Is there more clarity on capital gains taxes now?

Since the draft lists 15 criterion to decide if a person is a trader or an investor, and a decision can't be made on just one, the confusion persists.

Punit Shah,
Head, Banking and Financial Services Group, RSM & Co

"The draft instructions would be binding on assessing officers and should lead to a considerable decline in the discretion that can be applied."

Determination of whether profits from sale of shares and securities give rise to capital gains or business income has always been a subject matter of considerable debate and litigation. Considering the turmoil the draft instructions issued by the Central Board of Direct Taxes (CBDT)created, one wonders as to whether these instructions prescribe something so radical and new, which was as such not in the knowledge of the investors' community in the past.

Over the years, the courts have laid down various tests for factors to be taken into account in determining this question. These court rulings have examined the issue of the characterisation of income either as capital gains or business income and have considered several factors such as the intention of the assessee, the nature and quantity of the commodity purchased and sold, and so on. As there was considerable uncertainty and litigation over this particular issue, the CBDT considered it appropriate way back in 1989 to issue an Instruction (No. 1827) dealing with this crucial aspect.

The issue of characterisation of income is relevant even for foreign investors, especially FIIs. In most cases, the Authority of Advance Rulings held that, considering the facts and circumstances of the cases presented before it, the characterisation of the income earned by the foreign investors is in the nature of business income. It further concluded in most cases that as these foreign investors do not have permanent establishment (PE) in India, the gains earned by them are not liable to tax in India.

One would observe from the above sequence of events that the issue has always been a subject matter of considerable debate and judicial scrutiny.

The recent draft supplementary instructions by CBDT (May 16, 2006) is also a step in that direction. An attempt is made by CBDT to issue supplementary instructions (to Instruction No. 1827) by providing 15 specific parameters based on which this aspect would be determined by the assessing officers. The instructions would generally be binding on the assessing officers and should lead to considerable reduction in the discretion, which may be applied by the assessing officers in the determination of the characterisation of income. For FIIs, the question of taxability does not end by answering to these parameters, but the question of having PE in India becomes more relevant and will have to be examined on a case-to-case basis by the assessing officers, based on the facts of each case. The finance minister has repeatedly mentioned that FIIs are the investors and most of them do not have PE in India. Therefore, merely specifying of these parameters in the draft instruction should not prejudicially affect their interest.

Ashesh Safi,
Director, Deloitte Haskins & Sells

"The criteria listed in the instructions can not be considered to be exhaustive and, based on them, it is possible to take varying positions."

There is a long-drawn controversy whether income earned from dealing in shares is as a trader or as an investor. A line of distinction between trader and investor is thin. The CBDT is proposing to issue additional instructions to the tax officers to determine whether a person is a trader or an investor.

Instruction number 1827 dated August 31, 1989, was issued to provide guidance on the subject. In the earlier instruction, the CBDT discussed various tests laid down by the courts and said that the tests laid down by courts would help determine the issue but the ultimate decision would depend on the facts of each case.

The proposed instruction provides 15 criteria to determine whether a person is a trader or an investor. The criteria, among others, include whether dealing in shares is allied to usual trade or incidental to the business, whether the intention is to sell at a profit or for long-term appreciation, the scale of activities, whether investment is in sister concerns or independent companies and so on. Many of the above criteria are based on various court judgements. The instruction also provides that no decision should be made based on any single criterion but the total effect of all the criteria should be considered to determine the nature of activity.

The distinction between a trader and an investor is necessary as there are different tax implications for traders and investors. Income earned from sale of shares by a trader is characterised as business income and by an investor as capital gains. If the transactions in shares result in loss and the transactions are carried out as a trader, the losses can be set off against any other income. But if the loss arises to an investor, such loss can be set off only against specified capital losses. Similarly, rate of tax differs traders and for investors. This differential tax treatment leads to litigation between assessee and the tax officer.

Based on the proposed instructions, it is possible that varying position can be taken. The criteria listed in the instruction can not be considered as exhaustive. The instructions also do not provide examples of a person acting as a trader or as an investor. It may also be advisable to provide weightage to various criteria listed therein, for instance, weightage for securities held as stock-in-trade should be more than weightage for scale of activities, duration of holding and so on. Further, generally speaking, certain categories of persons for instance, mutual funds, foreign institutional investors, private equity funds, hedge funds and so on, are considered as investors rather than as traders, though their scale of activities may be large. The final instruction should consider all these aspects to provide clarity and to reduce discretionary application of the criteria.