13th August, 2012




FII Alert - Foreign Investments in India
Categorisation of gains arising on cancellation of Forex Forward Contracts

Introduction:

Recently, the Mumbai Bench of the Income Tax Appellate Tribunal (ITAT) in the case of Credit Suisse (Singapore) Limited (the taxpayer) had the occasion to examine the categorisation of gains arising on cancellation of foreign exchange forward contracts. The issue before the ITAT was whether such gains should be classified as capital receipts, capital gains, business profits or other income.

The ITAT has held that such should be treated as “Capital Gains” and consequently, the taxability of the same shall be determined by Article 13(4) of the India – Singapore Tax Treaty (tax treaty).

This SKP FII Alert brings to you the facts of the case and a summary of the decision of the ITAT.

Facts of the Case:

  • The tax payer is a company incorporated in Singapore and a tax resident of Singapore and is registered with the Securities and Exchange Board of India (SEBI) as a sub-account of Credit Suisse, a SEBI registered Foreign Institutional Investor (FII). It conducts portfolio investments in Indian Securities in its capacity as a sub-account.
  • In its computation of income filed for the year under appeal, the tax payer has claimed that gains on cancellation of foreign exchange forward contract are on capital account and thus not chargeable to tax in India.
  • Without prejudice to the above claim, and in the alternative, during the assessment proceedings, the assessee has claimed that even if the income is treated as capital gains, it is not taxable in India as per Article 13(4) of the tax treaty. It was further argued that if such income is treated as business income, it would not be taxable in India in view of Article 7 of the tax treaty since it did not have a Permanent Establishment (PE) in India as defined in Article 5 of the tax treaty.
  • In the assessment proceedings, the tax officer rejected the tax payer’s contentions and held that the gains from the forex forward contracts should be taxed as income from other sources under Article 23 of the tax treaty.

Issues before ITAT:

The issues before the ITAT were - whether gains realized by the tax payer on cancellation of foreign exchange forward contract are:

  • On capital account or
  • Capital Gains that are not liable to tax in India under Article 13(4) of the tax treaty or
  • Business profits not liable to tax in India under Article 7 of the tax treaty, given that the assessee does not have a PE in India as defined by Article 5 of tax treaty or
  • Income from other source under Article 23 of the tax treaty.

Contentions of the Tax Department:

  • The contracts for forward purchase of foreign exchange and their subsequent settlement cannot be said to be resulting in capital gains as the same were never held by the tax payer as capital assets but were always meant to be settled by way of a price difference.
  •  Further since the tax payer is not eligible to carry on business in India as per SEBI regulations, the income arising from settlement of forward contracts cannot be treated as business income.
  • Since such gains are not covered by any of the Articles of the Tax Treaty, the tax officer was justified in treating the same as income from other sources under Article 23 of the tax treaty read with the Income-tax Act, 1961.
  • Further, in the case of All India Tea and Trading, it has been held by the Calcutta High Court that for the purpose of Capital Gains, the asset held by the assessee included physical, actual, constructive, and also a symbolic possession of a property of any kind. The Revenue argued that in the present case the tax payer does not hold any such property and thus the gains therefrom cannot be treated as capital gains.

Contentions of the tax payer:

  • The tax payer contended that being a foreign investor, it was holding shares on capital account and since these shares were held as capital assets, the gain/loss on the foreign exchange forward contracts which had been entered into by it only for the purpose of hedging would be characterized as capital in nature.  
  • As an alternative, the tax payer cited the case of Citicorp Investment Bank (Singapore) Ltd wherein it was held that the gains arising from early settlement of forward foreign exchange contract should be treated as capital gains.

ITAT’s Observation:

The ITAT held that the gains realized by the tax payer on foreign exchange forward contracts are in the nature of Capital Gains covered under Article 13(4) of the Tax Treaty. For this, the ITAT placed reliance on the decision of the ITAT in the case of Citicorp Investment Bank (Singapore) Ltd. The ITAT further held that the department’s reliance on the Calcutta High Court’s decision in the case of All India Tea & Trading Co. Ltd. cannot be upheld since the facts of that case are totally different from the facts of the present case.

SKP’s Comments:

The ITAT has pronounced an important judgment in respect of categorisation of gain/loss on foreign exchange forward contracts. The judgment brings out the fact that gains/losses arising on foreign exchange forward contracts would be considered as “Capital Gains” and not Income from other sources”. FIIs and Sub Accounts often enter into forward contracts transactions to protect themselves against the risk of exchange fluctuations. The latest decision of the ITAT would be of great interest to such FIIs and Sub Accounts particularly those registered in Mauritius and Singapore since capital gains earned by such entities would be exempt in India by virtue of the tax treaties between India and these countries.