Financial instruments and taxability
Financial instruments are monetary contracts created as a financial asset of one entity and a financial liability of the other. There are various forms of financial instruments available for investors to optimize returns, and it is pertinent to choose the right mix of financial instruments to suit investment goals.
Broadly, financial instruments are characterized by investors based on assets or the nature of business. Instruments are categorized by “asset class” depending on whether they are equity-based (reflecting ownership of issuing entity) or debt-based (reflecting a loan the investor has made to the issuing entity). Typical forms of financial instruments are:
Equity: Investments that grant ownership in a joint stock company for return on investment (RoI). Voting rights may be traded on stock exchanges.
Debt: A contract that enables the issuing party to raise funds by promising to repay the lender as per the terms of a contract. Common forms of debt instruments include notes, bonds, debentures, certificates, or other agreements between a lender and a borrower. Debenture is a debt instrument that may or may not have physical assets or collateral. Bonds are fixed income instruments issued by parties to raise capital. Sovereign bonds carry low risk with low returns, compared with corporate bonds that offer better returns with potential risk.
Convertible or Mezz finance: Convertibles are hybrid instruments that offer characteristics of both debt and equities. Convertibles are most often associated with convertible debentures/bonds, which allow debt holders to convert their credit position into equity at an agreed price.
Futures and options: Derivatives are financial contracts that derive value from the underlying assets. Worldwide, the derivative instruments used are futures and options. The fundamental difference between the two are in the obligations they put on the buyers and sellers.
1. Futures contracts grant rights with obligations to the traders with the open position settled on maturity.
2. Option contracts grant buyers the right but not the obligation. It permits the buyer an option to buy call or put, where the seller of the option has an obligation to comply with the contract.
Tax attributes of financial instruments in India
Exit or disposal of instruments: Taxability of instruments are based on various factors under Indian domestic tax laws. However, characterization of gains from exit of such instruments plays a vital role in determining income tax liability.
Profits arising from the instruments held with the intention of business or stock are treated as business income, subject to a maximum base tax rate of 30%/40%. Instruments held for investment purpose would qualify as capital assets, and sale thereof would constitute transfer of capital asset, resulting in capital gains tax liability.
Concessional rate of capital gains tax at 20%/10% may be applicable, depending on the period of holding ranging from 12-to-36 months. In case of listed securities where securities transaction tax is paid, no capital gains tax is payable in India.
Conversions/repayment of debt not a transfer: Ideally, Mezz instruments have dual characteristics where the hybrid instrument is converted from debt to equity or permissible instruments. The event of conversion would trigger transfer of asset. Under Indian domestic laws, conversion of specific instruments such as convertible debenture or preference shares to equity is tax-neutral. Repayment of debt on a principal to principal basis would not have tax consequences.
Others: Settlement of derivatives with underlying asset is treated as rights for capital gains tax purposes. Rights associated to business where the contract for purchase or sale is settled otherwise than by actual delivery may be considered as business income. Importantly, income of non-residents is chargeable to tax in India or subject to the tax treaty entered between the country, whichever is more beneficial.
Tax attributes of financial instruments in Singapore
Singapore taxes income on a quasi-territorial basis, i.e. companies are taxed on all income accrued or derived from Singapore. Foreign income is taxable that is remitted or deemed remitted into Singapore. Normally, gains arising on disposal of investments are not subject to tax in Singapore, subject to satisfaction of the prescribed conditions. In order to provide certainty, Singapore tax laws settled the issue of capital gains characterization under the 20%-24 months’ safe harbor rule for disposal of equity investments.
Tax treaty benefit is available to the investors who are non-resident in Singapore furnishing a certificate of residence. Further, the Singapore Income-tax Act provides Singapore taxpayer relief against double taxation where Singapore has signed income-tax treaties with the countries.
At the outset, appropriate classification of a financial instrument like equity or combination of both, is an essential factor to obtain clarity from tax, accounting and realization perspective.
1. What is the character of income when convertible or Mezz instruments are transferred and its tax treatment?
Character of income arising from the transfer of convertibles is retained as capital gains on instruments transferred prior to the conversion. Appreciation of income from the convertible instrument transaction cannot be re-characterized as interest/dividend merely because the financial instrument has dual nature.
2.In case of convertibles held by Singapore investors, would the 20%-24 months’ safe harbor rule apply under Singapore tax laws, especially where the equity instrument is not clearly held for over 24 months?
The 2012 budget, in order to grant certainty to the taxpayer, introduced that gains or profits arising from disposal of ordinary shares in another company that are legally and beneficially owned by the divesting company immediately before the disposal, are sold during the specified period held as share for a continuous period of 24 months with at least 20% holding in the investee company, can access the relaxed provision.
Safe harbor rules obligate the taxpayers claiming the safe harbor provision to furnish information and supporting documents as required by tax authorities. Technically, the convertible instruments are not covered/specifically included in the safe harbor rule where claim of such benefit will have to be discussed with the comptroller before claiming the beneficial provision.
3. Would disposal of instruments by Singapore investors be eligible for tax treaty benefits in India?
Under the India-Singapore tax treaty, gains arising from alienation/transfer of instruments held in the Indian company are eligible for the benefits under Article 13 read with the March 2017 amendment to the India-Singapore tax treaty including the limitation of benefit clause. However, pursuant to the introduction of general anti-avoidance rule from April 2017 in India and the prevailing anti-avoidance rule under Singapore tax laws, sale transaction could be subject to examination of the anti-avoidance principles, due to lack of commercial rationale and determine the primary purpose test to be entitled for benefit under the applicable tax treaty.
Shailendra Sharma contributed to this article.
Vikas Vasal, national leader tax–Grant Thornton India LLP
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