Tax Treaties and the Duty of Consistency

India’s capital gain tax framework is riddled with inconsistencies.

In a capital gain scenario, the tax rate can vary dramatically depending on a variety of factors. Yet, when it comes to carrying forward or setting off capital loss, a similar level of nuance does not exist.

Complications arise when loss from transactions that, if profitable, would have resulted in gain taxed at lower rates (e.g., 10%), are allowed to offset gain taxed at higher rates (e.g., 20%). Logically, this undermines the principle of equitable treatment and creates opportunities for arbitrage.[1]

ITA Ss. 70 and 74 attempt to head this off but fall woefully short.

Fragmentation in capital gain tax rates make Sections 70 and 74 inadequate and prone to misinterpretation

ITA S.70 regulates the set-off of loss within the same category of income. Among other things, it operates to ensure that low-taxed long-term capital loss is not set off against high-taxed short-term capital loss. However, its effectiveness is limited because it assumes that tax rates vary solely based on the holding period of an asset and fails to account for the many other variables. This causes disputes.[2]

ITA S.74, dealing with the carry-forward and set-off of capital losses, exacerbates the problem. To carry-forward losses under ITA S.74, the ‘net result of the computation under the head ‘Capital Gain’’ must be loss. Unfortunately, even ignoring the other factors that affect the capital gain tax rate, there’s no clarity on whether this ‘net result’ refers to the net result for short-term capital assets, long-term capital assets, or both. A revenue-favorable view might unfairly restrict a taxpayer’s ability to carry forward losses, while a taxpayer-favorable interpretation could allow for an overly generous (and potentially unintended) treatment.

One possible (and my preferred) reading of Section 74 is that taxpayers can only carry forward a capital loss if they have an overall net loss under the head “Capital Gains”. For instance, if a taxpayer’s short-term capital gains exceed their long-term capital losses, they would not be able to carry forward the long-term capital loss because there is no net loss under the head, even though the losses cannot be set off against short-term gains due to the restrictions in ITA S.70. This outcome is particularly severe, but as is often said, there is no equity in taxation.

Uncertainty as to the existence of a duty of consistency under Section 90 exacerbates the limitations of Sections 70 and 74

ITA S.74’s lack of clarity is especially pernicious in a treaty context. ITA S.90(2) provides that in relation to a taxpayer entitled to benefit under a tax treaty, “the provisions of this Act shall apply to the extent they are more beneficial” to the taxpayer. Some taxpayers interpret this to mean they can treat certain gains as exempt under a tax treaty while still recognizing and carrying forward loss on other assets – assets that, if sold at a profit, would have resulted in an exempt capital gain. This interpretation assumes that the comparison of benefits between the ITA and the treaty can be made on a “per item of income” basis.[3] However, this approach undermines the "net result" requirement of Section 74, allowing taxpayers to minimize or eliminate gain recognition while maximizing the recognition of losses.[4]

The better view is that ITA S.90(2) requires taxpayers to adopt a consistent approach. The provision states that "the provisions of this Act shall apply to the extent they are more beneficial" to the taxpayer as a whole, not to individual items of income in isolation. A taxpayer should not be allowed to exclude gains on certain assets under a treaty while concurrently using domestic law to recognize and carry forward losses on other assets. In the context of ITA S.74, the consistency principle would require taxpayers to choose between two approaches: either (1) apply the provisions of the ITA for all gains and losses, allowing for the carry-forward of net losses, or (2) rely on the treaty to exempt gains, forfeiting the ability to carry forward losses. The assessment of which is more beneficial would depend on whether the taxpayer values the ability to offset future income with net losses more than the current benefit of a full exemption on gains.

It is important to clarify that the consistency principle would not require that taxpayers electing to rely on a treaty would necessarily suffer higher taxation on certain income streams otherwise subject to a lower domestic rate. A treaty merely allocates taxing rights; it does not impose new tax liabilities. For instance, the fact that a taxpayer chooses to be taxed at a preferential 10% rate under the treaty for interest income (instead of the 40% withholding rate under domestic law) does not imply that the treaty would raise the tax rate on interest payments already subject to a lower 5% withholding rate under domestic law. The treaty simply establishes the upper limit for tax, ensuring that taxpayers are not subject to more burdensome rates than those permitted by the treaty.

Treating grandfathered gain as exempt, and carrying forward non-grandfathered loss do not violate the consistency principle

India’s tax treaties with Mauritius, Singapore, and Cyprus introduced a grandfathering mechanism for investments made before April 1, 2017. Gain (or loss) from these grandfathered investments remain exempt, while gain (or loss) from non-grandfathered investments (i.e., those made on or after April 1, 2017) are taxable. This raises an important question: does a taxpayer act inconsistently by treating gains from grandfathered investments as exempt while recognizing and carrying forward loss on non-grandfathered investments?

The answer should be no, and recently the Mumbai tribunal came to the same conclusion.[5]

The grandfathering mechanism creates two distinct classes of capital gains even though both arise from the same type of transaction – namely, the disposal of shares in Indian companies. By applying the treaty, and without resort to domestic law, the taxpayer’s gain on grandfathered shares is exempt, while losses on non-grandfathered shares remain taxable, and therefore eligible for recognition and carry forward. This result does not require the concurrent application of treaty to some individual items of income and domestic law to others.

Given that domestic law does not require a domestic taxpayer to offset exempt capital gain against a taxable capital loss, there is no logical reason why a foreign taxpayer must do so under treaty. Moreover, to suggest that, simply because tax treaties do not include a mechanism for carrying forward and setting off loss, a taxpayer who elects for the treaty to be apply to exempt gain may not carry forward and set off a taxable loss, is illogical. It is also probably violative of India’s non-discrimination obligations under treaty.

Looking ahead

The tribunal's ruling in TVF Fund is both logical and well-reasoned. However, several other rulings, including Indium IV, appear to suggest that taxpayers are not required to maintain consistency and can simultaneously apply domestic law to certain items of income while invoking treaty provisions for others. This approach is problematic and could, over time, have an adverse impact on the exchequer.

To promote clarity and certainty in tax administration, it is imperative for the Central Board of Direct Taxes (CBDT) to issue guidance on whether taxpayers claiming treaty benefits are obligated to adopt a consistent approach across all items of income. A clear policy stance would mitigate ambiguity, reduce litigation, and ensure that the principles underpinning India’s treaty framework are upheld.

[1] See an earlier post discussing this issue here: https://www.linkedin.com/posts/joachim-saldanha_east-bridge-capital-master-mumbai-tribunal-activity-7187324261038981120-Fo93?utm_source=share&utm_medium=member_desktop

[2] See: East Bridge Capital Master Fund I v. DCIT (ITA No.2976/Mum/2023).

[3] The ruling in Indium IV (Mauritius) Holdings v. DCIT (ITA No. 2423/Mum/2022) is illustrative.

[4] See an earlier post for a more in-depth analysis of the Indium IV ruling here: https://www.linkedin.com/posts/joachim-saldanha_internationaltax-litigation-activity-7185726511843319809-Zgpc?utm_source=share&utm_medium=member_desktop

[5] The case is TVF Fund v DCIT (ITA No. 4632/Mum/2023)