Budget Connect+ EY Tax Alert - Financial Services. 11 July 2014

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1 11 July 2014 Budget Connect+ EY Tax Alert - Financial Services Tax Alerts cover significant tax news, developments and changes in legislation that affect Indian businesses. They act as technical summaries to keep you on top of the latest tax issues. For more information, please contact your EY advisor.

2 Introduction This alert summarizes certain significant tax proposals contained in the Finance (No.2) Bill, 2014 (Bill) and policy announcements made by the Finance Minister, Mr Arun Jaitley, during the Budget speech relevant to the financial services sector. The policy pronouncements made by the Finance Minister are expected to be implemented by the Government through legislative/ administrative announcements (where required) in the ensuing months. The Bill will be discussed in the Parliament before it is enacted and is subject to any amendments that may be made pursuant to these discussions. The direct tax proposals discussed in this memorandum are effective from the tax year commencing on 1 April 2014, unless otherwise specified. Key Policy Initiatives Some of the key initiatives announced by the Finance Minister as a part of his budget speech are summarized below: bond market and deepen the currency derivatives market by eliminating unnecessary restrictions. The regime for American Depository Receipts/ Global Depository Receipts shall be liberalised by allowing issuance of depository receipts on all permissible securities. International settlement of Indian debt securities shall be permitted. Indian Depository Receipt shall be replaced by a much more liberal Bharat Depository Receipt. Uniform KYC norms shall be introduced and inter-usability of the KYC records across the entire financial sector shall be made possible. To enable the Indian financial sector consumers to access and transact all financial assets, one single operating demat account concept shall be introduced. Banking Financial sector and capital markets Measures shall be undertaken to complete the ongoing process of consultation with all the stakeholders on the recommendations of the Financial Sector Legislative Reforms Commission like the enactment of the Indian Financial Code, which is considered necessary for better governance and accountability. Financial sector regulators shall be advised to take early steps for a vibrant, deep and liquid corporate A modern monetary policy framework shall be put in place after consultation with the Reserve Bank of India (RBI). Divestment of the Government stake in banks proposed in a phased manner with the Government continuing to have majority shareholding. A time bound programme to be launched as Financial Inclusion Mission on 15 August 2014 to provide all households in the country with banking services.

3 To permit long term financing for infrastructure, banks will be encouraged to extend long term loans to the infrastructure sector with flexible structuring to absorb potential adverse contingencies. Further, banks will also be permitted to raise long-term funds for lending to the infrastructure sector with minimum regulatory pre-emption such as Cash Reserve Ratio, Statutory Liquidity Ratio and Priority Sector Lending. A structure shall be put in place for continuous authorization of universal banks in the private sector in the current financial year. RBI will also create a framework for licensing small banks and differentiated banks. Insurance Foreign Direct Investment in the insurance sector shall be increased from 26% to 49% (under the approval route), with full Indian management and control. To reduce disputes, the following tax reforms have been proposed: Resident taxpayers permitted to avail of an advance ruling from the Authority for Advance Rulings (AAR) in respect of their income tax liability above a defined threshold 2 ; AAR to be strengthened by constitution of additional benches; To align transfer pricing regulations in India with the best available practices, a range concept for determination of arm s length price is proposed to be introduced. The arithmetic mean concept will continue to apply where the number of comparable companies are inadequate; Transfer pricing regulations shall be amended to allow use of multiple year data vis-à-vis single year data for comparability analysis. No retrospective changes shall ordinarily be introduced which would result into new liabilities. The Insurance Laws (Amendment) Bill, 2008 to be taken up for consideration of the Parliament. Tax reforms All fresh cases being questioned by the Indian Revenue authorities, arising out of the retrospective amendment in respect of indirect transfer of capital assets, effected by the Union Budget , shall be scrutinised by a High Level Committee to be constituted by the Central Board of Direct Taxes (CBDT) before any action is initiated in such cases. Measures to be taken to approve the legislative scheme for implementation of Goods and Service Tax. Direct Taxes Code, 2013 to be reviewed after considering the comments received from various stakeholders. Direct Taxes Tax rates The income-tax rates for corporate and non-corporate entities remain unchanged for both domestic and foreign taxpayers. Further, no changes have been proposed 2 No amendments have been proposed in the Bill in this regard.

4 in the rates for minimum alternate tax and dividend distribution tax. Tax on long-term capital gains on transfer of units Presently, where the tax payable in respect of any income arising from the transfer of a long-term capital asset being a listed security or unit or zero coupon bond exceeds 10% of the amount of capital gains before availing the benefit of indexation, such excess is to be ignored while computing the tax liability. The Bill proposes to amend the above provision and restrict the applicability of the concessional rate of tax of 10% only to long-term capital gains arising from the transfer of listed securities (other than a unit) and zero coupon bonds. Consequently, long-term capital gains arising on sale of units of a mutual fund (other than an equity oriented fund) would be taxable at the rate of 20% for domestic investors and 10% for non-resident invetsors. Period of holding in case of unlisted securities and units Currently, a share held in a company or any other security listed on a recognised stock exchange in India or a unit of the Unit Trust of India or a unit of a mutual fund or a zero coupon bond qualify as a long-term capital asset where the same is held for a period of more than 12 months. unlisted securities (other than a unit) [such as unlisted equity/ preference shares] and units of a mutual fund (other than an equity oriented fund) shall be considered as a long-term capital asset where the same are held for a period of more than 36 months. Consequently, for the aforesaid securities, lower tax rates applicable to long-term capital gains and indexation benefit (where available), shall apply only where the holding period exceeds 36 months. Characterisation of income earned by Foreign Portfolio Investors (FPI) Presently, characterisation of the income arising to FPIs 3 from transactions in securities being in the nature of capital gains or business income has been a subject matter of debate. In order to end this long standing debate/ controversy, the Bill proposes to amend the definition of capital asset to include any security held by a FPI in accordance with the regulations made under the Securities and Exchange Board of India, Act By virtue of the said amendment, any income arising to a FPI on transfer of such security would be characterised as capital gains. This would equally apply to equity shares, debt securities, derivatives, etc. The Budget speech clarifies that the above amendment has also been introduced to encourage fund The Bill proposes to amend the aforesaid provision to provide that 3 The CBDT vide a circular has clarified that FPIs would be treated as Foreign Institutional Investors for the purpose of the Indian tax laws.

5 managers (managing the funds of FPIs) to shift to India since their operational presence overseas was hitherto being linked to the apprehension that the presence in India may have adverse tax consequences. Transactions not regarded as transfer Currently, certain specified transactions are not considered as transfer for the purpose of charging capital gains tax. With a view to facilitate listing and trading of Government securities outside India, the Bill proposes that any transfer of a capital asset, being a Government security 4 (carrying a periodic payment of interest) made outside India through an intermediary dealing in settlement of securities, by a non-resident to another non-resident shall not be considered as a transfer for purpose of charging capital gains tax. Computation of dividend and income distribution tax The Bill proposes that the DDT should be applied to the amount of dividend distributed to shareholders by grossing up the said amount by the DDT rate of tax. Similar amendment is being proposed for calculating the income-tax payable on the amount of income distributed by mutual funds in respect of nonequity oriented schemes. An illustration of the existing and the proposed provisions has been tabulated below in respect of dividend on shares paid by a company to its shareholders: Particulars Prior to the amendment Amount (`) Dividend declared (A) Dividend distribution tax [A*15%] (B) Add: 10% (C) 1.28 Add: Education 3% (D) 0.42 Total tax outflow for the company (B+C+D) Total cash outflow for the company (A+B+C+D) Presently, dividend distribution tax (DDT) at a rate of 15% (plus surcharge and education cess) is computed with reference to the amount actually distributed/ paid by an Indian company to its shareholders. A similar provision applies to distribution of income by non-equity oriented mutual funds (the distribution tax varies from 25% to 30%). 4 As defined in the Securities Contracts (Regulations) Act,1956.

6 Particulars Post the amendment Amount (`) Dividend declared (A) Grossed up dividend (A/85%) [B] Extension of the benefit of the concessional rate of tax in the case of overseas borrowings (in foreign currency) made by business trusts (i.e Infrastructure Investment Trust or a Real Estate Investment Trust); and Dividend distribution tax [B * 15%] (C) Add: 10% (D) 1.50 Add: Education 3% (E) 0.50 Total tax outflow for the company (C+D+E) Total cash outflow for the company (A+C+D+E) Extension of the concessional rate of tax to any overseas borrowings (under a loan agreement or by way of issue of long-term bonds) made upto 30 June Interest paid on the long-term bonds would be subject to a concessional rate of tax irrespective of whether the lender has a Permanent Account Number in India or not. These amendments will take effect from 1 October Extension of scope of concessional rate of tax on overseas borrowings Currently, interest paid by an Indian company to a non-resident, in respect of approved borrowings made (during the period 1 July 2012 to 30 June 2015) in foreign currency from sources outside India (under a loan agreement or on issue of long-term infrastructure bonds) is taxable at a concessional rate of 5% (plus applicable surcharge and education cess). In order to further augment low cost long-term overseas borrowings, the Bill proposes the following amendments: Extension of the benefit of the concessional rate of tax to overseas borrowings (in foreign currency) made by way of issue of long-term bonds (of any sector) on or after 1 October 2014; The above amendment will take effect from 1 October Losses of a speculative business Currently, any loss in respect of a speculative business can be set-off only against the profits of another speculative business. For this purpose, where any part of the business of a company consists of the purchase and sale of shares of other companies, such company shall be deemed to be carrying on speculative business. Companies whose principal business is the business of banking or the granting of loans and advances are excluded from the aforesaid deeming provision. The Bill proposes to extend the aforesaid exclusion to a company, the principal business of which is trading in shares.

7 Speculative transactions in commodity derivatives REITs and IITs, would be exempt from tax in the hands of the investors. Presently, eligible transactions in respect of trading in commodity derivatives carried out on a recognised association are not considered as speculative transactions. Earlier this year, the CBDT had clarified that eligible transactions shall include only those transactions in commodity derivatives which are carried out on a recognised association and are subject to commodities transaction tax. The Bill also proposes to levy securities transaction tax on transactions in units of REITs and IITs on the same lines as applicable to transactions in equity shares of a company. Accordingly, capital gains arising on sale of units of REITs and IITs listed on a recognised stock exchange in India would be taxable at a beneficial rate applicable to capital gains arising on sale of equity shares of a company listed on a recognised stock exchange in India. The Bill proposes to incorporate the aforementioned clarification of the CBDT in the Income-tax Act, 1961 (Act). The above amendment will take effect retrospectively from 1 April Taxation of Real Estate Investment Trust (REITs) and Infrastructure Investment Trust (IITs) However, capital gains arising to the sponsor of REITs and IITs on transfer of shares of a special purpose vehicle to REITs and IITs in exchange of units would not be eligible for such beneficial treatment and would be taxable in the year in which such units are transferred. Extension of benefit of concessional rate of tax on dividend received from specified foreign company Recently, the Securities and Exchange Board of India had introduced draft guidelines for REITS and IITs. To promote the same, the Bill proposes to grant a pass through status to interest income earned by REITS and IITs. Such interest income would be taxable in the hands of the investors and accordingly REITs and IITs will be required to withhold tax at specified rates. Any other income earned by the REITs and IITs would be taxable at maximum marginal rate and distributions made therefrom, by Presently, dividend income received by an Indian company from a specified foreign company 5 is taxable at a concessional rate of 15% (plus applicable surcharge and education cess), where the said dividend income forms part of the total income of the Indian company in the financial year (FY) , FY and FY A foreign company in which the Indian company holds 26% or more of the nominal equity share capital

8 With the intention of encouraging the repatriation of foreign dividends into India, the Bill proposes to extend the benefit of the concessional rate of tax on such dividends received during FY and subsequent years. Tax deduction at source from non-exempt payments made under life insurance policy Any sum received under a life insurance policy which does not fulfill the conditions specified under section 10(10D) of the Act shall be taxable in the hands of the policyholder. expenditure under the current income tax law and whether the same would be covered under the existing provisions of section 37(1) of the Act. The Bill proposes that such CSR expenditure shall not be deemed to have been incurred for the purpose of business and shall not be allowed as a deduction while computing business profits. However, the CSR expenditure which is of the nature described in section 30 to section 36 of the Act shall be allowed as a deduction subject to fulfilment of conditions, if any, specified therein. The Bill proposes to introduce a new provision to provide for deduction of tax at the rate of 2% on any sum paid under such policies. However, the said tax withholding will not be applicable, where the aggregate amount of such payments to the payee during the tax year is less than ` 100,000. The said amendment will be effective from 1 October Deductibility of Corporate Social Responsibility (CSR) expenditure The Companies Act, 2013 (Cos 2013) mandates certain companies (which have net worth of ` 5,000 million or more, or turnover of ` 10,000 million or more, or a net profit of ` 50 million or more during any financial year) to spend at least 2% of its average net profit for the immediately preceding three financial years on activities relating to CSR. There was lack of clarity as regards the deductibility of the CSR Return of income to be filed by a mutual fund, securitisation trust, venture capital company and venture capital fund Currently, a venture capital company/ venture capital fund (where they have earned only exempt income), mutual fund, securitisation trust, are not required to file a return of income since the income earned by them is exempt from tax. The Bill proposes to make it mandatory for a mutual fund, securitisation trust, venture capital company and venture capital fund to file a return of income, where the total income (including the exempt income) exceeds the maximum amount not chargeable to tax. Further, the requirement to file a statement of income distributed and tax paid thereon by mutual funds and securitisation trusts is dispensed with. No similar dispensation from filing of Form No 64 is proposed for

9 venture capital companies and venture capital funds. Use of electronic clearing system for acceptance or repayment of loans and deposits Currently, no person is inter alia allowed to take any loan or deposit aggregating to ` 20,000 or more from any other person otherwise than by way of an account payee cheque or account payee bank draft. Similarly, no loan or deposit can be repaid otherwise than by an account payee cheque or an account payee bank draft, if the amount of such loan or deposit together with interest or the aggregate amount of such loans or deposits together with interest, if any payable thereon, is ` 20,000 or more. Given that in the present times many banking transactions take place by way of internet banking facilities or by use of payment gateways, the Bill proposes to provide that any acceptance or repayment of any loan or deposit by use of an electronic clearing system through a bank account shall be permitted. Transfer Pricing Definition of international transaction Presently, transactions entered with an unrelated person are deemed to be transactions between associated enterprises if there exists a prior agreement in relation to such transactions between such unrelated person and an associated enterprise or the terms of the relevant transaction are determined in substance between such unrelated person and an associated enterprise. The present provisions do not provide whether or not such unrelated person should also be a non-resident. This has been an area of controversy in the recent past. The Bill proposes that such transaction shall be deemed to be an international transaction irrespective of whether such unrelated person is a resident or non-resident, as long as either the enterprise or the associated enterprise is a nonresident. Advance Pricing Agreement (APA) Roll back provisions The Government in 2012 introduced the APA scheme to provide certainty to taxpayers for determining the arm s length price in relation to international transactions. APA is an agreement between the taxpayer and the Indian Revenue authorities on an appropriate transfer pricing (TP) methodology for a set of international transactions over a fixed time period in future. It is proposed to now introduce roll back provisions in the APA scheme. Salient features of the roll back provisions are as follows: Roll back refers to the applicability of the TP methodology and Arm s Length Price agreed in an APA to international transactions entered prior to the period covered under the APA.

10 Roll back period shall not exceed year 6 months; four years preceding the first financial year for which the APA is applicable. The procedure, conditions and 24% pa for the period beyond 6 months and upto 1 year; and manner in respect of roll back of APAs shall be prescribed 30% for any period beyond 1 year subsequently. This amendment will be effective from 1 October Indirect Taxes Service tax Effective service tax rate unchanged at 12.36%. Definition of intermediary under Place of Provision of Service Rules widened to include broker/ agent for supply of goods. Therefore, commission agent of goods (which includes securities) is taxable based on place of location of service provider with effect from 1 October Mandatory requirement to make pre-deposit for filing appeals before Commissioner (Appeals) and CESTAT aligned with the Excise laws, as under: Pre-deposit of 7.5% of the service tax demanded or penalty imposed or both at first stage of appeal. Pre-deposit of 10% of the service tax demanded or penalty imposed or both at second stage of appeal Penalty waiver not available in cases where extended period of limitation of 5 years is involved. Advance ruling is now an option extended to resident private limited companies. Key amendment relating to assessments: Rationalisation of procedures for claiming exemption/ refund of service Increase in interest rates for delayed payment of service tax: tax on input services for units of a Special Economic Zone (SEZ) and developers: Extent of delay Simple interest rate per annum (pa) Service tax authorities required to issue authorization of Form Upto period of 6 months 18% pa A2 within 15 days of application; More than 6 months and upto 1 year 18% pa for the first 6 months; and 24% pa for delay beyond 6 months Exemption available from date of issue of Form A1 by the SEZ authorities; More than 1 18% pa for the first Relaxation given to service providers to grant exemption up to

11 3 months of provision of service of receipt of Form A2 from a unit in a SEZ/ developer; Clarity on services used for authorised operations of SEZ unit/ developer - invoice requirement and use for furtherance of authorised operations. Other key changes: Domestic reverse charge extended to the following services: Services provided by a recovery agent to a banking company, financial institution, or a non-banking financial company; Services provided by the director of body corporate to such body corporate. Exemption provided to Life micro insurance products approved by Insurance Regulatory and Development Authority, having a maximum coverage of ` 50,000, under the mega exemption notification. In case of transfer of business/ change in ownership, etc, authorities empowered to recover dues of the predecessor from the assets of the successor purchased from the predecessor. Cenvat credit Introduction of timeline of 6 months from the date of the invoice/ other relevant document for availing cenvat credit on inputs and input services. Rationalisation of timing of claiming cenvat credit: For reverse charge, where whole service tax is liable to be paid by service receiver, cenvat credit available on payment of service tax. Payment of value of services no longer a pre-requisite for availing cenvat credit. For partial reverse charge, cenvat credit to be availed on the payment of service tax and the entire value of services. Time limit for payment of value of service under reverse charge reduced to 3 months from date of invoice. Where payment is not made within the said period, point of taxation would be the following day on which the said period expires. Customs notified exchange rates for determination of taxable value in case of imports to no longer be applied. Separate Rules to be prescribed in this regard. Exporter entitled to re-avail cenvat credit reversed on account of nonreceipt of export consideration within the prescribed timeline, if such export consideration is received within one year of such prescribed timeline. Customs Peak rate of basic customs duty remains unchanged.

12 Excise No change in the basic excise duty rate of 12%. Comments While the Budget has proposed a number of favourable policy initiatives and forward looking ideas for the financial services sector, contrary to the expectations, the Bill has not addressed some of the following key areas: Exclusion of FPIs from the indirect transfer regime in order to retain investor confidence and promote investments in the Indian capital markets. Extension of the tax passthrough status presently available to grandfathered venture capital funds and venture capital sub-category of Category I Alternative Investment Funds (AIFs) to other sub-categories of Category I and II AIFs and for all streams of income (including income not earned from a venture capital undertaking). Deferral of GAAR by potentially one year; further, clarifications with respect to the GAAR provisions based on the report of the Expert Committee and announcements made by the previous Finance Minister.

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