31st July, 2012

FII Alert - Foreign Investments in India
Taxation of income earned by FIIs from Indian debt instruments

Recently the Bombay High Court has pronounced a very useful and interesting decision which will be greatly appreciated by FIIs investing in Indian debt instruments. The issues before the High Court were in respect of a Cypriot entity which earned a surplus from disposal of a Govt. security and claimed that surplus to be capital gains. This alert highlights the facts of the case and the decision of the High Court.

Facts of the case:

The tax payer – Credit Suisse First Boston (Cyrpus) Limited (CSFBC) is a company incorporated in and is a tax resident of Cyprus. It is registered in India with the Securities & Exchange Board of India as an approved sub account of Credit Suisse First Boston, a Foreign Institutional Investor (FII). CSFBC had invested in certain Government securities in India. As per the terms of issue of the said securities, interest was payable every six months (it is not clear from the facts given in the decision as to what were the due dates for this purpose but the dates appear to be other than 30th September and 31st March). During the financial year ended 31st March, 2001, CSFBC sold some of the securities and earned a surplus. In its tax return for the said year, CSFBC offered to tax the interest income actually received during the year while the surplus received on sale of the securities was treated as capital gains and, taking benefit of Article 14(4) of the tax treaty between India and Cyprus (hereinafter referred to as DTAA), the same was considered as exempt from tax in India. CSFBC did not offer to tax the interest income on the debt securities for the broken period ended 31st March, 2001. In the assessment order, the tax officer took a stand that CSFBC should have offered to tax the interest for the period from the last date upto which interest was actually received during the year upto 31st March, 2001 since the same is considered to have accrued to it. The tax officer also took a stand that the surplus on sale of the securities should not be categorised as capital gains but should be treated as interest within the meaning assigned in Article 11(4) of the DTAA. Accordingly, he taxed the entire capital gains as interest income.

In the first two stages of appeal, the matter was decided in favour of CSFBC and therefore, the Revenue took the matter to the Bombay High Court.

Issues before the High Court:

  1. Whether the interest income that is deemed to accrue or arise on a proportionate basis upto the end of the financial year on the securities held by the respondent on that date should be charged to tax in the year under appeal and
  2. Whether the gain from the sale of the securities would constitute interest income or capital gains.

Contentions of the appellant (Income Tax department):

It was argued that interest income accrues from day to day and that when an investor purchases certain securities, it pays not only cost of securities but also the interest which has accrued, on a day to day basis, from the last date of payment of interest to the date of purchase. Similarly, when the investor sells the securities, it receives not only sale value but also the broken period interest which has accrued on the securities till the date of sale.
It was contended that interest income accrues as and when the assessee acquired a right to receive such income or the right becomes vested. It was further argued that surplus on the sale of securities would not fall within Article 14(4) of the DTAA as Government securities are specifically referred to in Article 11(4). Reference was also made to the mercantile system of accounting whereunder, according to the Revenue, it was mandatory for an investor to accrue the income as at the last date of the financial year.

Contentions of the Respondent (CSFBC):

CSFBC claimed that the proportionate interest on securities purchased by it had neither accrued nor become due and payable on the last date of the financial year. Such interest can accrue on the securities in question only on the dates specified in the terms of issue of the securities and not on any earlier day during the currency of interest period. It was also contended that any profit or loss which a holder of a security realises by the sale thereof to another person does not enter into the concept of Interest. Article 11 of the DTAA merely provides which of the States is entitled to tax the interest arising in a Contracting State and the rate at which such interest may be taxed. It must be appreciated that the price realised upon the sale of the debt claim itself is not interest.

High Court’s judgement:

The High Court has upheld the decisions of the lower appellate authorities and has dismissed the appeal filed by the Revenue. It has been observed that the right to receive the interest on the Government securities vested in the respondent only on the due dates mentioned in the securities. Consequently interest accrued on the securities only on the due dates and cannot be said to accrue to the respondent on any date other than the dates stipulated therein. The contention that the interest accrues for broken periods between two consecutive dates is without any basis in law. If the security is sold before the due date of the payment of interest, it cannot be said to have accrued to the respondent. It is only the holder of the security on such date to whom interest can be said to accrue. Therefore, the High Court held that the tax officer was not justified in taxing accrued interest in the hands of CSFBC. On the second issue, it was held that any profit or loss which a holder of security realises does not enter the concept of interest. Such profit or loss may, depending on the facts of each case, constitute a business profit or loss, a capital gain or loss or income falling under Article 21 but certainly not interest income. Also going by the definition of Interest and Capital Gains provided by Article 11 and Article 14 respectively of the DTAA, it can be clearly stated that the income arising on the sale of securities falls within the definition of capital gains. The specific mention of Government securities constitutes merely an inclusive provision by way of an illustration. Consequently, the High Court held that the gains arising to CSFBC on sale of Government securities was rightly categorised as capital gains and the same were exempt from tax in India vide Article 14 of the DTAA.

SKP’s Comments:

This judgement is very useful and brings out the fact that even if the assessee follows mercantile system of accounting, interest would accrue on the securities only on the due dates and cannot be said to have accrued on any date other than the dates stipulated in the terms of issue. The other conclusion reached by the High Court is also very important i.e. when the debt securities are sold by an FII, the sale consideration received has to be taken into consideration in entirety while computing capital gains and that no portion of the same can be said to constitute interest income in the hands of the investor.
These findings would be of great interest to FIIs and Sub Accounts in general and to entities registered in Mauritius and Singapore in particular since capital gains earned by such entities would be exempt in India by virtue of the tax treaties between India and these countries. In such cases, there was always a doubt about the categorisation of the surplus arising on sale of the debt securities. The Bombay High Court’s decision would be extremely useful to such entities as it clarifies the issue of categorisation and clearly lays down that the surplus would be treated as capital gains. The same logic would also hold true for Qualified Foreign Investors who may be contemplating investments in Indian debt instruments.