Last week, Central Board of Direct Taxes issued administrative guidance to its officers in relation to taxability of income arising out of sale of shares securities. The moot point being that is the security held as 'stock-in-trade' and hence taxable as business income, or is it held as an investment and hence taxable as capital gains.
The tax laws are silent, though the courts have enunciated various tests for determining the question. These tests warrant study of multiple facts and circumstances such as nature and quantity of security, intent of the taxpayer (whether resale for profit or investment), frequency of transaction etc.
In August 1989, the CBDT issued an instruction, re-emphasising the principles enunciated by courts and holding that the total effect of all factors be considered and a sole circumstance would not be conclusive.
With the liberalisation of the Indian economy and opening up of capital markets for domestic and institutional players, there was clearly a case to re-examine the 1989 guidelines.
The recent, simplified and watered-down version now lists three principles for determining the nature of securities, which in turn will determine the characterisation of income -- first, the accounting treatment, second, the magnitude and frequency of transactions and period of holding; third, the motive for holding securities, that is, whether to earn profit or derive income by way of dividend.
The circular suggests that a taxpayer may have two portfolios-investment portfolio, comprising securities as capital assets and trading portfolio, comprising stock-in-trade. Hence, income need not be classified solely as business income or capital gains. The ramifications of the circular would vary depending on the category of the taxpayer - whether individuals participating in portfolio management schemes, day traders, or foreign and domestic institutional investors.
The circular is binding on the revenue, not on the taxpayer, and hence the odds of litigation cannot be ruled out.
Ambiguity on taxation of FIIs continues with the recent announcement and I am wondering if the circular could have left out the FII category in the light of special provisions (Section 115AD) enshrined in the income-tax law. The 1993 regulation provided beneficial rates of taxation for FIIs in times when short- and long-term gains were taxed at 30 per cent and 20 per cent, respectively. Over the years, long-term capital gains on listed securities were made exempt and short-term capital gains taxed at 10 per cent with payment of applicable securities transaction tax.
Categorisation of income earned by FIIs as capital gains is a favoured position of the revenue, given its disposition to principles articulated in the latter decision of Fidelity. Under bilateral tax treaties with India, FIIs are taxable on business income only if they have a permanent establishment (PE). It's a settled position that FIIs transacting businesses through custodians would ordinarily not have a PE in India and therefore FIIs are inclined to take "no PE, no tax" argument.
The 1993 legislative intent behind formulation of special provisions for FIIs was to "promote capital market" and grant "tax incentive" for investing in Indian securities. Reading of the law, together with the legislative intent, suggests that such beneficial provisions should override general provisions. Hence the argument that FIIs' income should be classified as business income is flawed in the first place. The new circular seemingly would raise questions on such classification and open the debate.
Nonetheless, the position on taxability of FIIs and other categories of taxpayers in so far as trading in derivatives (futures and options) is concerned, seems settled. The AAR, in the case of Morgan Stanley, applying the principles and keeping in perspective the nature of a derivative instrument, held that income from sale and purchase of derivatives would be business income and not speculative. No room for interpretation was left by the Finance Act, 2005, and the transactions in derivatives were excluded from the purview of speculative transaction.
In the context of other categories of taxpayers, particularly PMS investors and day traders, there is a clear arbitrage to offer income from sale of securities as capital gains. The circular will now act as a renewed impetus to the revenue officers to examine the transactions taking into consideration the three principles. Though the circular seems to suggest that the onus to demonstrate classification of securities is on the taxpayer, the revenue officers will invariably assume an upper hand in such determination.
The debate on characterisation of income of FIIs in matured economies is far from settled and contents of recent circular seem to have been influenced by the Canadian laws, wherein frequency of transactions and length of holding period are relevant in determining the characterisation issue. Having said that, the Canadian rules distinguish between an investment dealer and a pension fund. The former will find it difficult to argue that income from sale of security is not business income and the latter could easily contend that his income should be taxed as capital gains.
In closing, I feel that the circular is nebulous, at least in so far as taxability of FIIs is concerned, given the special provisions under the tax code. It doesn't seem to resolve the debate on classification of securities since the dividing line between a trader and an investor is blurred, besides dwelling into intricacies of accounting standards.
Equally, the guidance is arbitrary and superficial from a tax administration viewpoint. It would have been simpler to define the period of holding and /or quantum of trade (as percentage of holding in a company), diversity of portfolio of an FII and nature of FII (predominantly pension fund oriented or participatory note driven).
Matured tax jurisdictions, in addition to following international principles of accounting, eliminate disputes on characterisation by prescribing the so-called "mark-to-market rules," under which institutions are required to mark certain securities, held by them, to market annually. This results in reducing tax administrations' discretionary power. It's time to reflect if we need to adopt international best practices and revise the 93 laws in response to the dramatic increase in FII.
The author is a Partner with BMR & Associates and views are personal. Contact him at mukesh.butani@yahoo.com
