The confusion over the tax treatment of FIIs investing in Indian equities is set to end soon. FIIs need not, the finance ministry feels, be treated solely as investors, as ruled by the Authority for Advance Ruling (AAR) in the Fidelity case recently. They could be treated as traders as well, depending on the facts of each case. This means that most FIIs will escape having to pay any tax in India. FIIs from Mauritius will not be affected in either case.

Traders have to pay 33.7% tax on their business income. Investors, on the other hand, are eligible to have their income treated as capital gains and pay 10% as tax, if the income is derived from sale of shares within a year of their purchase, or no tax at all, if the shares were held for at least a year before being sold. FII traders tax obligations are subject to provisions of the bilateral tax treaty applicable to them. As per most such tax treaties, FIIs are not obliged to pay tax on business income earned as traders, unless they have a permanent establishment in India. Most FIIs do not have a PE in India.

Over the last one year or so, there has been ambiguity in terms of the taxation of portfolio investors in India with one view being that they are traders in stocks and another view that they are investors in stocks. The confusion was compounded after a recent AAR ruling on the Fidelity Group. The AAR, which is a quasi-judicial authority, had ruled that the income from sale of Indian equities by 38 odd offshore funds managed by the Fidelity Group will be treated as capital gains.

The authority went by FII guidelines and Sebi regulations on FIIs. However, in an earlier ruling to Fidelity Advisor Series VIII, the authority had categorised the income from trading in shares as business income.

The finance ministry, which has examined conflicting verdicts given by the AAR to the US-based Fidelity Group, has veered around to the view that the FIIs can also trade in stocks and earn business income. They will, however, have to maintain separate books of accounts on their India trades.

Tax authorities normally look at the facts and circumstances of each case and apply a set of norms to determine whether an FII is a trader or an investor. These norms are up for review. The Central Board of Direct Taxes (CBDT) has already come out with a draft circular listing out 15 parameters to determine this.

The norms include the scale of activity, ratio of sales and purchases to the holding, total number of stocks dealt in and so on. According to a top government official, finance minister P Chidambaram has now asked the CBDT to finalise these norms which are based on judgements by various courts.