Over the past one year, since the stock market has been in a downward spiral, several investors have migrated from direct equity and mutual funds to portfolio management schemes (PMS).

Several instutions offer PMS to their clients as an alternative to mutual funds with the assurance that the portfolio would be tailor made to limit risk and volatility and optimise return.

Very often, these are just tall claims, but that is a subject for another day. Today, we are examining the nature of PMS and the tax implications for investors opting for PMS.

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A PMS per se, is akin to the structure of any MF scheme where the collective funds of various clients are pooled together and invested in the market. There are two major differences ---

1. An MF scheme has restrictions imposed upon it by its offer document as to the extent to which it can invest in equities and debt. The PMS is restricted by the mandate imposed upon it by the investor or by the internal policy of the PMS house.

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2. Investor in MF schemes is the owner of units and his fortune depends upon the NAV. Each unit consists of a tiny portion of each and every share the scheme owns.

On the other hand, the PMS investor uses the portfolio manager as his agent to buy or sell shares, either discretionary or otherwise (with or without the approval of the investor), but the result is that all the transactions result in the investor, and not the MF, being the owner of the shares.

Now, the question is whether such profits earned through a PMS are taxable as business income and taxed at the slab rate applicable to the investor or will the individual transactions be subject to the capital gain tax?

The Background

In the case of an investor, capital gains arising out of equities sold on a Recognised Stock Exchange in India or equity-based units and equity-based units of Mutual Funds (MFs) repurchased by MFs where Security Transaction Tax (STT) is paid---

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a) Long-term capital gain is exempt under Sec. 10(38)

b) Short-term capital gain is taxed @15.45% flat, under Section 111A and 115AD.

In the case of all other assets, including equities which have not been sold on a Recognised Stock Exchange in India ---

a) Long-term capital gain is charged to tax at the flat rate of 20.6% after applying cost inflation index. However, if the assets happen to be units of debt-based schemes of MFs or equities not sold on a Recognised Stock Exchange, additional option of paying the tax @10.3% of the capital gain arrived at without indexation is also available, if more beneficial.

b) Short-term capital gain on the above assets has to be aggregated with the investors other income and is taxable at the slab rates applicable to him.

On the other hand, if the dealings in securities is classified under the head Profits and Gains from Business or Profession, the exemption on long-term capital gains as well as the concession on short-term gains is lost. However, the new amended Sec. 36 allows the STT paid as deduction only from business income.

Now, though the tax treatment for both classes of assessees is different, the Act does not define the term investor or trader.

In other words, the aggregate number of transactions in ones portfolio or the periodicity thereof is not a determinant of the fact whether one is an investor or a trader. Therefore, in the absence of a specific definition, the categorisation of a particular assessee would depend upon the circumstances of each case.

It is even possible for the same person to be an investor and a trader for the same financial year. In such a case, the income from the investment transactions is classified as Capital Gains u/s 45 while the income from trading transactions is classified as Business Income under section 28 of the Act.

Other differences

An MF has a specific exemption for its income u/s 10(23D). A PMS on the other hand functions merely as a pass-through vehicle and the actual liability of tax emanating from the securities transactions carried out by the PMS is that of the individual owning the securities.

Under these circumstances, a question arises whether the transactions carried out by the PMS on behalf of its clients result in Capital Gains or Business Profits for such clients.

CBDT has empowered the ITOs to take the decision on case to case basis. The draft instructions have listed out 15 parameters to check if an assessee is a trader or an investor.

The main parameters are frequency of trades, the time period of the holding, whether the purchase is made solely with the intention of resale at a profit or for long-term appreciation and/or earning dividend and interest, and whether the scale of activity is substantial. These instructions apply to all market participants including domestic and foreign players.

Well, does it apply to PMS?

Unlike a Mutual Fund, which has a specific exemption for its income under section 10(23D), the Act has not conferred any such tax benefit on a PMS

It is our considered opinion that he cannot be considered to be having a business of trading in equities even if the number of transactions, their volume and frequency is very high.

Any businessman or a trader will not delegate the entire authority and responsibility for actions to someone else in his confidence for the specific purpose of relieving himself to attend to his main interests, which are evidently not investment in equities.

Agreed, day trading where the buy or sell transactions in shares are settled during the same day without any delivery of the securities may be treated as business or speculative transaction, even if the individual is involved in an activity that is diverse from the securities business, such as being a salaried employee, a professional or even a person having business related with other product than shares. Day-trading is specifically conducted by the individual himself or by his broker under specific instructions from the individual.

On the other hand, in the case of PMS, the individual appoints a specialist having domain knowledge of the capital markets for handling his investments, specifically to free himself to attend to his main profession or business. This is akin to appointing a lawyer for legal matters or an architect for the design of a building.

Employing experts practicing in their chosen domain is a way of optimising resources and it does not in any way materially change the nature of the business of the person appointing them.

Any transaction executed by the specialist will be treated as if it was transacted by the person who appointed the specialist and will be taxed accordingly.

Conclusion

Unless the Income Tax Act clearly specifies the methodology of classification of a businessman vis-a-vis an investor, litigations will be rampant. The current criteria being subjective in nature, it is open to rent-seeking by the ITOs.