News

20th June, 2006

PMS investors fall in a tax trap

The backroom boys in fund houses and large brokerages are grappling with a tricky question. It relates to the Rs 7,000-crore portfolio management services (PMS) business. Often a rage among well-heeled investors, PMS falls somewhere between buying MF units and investing directly in stocks. A month after a CBDT communiqu sparked a debate on taxing FIIs, the question today is whether these PMS investors should fork out more tax.

The moot point is whether the money made by a PMS investor is business income or capital gains. If the nature of earnings is capital gains, then the investor is exempted of long-term capital gains, and all he pays is a 10% tax on short-term capital gains. However, if the gains from PMS are construed as business income, then the investor would have to pay a tax which may be as high as 30% something that could be a big blow to the PMS business.

In a PMS, the deals are undertaken in the name of the client but they are done through the PMS fund manager and the client has no say on what stocks the manager picks or dumps. Thus, as in direct investment, the deals happen in clients name, while like a mutual fund the use of expert advice of fund managers come into play.

The reason why PMS gain may be considered as `business income' (and carry a higher tax burden) is the hectic portfolio churning that takes place. This is quite different from a direct investment in stocks (unless the investor concerned is a day trader).

A PMS manager exits stocks when the target indicated by the client is reached and then moves to other counters where there are opportunities.

A draft release by tax authorities lists a number of factors that will determine whether the nature of the income is business income or capital gains. A few of the factors which point out that PMS may be considered as business income 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.

In cases where the number of transactions are large, and where the sale is made within a few weeks or just days of the position, there is a chance that the activities might not look like an in-vestment. Further, any kind of quick sale, which is a re-sale at a profit, would not look as if the investment was made with the intention of holding the shares for a long period and consequently could be classified as business income.

According to Punit Shah, partner, RSM & Co, "Several domestic investors engage professional portfolio managers to make in-vestments under PMS. Under PMS, generally the investors do not have control over several investment decisions such as volume of transaction, holding period, total number of stocks dealt in etc. Therefore, such parameters cannot be determinative in concluding the characterisation of the gains earned by such investors."

While the nature of the gain is something that concerns all domestic investors - brokers, corporates, financial institutions, finance firms - it is particularly significant for PMS, simply because of the portfolio churn or "frequency of trades".

A fortnight ago, some of the fund houses have collectively made a representation to tax authorities that gains from PMS should be considered as capital gains for the investor. "It is similar to making investments in mutual funds with an expectation to earn a return and therefore, more in the nature of capital gains rather then business in-come," said a fund manager who refused to be quoted.