[Opinion] Finance Bill 2023 – Direct Tax Proposals impacting Investments

Authored by Vinay Dalvi | Chartered Accountant

Table of Contents

1. Introduction

2. Market Linked Debentures (‘MLD’)

3. Amendment to section 193 of the Act

4. Taxation of unit holders of a business trust

5. Proposed amendment to section 56(2)(viib) of the Act

6. Amendments to section 54 and section 54F of the Act

7. Concluding Remarks

1. Introduction

On 1 February 2023 the Hon’ble Finance Minister (‘FM’) tabled the much awaited Finance Bill 2023 (‘FB 2023’) before our democratically elected representatives in the Lok Sabha. FB 2023 was referred to by the FM in the budget speech as the first budget in the Amrit Kaal which envisions a prosperous and bountiful period of growth for India.

India has attempted to position itself as an attractive investment destination in recent times by implementing a slew of measures which include tax, regulatory and policy changes. FB 2023 also seeks to further this attempt, especially in a post COVID-19 recovery era. While FB 2023 is still being analysed in greater detail, the direct tax proposals of FB 2023 pertaining to investments may have caught the eye of many. This article seeks to discuss certain direct tax proposals of FB 2023 which may have a bearing on investments and which may be of interest to tax and finance professionals as well as the general population.

2. Market Linked Debentures (‘MLD’)

The Explanatory Memorandum (‘EM’) to FB 2023 explained MLDs to be listed securities which give returns in the nature of interest. The interest rates of MLDs are pegged to a particular capital market index. Hence, the returns earned by MLD holders may fluctuate based on the performance of respective indices. MLDs have been an investment option used by investors to earn potentially higher returns from a debt instrument as compared to traditional debt instruments with a fixed rate of interest.

As per the EM to FB 2023, MLDs are currently being taxed as long term capital gains (‘LTCG’) at the rate of 10% (without indexation). However, as per the Indian tax authorities (‘ITA’), MLDs are to be viewed as derivatives which are to be taxed at applicable tax rates. In order to codify this position in law, the FB 2023 has proposed to insert section 50AA of the Income-tax Act, 1961 (‘Act’) to tax the gains on transfer, redemption or maturity of MLDs as short term capital gains (‘STCG’). The amount received by the investors of MLDs shall be treated as the sale consideration. Cost of acquisition and expenses on transfer shall be deducted from the sale consideration to arrive at the taxable capital gains. The FB 2023 also proposes to insert a definition of MLDs which is quite wide. The proposed amendment is to be made applicable w.e.f FY 2023-24.

This proposed amendment may prompt existing MLD investors to re-evaluate their investment strategies considering gains on MLDs are proposed to be taxed as STCG irrespective of the period of holding. Further, it appears that the ITA may not extend grandfathering benefits to existing MLD investors ie provide relaxation from this proposed provision to existing MLD investors. Furthermore, gains on MLD investments earned by foreign investors may have to be evaluated in light of the capital gains and interest related provisions under respective tax treaties. It may be noted that some tax treaties cover, inter alia, income from bonds/ debentures within the ambit of interest income whereas gains from MLDs may also be covered under the capital gains related provisions of the same tax treaty.

3. Amendment to section 193 of the Act

Section 193 of the Act provides for tax deduction at source on the interest earned on securities by residents. As per clause (ix) of proviso to section 193 of the Act, TDS deduction is not required on interest on securities which are in dematerialised form and listed on a recognised stock exchange in India.

The EM to FB 2023 states that recipients under report income due to the TDS exemption. Accordingly, FB 2023 has proposed to omit the above mentioned provisions and effectively make TDS applicable on interest on listed securities w.e.f 1 April 2023.

Since the amendment is proposed to be effective from 1 April 2023, investors may have to be wary of the impact this provision has on the cash flow generated from the securities held by them.

4. Taxation of unit holders of a business trust

The EM to FB 2023 states that a special taxation regime for Real Estate Investment Trust (‘REIT’) and Infrastructure Investment Trust (‘InVIT’) was introduced vide Finance (No.2) Act, 2014 to address the challenges of financing and investment in infrastructure. Business trusts (ie REIT and InVIT) invest in special purpose vehicles (‘SPV’) through equity and debt instruments. Under the special taxation regime for business trusts, pass-through status was accorded to business trusts for interest income, dividend income and rental income received from SPVs ie such income is exempt to the business trust. The income distributed to unit holders by the business trust is deemed to be of the same nature as received by the business trust and taxable in the hands of the unit holders, as applicable.

However, the EM to FB 2023 remarks that distribution to unit holders has been observed to also include another form of distribution ie repayment of debt. Such repayment of debt is neither taxed in the hands of the business trust nor in the hands of the unit holders.

In order to bring such amounts within the tax net, the FB 2023 has proposed, inter alia, the following provisions:

• insert clause (xii) under sub-section 2 to section 56 of the Act to provide that distributions from business trusts to unit holders (which is not in the nature of interest income, rental income or dividend income) shall be taxable as income from other sources (‘IFOS’) in the hands of unit holders
• insert proviso to the aforesaid clause which provides for deduction of cost of acquisition where the units are redeemed by the unit holders.

In light of the above proposed amendments, unit holders may now be required to evaluate investments made since previously untaxed distributions are now proposed to be taxed. This may impact the projected returns (ie IRR) computed by unit holders on their holdings. Other potential tax implications of the above proposed provisions may arise in case of sovereign wealth funds and pension funds which may invest in business trusts in pursuit of steady returns. Under the present provisions of section 10(23FE) of the Act, income in the nature of interest, dividend and LTCG is exempt for sovereign wealth funds and pension funds subject to fulfilment of certain conditions. However, FB 2023 has not envisaged incorporation of a corresponding amendment in section 10(23FE) of the Act to exempt IFOS as well. Separately, in view of the proposed provisions, it may also be worthwhile for investors to evaluate applying for lower/nil TDS certificates in order to preserve cash flows and reduce immediate tax leakage.

5. Proposed amendment to section 56(2)(viib) of the Act

Most professionals in the tax and finance fraternity may be conversant with the fair market value provisions under the Act. One such provision is section 56(2)(viib) of the Act which governs the subscription price on issue of shares by closely held companies. This provision provides a specific valuation mechanism whereby the value of a closely held company is to be computed under rule 11UA of the Income-tax Rules, 1962 (‘Rules’). Shares subscribed by residents in excess of the value computed under rule 11UA of the Rules attract section 56(2)(viib) of the Act and the excess consideration shall be taxed as IFOS in the hands of the closely held company issuing shares.

FB 2023 has now proposed to amend the abovementioned section and include non-residents as well within its ambit w.e.f FY 2023-24. Therefore, non-residents who enjoyed flexibility under the Act with respect to valuations while investing in primary issue of shares may have to undertake valuation exercises under the Act and under foreign exchange regulations. This may make fresh investment more cumbersome and add to further woes for Indian entrepreneurs during “funding winter”.

6. Amendments to section 54 and section 54F of the Act

Section 54 and section 54F of the Act provides for deduction in respect of capital gains which are reinvested in residential house property by the taxpayer. As per the EM to FB 2023 the primary objective of the aforesaid sections was to mitigate the acute shortage of housing and to give impetus to house building activity. However, the EM states that huge deductions are claimed by wealthy taxpayers who purchase expensive residential houses.

The FB 2023 has proposed to limit the amount of deduction under section 54 and section 54F of the Act to INR 10 crore each. This proposed amendment if enacted into law is to be applicable w.e.f FY 2023-24.

While the proposed amendment is aimed at curbing the deductions claimed by various high net worth individuals, this could potentially affect one off transactions undertaken by other taxpayers who may not fall within the high net worth category.

7. Concluding Remarks

This was the last full budget presented by the FM before the crucial general elections in India next year. Hence, expectations from the industry as well as the common man were high from the FM. In the days to come, as experts decode the fine print of the budget and the FM receives representations/ feedback from various stakeholders, it will remain to be seen which proposals of FB 2023 make the cut and are finally enacted into law. Until then, it is imperative for tax and finance professionals as well as the common man to evaluate the potential impact which the FB 2023 proposals will have on business/ profession, investments and incomes.

Dive Deeper:
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