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Income Tax department vs FIIs

There is an old Bengali saying that can be literally translated as "A blind maternal uncle is better than no maternal uncle". Maternal uncle in this context is colloquial shorthand for "policeman" with a complicated etymology derived from the fact that a maternal uncle is the nephew's father's brother-in-law with all the pejorative connotations.

Idiomatically therefore, the suggestion is that a blind policeman is better than no policeman at all. I wonder if that is really true. Especially, if you stretch a point and include taxmen and other financial regulators in the definition of police.

Consider the events of this week. The Income Tax (IT) department suddenly slapped a notice on several Mauritius-based foreign institutional investors (FIIs) suggesting that the double taxation treaty did not apply to them. I'm not getting into the rights and wrongs of this but the notices were for Assessment Year 1997 or Financial Year 1995-96. What's more, there have been FIIs using the Mauritius route ever since late-1993.

Since this point of law or interpretation of law has been on the statute books for that long, surely somebody read the fine print a long time ago? What took the IT department so long to serve notices? It does, after all, considerably alter the assumptions under which investors do business. If the FIIs in question had entered India with the knowledge that they would pay a dual tax load on their capital gains, their expectations would have differed substantially. After a six-year period of peaceful operations, it is startling to suddenly discover that there is a big retrospective change in financial parameters.

If the IT department does indeed win this ruling, it would be a Pyrrhic victory. This could destroy the attractiveness of India as a destination for portfolio investment. In which case, the IT department would suddenly cease to collect any taxes at all from FIIs because they wouldn't be around. The macroeconomic consequences would be a nightmare.

There are a couple of other areas where blindness or lethargy on the part of the IT department have led to market inefficiencies and loss of possible collection opportunity. One old problem arises with the whole concept of stock lending.

In most markets, big institutional investors lend their stocks to short-sellers. The mechanism works like this. X shorts, Y wants delivery, Z lends X the stocks that X gives in delivery to Y. X then pays a market rate of interest to Z until such time as he buys back the stock off the market and returns it to Z. Z gets an interest income from loaning an asset that he has no intention of parting with. X gets time to settle his affairs and fish for maximal capital gains. The exchange and regulators are happy since there is no fear of default. Z pays tax on the interest income and X pays tax on any capital gains he made.

If stock lending could be introduced to the Indian markets, it would considerably smoothen the entire market mechanism. Delivery defaults and short-squeezes would cease to be such fearsome possibilities. It would be a considerable improvement on the current ulta badla system since it would introduce a class of shorters who actually delivered shares. It would also be easier to administer and oversee and ease the problems that make rolling settlement carryover impossible.

If stock lending mechanisms existed, rolling settlements could allow a "carryover" since delivery could always be arranged. It would also benefit big passive investors like Unit Trust of India (UTI) and Life Insurance Corporation (LIC) who could generate considerable interest income by safely lending stocks. Administering it would be easy enough since we can assume that credit-checking systems based on minimum net worth could be easily implemented.

It's a win-win situation for everyone. Even for the IT department, since it generates two extra collection possibilities per stock-lending deal, of which there are none at present. But the entire concept stumbles on the IT tax treatment. As far as IT is concerned, the stock lender is held liable for capital gains.

In terms of Indian IT treatment, the stock lender has made a capital gain (or loss) the moment delivery is given. The stock-borrower is liable to pay income tax for the "commission" generated in facilitating the deal. Since this is unacceptable to participants, there is no stock-lending mechanism. So there can be no rolling settlement shorts and hence the noticeable loss of liquidity for lack of a hedging mechanism when rolling settlement was introduced.

The third area of offbeat treatment arises with Employee Stock Option Plans (ESOP). The Indian employee is taxed at short-term capital gains rates the moment he gets his shares. So in the case of someone like Narayana Murthy's driver or a young dot com professional, he may have to borrow once to buy the stocks, and borrow again to pay a notional capital gain tax.

I have no idea whether the IT department gives refunds if the share price takes a bath and the notional capital gain turns into capital loss. I have also no clue whether, in the event of an eventual sale where the employee cashes in a real capital gain, what prices he will be taxed on, and at what rates. Those are grey areas where no precedent, to my knowledge, yet exists.

In the case of ESOPs, it seriously detracts from their attractiveness and hence, their utility in retaining employee loyalty without huge cash outflows upfront. It also reverses the common sense of taxing capital gains only as and when they are realised. If you extended it, you would have utter absurdity. Employees with large options would be paying astronomical annual capital gains without ever having sold a single share.

But the IT department at least has the point that it collects cash upfront in the case of ESOPs. There is of course much lobbying in progress and many legal attempts being made to change the IT policy with regard to ESOPs. The damage it may do to the development of the IT and pharmaceutical industry in the long run is considerable but the IT department takes the cash upfront.

In the other two cases cited, it seems to be a short sighted policy on the part of the IT department to follow through on its current treatment. Even if it wins legal sanction, in both instances it loses out on potential collections.

Devangshu Datta

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