FIIs' capital gains come under special tax clause

FOREIGN ENTERPRISES

Section 115AD of the Income Tax Act deals with the income of foreign institutional investors (FIIs).

As observed by the Authority for Advance Rulings (AAR) in Universities Superannuation Scheme Ltd (2005) (275 ITR 434 (AAR)): "Under the scheme for permitting FIIs in our capital market as is evident from the Budget speech of the finance minister, a special provision""Section 115AD""has been inserted by the Finance Act, 1993, with effect from April 1, 1993. It deals with tax on income of FIIs from securities or capital gains arising from their transfer. It needs no elaboration to hold that Section 115AD, being a special provision for FIIs, overrides the general provisions."

Despite the specific provision of Section 115AD, it appears that the section will apply only in case of capital gains, whether short-term or long-term.

But if the income earned by FIIs falls in the category of "business profits", the same can be taxed in India only if the FII has a "permanent establishment" in India. The issue was raised in a recent case before the AAR in Fidelity Advisor Series VIII (2004) 271 ITR 1 (AAR).

The AAR, after discussing the relevant case laws, laid down certain principles to determine the true nature of income""whether the income could be treated as "business income" or whether the income would be in the nature of "capital gains".

It was held that "having regard to the objects of the company, its investment in India, the registration with the Sebi, obtaining FII licence and the enormity and frequency of purchases and sales, we are persuaded to conclude that the applicant (the 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 in India.

In this case, the AAR observed that the applicant does not have any branch or office in India, nor does it have any place of business in the country that could lead to an inference that the applicant has a permanent establishment in India.

But if the income from transfer of securities or shares falls in the category of capital gains, the income will be taxed as per the provisions of Section 115AD of the Income Tax Act, unless the income is exempt under the relevant tax treaty. It may be clarified that Section 115AD is applicable both in case of capital gain and capital loss.

Further, once Section 115AD is found applicable, the FII cannot opt out of the section. In fact, Section 115AD is a special provision, which will override the other general provision of the Income Tax Act (Universities Superannuation Scheme Ltd (2005) 275 ITR 434 (AAR).

Interestingly, while delivering judgment in case of Fidelity Advisor Series VIII (2004) 271 ITR 1 (AAR), the authority did not consider the provisions of Section 115AD at all.

On other hand, in case of Universities Superannuation Sch-eme Ltd (2005) 275 ITR 434 (AAR), the earlier decision in Fidelity Advisor Series VIII (2004) 271 ITR 1 (AAR) was not brought to their notice.

These two judgments of the authority, which appear to be somewhat contradictory, have been discussed above with a view to reconcile the rationale laid down by the authority.

agar@bol.net.in