Taxation of share capital gains in source countries questionable
Partner, Ernst & Young
One of the arguments put forward by the Finance Minister in defending taxation of Hutchison - Vodafone type transactions is that capital gains on the transactions may not be getting taxed anywhere and should be taxed in India as they arise from the assets located in India. This argument, if valid, could indeed be persuasive in defending the Budget 2012 proposals. However, the premise underlying this argument, that such income is taxed nowhere, is questionable. In fact, capital gains on shares represent income that has already been, or will be, taxed in the country where the corporate assets are located. They are not tax-free income, but after-tax corporate earnings.
Corporate earnings are first subject to corporate income tax in the country where the assets are deployed for production or generation of income. Earnings that remain in the company after payment of corporate income tax then attract another tax in the form of dividend distribution tax when they are distributed to the shareholders. Capital gains tax will be a Third Tier tax over and above the corporate income tax and the dividend distribution tax. Conceptually, ignoring the speculative movements in stock markets, capital gains on shares are nothing but the present discounted value of current and anticipated future after-tax earnings of the company. These earnings are reflected in the value of shares as capital gains only until they are distributed to shareholders as dividends. As dividends are paid, the value of shares and the associated capital gains will come down. Thus, share capital gains do not represent a separate form or source of income or value-added in the economy. They are corporate income that has already, or will have, borne tax as corporations realize their earnings.
Corporate source earnings, conceptually, should attract the same amount of tax as those earned by individual shareholders from a business carried on directly, such as through a proprietorship. Taxation of dividends and capital gains in addition to the corporate income tax could amount to double or triple taxation, which is contrary to the principle of tax neutrality. It is one of the reasons that several international jurisdictions (Germany, France, Hong Kong, and Singapore) do not apply tax to share capital gains, especially for significant shareholdings, i.e., in excess of 10-20%, or tax them at much reduced rates.
It is again on the basis of this principle that dividends also are not taxed at all or taxed at a much reduced or preferential tax rate. In some countries dividends are taxed based on the so-called imputation system where shareholders include dividends in their income but are allowed an imputation credit for the underlying taxes already paid at the corporate level. The credit serves to eliminate double taxation of corporate income.
In India, dividends bear one-half of the full corporate tax rate, with no further tax at the shareholder level. Long term capital gains on listed securities traded at the stock exchanges are completely exempted from tax. Perhaps it is the same logic why India has conceded full exemption to the capital gains under its treaties with Mauritius and Singapore.
This issue was also examined by the Kelkar Committee in its Report on Direct Taxes (2002) which recommended full exemption for long term capital gains on corporate equity. This recommendation was not made as incentive for corporate investments, but as a basic principle of avoiding double taxation of corporate source income. In fact, the Kelkar Committee Report states explicitly that capital gains other than on corporate equity should remain fully taxable.
The Government of India has taken appropriate steps over the past two decades to strengthen the corporate tax base and bring the effective tax rate on corporate earnings to the full statutory tax rate. Indications are that the effective corporate income tax rate in India is now in the range of 24% compared to the statutory corporate rate of 30% (which is the same as the top individual rate).
The remaining gap is filled, at least partially, by the dividend distribution tax, leaving little room for an additional Third Tier tax on share capital gains.
Even if there were any logic in applying tax on the share capital gains, the tax should apply in the country of residence of the shareholders and not in the country of source of income. This is indeed the case in virtually all countries around the world, with the notable exception of India (and, in limited instances, China).
In most international tax treaties, the right to taxation of share capital gains is given to the residence country, except for capital gains on shares of companies holding mainly real property. Both OECD and UN model tax agreements reflect this principle.
In a recent communication to the United Nations, the Indian tax authorities took a stand that India cannot be forced to accept the transfer pricing rules of the OECD (reflecting the view that OECD is a club of rich countries which does not properly recognize the interests of developing countries). While India is flexing its muscles in the negotiations, the issue of taxation of share capital gains is quite distinct. The arena to show the muscles is the Tier One tax, i.e., corporate income tax.
Capital gains tax, being a Third Tier tax, should be levied in the country of residence, except in limited circumstances such as capital gains on shares of special purpose entities holding real property.