Among the litany of amendments in the direct tax section in the recent Finance Act, 2014, there is one piece of amendment that has perhaps not received the attention it deserves.
The amendment to Sec 2(14) of the Income Tax Act has redefined the term 'Capital Assets' by bringing in all kinds of securities dealt with by Foreign Institutional Investors (FIIs) under the banner of 'Capital Assets'.
The implication of this is that after 1st April 2014, securities held by FIIs - even if they have been dealt as stock in trade - shall be considered as Capital Asset and not as Stock in Trade.
Is that one more amendment with 'malice'? Read on to find how the differing interpretation of various Judicial Forums on FII investment left no option to the law makers but to bring about this amendment.
What are FIIs:
Currently there are more than 1450 FIIs registered with SEBI and with garguantuan funds avaiable at their disposal, the FIIs have been able to exert considerable influence on the stock prices and indices. A look at the volume of trades that FIIs do every day leads one to the inescapable conclusion that they are traders in stocks and seldom investors. To provide a perspective, the FII Investments on 4th August 2014 (Source: NSDL website) shows that the total gross purchases were in the region of Rs. 5,353 crores while Gross Sales were in the region of Rs. 8,093 crores. On the same day, FII purchases in Derivatives Segment was Rs. 24,295 crores while sales Rs. 105,700 crores
The total volume in a month can therefore be staggerring, not to mention the annual purchases and sales.
The key take-away from this is that the investments are not lasting and infact undergo constant churning depending on the risk perception of the FIIs. Local sentiments, global developments, direction in which Interest rates move both locally and internationally are but some of the factors that these FIIs constantly track to buy or sell. The intention, seldom, if at all is to stay for a lasting tenor. This essentially is the difference between FII Investments and Foreign Direct Investments (FDI).
Sec 115AD: Cherry Picking :
Now, some fundas about FII taxation as per the Income Tax Act. Under Sec 115AD of the Income Tax Act FIIs are subject to a flat rate of tax of 15% on Short Term Capital Gains arising out of Listed shares and Units of an Equity Oriented Fund (EOF). There is no concession on this matter as all assessees are subject to the same levy. However a concessional rate of 10% on Long Term Capital Gains on unlisted securities is the sweetener. Note that Long Term Capital gains on listed shares or units of an EOF are anyway exempt from tax u/s 10(38).
A snapshot of FII taxation and Resident Taxation on transfer of Securities:
Long Term Capital Gains:
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For FIIs (Sec 115AD)
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For Residents (Sec 111A, 112)
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Long Term Capital Gains
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10%
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20.00%
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Exempt u/s 10(38)
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Exempt u/s 10(38)
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Short Term Capital Gains
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30%
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30.00%
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30.00%
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30.00%
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15%
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15%
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Did the FIIs or for that matter, the Income Tax Department, whole-heartedly embrace this section? More as we read on.
The Fidelity Case:- 2004
It was ten years after Sec 115AD was introduced that litigation on FII taxation came into the public domain. In 2004 or thereabouts, Fidelity Advisor Series VIII, an FII sought the ruling of the Authority for Advance Rulings ('Authority' / 'AAR') on whether its income from sale of portfolio investments will be considered as Business Income, and if so, whether such income will be taxable in India in terms of the Indo-US DTAA. The Authority after going through the objects of the Applicant, the frequency and volume of trade etc., agreed with the Applicant that it was trading in securities as if it were its 'stock in trade' and therefore, the gains shall be 'Business Income'. In the process it rejected the Department's stand that the income was 'Capital Gains'. It further found that as the Applicant did not have a branch or office or advisor in India to constitute a Permanent Establishment (PE) no part of the business income can be related to operations within India and hence cannot be taxed in India as per the Indo-US DTAA.
The key take-aways from this Ruling are:
a. FIIs that put through huge volume of transactions and in frequent intervals would be considered as engaging in 'Business';
b. Engaging Brokers and Custodians does not amount to constituting a PE if they extend similar services to other Clients - in short they are Independent Agents;
- As per Indo-US DTAA, Business Income can be taxed in India only if it can be attributed to a PE in India; and in view of the above, no part of the Business Income shall be taxable in India.
This ruling held forte till 2007 and FIIs who carried on 'business' in Securities could rely on the persuasive value of this Ruling to completely avoid taxation.
Fidelity case -2007: A reversal of the earlier Ruling:
Come 2007, the Authority had occassion to give a ruling on an identical issue where interesting the Authority came out with a diametrically opposite view based on broadly two factors:
a. On a conjoint reading of SEBI regulations, FEMA regulations and the Modified Guidlines for FII (Taxation Aspects) it is clear that FIIs were never in the first place permitted to trade in securities and it would be preposterous to impute an intention on the part of the FIIs to violate the guidelines for entry; and
b. The Applicants did not provide sufficient documents by way of books of accounts to enable the Authority to discern the treatment in theirr own books - as Investments or as Stock in Trade.
In the result, going by the twin theory, the AAR held that income from transfer of securities by the applicants would necessarily have to be in the nature of Capital Gains. This Ruling came as a body blow to the FII community and although the Ruling itself was not applicable to other FIIs who were not before the Authority, many had to take a cautious route of Capital Gains given the Income Tax Department's aggressive posture.
Royal Bank of Canada-You are at your wit's end!
As if one reversal was not enough, the Authority in the Royal Bank of Canada (RBC) in 2011 made another reversal, now holding that income from transfer of derivative securities by FIIs would constitute 'Business' and negatived all the reasons cited by Fidelity 2007 Bench of the AAR in coming to its conclusion. Importantly, it held that income should not be characterized based on SEBI regulations, but on the nature of transactions that have taken place.
Having held that the nature of income was 'Business', it further relied on the Indo-Canada DTAA to hold that in the absence of a PE in India, the applicant was not liable to any tax on such Business Income.
Clearly it was back to square one!
Enter, The Income Tax Appellate Tribunal:
It needs to be noted that the ruling of the Authority is binding only on the parties to the case. However, it does have a persuasive value in deciding other cases. In contrast, the decisions of the Income Tax Appellate Tribunal, High Courts and the Supreme Court, have a binding effect in deciding other similar cases as well. By the year 2011, the ITAT came into the picture of FII taxation.
In 2011, the LG Asian Plus Ltd case went upto the Mumbai Tribunal to decide whether income from trading in derivatives is Business Income or Capital Gains. This time, parties to the dispute indulged in cherry-picking so much so that they even relied on the Rulings that went against them - only to obtain a favourable verdict on this very case.
The FII happily borrowed from the Fidelity 2007 Ruling ( and cleverly avoided the later RBC Ruling) to claim that :
a. As an FII registered and functioning under SEBI guidelines, it could not undertake any business in securities ( and derivatives were part of Securities);
b. Sec 115AD is a mandatory provision for FIIs and all income arising from transfer of securities would have to be offerred as Capital gains only.
On the other hand, and giving the Fidility 2007 a go by, the Department brought in new theories to contend as follows:
- Under Sec 43(5) as it then stood, income from sale of derivatives would be speculative business and by implication should fall under Business Income'
- The Speculative loss thus incurred by the assessee could not be set off against Short Term Capital gains from Shares; and
- That at any rate, Sec 115AD does not presuppose the absence of business income arising from transfer of securities; and
- Therefore, the loss on derivative trading cannot be automatically taxed as Capital Gains, but as Business Income.
In the result, the Tribunal affirmed that income from transfer of any security-whether Shares or derivatives or otherwise- would be covered under Capital Gains only. It held the view that FIIs have always been considered as Investors and Sec 115AD was a special provision to deal with FII taxation. It also dismissed the Department's theory of classifying the income as Business explaining that Sec 43(5) operates only when the income falls under 'Business Income' but does not by itself help classify a certain income as 'Business' or otherwise.
This view was later also upheld in Platinum Asset Management Ltd Vs. DDIT(Intl Taxn) by the Mumbai Tribunal in the year 2013 on the same reasoning.
Heads I win, Tails You lose!
Fidility 2004 to Platinum AMC 2013, shows that neither the contesting parties nor the adjudicating forums have followed any consistent principle. The FIIs claimed and infact succeeded in Fidility 2004 that they were traders with no PE in India so that they could avoid tax completely in India. Post the Fidelity 2007 ruling, they came to accept the status of Investors because it enabled them to set off loss on derivatives ( which was perhaps their major activity) against Gains on other securities. As for the Department, the strong reliance placed on SEBI Regulations, Memorandum explaining Sec 115AD and the principle of 'generalia specialibus non derogant in the Fidelity 2007 case, were all forgotten. In LG Asian and Platinum AMC, the Department claimed that derivative trading took the colour of 'Business' only to deny set off of the loss. An example of unprincipled and shifting stand on the part of the Department.
Unfortunately, all of us are witness to such a spectre with alarming frequency nowadays.
Enough is Enough-End of the Roller Coaster Ride:
Before any further reverses could be attempted, you now have this amendment. With this amendment, all Securities dealt with by FIIs - whether Stocks or Derivatives- are to be considered as 'Capital Assets' and income arising from their transfer has to be offered as Capital Gains u/s 115AD of the Income Tax Act. There is no scope for any interpretations by either the judicial forums or the parties. In the new dispensation, thanks to the Double Tax Avoidance Agreements, the clear winners are those FIIs established out of Mauritius, Singapore and other jurisdictions as the gains on transfer of securities are taxable only in the country of residence ( not India) where there is either nil or negligible taxes.
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