Balancing act?

Foreign institutional investor (FII) celebrations following an amendment exempting them from the purview of minimum alternate tax (MAT) was rather short-lived. With the good came the bad when the revenue authorities retrospectively raised demands in respect of FII profits made prior to 1 April 2015. After months of eminently avoidable confusion and the report of the Justice AP Shah Committee, the government has agreed to resolve the issue through legislative process.

Earlier this year, several FIIs were slapped with notices from the tax authorities subjecting their past incomes to MAT. This retrospective demand for tax took the foreign investor community by surprise, more so since it came from a government that pitched to end “tax terrorism” and provide a stable, predictable and non-adversarial tax regime aimed at reviving India as a preferred investment destination. This article examines the genesis of the MAT regime, and recent controversies and confusion which could perhaps have been avoided.

MAT: genesis and controversies

MAT in its current form was introduced in 1996 to bring “zero tax” companies within the tax net. Indian companies prepare their accounts in accordance with the provisions of the Companies Act but their taxable income is computed in accordance with the Income Tax Act (ITA). Consequently, despite having distributable profits and distributing dividends to shareholders in line with the Companies Act, companies could escape tax liability under the ITA. MAT was introduced to ensure such companies pay a minimum tax of 18.5%.

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Section 115JB(1) of the ITA states that if the total income of a company as computed under the ITA is less than 18.5% of its book profits, then this profit will be deemed to be its total income and taxed at 18.5%. It further provides that every company must prepare its profit and loss account in line with the Companies Act. However, foreign companies without a place of business in India are not required to prepare profit and loss statements under the Companies Act. The legislative gap between the provisions of the Companies Act and the ITA had led to confusion on the applicability of MAT to foreign companies.

FIIs – now deemed to be foreign portfolio investors under the Securities and Exchange Board of India (Foreign Portfolio Investors) Regulations, 2014 – are essentially financial investors such as hedge funds that are incorporated overseas and do not have a physical presence in India. They have historically argued that since they do not maintain profit and loss accounts with respect to their investments in India, there is no basis for the computation of the MAT payable by them and hence they should not be subject to such taxation. However, due to conflicting interpretations of the ITA, whether MAT applies to foreign companies without a physical presence in India remained unsettled and was at the root of the controversy surrounding MAT.

Applying MAT to FIIs: Trends in interpretation

In 1998, the Authority for Advance Rulings (AAR) held (in re P No. 14 of 1997) that foreign companies would be subject to MAT. However, a material fact in this case was that the foreign company in question had a project office in India.

In 2010, in the Timken case, the AAR analysed the rationale for the introduction of MAT and found that the legislature intended that foreign companies without a physical presence or permanent establishment in India would be exempt from it.

The AAR held that the while “company” as defined under the ITA includes both domestic and foreign companies, the definition is preceded by the words “unless the context otherwise requires”, hence, each clause of the statute must be construed with reference to its context and other clauses to make it a consistent enactment. Accordingly, the AAR held that in the absence of the ITA providing any specific guidance on how the book profits of foreign companies without a place of business in India would be calculated, it was difficult to accept that the legislature intended MAT to be applicable to these companies.

While arriving at this conclusion, the AAR relied on past budget speeches, explanatory statements to the finance bills, and circulars issued by the Central Board of Direct Taxes. It held that the intention of the provision was to tax companies that prepare profit and loss statements in accordance with the Companies Act and exempt foreign companies without a place of business in India.

It is pertinent to note that the AAR also considered the practical difficulties for foreign companies in preparing their accounts and observed that expecting foreign companies to recast their global accounts in accordance with the Companies Act would be a “massive exercise” and could potentially subject to tax the entire global income of foreign companies, which may not have accrued, arisen or been received in India.

Castleton case: stirring the controversy further

The reasoning in the Timken case did not resonate with the AAR in the Castleton case in 2012. Instead, the AAR relied upon its 1998 ruling and concluded that section 115JB is applicable to both domestic and foreign companies.

The AAR held that section 115JB(1) is the charging section, whereas section 115JB(2) is merely procedural in nature, explaining how profit and loss statements should be prepared. Thus, tax liability does not depend on the obligation to prepare the accounts in accordance with the Companies Act and mere difficulty in procedural provisions cannot be a ground for non-compliance with the charging provisions. The AAR took note of the difficulty faced by foreign companies in preparing their profit and loss statements, but held the difficulties were for the legislature rather than the AAR to consider and remove.

If the AAR’s position in Castleton were to apply to all foreign investors, the key challenge would lie in preparing profit and loss statements as the Companies Act does not clearly state how foreign companies without a place of business in India should do this.

Castleton case: The after-effects

One of the consequences of the Castleton ruling was that FIIs without a place of business in India would also be subject to MAT. FIIs became seriously concerned about this, prompting the government to engage with them to allay their concerns and reaffirm its commitment to bring certainty to the tax regime. Subsequently, as part of the Finance Bill, 2015, the government introduced an amendment to section 115JB, prospectively exempting income earned by foreign companies from MAT from the 2015-16 financial year (i.e. from 1 April 2015 onwards).

Despite its best intentions, the amendment led to some unpleasant consequences and the government once again found itself in a tight spot. While the amendment was aimed at bringing in greater clarity, instead it introduced further ambiguity.

Since the amendment applied prospectively, in view of the Castleton ruling, the tax authorities interpreted the amendment to mean that while FIIs were exempt from MAT from the financial year 2015-16, they were liable to pay MAT on their income for the previous financial years. Consequently, shortly after the amendment, the tax authorities issued demand notices to 68 FIIs for a total of ₹6.03 billion (US$100 million). Additionally, the finance minister issued a statement saying that the government would pursue MAT demands which are likely to add up to ₹400 billion.

Justice AP Shah Committee

FIIs were understandably unhappy about such retrospective tax demands, and requested government intervention. However, this was turned down on the grounds that issues arising out of judicial and quasi-judicial decisions should be settled by exhausting legal remedies and not through legislative action.

The retrospective tax demands coupled with the government’s aggressive stance had an adverse impact on investor sentiment, leading to widespread selling by FIIs along with adverse effects on the rupee. The BSE’s Sensex suffered significant losses in the trading sessions after the demands were issued.

Faced with such negative sentiment and adverse results, the government took interim measures to resolve the issue, with a view to avoid tinkering with the ongoing judicial process. In May, it appointed the Justice AP Shah Committee to examine the issue of applying MAT to FIIs, and issued a circular to the tax authorities advising them to refrain from issuing fresh notices to FIIs and using coercive measures in respect of the notices already issued, unless such demands were likely to be barred by limitation in the near future.

Initially, the government’s stand was that it would await the outcome of the Castleton appeal before the Supreme Court (which is now likely to come up for final hearing on 29 September) before deciding on a future course of action. This approach was based on the premise that it would avoid setting a precedent by introducing retrospective legislation to annul judicial and quasi-judicial decisions and at the same time offer a solution to the current controversy without necessarily going through the process of amending the law.

Subsequently, the Justice AP Shah Committee, in a quick turnaround, submitted its report to the government rejecting the interpretation of the AAR in the Castleton case and recommended: (i) an amendment to section 115JB of the ITA, clarifying the complete inapplicability of MAT provisions to FIIs; or (ii) issuing a circular clarifying the complete inapplicability of MAT provisions to FIIs.

Consequently, on 2 September, the Central Board of Direct Taxes issued instructions confirming and accepting the recommendations of the Justice AP Shah Committee to bring in the necessary amendments to the ITA and provide relief to FIIs in respect of their income arising prior to 1 April 2015.

The government’s change in stance to settle the controversy by bringing an amendment to the ITA instead of awaiting a judicial pronouncement comprehensively settles the controversy. It also avoids the confusion that would have arisen if the Justice AP Shah Committee and the Supreme Court had differed on the applicability of MAT.

However, the real issue that requires consideration is whether it was the legislative intent to impose MAT on FIIs. If not, then was the amendment to section 115(JB) with prospective effect necessary and were the demands raised by the authorities rather premature?

International tax treaties

Notwithstanding the current controversy, it must be noted that under the ITA, a foreign investor has the right to choose whether to be taxed in accordance with the provisions of the ITA or the applicable tax treaty, and pick the regime that is more beneficial. However, the Castleton ruling effectively nullified this right when it held that the non obstante clause in section 115JB meant that the provision overrides other provisions of the ITA allowing FIIs to make a choice. This was particularly detrimental to FIIs based in Mauritius and Singapore, which have treaties that allow for a beneficial capital gains tax regime. However, the government had subsequently clarified that MAT will not apply to FIIs claiming benefits under those tax treaties, as has also been reaffirmed by the Justice AP Shah Committee.

Better tax administration needed

One of the biggest causes for FII discontentment is the unpredictability of administrative action by the tax authorities. While the tax authorities are technically acting within their powers, the issue of demand notices in a retrospective manner merely on account of a change in judicial interpretation is counterproductive as it creates an environment of unpredictability.

Such action assumes particular significance for FIIs. These are open-ended funds that see daily exits by investors and could find it difficult to recoup the tax charged for previous financial years from past investors, if the FII’s reserves for contingent liabilities are insufficient to meet such retrospective tax demands.

It is also pertinent to note that an AAR ruling is binding on the applicant, the Commissioner of Income Tax and the subordinate tax authorities in respect of an applicant’s transactions. Considering that the Castleton ruling continues to be sub judice in the Supreme Court, the urgency of raising tax demands by the tax authorities on an unsettled legal position has highlighted the need for a better and more coordinated tax administration.

In terms of the present controversy, it is important to evaluate the government’s stand regarding the applicability of MAT to FIIs. If its intention was to exempt FIIs, then instead of introducing a prospective amendment it could have issued a clarification stating that MAT would not apply to foreign companies without a presence in India. At the same time, it is arguable, in favour of the government, that issuing a circular in respect of a matter that is sub judice may have been perceived as the executive transgressing over the judiciary’s domain and thus interfering with the constitutionally guaranteed principles of separation of powers.

While it is unclear why the government chose introducing a prospective amendment over a clarification, what is certain is that the amendment provided the rather avoidable fertile ground for confusion in the minds of the tax authorities. Despite judicial precedents ruling otherwise, an amendment that provides prospective exemption undoubtedly creates an impression that MAT must apply for the years for which the exemption is not available.

The appointment of the Justice AP Shah Committee and subsequent directions to the tax authorities not to issue fresh notices to FIIs or act aggressively in respect of the notices already issued created further confusion and highlights the uncoordinated nature of tax administration in India.

More recently, the government’s response to the Justice AP Shah Committee Report, albeit welcome, is in fact yet another instance of the government’s roll-back on its prior stated position. Initially, when FIIs urged the finance minister to take steps to resolve the controversy arising out of the Castleton case, he had expressed reservations in tinkering with ongoing judicial processes. However, now by agreeing to retrospectively amend the ITA the government has in effect rendered the Castleton appeal infructuous and arguably interfered with the ongoing judicial process. Equally, it is arguable that such an amendment is being proposed to finally settle the MAT conundrum and avert any further controversy that could have arisen in the event that the ruling in the Castleton appeal conflicted with the recommendations of the Justice AP Shah Committee.

Nonetheless, this entirely avoidable controversy has put pressure on the government to not only bring predictability in the tax regime but also greater coordination in the manner in which it administers tax collection. For the future, one hopes to see greater administrative prudence from the government in clarifying its tax policies and settling controversies early on. This would go a long way in avoiding any negative impact on India’s image as an investment destination.

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Shinoj Koshy is a partner at Luthra & Luthra, where Shikhar Kacker is a managing associate.