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Shares sale: Capital gain on business profits
June, 28th 2007
The Taxman and courts have been unduly confused in determining whether profits from an assessees dealings in shares are to be classified as capital gains or business profits.
At present, short-term capital gains are taxed on transfer of shares at 10 per cent, while long-term capital gains do not attract any tax.
The Income-Tax (IT) Act describes capital asset as a property which does not include stock-in-trade and is held for business purpose. Profits from such business is charged under Section 28 (III) of the I-T Act.
In 1989, before electronic trading was introduced and Sebi did not exist, the Central Board of Excise and Customs (CBDT) issued instructions providing criterion for distinguishing between shares held as stock-in-trade and as capital assets.
The Supreme Court had held certain factors relevant in determining the classification of a transaction, for example, whether the purchase and resale of the commodity was in the cause of the assessees usual trade or business and the quantum and frequency of such transactions. Possibly such instructions made sense in a high tax rate regime. One doesnt know if the collections soared.
What has warranted the CBDT to issue its latest circular on June 16, supplementing the 1989 instructions, are two inconsistent rulings by the Authority for Advance Ruling for Income Tax, for different entities of the Fidelity group, holding that profits on the sale of shares by FIIs may be treated as capital or revenue receipt depending on the facts involved.
In the Fidelity Northstar case, the authority, while observing that the Sebi regulations cannot be used as determinants for classification, has on the examination of Section 115 AD of the IT Act, read with regulation 18(3) of the Sebi FII regulations, concluded that FIIs can invest in but not trade in shares. Regulation 18 requires FIIs to maintain proper books of accounts in respect of all transactions and realisation of capital gains thereon, leading to the inference that trading is not permitted.
The 2004 ruling (Fidelity Advisor), while proceeding on the basis of the same Sebi regulations, concluded that the income was business profit in view of the volume and frequency of the transactions.
Little wonder the CBDT has sought to authorise assessing officers (AOs) with wide powers to investigate a transaction. These range from quantum, holding period for the securities bought and sold, ratio of sales, time devoted to the activity, object clause in the memorandum of association, involvement of promoters and related companies, and whether the securities are listed.
It is acknowledged that investment in listed shares and other instruments traded on the stock exchange is not an appropriate avenue for persons with limited resources, experience and low-risk tolerance, which is why investors rely on brokers, mutual funds, portfolio managers and FIIs.
There is some speculation that this has been issued to accommodate FIIs, especially with the rider that the same assessee can hold both portfolios. And its the AO who decides the classification of the portfolios.
Expectedly, this has created a lot of consternation among small investors, who were actually expecting a circular clarifying that once the securities transaction tax is paid, it is the assessees right to determine his classification. Particularly as Sebi requires all members to obtain details of the prospective clients and sub-brokers in accordance with a KYC format, and accords statutory recognition to a small investor being a person buying or selling securities, on a cash transaction not exceeding Rs.50,000 a day.
The suspicion is that this circular is tailored to benefit FIIs, in particular those covered by the Mauritius or US double taxation avoidance treaties. Otherwise, there is no explanation why an investor should try to portray himself as a trader as tax on business profits is far higher.
Most investors would prefer to have their income from sale of shares to be classified as capital gains, and rely on the information and disclosures available with Sebi, without contending with the unrestrained intervention of an AO. The next step would probably be making an investors status dependent on a minimum lock-in period to establish his classification.
Kumkum Sen is a Partner at Rajinder Narain & Co
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