In a recent case, the AAR held that the surpluses made by FIIs in the stock market should be taxed as capital gains and not business income.
Ever since liberalisation become the watchword for fiscal policy, foreign institutional investors (FIIs) have been treated with velvet gloves. Section 115AD was inserted in the Income-Tax Act, 1961 by the Finance Act, 1993, levying a 10 per cent tax on the short-term capital gains made in the stock market by FIIs.
FIIs have been happy with this arrangement and, in this context, the Double Taxation Avoidance Agreements (DTAAs) too have come in handy.
Mauritius levies practically no tax on capital gains. Our DTAA with that country has helped FIIs routing their investments through that country get the benefit of nil tax on the capital gains made in the Indian stock market.
In the Azadi Andolan case, the Supreme Court pointed out that if there is revenue loss, it is for the Government to act and not for the courts to intervene by way of interpreting the statutes and circulars. Complaints about Indian companies rerouting their investments in the stock market through Mauritius are on the rise. Such round tripping of funds becomes unavoidable. All talk of revamping the treaty with Mauritius has so far proved to be of no avail. On the other hand, the treaty with Singapore was fine-tuned and it now takes care of abuse of the treaty provisions, by restricting tax benefits to bona fide Singapore investors.
Mauritius has remained the first major source for FIIs in the Indian stock market with investment totalling Rs 38,024 crore. The US comes a distant second with about Rs 18,048 crore.
Judicial authorities were also seized of the matter concerning the taxing of the surplus made by FIIs in the stock market. In a number of rulings concerning American companies, the Authority for Advance Ruling (AAR) held that income from sale of shares was only business income and not capital gains. Under the Indo-US DTAA, such business income earned by a foreign company in India is taxable only if such foreign entity has a permanent establishment (PE) in India.
The AAR took into account the objects clause in the memorandum of association (MoA) of those companies, which declared that they were formed in order to carry on the business of acquiring, investing in and holding securities and ultimately selling them for profits. The AAR also noted FIIs were involved in large-volume transactions in the Indian market. These rulings were handed down by the AAR in such leading cases as Fidelity (271 ITR 1), Morgan Stanley (272 ITR 416), General Electric Pension Trust (280 ITR 425) and TCW/ICICI Equity Fund (250 ITR 194). These rulings have helped FIIs in the US, as they did not have PEs in India.
FIIs with PEs
What happens if those FIIs did have a PE in India? In that event, such business profit will be taxed at the normal rate, which is much higher than the concessional rate applicable to short-term capital gains tax. In the latest case involving the Fidelity group of the US, the AAR held that the surpluses made by FIIs in the Indian stock market should be taxed as capital gains and not business income. The AAR pointed out that these FIIs were constituted in US and Canada for carrying out investment activities.
It scrutinised the number and frequency of purchase and sale transactions in shares and found that such number was low. It showed that they were indulging only in investment, and not business, activities in the Indian stock market. This ruling has created controversy about the treatment to be given for profits made by FIIs in the Indian stock market. Already, FIIs have the benefit of the 10 per cent short-term capital gains tax regime if they deal in listed securities. Not all countries have a zero tax system for capital gains. The latest AAR ruling makes it necessary to go into a lot of details before deciding whether profits are business related or mere capital gains.
Trader or investor?
The Central Board of Direct Taxes (CBDT) is all set to issue final instructions listing parameters to determine whether a person is a trader or investor in shares. These instructions will no-doubt cover FIIs too. The holding pattern of securities bought and sold, ratio of sales to purchases, the time devoted to share market activity, the source of funding and the total number of stocks dealt in will all become relevant matters.
If, however, the Government takes a policy decision that to give a further boost to the capital market, the capital gains part of the income of the FIIs or the business income should not be taxed at all, amendments will have to be made to Section 115AD of the Income-tax Act, 1961 dealing with the tax treatment for income of FIIs.
T. C. A. Ramanujam (The author is a former Chief Commissioner of Income-Tax.)