“Mutual funds are not defined as shares in the treaty as well as in the Income Tax Act, so the taxpayer got the benefit,” said Mayank Mohanka, founder of TaxAaram India.
Here’s a closer look at the residual clause of DTAAs that exempt mutual funds from capital gains tax, which countries’ DTAAs have it, and what other requirements non-resident Indians (NRIs) need to meet to claim tax residency in another country.
The all-important residual clause
India’s DTAA with the foreign country must have a residual clause under ‘capital gains’ that says gains from “the alienation of any property other than that referred… shall be taxable only in the contracting state of which the alienator is a resident”.
Gautam Nayak, partner at CNK & Associates, said, “In several DTAAs (though not all), gains from transfer of assets other than immovable properties and shares of a company fall under the ‘residual clause’. This clause says the gains are taxable only in the country of residence of the seller.”
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However, to avail of his exemption, the taxpayer needs to be a tax resident of a country that doesn’t tax capital gains. To qualify for tax residency status, the taxpayer needs to satisfy all the conditions of DTAA between India and the country of residence.
Countries that meet both these conditions – meaning they have a residual clause under ‘capital gains’ in their DTAA with India and don’t tax capital gains – include the United Arab Emirates, Singapore and Mauritius. India has more than 90 DTAAs with various countries, so more countries may meet these conditions.
Under India’s DTAAs with the United Kingdom, the United States and Canada, any capital gains from Indian assets are to be taxed as per Indian tax laws. These DTAAs state, “Each contracting state may tax capital gains in accordance with the provisions of its domestic law.”
Tax residency
To avail of DTAA benefits as a tax resident of a foreign country, you need to comply with article 4 of the DTAA, which lays down the conditions to be a tax resident of that particular country.
Riaz Thingna, partner at Grant Thornton Bharat, said, “For claiming the capital gains exemption, one needs to check the residential status of the NRI as on the date of transfer or sale of the capital asset. As long as the NRI is a not resident in India on the date of transfer of the mutual funds, irrespective of whether he was a resident or non-resident at the time of their acquisition, capital gains will be exempted from tax in India as per the DTAA provisions for certain countries such as Singapore, UAE, Mauritius, Luxembourg and Switzerland.”
“Since capital gains from mutual funds are not taxable in India as per the DTAA as well as Singapore’s local laws, it leads to double non-taxation of income. In such cases, the ‘limitation of relief’ clause under the India-Singapore DTAA is triggered, which means that the source country may get the right to tax such income. They may argue that the income would be taxable in India. However, this clause is only present in the India-Singapore DTAA,” Thinga added.
Parizad Sirwalla, partner and head, global mobility services, tax, KPMG, said, “In general, the benefit will be available to an individual who is a resident of the other country as per article 4 of the relevant DTAA, subject to satisfying all other conditions. This is possible if the individual is resident of the other country and non-resident of India as per respective country’s domestic tax law.”
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There could be a scenario in which the “individual is a resident of both India and the other country as per respective domestic tax law. However, as per tie-breaker rules (generally prescribed in article 4(2) of the DTAA) the person qualifies as an ultimate tax resident of the other country,” she added.
Apart from being a non-resident Indian, the person also needs to submit a tax residency certificate (TRC) from the country in which he resides to get the DTAA’s benefits.
“The TRC mentions the residential status in the foreign country and other details of the individual. If it does not carry the tax identification number of the individual in the foreign country; his status (individual or company); nationality; period of the residency, and his address in the foreign country, the individual has to additionally furnish Form 10F to the Income Tax Department of India. If the TRC has all these details, Form 10F is not mandatory,” said Prakash Hegde, a chartered accountant in Bengaluru.
“Whether the initial investment is made from resident account, NRO (non-resident ordinary) or NRE (non-resident external) account generally does not have a bearing,” said Naisar Shah, director at PR Bhuta & Co.
New rules to prevent abuse
Bhuta said, “The Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (MLI) was developed to quickly and efficiently update bilateral tax treaties to prevent tax avoidance in cross-border situations. The principal purpose test (PPT) is a key anti-abuse provision introduced under Article 7 of MLI. MLI provisions in the India-UAE and India-Singapore DTAAs came into effect from 1 April 2020.”
The PPT is designed to ensure that tax treaties are not abused. After considering the facts of a case, if the tax authorities reasonably conclude that one of the main reasons the individual relocated to the UAE or Singapore was to benefit from the capital gains tax exemption on mutual funds, they may use the PPT to deny that exemption.
However, while the PPT is now included in many tax treaties, it doesn’t cover them all just yet.
Remember, tax rules can change
As things stand, you don’t have to be an NRI at the time of the initial investment to qualify for DTAA benefits. However, keep in mind that tax rules are subject to regular reviews.
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“This issue needs to be looked at from the legislative intent angle, too. Treaties were amended bilaterally in 2017 to exclude share sale from the treaty benefit to curb the practice of escaping tax liability on selling of underlying assets in the guise of share sale. But mutual fund investments in India, don’t give you control of any Indian company. So, this functional distinction between a share and a mutual fund unit is very important consideration to be kept in mind. However, there may be instances where mutual funds bought through Indian income prior to becoming an NRI are claimed as exempt,” said Mohanka of TaxAaram India.
“I believe that since this issue has come into the limelight, the government may again try amend treaties to include mutual fund units as well. If that is not possible then we can expect a new definition of shares that includes units of mutual fund in the upcoming Income Tax Act,” he added.