Destination test: FPI fund transfers under taxman’s lens?

Subject: Economy

Section: Capital market

Context: Several Foreign portfolio investors (FPIs) receive tax notices.

Key Points:

Foreign portfolio investors (FPIs) have received a slew of notices on foreign remittances made outside India under Section 133 (6) of the Income Tax Act.
Tax authorities are seeking KYC details, names of ultimate beneficial owners, holdings and nature of remittances.

What is the reason for notices?

The main reason is the suspicion of using investment treaty provisions to avoid tax by non treaty nations.
For a fund investing from Singapore into India, capital gains will be taxable. But the dividend or interest income will be subject to tax at the concessional rate of 10 per cent.
To be eligible for the concessional rate, the fund needs to demonstrate that it is the beneficial owner of the income and a tax resident of Singapore.
The Singapore fund, however, may be repatriating the gains made from investing in India to a country like Mauritius or the US. This is being looked upon with suspicion.
The tax office may wants to curb such practices and disallow treaty benefits to these funds.
If the money has gone to a country other than where the fund is based, it could imply that the fund has been treaty shopping.
If even the bank account is being operated from another country, the “substance” of the fund could be called into question and lead to denial of treaty benefits. Taxes where exemption was claimed could become payable, along with interest and penalities.
A substance test typically requires a fund to prove its presence in a particular jurisdiction, by way of its registered office, staff, cash flows, etc.

Substance test

In the context of taxation and investment treaties, the term “substance test” refers to a requirement or criterion imposed by countries to determine the legitimacy of a foreign entity’s claim to tax benefits or treaty protections.
It is used to ensure that companies or individuals have a substantial presence or economic activity in a country before they can take advantage of favorable tax rates or the protections granted by bilateral investment treaties.
The substance test is designed to prevent “shell” or “mailbox” entities from exploiting tax and investment treaty provisions for tax avoidance or treaty shopping purposes.
The test ensures that tax and investment treaties are used for their intended purposes, promoting economic development and cooperation, rather than for abusive practices.