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FIIs in tax haze on share sale
June, 18th 2007
Foreign institutional investors (FIIs), particularly funds operating from destinations other than Mauritius, will have to grapple with greater uncertainty surrounding the tax treatment of profits from the sale of shares. Last weeks circular issued by the Central Board of Direct Taxes has also raised the tricky issue on whether local investors in portfolio management services (PMS) will have to pay a higher tax.

Significantly, even Mauritius-based FIIs, who pay no tax now on the back of a treaty that India has with the country, may find the going tough if tax authorities can prove that they have a permanent establishment (PE) here. A PE does not necessarily mean an office in India. It could also mean an FIIs relationship with banks and custodians in India. Most FIIs from destinations like the US pay a 10% tax on short-term gains profits from sale of shares within a year of purchase.

This settled position may now come into question. The circular lays down the broad parameters to distinguish between a trader and an investor. However, it certainly does not rule out the possibility that FIIs can have business income. Such FIIs will not have to pay tax in the absence of a permanent establishment, international tax expert, Nishith Desai told ET.

If shares are held as trading assets, profits from the sale of such shares are treated as business income and taxed at a maximum of 30% for individuals and 33.99% for companies. However, if the stocks are held as a capital asset, the earnings are treated as capital gains. An investor in shares does not have to pay any tax if he sells the shares after one year of holding them. Shares sold within a year of holding attracts a 10% tax.

According to Punit Shah, leader-financial services of PwC, The uncertainty over the FII tax regime could grow. Our experience is that many FIIs are filing returns as capital gains, paying a 10% tax. The circular has reproduced certain principles laid down by judicial pronouncements which seem to hint FIIs are earning business income rather than capital gains. Mr Shah also felt tax obligation of PMS investors could go up.

Currently, all PMS profits are shown as capital gains. With the circular, PMS investors, like other market players, will have to segregate their portfolio of stocks as capital assets and trading assets something they dont do now. The tax liability may go up since the profits from the two classes of assets will attract different taxes.

The Central Board of Direct Taxes (CBDT) circular allows an individual, including an FII, to have two portfolios one for trading in shares and the other for investment. An investor pays a lower tax than a trader in shares. But taxpayers will have to produce records and evidence to prove that the stocks are held as a capital asset or a trading asset.

Several traders in stocks have been camouflaging their income from shares as investment income to save on tax. The party will end now as assessing officers will be guided by three principles: whether the shares purchased were held and valued as stock-in-trade; whether the transactions were substantial or not and the motive was to realise profits or earn dividends.
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