The memories of the stock market fall of May 2006, widely ascribed in the press to the Central Board of Direct Taxes (CBDT) draft supplementary instructions stipulating criteria to distinguish an investor from a trader in stocks, have not yet faded and CBDT has once again brought this issue to the limelight.

CBDT, last Friday, issued a circular to provide guiding principles to assessing officers to determine whether shares are held by a taxpayer as investment or stock-in-trade. The circular supplements an internal instruction issued by CBDT in 1989 dealing with the same issue.

Characterisation of income assumes significance because under the Indian tax laws, gains arising from the sale of securities when held as stock-in-trade are considered as business income and when held as investments are considered as capital gains. Further, tax rate concessions are available in respect of transactions in listed securities, on which securities transaction tax is payable, only where income is treated as capital gains.

However, where income is treated as business income, the gains are generally taxed at a higher rate without any exemptions for long-term holding. The circular provides several guiding principles all of which merely summarises the principles laid down in several judicial decisions dealing with characterisation of income, including a recent advance ruling.

By way of an example, one of the principles state that the purchase and sale of shares with the motive of earning profit would lead one to infer that the transaction is in the nature of trade/adventure. However, where the object of the investment in shares is to derive income by way of dividend, the transactions of purchase and sale of shares would yield capital gains.

The circular emphasises that it is possible for a taxpayer to have two portfolios ie an investment portfolio comprising securities held as capital assets and a trading portfolio comprising securities held as stock-in-trade. The circular clarifies specifically that no single principle would be decisive and the total effect of all the principles should be considered in the aforesaid determination.

The first question that comes to ones mind having a look at the manner in which the circular is issued is whether CBDT could have approached this issue differently. In a novel approach, CBDT released draft supplementary instructions that it proposed to issue for comments by the relevant stakeholders.

There were many press reports highlighting the impact that the instructions will have on several investors including foreign institutional investors, retail investors and portfolio management services clients. Press reports also highlighted practical difficulties that the investor community faces when the revenue authorities undertake scrutiny assessments of tax returns filed.

No one would question the fact that the Indian capital markets and the investor community have matured in recent years. One wonders whether principles outlined in judicial decisions rendered in a different investment environment should still continue to determine the distinction between a trader and an investor as are now contained in this circular.

For instance, how many investors in todays market would be acquiring shares only to earn dividend (given that dividend yields are generally low)? Investment in shares is inherently risky. Almost every investor in shares would expect to not only earn dividend on his investment but also expect an upside on the investment to compensate the higher risk assumed.

Applying the principles in the circular such an investor would be regarded as a trader earning business income and not an investor realising capital gains. Circulars issued by CBDT are binding on revenue authorities. Hence, assessing officers will need to analyse the facts and circumstances of each case and conclude whether the assessee holds securities as investments or as stock-in-trade.

In the absence of specific objective guidelines on how the principles are to be applied, it is likely that this circular will increase the dialogue between taxpayers and revenue authorities in scrutiny assessment proceedings. CBDT could have considered, for example, prescribing a turnover criteria to exclude the retail investor community from the purview of the circular to avoid unintended scrutiny.

Another aspect that is not clarified in the circular is the application of the circular to FIIs. Responding to the public debate following the release of the draft instructions, the finance minister clarified that the tax laws had different provisions to tax foreign investors and that the draft instructions were aimed at clarifying the governments position on domestic investors and traders.

In the absence of specific clarification from CBDT, the circular would appear to apply to all categories of taxpayers. The circular once again raises the long standing issue of characterisation of income. There is a clear need for specific guidance or legislative amends on the issue to put this matter to rest once and for all.

GAURAV TANEJA
(The author is national tax director and partner Ernst & Young India)