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Divining the dividing line
July, 01st 2006

As trading profits are taxed at the maximum rate, there is every temptation for a dealer in shares to designate himself as an investor.

The draft instructions of May 16, 2006, issued by the Central Board of Direct Taxes have created confusion in the stock market. The Board has called for comments about certain tests to be applied to distinguish between shares held as stock-in-trade and shares held as investment. This issue has been thrashed threadbare, and there are quite a few court rulings too.

For several years now, successive governments have been obsessed with the stock market. Policies are framed with an eye on the Sensex. The Finance Ministry takes credit when the index goes up. But what when the index falls? In such situations, taxation plays an important role. The long-term capital gains tax was exempted to encourage investors to stay invested for at least a year. Short-term capital gains are taxed at 10 per cent. These laws are applicable to all those dealing in the stock market.

Trading profits

What about the trader? A trader in shares will be taxed at the rate applicable to his total income. The maximum marginal rate is 30 per cent. Adding surcharge and cess, the tax on traded profits at the maximum will be 33 per cent. In the past six months, those who played the stock market, whether as traders or investors, must have made lots of money. In April-May, the buoyant share market added Rs 800 crore to the Government's kitty by way of Securities Transaction Tax (STT). This is collected on the value of the transaction, irrespective of the profit or loss from it. Both the investor and the trader have to pay STT.

As trading profits are taxed at the maximum rate, there is every temptation for a dealer in shares to designate himself as an investor and claim the benefit of the lower or nil tax rates on capital gains. How to make the distinction between trader and investor? The CBDT is of the view that the questions to be considered for deciding the matter will centre round the intention of the dealer, the scale of activity, the continuity and the regularity of the transactions in the stock market, the utilisation of own funds or borrowings for purchase of shares, the objects declared in the Memorandum and Articles of Association in the case of a corporate assessee, the normal holding period of securities bought and sold, the nomenclature given to the transactions in the balance-sheet, and so on.

Board's advice

The Board has advised its officers that no single criterion be taken as decisive and that the total effect of the various criteria be considered to determine the nature of activity. Justice Rowlatt stated the question simply and decisively: "Is the article acquired for the purpose of trade?" If it is, profit from sale must be taken to revenue account. The profit is chargeable as capital gains if the sale is of a capital asset, and as business profit under Section 28 of the Income-Tax Act, 1961 if the sale is in the course of business or the transaction constitutes an adventure in the nature of trade.

In the case of the FIIs, the question will depend on the maintenance of a permanent establishment (PE) in India. It will also depend on the terms of the Double Taxation Avoidance Agreement (DTAA). The Authority for Advanced Ruling (AAR) has held that the FIIs are not taxable either for capital gains or for business income if they have no PE in India. It has also been held that Section 115 AD of the I-T Act is a special provision meant for the FIIs and will override the general provisions. They cannot opt out of Section 115AD and claim the benefit of indexation for computing capital gains on sale of shares (Universities Superannuation Scheme Ltd 275 ITR 434 AAR).

Settling the controversy with regard to domestic investor is best left to the courts. Instructions of the CBDT will only add to the confusion.

T. C. A. Ramanujam
(The author is a former Chief Commissioner of Income-Tax.)

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