Corporate Law

Taxation of Investment Income in India: In pursuit of macroeconomic objectives

Suranjali Tandon


The ideal taxation of financial markets is a difficult matter but is quite often the pre-occupation of experts. In principle, an exemplary system would be one that is neutral and does not make tax a significant consideration for an investment decision. Yet, in practice this principle is abandoned, partially, in pursuit of macroeconomic objectives. This is manifest in the concurrent complexity of the Income Tax Act, amended to accommodate such objectives.  Often the law is assumed to be independent of these objectives. On the contrary, amendments to the law must be interpreted in the light of the macroeconomic setting. This is borne out in historical narrative of tax policy, which will be discussed briefly in this article.

Post-independence, in an effort to achieve finance stability and foster growth, corporate and individual taxes rates were kept exceptionally high. Top marginal income tax rates  were 97.5 per cent until early 1970s. Such high rates were the norm until 1970s, when the evidence of widespread evasion encouraged rethink. Then in 1991 following the severe balance of payments crisis, India embarked on liberalisation of its capital account. Acknowledging that foreign investors were important to develop financial market and for participation of funds  in India, a series of incentives were offered to foreign investors. Alongside the change in objectives, tax treatment of principle incomes of capital also changed manifold over the decades.

But as is said, more things change the more they remain the same. Thus complexities in taxation of incomes to capital, often the result of that in financial markets, continue to worry taxpayers. A company  can choose to distribute its profits as dividend to reward the risk taking by shareholders or issue bonus shares. Alternatively it can retain these profits, which can then be used to fund future expansion or buy back share capital. Thus in case where the tax treatment of each of these use cases varies widely the decision can hinge on the relative tax treatment. It is observed that in India, the differences were deliberately introduced to influence companies’ strategy to reinvest. For example, until 1987 a tax on undistributed profits was charged so that individuals would not incorporate and avoid payment of tax. Undistributed profits thereon, considered as an important source of finance for reinvestment, remained untaxed until in 2013.When it was observed that unlisted companies used reserves to buy back shares. This compelled the government to introduce a tax of 20 per cent on buy backs, i.e. amount paid less receipts from the shares. To end arbitrage, in 2019, this was introduced also on buy back of shares of listed companies.

As for the incomes distributed,  treatment of dividends went through a series of change since the 1950s. In the early 1950, companies paid the tax and  credit was made available proportionately to individuals. To remove such legal fiction, where the tax paid by the company was deemed to be paid by the shareholder, dividends were made taxable in the hands of the shareholder, subject to withholding. This treatment continued until 1997. It was seen that companies were distributing exorbitant profits that could be ploughed back. Therefore, a unique dividend distribution tax (DDT) was levied at the level of the company and dividend was made exempt in the hands of the investor. The rate of this tax was revised upwards to 12.5 per cent in 2007 and 15 per cent in 2010. Later in 2014, to apply the tax to the proper base, grossing up of dividends was mandated, making the effective rate of 20.6 per cent.

In addition to this to make the tax progressive, in 2016 an additional dividend tax of 10 per cent was introduced on dividend above INR 0.1 million.  Numerous representations were made to persuade the government to reconsider such tax treatment, primarily since tax paid would not be available for credit in the home country of foreign investors.

Over the years, financial markets in India evolved with the introduction of special investment vehicles such as alternative investment funds[1] in 2012 and Real Estate Investment Funds and Infrastructure Investment  Funds in 2014 that were considered an important source of finance for infrastructure and startups. Since the investors in the fund structure, separated from the investment by layers of SPVs, would often earn returns through multiple layers, the levy of DDT affected these returns.  Amendments to the Income Tax act since 2014 made specific exemptions for dividend distributed to an SPV with controlling interest in the trust[2] and to mitigate cascading effect of DDT on AIFs(alternative investment funds). [3] On the other hand, Debt oriented funds paid 25 per cent tax on distribution while equity-oriented funds were tax-free until 2018.  With the reversion to the classical system of taxation in 2020, these benefits for REITs and InviTs were carried into the amendments, despite the initial reluctance observed after the introduction of the finance bill.[4]

Capital gains too have been subject to a series of revisions. For one, the distinction between short term and long term gain was drawn in 1962 and it was applicable at different rates between corporate and non-corporate assesses. Over the years, the rate of capital gains tax, deduction from such gains, period of holding and the exemptions on reinvestment of proceeds was also tweaked from time to time.  There were also efforts to draw parity between assets, such as that in 1977 the distinction between the exemption from reinvestment was extended to assets other than residential property.

In the 1990s investment in equity gained priority owing to the focus on industrial growth and a relatively liberalised capital account. Tax on long term capital gains (LTCG) was thus brought down to 10 per cent and 15 per cent on short term gains for FII in 1992-93. In 2004, to encourage financial markets LTCG on equity was exempt and in its place a securities transactions tax was introduced. Then LTCG was exempt for Venture Capital Funds.  Realising that the revenue foregone from the exemption to  long term gains from equity, estimated at INR 36,700 (US$483) billion,  was substantial, it was withdrawn in 2018. Now long term capital gains on equity upwards of INR 100,000 is taxable in the hands of the investor at 10 per cent. The qualification for gains to be classified as long term, is that the asset be held for specified time period.  The holding period prescribed varies widely across assets. From 12 months for listed equity to 36 months for others.

An important feature of India’s Income Tax Act is that it classifies the treatment of equity and all others, there is no specific mention of debt. As a result, debt mutual funds are lumped with all other assets, including residential property in terms of tax treatment of capital gains.

 In so far as profits are used to issue bonus shares, their tax treatment varied in terms of the cost of acquisition. At present their cost is taken as nil and tax is applicable on full value of sale consideration.

The simplifying description of the tax treatment of returns to capital illustrates that the changes in macroeconomic priority were often accommodated into the Act. An important consideration for policy is if such incentives worked. The view in the1970s that tax did not have correlation with investment transitioned in the 1990s when tax was considered as an important factor. There is information to suggest the latter. For example, buy back tax reduced instances and size of buybacks among listed companies, as much as the imposition of higher dividend tax. On the other hand preferential treatment to  REIT and InvITs did not bring in the quantum of investments as desired.

Dividends are now taxed progressively at rates of income tax while gains from sale of equity-based assets require a shorter holding period. The current structure deters liquidity in debt based investments and taxes buy-backs as well as dividends more than long term capital gains. One may conjecture that the system is geared to encourage ploughing back of profits for reinvestment. In the present circumstance of imminent slowdown, this may work to the advantage of the company. That being said, the sluggish corporate debt market at the moment necessitates the rationalisation of the tax treatment of debt and equity.

[1] These existed as venture capital funds prior to 2012

[2]  100 per cent

[3] Para 143, Page 25, Budget Speech 2012-13

[4] The tax treatment specified in the Finance Bill was different from that of that finally implemented in the Finance Act 2020.

The author is an Assistant Professor at the National Institute of Public Finance and Policy.

Image credits – Financial Express

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Categories: Corporate Law