CBDT circular will not impact FII income

FOREIGN ENTERPRISES

The draft instructions issued by the Central Board of Direct Taxes (CBDT) on May 16, 2006, have been drafted in a way that FIIs will fall in the category of "trader" in securities.

Therefore, the apprehension which led to panic was that FIIs would no longer enjoy concessions under Sections 115AD 10 (38) of the Income-Tax Act and would be liable to pay 40 per cent tax.

Further, the draft instructions make no distinction between Indian investors and FIIs. They are silent on provisions of Section 115AD that were incorporated especially for FIIs.

However, if the legal position is carefully analysed, it will be clear that FIIs will be hardly affected by the instructions issued by the CBDT. Because, if the income earned by an FII falls in the category of "business profits," the same can be taxed only if it has a "permanent establishment" in India.

The aforesaid issue was raised in a recent case before the Authority for Advance Rulings in Fidelity Advisor, Series VIII (2004) 271 ITR 1 (AAR). The authority, after discussing the relevant case laws, laid down certain principles to determine the true nature of income, that is, whether it is a "business income" or a "capital gains."

It was held that "having regard to the objects of the company, its investment of the amounts in India, the registration with Sebi, obtaining FII licence and the enormity and frequency of purchases and sales, we are persuaded to conclude that the applicant (FII) held the shares and securities as business assets and the profits from the purchases and sales of shares are in the nature of business income."

Such business profits can be taxed in India only if the FII has a permanent establishment here. In this case, the authority observed that neither does the FII have any branch or office in India nor does it have any place of business in India that can lead to an inference that it has a permanent establishment in India.

Thus, there is nothing new in the instructions. The recent judicial pronouncements have also held that the income of FIIs should be treated as "business profits."

The finance minister also clarified on May 18, 2006, that "no FII has been assessed as a trader but has instead been treated as an investor, because they have no permanent offices in India."

It is, therefore, felt that the draft instructions issued on May 16 will support FIIs in claiming that they are "traders" in securities. Therefore, the profit made by them is "business profit," which cannot be taxed because they have no "permanent establishment" in India.

FIIs are, however, advised that to avoid creation of "permanent establishment" in India, they should strictly adhere to the norms prescribed in their countries' respective tax treaties, as explained by the AAR in the Fidelity Advisor Series VIII (2004) 271 ITR 1 (AAR) and Universities Superannuation Scheme Ltd (2005) 275 ITR 434 (AAR). Let them be assured that if they have no "permanent establishment" in India, there will be no tax on sale or purchase of securities in India.

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