Taxman tests waters on FPI derivative trade

At least two foreign portfolio investors (FPIs) from Mauritius have been asked to pay tax on their earnings from equity derivatives.

While offshore institutional investors from jurisdictions like Mauritius and Singapore pay capital gains tax on profits from stock sale (as local investors do), they do not pay tax on the money made from derivative trades.

Curiously, the present tax demands have been raised not because the FPIs in question own paper companies with no 'substance' in the tax haven to fish for treaty benefits. The tax assessing officers (AOs) have claimed tax on the grounds that equity derivatives are closely linked to equities: since stock derivatives derive their value from stocks, the underlier asset, derivative gains should be taxed like gains from stock trades in the spot market.

Indeed, the Dispute Resolution Panel, which offers an alternative mechanism to settle differences over tax demands, has upheld tax assessment order issued to one of the FPIs.

According to the panel, which is a collegium comprising three income tax (I-T commissioners), said, "The draft order passed by the AO has been perused by the panel. The panel observes that there is a thin line of distinction between shares and stock derivatives. There is no doubt that the stock derivatives draw their value from underlying shares, hence, they are nothing but shares which will be covered by the newly inserted Clause (3A) of Article 13 to the Double Taxation Avoidance Agreement (DTAA) between India and Mauritius."

Significantly, in a matter pertaining to another FPI, the tax department has made a tax demand on transfer of entitlement to equity rights. A sale of rights entitlement does not strictly amount to stocks changing hands from the seller to the buyer - like derivatives, the value of a rights entitlement is also directly related to the underlying stocks.

Although a predominant number of DRP rulings are pro-revenue, the unusual stance of tax officers (confined to a few FPIs at present), has surprised tax practitioners. It has stoked the question whether the I-T department was testing the waters and awaiting the views of the Income Tax Appellate Tribunal (ITAT) as and when the FPIs challenge the orders before the quasi-judicial authority.

"The tax treaties clearly distinguish the tax treatment for equity shares and for other securities. Derivatives may be deriving their value from underlying equity shares, but legally speaking they are not shares itself and cannot be taxed as such. As per the relevant clauses of the tax treaty, the capital gains on derivatives would not be taxed in India," said Punit Shah, partner at Dhruva Advisors.

All assets of FPIs are treated as 'capital assets', generating capital gains or losses. Currently, FPIs from Mauritius pay no tax on derivatives gains and pay capital gains tax only from spot sale of stocks purchased after March 2017, thanks to the current treaty. However, derivatives earnings of resident Indians are taxed at the full income tax rate of 30% or more. FPIs from Mauritius also pay a lower tax of 10% on their interest earnings from debt securities listed in India.

According to Rajesh Gandhi, partner (tax) at Deloitte India, "Tax authorities could be similarly concerned about the nature of gains from sale of rights entitlement as well. However, rights entitlements as well as derivatives are a separate class of assets even though they reference the underlying equity shares. Hence, income from sale of rights and derivatives should be exempt under treaties with Singapore, Mauritius, Ireland, etc as well as for a Gift City fund."

"The position on taxing derivatives may mark a significant shift. If upheld by the courts, it could affect FPIs from all treaty jurisdictions - and just not investors from Mauritius," said Richie Sancheti, founder of the law firm Richie Sancheti Associates.

Last March, India and Mauritius signed a protocol to amend the treaty. The protocol is yet to come into force and the amendments are expected to be given effect prospectively. The proposed agreement, which does not indicate the probability of tax on derivative gains in future, would however require FPIs from Mauritius to meet the 'principal purpose test' (PPT) in line with the multilateral convention adopted by several countries including India. While the General Anti-Avoidance Rule (GAAR) makes it necessary for FPIs to have a substance in Mauritius to derive tax benefits, PPT goes a step further and requires the overseas investor to have a 'commercial rationale'.