(The following post has been contributed by Ravichandra S. Hegde of J. Sagar Associates)
Profits earned from derivative transactions are business income, not liable to be taxed in India at the hands of the FII: AAR
The Authority for Advance Rulings (“AAR”), Income Tax, in its recent decision dated March 22, 2010 has held that the special provision in the Income Tax Act, 1961 (“the Act”) cannot be pressed into service if it denies the benefit otherwise due to a Foreign Institutional Investor (“FII”) under the Treaty provisions, notwithstanding their conflict with the domestic laws.
In this case, AAR was called upon to determine the incidence of taxation as contained under the provisions of Section 115 AD of the Act for derivative transactions which were carried out by the Royal Bank of Canada (“RBC”), a registered FII. The question was whether the profits / losses from derivative transactions could be termed as “business income” under the Act read with the Agreement for Avoidance of Double Taxation Treaty between India and Canada (“Treaty”). The derivative transactions were carried out by RBC through Citibank, Mumbai which was appointed as the settlement agent and domestic custodian for RBC. The Application before AAR was filed by RBC claiming that the said derivative transactions were carried out as part of its trading activity with the objective of reselling the same at an appropriate time and earning income. RBC contended that the trades were executed only for the purposes of earning trading profits and not for earning any dividend income. It also contended that the income earned by buying and selling of equity shares would be in the nature of business income and cannot be treated as a capital gain under the Act. As RBC did not have a permanent establishment in India, it submitted that its business income from trading in derivatives, shares and other securities on the exchanges cannot be taxed in India in terms of the Treaty.
The DIT (International Taxation) Mumbai (“DIT”) had contented that the income derived from trading should be treated as a capital gain as the same arises from the investments made by RBC. It further objected to RBC’s contention stating that under SEBI and FEMA Regulations, RBC can only make investments and that trading in securities would be an investment which can result in capital gains but not business income. The Department also contended that RBC could only have earned capital gains from the transfer of securities as FIIs can only be investors but not traders in securities. Hence, it was deduced by the department that RBC’s income from dealing in derivatives and shares has necessarily to be brought within the purview of Section 115 AD which is a self contained code applicable to FIIs. The Department had also contended that under SEBI Regulations, only investments can be made by the FII and purchases of shares can only be on capital account and that the expression ‘trade’ employed in Regulation No. 5(6) of the FEM (Transfer of issue of security by a non-resident) Regulations, 2000 is used in a generic sense which must be confined only to investment. The department also took up the stand that if Section 115 AD is construed as including business income, it would be in the teeth of SEBI Regulations in as much as SEBI regulations would be violated.
AAR rejected the interpretation of the department and agreed with the submissions made by RBC. AAR also referred to its earlier decisions in the matter of Morgan Stanley and Co and Fidelity North Star Fund, where similar issues were raised for determination. It was held that RBC was allowed to trade in securities and derivatives and there was no bar either under Section 15 of SEBI Regulations or under FEMA. It said that on a contextual interpretation, the expression ‘investment’ was construed in a broad sense and in conjunction with the word ‘traded on’. Hence investment in derivatives does not exclude trading transactions.
Interpreting Section 115AD of the Act, AAR said that there was a clear indication in the Section itself that business income is not covered by the said Section. The following observations are relevant to quote:
It appears to us that the purpose and purport of Section 115AD is to provide for special or concessional rate of taxation in relation to the securities received or arising from the income of FII. Two categories of income shall specify in the section. The income in clause (b) arises on account of transfer of securities; it may be short term or long term capital gains. The income in clause (a) is received “in respect of securities”; however, it excludes income by way of dividends. It must be noted that the expression “in respect of” is of wide import, more or less synonymous with the expression ‘in connection with’ or ‘in relation to’. There is no particular reason why the income on account if trading in securities is excluded from the purview of Section 115 AD. … We have already referred to the relevant Regulations and the finding of this Authority that trading in derivatives is permitted and not prohibited under the said Regulations. There is no warrant to place a restricted construction on clause (a) of sub-section(1) of Section 115 AD that only the income on account of holding the securities (like fruits from a tree) is covered by clause (a). If such restricted scope was intended to be given to clause (a), there should have been a more explicit language to that effect especially to counteract the effect of the wide expression ‘in respect of’. …
A copy of this decision can be accessed here.