H P Agrawal: Tax on business profit of FIIs

FOREIGN ENTERPRISES

Investment in Indian stock market by foreign institutional investors (FIIs) has become substantial. Normally, the FIIs do not have any branch office or a place of business in India nor do they have any employees working for them in India.

The business operations of purchase and sale of shares are carried out through Indian brokers and the Indian securities are held by their domestic custodian.

The taxability of the FIIs income from investment in India will depend upon:

Whether the gains arising from sale of investment in India will be treated as "business income" or as "capital gains".

Whether the FII, in the course of investment transactions, will be deemed to have a permanent establishment in India.

As a general legal proposition, if the income earned by the FIIs falls in the category of "business profits", then the same can be taxed in India only if the FII has a "permanent establishment" in India.

If, however, the income is categorised as "capital gains", the same will be liable to tax in India unless the concerned tax treaty specifically exempts such income from tax.

These issues were raised in a recent case before the Authority for Advance Rulings (Fidelity Advisor Series VIII 271 ITR 1).

The Authority after discussing the relevant case laws laid down the following principles to determine the true nature of income "" whether the income could be treated as "business income" or it will be in the nature of "capital gains".

Where a company purchases and sells shares, it must be shown that they were held as stock-in-trade and the existence of the power to purchase and sell shares in the memorandum of association is not decisive of the nature of transaction;

The substantial nature of transactions, the manner of maintaining books of account, the magnitude of buys and sales and the ratio between purchases and sales and the holding would furnish a good guide to determine the nature of transactions;

Ordinarily, the purchase and sale of shares with the motive of earning a profit, will result in the transaction being in the nature of trade/adventure in the nature of trade; but where the object of the investment in shares of a company is to derive income by way of dividend, then the profits accruing by change in such investment (by sale of shares) will yield capital gain and not revenue receipt.

It was held "having regard to the objects of the company, its investment of the amounts in India, the registration with the Sebi, obtaining the 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."

Regarding creation of a permanent establishment in India, the Authority held that "the applicant FII does not have any branch or office in India, nor does it have any place of business in India that could lead to an inference that the applicant has a permanent establishment in India."

agar@nda.vsnl.net.in