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    Applicability of concessional rate of tax on sale of listed shares by a non-resident - A catch-22 situation

CA Bikash Kumar Jain
ACA, B.Com(Hons.)

bikashkumarjain@gmail.com

Section 112(1) of the Indian Income-tax Act, 1961 (‘ITA’) provides for a 20% tax rate on long-term capital gains for residents and non-residents. However, the proviso to section 112(1) provides that a 10% concessionary tax rate is available for gains arising on sale of listed shares as long as the taxpayer has not computed the gains using the cost indexation facility under the second proviso to section 48 of the ITA.

Under the second proviso to section 48, cost indexation benefits cannot be extended to non-residents in computing capital gains on shares since protection from foreign currency fluctuations has been provided to them as per the first proviso to section 48.

On a combined reading of section 112 and section 48 of the ITA, it can be inferred that tax on long-term capital gains earned from transfer of listed shares would be lower of the following:

  • 20% of the gains after giving effect to the second proviso to section 48 (i.e.; 20% with indexation benefits)   

  • 10% of the gains before giving effect to the second proviso to section 48 (i.e.; 10% without indexation benefits)  

The long-term capital gains on sale of shares of the listed companies are otherwise exempt from tax under section 10(38) of the ITA if the sale of the shares takes place through the recognized stock exchange on which security transaction tax is paid. Therefore, the proviso to section 112(1) has relevance to off market transaction like buy-back, open offer, etc. The Cairn-Vedanta deal whereby Cairn Energy plc is supposed to sell a 40% stake in Cairn India to Vedanta is a fresh example of such off the market transaction.

Legislative intent for insertion of proviso to section 112
 
The proviso to section 112(1) was introduced by the Finance Act, 1999 with effect from 1 April 2000. Prior to the insertion of the proviso, section 112(1) provided for uniform rate of 20% tax on all long-term capital gains accruing to all the categories of assessees. However, certain categories of non-residents viz. foreign institutional investors were having the benefit of lesser rate of tax of 10% (vide section 115AD) in respect of gains arising from the transfer of securities. The proviso in discussion was enacted with a view to provide maximum rate of 10% on long term capital gains in respect of listed securities. By insertion of this proviso, a level playing field between resident and non-resident was intended to be carved out. 
 
With respect to the reduction of tax rate on long term capital gains in respect to shares and securities, the Memorandum to the Finance Bill, 1999, stated as follows:
 
“Therefore, it is proposed to limit the tax on long-term capital gains at 10% of the capital gain on securities as defined in section 2(h) of Securities Contracts (Regulation) Act, 1956 and listed in recognized stock exchanges in India before allowing adjustment for cost inflation index for all assessees. In other words, the benefit of cost inflation index shall continue as before but where the tax on long term capital gains exceeds 10% of capital gains, such excess shall be ignored.”
 
The use of the word “all assessees” suggest that no class of taxpayers is excluded from the beneficial provisions of the proviso to section 112(1). In other words, the proviso below sub-clause (d) is a proviso to section 112(1) of the ITA applicable to both the residents and non-residents. 
 
Issue
 
Whether a non-resident is eligible to pay tax on long term capital gain arising from the sale of listed shares through a private arrangement/ off market mode at a concessional rate of 10% as per the proviso to section 112(1) of the ITA?
 
The issue of whether the 10% rate is available to long-term gains derived by a non-resident on the sale of listed shares has been controversial, with the Indian judiciary adopting divergent views.

The Authority for Advance Ruling (‘AAR’) in the case of Timken France vs. DIT [294 ITR 513 (AAR)] dealt with the issue as to whether the taxpayer could avail the benefit of concessional rate of 10% as per section 112, in respect of long term capital gains arising from transfer of listed securities, considering that the indexation benefit envisaged under the second proviso to section 48 is not applicable to nonresidents.    
 
The AAR held that the benefit of section 112 cannot be denied to non-resident taxpayers on the basis that they are also entitled to another relief/ benefit (protection against foreign currency fluctuations) under first proviso to section 48. It was held that the non-resident taxpayer is entitled to the benefit under section 112 in respect of the long-term capital gains arising from the sale of shares of the listed Indian company, since the said provision did not make any distinction between a resident and a nonresident. The AAR also distinguished the decision of the Mumbai Tribunal in the case of BASF Aktiengesellschaft [12 SOT 451 (Mum)] wherein the Tribunal held that the Legislature never intended to give the benefit of proviso to section 112(1) to those case where long-term capital gain is required to be computed under the first proviso to section 48.
 
In an another ruling in the case of Fujitsu Services Ltd., In re [225 CTR 121 (AAR)] that covered materially the same set of facts, the AAR reiterating its position taken in the case of Timken France (supra) held that section 112(1) of the ITA does not distinguish between residents and non-residents and, therefore, a non-resident is entitled to the benefit of the concessional tax rate of 10% in appropriate cases. Rejecting the contention of the tax authorities, the AAR concluded that, since indexation benefits are not available to non-residents, eligibility for benefits under the second proviso to section 48 should not be a condition precedent for invoking the lower rate of tax under section 112(1). Rather, indexation is simply an alternate method available to residents to account for inflation when calculating capital gains. The AAR concluded that the concessionary tax rate on long-term capital gains cannot be denied to a non-resident company on the grounds that the company is not eligible to take advantage of the indexation benefit.
 
Accordingly, in view of the aforesaid rulings, irrespective of whether or not a taxpayer is entitled to claim benefit of second proviso to section 48, as long as the taxpayer is not giving effect to the same for the purpose of computing capital gains, the benefit under the proviso to section 112(1) should be allowed to the taxpayer and it cannot be denied on the ground that the second proviso to section 48 is not applicable.
   
Following the principle laid down in the case of Timken France (supra), similar view was reiterated in the following host of rulings:
-        Four Star Oil and Gas Co., In re [312 ITR 104 (AAR)]
-        Compagnie Financiere Hamon vs. DIT [310 ITR 1 (AAR)]
-        Burmah Castrol Plc. In re [307 ITR 324 (AAR)]
-        McLeod Russel India Ltd., In re [299 ITR 79(AAR)]
 
Even admitting that the ruling of the AAR is binding only on the applicant and the tax authorities with respect to the transaction for which the ruling was sought, it appeared that it was time for the applicants to approach the AAR on new and sunrise areas rather than beating a dead horse. However, the self-assuredness was not destined to last long and recently, the AAR in the case of Cairn U.K. Holdings Ltd., In re [AAR No. 950 of 2010] decided on 1 August 2011 held that if the applicant is not eligible for the indexation benefit, the benefit of lower rate of tax of 10% would also not apply.  For not following its previous rulings, the AAR mentioned the following:
 
“The ruling in Timken France was thereafter followed by this Authority in a host of other cases. We are of the view that a ruling under the Act is confined to the facts and the law projected in the application leading to the ruling and binding only on that party and the revenue. In a case where, with respect, certain aspects germane to the issue are not examined and the authority has taken a view, we think that we are not hampered from taking a fresh look on that issue when raised before us.”
 
Conclusion
The decision of the AAR in Cairn U.K. (supra) has unsettled a position of law which was consistently followed by the AAR in the past, leading to uncertainty in withholding taxes involving non-resident selling shares of a listed company in a private arrangement.
Therefore, until the issue is ultimately decided by the Supreme Court in pursuance to the appeal filed by the Revenue against an earlier favorable ruling or the Central Board of Direct Taxes release clarifying guidance, it’s a catch-22 situation.


The view expressed are strictly personal. We and author are not liable for any damage caused to any person.
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