Trader or investor? Tell FIIs who they are
The fact remains that there is no legislative prescription to distinguish between a trader & an investor in shares.
By Hema Ramakrishnan, TNN |
A few days before the Budget, finance minister P Chidambaram met up with some high profile foreign institutional investors (FII) to elicit their views on policy prescriptions for the capital markets. North Block officials present at the meeting were taken by surprise as there were no major suggestions on policy changes by this group.
One of them, however, wanted to know whether an FII investing directly in Indian stocks would be categorised as a trader or an investor. The question was not out of the blue, given the controversy over the issue following a sequence of events over the last one year or so.
Post Budget, another set of assesses—venture capital funds—are also hoping for clarity in the tax treatment on profits from sale of shares. Going by the provisions in the Finance Bill, VCFs will have to pay tax on any income, including capital gains, earned from their investments in firms operating in a host of sectors, ranging from manufacturing and real estate to non-tech services.
The controversy on whether a taxpayer is a trader or investor in shares sparked off in May last year after the Central Board of Direct Taxes (CBDT) unveiled draft instructions to assessing officers. These instructions listed out norms to distinguish between a trader and investor in shares.
All assesses were covered by these norms. The intention, which was not made public, was to curb the misuse of the concessional capital gains tax regime enjoyed by investors in listed equities.
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Investors 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 are held for at least a year before being sold. Traders, on the other hand, have to pay a 33.9% tax as profits from sale of shares are treated as business income. The tax department had evidence of many domestic market players camouflaging their business income as investment income to save tax. The list of norms in the draft instructions included frequency in purchase and sale of shares, scale of activity, total number of stocks dealt in and so on. These were based on various judicial pronouncements.
Stock markets tanked as there were apprehensions that the instructions would impact FII inflows. Policy managers did some damage control, saying that it would not impact most FIIs.
The reason: FII traders’ tax obligations are subject to the provisions of the bilateral tax treaty applicable to them. 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.
The dust had not settled over the issue. Eight months later another judicial pronouncement added a new twist to the tax treatment of FIIs investing directly in Indian stocks. This was a verdict given by the authority for advance ruling (AAR) to the US and Canada-based Fidelity group.
AAR is a quasi-judicial body which gives rulings on the potential tax liability of foreign investors. It had ruled that profits from the sale of Indian equities of offshore funds managed by the Fidelity group would be treated as capital gains. What this implied was that FIIs were investors in shares and not traders.
The ruling came as a blow to several US-based FIIs who were hoping to get a capital gains tax waiver on their portfolio investments. These FIIs were banking on an earlier ruling given to Fidelity Advisor Series VIII. Here, AAR had categorised profits from sale of shares as business income after examining the frequency in purchase and sale of shares.
Some tax experts said the two rulings were contradictory to each other. Nevertheless, the US-based FIIs did not want to take chances. As many as 60 funds paid up capital gains tax. Unlike their counterparts in the US, Mauritius-based FIIs were not impacted by the ruling.
This is because Mauritius does not tax capital gains and FIIs routing their investments through Mauritius do not have to pay capital gains tax in India. A similar dispensation is in place for Singapore-based FIIs. AAR’s ruling was in sync with the tax department’s stand. The department holds the view that FIIs are investors in shares, going by the nomenclature “capital gains” used in the FII regulations.
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However, the fact remains that there is no legislative prescription to distinguish between a trader and an investor in shares. Over the last 40 years or so, courts have laid down various tests to differentiate between trading income and investment income. Tax officers have applied these tests to facts of each case and arrived at a decision.
A similar practice is followed by tax authorities in developed countries such as the UK or the US—the distinction between an investor and a trader in shares is based on judicial decisions or case laws.
There is nothing black and white in their income tax legislation. The issue could be settled if policy managers conclude that assessing officers would continue to be guided by judicial pronouncements and adopt a case by case approach. This means CBDT would have to come out with a final set of instructions on tests to determine whether a person is a trader or in investor in shares.
Besides FIIs, VCFs will also need clarity on the tax treatment on profits from sale of shares following policy changes in this Budget. Currently, VCFs registered with Sebi enjoy the benefit of a pass-through status under the income-tax law—they don’t pay tax on any income earned from investments made in a VCU.
The government has now proposed to limit the tax benefits to investments made by venture funds in nine select sectors from April 1, 2007. This means Sebi-registered VCFs which have invested in sectors other than those specified in the Finance Bill will have to pay tax on the income that accrues to them from these investments after April 1, 2007.
Most of the funds are set up in the form of trusts. If the trust is a specific one, the income of the trust is taxable either in the hands of the trustee, or in the hands of the beneficiary. The only exception to this general rule is in the case of trusts carrying on business.
In such cases, the entire income of the trust is taxable in the hands of the trustee at the maximum marginal rate. If the Budget proposal is passed by parliament, trustees who are held to carry on business will have to fork out a 33.9% tax on business income.
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Their income from sale of shares would be categorised as business income. The bottom line is that clarity is needed on the tax treatment on profits from sale of shares in the interest of all tax payers.
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