Tax Implications on Capital Gains for Foreign Investors in India
Updated: Jun 6
Our esteemed external taxation expert, Mr Chetan Daga has, as reproduced below, simplified the judgment of the Income Tax Appellate Tribunal, Mumbai in the recent case Legatum Ventures Limited v/s Asstt. Commissioner of Income Tax. He is the Co-Founder of AdvantEdge Consulting Group, engaged in tax consulting, tax litigation, managed accounting, and compliance services.
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In a recent landmark judgement, the Mumbai Tax Tribunal held that while calculating the tax on capital gains arising out of the transfer of unlisted securities, no exchange rate fluctuation benefit can be availed.
Let us explain through an illustration:
Say, a non-resident taxpayer acquired 100 shares in ABC Private Limited at USD 10 per share and sold these shares at the same price of USD 10 per share. Effectively, the transaction happened at cost, hence the taxpayer didn’t end up making any profit or loss. So, the assumption would be that no tax will be payable. This assumption would stand as incorrect if the Mumbai Tribunal’s recent judgement is applied.
Well, let us assume that the USD to INR exchange rate at the time of making the investment was USD 1 = INR 60 and at the time of the sale was USD 1 = INR 80. If calculations are done in INR terms, the purchase price is INR 6,000 and sale price is INR 8,000, resulting in a gain of INR 2,000. This gain of INR 2,000 is purely on account of currency fluctuation, as the USD value invested and received by the taxpayer was the same. The question is whether the amount of INR 2,000 is taxable in India.
No. of Shares Acquired = 100
Acquisition Cost (in USD) = USD 10/share
Acquisition Cost (in INR) = INR 60/share @USD 1 = INR 60
Total Acquisition Cost (in USD) = USD 1000
Total Acquisition Cost (in INR) = INR 6000
Sale Price (in USD) = USD 10/share
Sale Price (in INR) = INR 80/share @USD 1 = INR 80
Total Sale Price (in USD) = USD 1000
Total Sale Price (in INR) = INR 8000
Capital Gains on Sale
When calculated in USD = USD 1000 – USD 1000 = 0
When calculated in INR = INR 8000 – INR 6000 = INR 2000
The Mumbai Tax Tribunal held that while calculating the tax on transfer of unlisted securities, provisions of Section 112 (1) (c) (iii) shall apply without considering exchange fluctuation benefit.
Background of the Law
Wondering what was the confusion till date? This judgment deals with two seemingly conflicting provisions of the tax law. The tax law provides that where a non-resident taxpayer transfers any capital asset in India, it can calculate the capital gains by converting the sale price and purchase price into the foreign currency used for purchasing the asset. This effectively ensures that any gain/loss arising due to currency fluctuation is eliminated (1st proviso to section 48 of the Income-tax Act, 1961). A separate provision of the tax law (section 112 (1) (c) (iii)) states that for capital gains arising from transfer of unlisted securities, the tax rate shall be 10% on gains calculated without eliminating the exchange fluctuation difference. The question before the Tax Tribunal was, which of these two provisions should be applied?
The Tax Tribunal held that there is no conflict between the two provisions of the tax law referred to above. The first provision, which eliminates currency fluctuation differences, applies generally to all assets transferred by a non-resident taxpayer. The second provision, which calculates tax without considering exchange fluctuation benefit, is specific and applies only to the transfer of unlisted securities. Thus, when unlisted securities are transferred, the specific provision will be applied and exchange fluctuation benefit is unavailable. If any asset other than unlisted securities is transferred, the exchange fluctuation benefit continues to remain available.
What our advisors say
Gains arising to a non-resident investor, from transfer of unlisted securities, are taxed at a concessional tax rate of 10%. As a trade-off, the exchange fluctuation benefit is not available. In contrast, where the exchange fluctuation benefit is available, the tax rate is 20%. This judgment is being criticized on the real-income theory based on the contention that exchange fluctuation benefit is not real income for the non-resident taxpayer, and hence should not be taxed.
In our considered view, while this argument is attractive on first impression, this contention is misplaced. The real-income theory needs to be applied with reference to the jurisdiction where the income-earning activity takes place. Where the investment is made in INR and realized in INR, the income arises in INR and is being taxed accordingly. Conversion of INR value into foreign currency, is a treasury function of the taxpayer, arising overseas, is unconnected to India and therefore should not influence tax calculations. If the exchange control regulations permit, the non-resident taxpayer may not convert the INR price into foreign currency, in which case, the so-called real income argument remains a notional argument.
Foreign investors holding investments in unlisted companies in India should take cognizance of this judgment and the arguments made therein. If tax arises in India on account of currency fluctuation, it is bound to hurt the investor. While it is likely that this judgment shall be contested before the appellate authorities, a conscious position needs to be adopted. This judgment will also be crucial in cases where the non-resident taxpayer makes applications to the Indian Tax Authorities seeking a certificate for tax withholding at lower rates. The above judgment of the Mumbai Tax Tribunal, in our considered view, is an appropriate and harmonious interpretation of the law.