Panic in stock market unfounded

FOREIGN ENTERPRISES

Government of India has all along laid a red carpet to welcome FIIs in India. While presenting the Budget for 1992-93, Manmohan Singh had announced the decision to allow reputed foreign investors to invest in the Indian capital market. There was no restriction on the volume of investment by FIIs in the primary/secondary market. Also, no lock-in-period was prescribed for the investment.

Simultaneously, tax concessions were incorporated in the Income-tax Act, specifically to cater to FIIs. As observed by the Authority for Advance Rulings (AAR) in Universities Superannuation Scheme Ltd (2005) 275 ITR 434: "Under the scheme for permitting Foreign Institutional Investors in our capital market, as is evident from the budget speech of the honourable 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".

It is to be particularly noted that FIIs are allowed to appoint a custodian of securities for confirmation of transactions, settlement of purchase and sale, and for information report. As a result of this procedure, a registered FII can operate in India without any branch office or a place of business in the country. The legal significance of this arrangement is that FII need not have any Permanent Establishment in India.

Section 115AD, which specifically deals with income of FIIs from investment in India, provides that a short term capital gain is taxable @ 10%, where the transaction is subject to Securities Transaction Tax, and the long term capital gain is taxable @ 10%. But by the virtue of exemption provided in Section 10 (38), long term capital gains would be totally exempt from tax provided  the transaction is chargeable to Securities Transaction Tax.

Thus in sum total, FIIs are liable to pay tax @ 10% on short term capital gain and a nil tax on long term capital gain.

Where, however, the income earned by FIIs falls in the category of business profit, it appears that the provisions of Section 115AD will not apply. But at the same time, business profits of the FIIs can be taxed in India only if the FII has a Permanent Establishment in India. Where there is no Permanent Establishment, there will be no tax in India at all "� See  Fidelity Advisor Series VIII (2004) 271 ITR 1 (AAR), Universities Superannuation Scheme Ltd (2005) 275 ITR 434 (AAR).

The above legal position stood well settled till a doubt was created by issuance of draft instructions by CBDT on May 16, 2006. The impact of the  ill-drafted instructions was so devastating on the stock market that the Sensex recorded the largest fall of 826 points in one day on May 18, and again of 452 points on May 19. This is the largest fall in the BSE history of 150 years.

The draft instructions issued on May 16 pertain to guidelines issued by CBDT to determine whether a person is a trader in stock or an investor in stock. It may be clarified that if an FII is a trader in securities, the profit made by the FII will fall in the category of 'business profit'. Such a profit will be liable to tax @ 40% (+ surcharge and education cess). On the other hand, if the transaction in shares results in short-term capital gain, the rate of tax is 10%, and in case of long-term capital gain there is no tax at all.

The draft instructions have been so drafted that FIIs would certainly fall in the category of 'trader' in securities. Therefore, the apprehension which led to panic was that FIIs would no longer enjoy tax concessions granted to them in Section 115AD  and  Section 10 (38) of the Income-tax Act; they will be liable to pay tax @ 40%.  Further, the draft instructions make no distinction between Indian investors and FIIs. The instructions are completely silent about provisions of Section 115AD that were specially incorporated for FIIs.

If, however, the legal position is carefully analysed, it will be clear that FIIs will be hardly affected by the instructions issued by CBDT. Because, if the income earned by an  FII 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.

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 "� 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 of the amounts 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 (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 the instant case, the Authority observed that the applicant FII does not have any branch or office in India, nor does if have any place of business in India that could lead to an inference that the applicant has a permanent establishment in India.

Thus, in fact, there is nothing new in the instructions. The recent judicial pronouncements have also held that 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 in fact support the FIIs in putting up their claim that they are 'traders' in securities. Therefore, the profit made by them is in the nature of 'business profit' which can not be taxed in India 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 respective Tax Treaty as explained by the AAR in 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 there is no 'permanent establishment' in India, there will be no tax on sale-purchase of securities in India.

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