31st January, 2013

FII Alert - Foreign Investments in India
Derivative Income is Capital Gains


Recently, the Mumbai Bench of the Income-tax Appellate Tribunal (ITAT) in the case of Platinum Investment Management Ltd A/c Platinum International Fund (Platinum / taxpayer) held in favour of the taxpayer that gain/loss arising from derivative transactions is to be treated as capital gain/loss and not as business profit/loss. While deciding so, the ITAT relied on the decision in the case of LG Asian Plus Limited.

Facts of the Case

  • Platinum is a sub-account of an FII registered with SEBI. It is incorporated in Australia. The only activity in which the taxpayer is engaged is purchase & sale of securities including derivatives. The taxpayer filed its return of income treating the income earned from disposal of shares and derivative transactions as “Capital Gains”. The taxpayer had earned income as under:
Short term capital gains on sale of shares
Rs. 274 million
Short term capital gains on sale of derivatives
Rs. 1,290 million
Short term capital loss on sale of derivatives
(Rs. 1,704) million
(Rs. 140) million

Accordingly, the taxpayer did not pay any tax as it claimed a net loss.

  • The Assessing Officer (AO) held that the loss from derivative transactions constituted business loss. He then proceeded to apply the Treaty provisions between India and Australia and held that since the taxpayer did not have a Permanent Establishment in India, the said business loss was not subject to Indian tax laws and accordingly, the AO disregarded the said loss from derivatives. This led to taxation of the profits from derivative transactions and shares as capital gains.
  • The AO thus gave two different treatments to the income/ loss arrived by the assessee from the derivatives transactions. He treated the loss suffered by the assesse as business loss and considered the income (gains) arising from transactions in derivatives as capital gains.
  • Being aggrieved, the taxpayer appealed before the first appellate authority – Commissioner of Income-tax (Appeals) [CIT (A)], who in-turn held that both profit and loss on derivatives should be treated as business income and reiterated the view of AO that the resultant business loss cannot be set-off against the capital gains from shares.
  • The taxpayer took the matter before the ITAT in second appeal.

Issues before the ITAT

  • Whether the CIT(A) was correct in considering the profit and loss from derivatives as ‘Business Income’?
  • Whether the tax authorities were correct in suo-moto applying the provisions of the tax treaty, and placing the taxpayer in disadvantageous position?

Taxpayer’s contentions

  • As per SEBI (FII) Regulations, 1995 the taxpayer being an FII, is permitted only to “invest in shares and derivatives”. Hence, the loss arising from transaction in derivatives cannot be treated as business loss.
  • Further, even if the loss arising from transactions in derivatives is treated as business loss, the same is liable to be set-off against the short term capital gain arising as per provisions of Sec 71 of the Income Tax Act, 1961.
  • The AO’s treatment of considering the loss as business income was based on wrong facts that the derivatives were sold in one day, following which he considered the holding period as “NIL”. Factually, the transactions were closed out on various dates within the month and not on the same day.
  • The ruling of the AAR in case of Royal Bank of Canada (where it was held that the transactions in derivatives carried out by the Bank were to be classified as business transactions) does not apply to the assessee as the ruling is with reference to a bank and not an FII.
  • The issue relating to treatment of income from derivatives is settled by the decision of the Mumbai Bench of the ITAT in the case of LG Asian Plus Ltd and therefore, the order of CIT(A) is not sustainable.
  • As per Sec 90(2) of the Income Tax Act, the taxpayer has the option to pay taxes as per the   Tax treaty or the Income Tax Act, whichever is more beneficial to it. Accordingly, the department cannot apply the provisions of tax treaty to the taxpayer’s disadvantage.

Revenue’s contentions

  • FIIs are permitted to invest in shares in recognised stock exchanges but not in derivative transactions. Further, referring to the various clauses of the constitution of Platinum Trust, it was contended that the taxpayer was allowed to short sell and therefore, the derivative transactions which were entered into to hedge against its investments cannot be treated as investments but the very nature of the transactions is speculative. Hence, the AO has rightly treated it has business income.
  • Reliance was placed on AAR ruling in the case of Royal Bank of Canada where, on identical facts, it was decided that the income arising from derivatives would be in the nature of business income and not capital gains.

ITAT’s decision

  • When a direct decision of the coordinate bench of this Tribunal is available on an identical issue, then the same is binding on the ITAT in absence of any contrary decision of the ITAT or any High Court.
  • As per SEBI (FII) Regulations, 1995 together with section 115AD of the Act, an FII is allowed to only invest in securities and the income so derived is to be taxed as per this section alone.
  • As per Press Note dated 24/03/1994 issued by the Ministry of Finance, FIIs have been considered as investors and income from transfer of securities (including derivatives) is chargeable to tax under the head capital gain as long-term or short-term gain depending upon the time period for which such securities are held.
  • Further, Section 43(5) of the Act defines speculative transaction and is relevant only in context of income under the head profit and gains of business or profession. Since, FIIs are specifically covered under Section 115AD, the former section does not hold good.
  • Accordingly, the ITAT held that the income arising from the derivative transactions to the taxpayer, being an FII, cannot be treated as business profit or loss, whether speculative or non-speculative, but the same has to be categorised as capital gain or loss. Hence, the order of the CIT(A) was set aside and issue was decided in favour of the assessee.
  • Since the first ground itself was held in favour of the taxpayer and against the Revenue, the ITAT did not pass any judgement on the other issue raised before it viz. whether the AO was right in thrusting the Treaty provisions on the taxpayer.

SKP’s comments

  • As more and more foreign investors show interest in Indian stocks, the debate revolving classification or categorisation of income from derivatives is bound to become more intense.
  • In case of those FIIs that invest in India through the Mauritius route, the debate is only academic since capital gains would not be taxable in India as per the Treaty between India and Mauritius and so is the case with business profits if the FII does not have a PE in India (which is generally the case). However, in those cases where the FII belongs to a non treaty country or to a country where the treaty with India allows India to tax the gains, this debate is very relevant and important.  
  • An interesting issue that was raised before the ITAT was whether the AO is right in thrusting the Treaty provisions on a taxpayer has not been decided upon by the ITAT. We believe that if the ITAT had gone into this issue, the decision would have been in favour of the taxpayer. However, we shall have to wait for another case to come up before we get an idea of how the ITAT would view such an issue.
  • The ITAT has, for the time being, given a clear verdict that FIIs duly registered with SEBI can only invest in India and that their transactions in shares, derivatives and other securities would give rise to capital gains/loss and not business income.