. has accepted the same.
  • To avail the DTAA benefits, there is no standard set of documents on the basis of which the DTAA benefit can be said to have been correctly allowed. It depends on the facts of each case. QDPs are expected to obtain Tax Residency Certificate (TRC) from QFIs for this purpose. These TRCs shall serve as evidence of residence in a particular country. However, the FAQs go on to state that while a TRC is necessary, it is not a sufficient condition for availing benefits of the tax treaties. This has, as expected, kept a window of possible disputes in future between QDPs/QFIs and the tax department open.

SKP’s Comments

The clarifications by the department are a welcome move. It is however obvious that the Government has not changed its mind on casting the primary burden of all compliances regarding TDS on the QDPs. Any default, mistake etc in this regard becomes the liability of the QDP. This perhaps is to ensure that very stringent measures are adopted by the QDPs to check the genuineness of the QFIs. However, on account of the fact that the Act does not not prescribe any time limit for scrutiny of transactions for TDS purpose, QDPs would have a Damocles’ sword hanging over their heads all the time and they would be under constant apprehension of their stand vis-à-vis granting of treaty benefits being challenged several months/years down the line. In such cases, if at all a demand is raised by the tax department, the QDPs would be forced to pay the same and at that time, if the QFI client is no longer invested in India, the QDPs would find it extremely difficult to recover the tax from the QFI. This situation is clearly to the detriment of the custodian industry and it is unlikely that any QDP would be happy with the same..

As mentioned earlier, the entire industry was waiting patiently for the “clarifications” from the CBDT on the tax matters relating to QFIs. It was believed that the clarifications, when they come, will ease the burden on the QDPs. These hopes have now been dashed. It remains to be seen how the QDPs (as on 3rd December, fifty six depository participants have registered with SEBI as QDPs) will now proceed with accepting QFI clients. India needs foreign investments badly but whether QDPs will wholeheartedly support the Govt. in its endeavour to attract foreign investments remains to be seen.