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CBDT needs to clear air on PMS investors
June, 19th 2007
Characterisation of income on disposal of securities as business income or capital gains has been a matter of considerable debate, with a host of decisions laying down relevant tests. The issue is relevant as capital gains are subject to concessional taxation regime.

The issue has come to fore in recent years on account of evolvement and increased activity in Indian capital markets with a host of rulings by the AAR in recent years. CBDT had earlier issued an instruction in 1989 and laid various tests like connection to usual trade or business, nature and quantity of purchase and sale and repetition of transactions.

Taking into consideration the subsequent developments and the recent AAR ruling in Fidelitys case, CBDT has now issued a circular to supplement the earlier instruction and prescribed parameters viz, substantial nature of transactions, manner of maintaining books of accounts, magnitude of purchases and sales, ratio between purchases/sales and total holding and motive of transaction for determining the characterisation of income.

One of the categories of assessees on whom the impact of the circular needs to be considered is an investor in discretionary portfolio management schemes (PMS).

Investors in a discretionary PMS generally comprises businessmen, professionals, and artists, who have surplus funds from their main activity and desire to earn capital appreciation, but do not have the time, relevant expertise and infrastructure. Such investors prefer to rely on professional management through PMS.

The latest circular does not specifically refer to investments in discretionary PMS schemes but is rather aimed at offering general guidance on direct investments in securities, where the intention of the investor can be gauged from his own activities.

In a discretionary PMS, the decision to manage the portfolio and buy and sell securities is entirely on the portfolio manager.

The investor does not have any control over the decisions of purchase and sale, frequency and magnitude of transactions. The investor is primarily interested in capital appreciation on his overall portfolio. The investor does not participate in the ongoing management of the portfolio under PMS. The investor generally treats the portfolio in discretionary PMS as investment in his books of accounts and not as stock in trade.

Investors generally ascribe only a portion of their wealth to a discretionary PMS. Vis--vis their other assets, the quantum of the PMS portfolio may not be substantial. Also, the quantum of portfolio under PMS is fixed and not altered frequently.

The Sebi regulations also indicate the primary intention in a PMS to undertake investments on behalf of the client based on his investment objectives.

The portfolio manager cannot engage in speculation or short-selling, but only carry out delivery-based transactions. He cannot also borrow on behalf of his clients.

It would be noted from the above that a discretionary PMS is much like a mutual fund, where the investor merely invests in units of mutual fund. The investments are purely at the asset managers discretion, which has its own infrastructure and expert professionals who manage investments on behalf of the investor for a fee which is then passed on to investors.

Similar to mutual funds, in a discretionary PMS there is a genuine case for determining characterisation, considering the PMS as an investment and not based on the underlying conduct of investment activities of the portfolio manager, which are out of the investors control. Considering the peculiar circumstances of a PMS investor, it is important that CBDT issues a suitable clarification to clear any confusion among this class of investors.

Punit Shah
(The author is the leader of the Financial Services tax practice of PwC)
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