Taxability of FIIs in India: Part 2

In an earlier post I had made an assertion that the law relating to taxability of FIIs remains largely unsettled. In this post I shall attempt to provide evidences/reasoning for the aforementioned assertion. It is to be noted that this post does not deal with the taxation of derivative transactions by FIIs. The same has been dealt by Ravichandra S. Hegde of J. Sagar Associates here. This post deals with the taxability of FIIs relating to the purchase and sale of equity shares.


As a starting point it is first essential to understand the business activity of a FII. Conventionally, a FII is used to denote an investor who is in the form of an entity engaged in investing money in a foreign financial market. Legally clause 2(f) of the SEBI (Foreign Institutional Investors) Regulation, 1995 defines FII to be “an institution established or incorporated outside India which proposes to make investment in India in securities.” The legal definition of a FII is functional in nature i.e. the definition signifies the principal business activity of a FII (investment in securities).

The fundamental dispute relating to taxability of FIIs in regard to purchase and sale of securities revolves around the question of characterization of Income. Simply put, the question is whether the income generated at the hands of the FII through transactions relating to purchase and sale of equity shares or other securities are in the nature of “business income” or “capital gains”. The revenue in various cases has contended that the income generated at the hands of a FII should be characterized as “capital gains”. Per contra, the FIIs have contended that the income generated through purchase and sale of equity shares is in the nature of “business income”. The rationale for this is not far to seek; if the FIIs are successful in their contention then it would necessarily mean that they can only be taxed in India if the department is able to show a permanent establishment of a given FII in India.

Prior to 2007 the AAR in various cases namely XYZ/ABC, Equity Fund, Fidelity Advisor Series, VIII, USA and Morgan Stanley had concluded that the income generated by the FIIs was in the nature of “business income”. It would not be entirely correct to apply Morgan Stanley to the present issue as the question in Morgan Stanley was regarding the taxability of derivative transaction by FIIs. However in 2007 the AAR in Fidelity Northstar Fund (hereinafter “fidelity”) held that the income generated by the FIIs through purchase and sale of equity shares was in the nature of “capital gains”. In fidelity the question before the AAR was whether securities which were the subject matter of purchases and sales by the applicant were held by the applicant by way of stock in trade so as o give rise to “business income” or investment in capital assets so as to yield “capital gains”. The AAR came to the latter view i.e. the profit arising to the applicant was in the nature of “capital gains” and not “business income”. The conclusion drawn by the AAR in fidelity was based on two grounds (i) SEBI regulations (ii) sec. 115AD of the IT Act, 1961.

(i) SEBI Regulations - The AAR relied on Lord Reid’s observation in J. Harrison Ltd. v. Griffiths ([1962] 40 TC 281 (HL)) which was quoted by the Supreme Court of India in CIT, Bombay v. Holck Larsen as a test to determine in a given situation whether one is a dealer in shares or investor in shares. Lord Reid observed as under:

“In the present case the question is not what (sic) [whether] the transaction of buying

and selling the shares lacks to be trading, but whether the later stages of the whole operation show that the first step- the purchase of the shares- was not taken as, or in the course of, a trading transaction.”

In order to ascertain the above highlighted first step the AAR in fidelity relied on the SEBI regulations pertaining to FIIs especially the 1995 regulation. After the perusal of the same the AAR was of the view that since the SEBI regulations do not allow FIIs to trade in securities in India, it would be legally untenable to conclude that the first step to purchase FIIs would be in contravention of all the SEBI regulations. The following part of the ruling is apposite”

“It cannot be lost sight of that regulation 15A of SEBI Regulations referred to above, permits dealing in offshore derivative instruments only and none other. The words transact business and the transaction of business in Clauses (a) & (c) respectively of Sub-regulation (3) of Regulation 15 postulate transaction of sale and purchase, they do not refer, as such, to the trading activity. It needs no emphasis to point out that transact business is different and distinguishable from carrying on business. Transact business is a general term which refers to carrying on all types of activities whereas business transaction refers to only commercial trading activities. Thus it follows that the aforementioned words and expressions, in the context in which they are used, do not deal with the subject of trading in securities much less do they permit activities of trading in securities by a FII. In no way, the framework of the provisions of the Guidelines, Acts and Regulations, discussed above, can be so interpreted as to lead to the inference that trading in Indian securities is open to the FIIs.”

 

“In our view it will be preposterous to impute an intention to FIIs, who responded to the offer of investment in securities in response to the guidelines, got themselves registered under the SEBI Regulations and undertook to abide by those regulations that they would, in the very first step itself, have intended to violate all the legislative requirements which provided them the opportunity to enter the capital market in India. That the FIIs could not have intended to trade in the first step of purchase of shares, is also strengthened by the fact that in the income tax returns filed by many of them, in consonance with the above legislative provisions, they have shown their income as capital gains”

In 2010 the AAR in Royal Bank of Canada (hereinafter “royal bank”) implied that fidelity may be incorrect inasmuch as holding that the FIIs are prohibited from trading in shares and securities as per the SEBI and FEMA regulations (see para. 15 and 15.1 of the ruling). However, the Royal Bank case may not be an authority on this point as the question in royal bank was with regard to derivative transaction by FIIs similar to the one in Morgan Stanley.



(ii) Sec. 115AD – the AAR in fidelity opined that s. 115AD is a self contained and special provision for charging to tax the income of FIIs from securities and since s. 115AD does not contemplate FIIs deriving income from “business income” there would be no question of classifying the income generated by FIIs through transfer or sale of securities as “business income”. This view has not been subscribed to by the AAR in Royal Bank. The following part of the Royal Bank case is relevant



“It must be noted that the expression “in respect of” is of wide import, more or less synonymous with the expression ‘ in connection with’ or ‘ in relation to’. There is no particular reason why the income on account of trading in securities is excluded from the purview of section 115AD.......................”


“There is no warrant to place a restricted construction on clause(a) of sub-section(1) of section 115AD that only the income on account of holding the securities (like fruits from a tree) is covered by clause(a). If such restricted scope was intended to be given to clause(a), there should have been a more explicit language to that effect especially to counteract the effect of the wide expression ‘ in respect of’. The argument of the learned counsel for the Revenue that clause(a) of sub-section(2) which excludes the deduction admissible to business income a clear pointer that income on account of trading in all types of securities is not contemplated by section 115AD does not appeal to us.”

Concluding the two latest judgements i.e. fidelity and royal bank showcase contrasting opinions on the taxability of FIIs in relation to purchase and sale of equity shares. Though one may argue that royal bank was only concerned with derivative transaction; it cannot be undermined that both royal bank and fidelity provide contrasting interpretations of S. 115AD of the IT act (a key aspect as far as the taxability of FII in relation to purchase and sale of equity shares is concerned). Apart from this fidelity does not follow the ruling in XYZ/ABC Equity Fund  and Fidelity Advisor Series on the rationale that in both the cases the AAR had not applied the test laid down by the Supreme Court in CIT, Bombay and subsequently not taken the SEBI regulations into consideration. At present the law on this point is far from settled as their are contrasting rulings delivered by the same authority. Ultimately, the taxability of FIIs would be a mixed question of law and fact. Nevertheless some uniform and well reasoned answers needs to be found for the questions mentioned as under:

(1) Is it correct to import SEBI regulations in classifying the income generated by FIIs in India?

(2) If (1) is in the affirmative, then does SEBI regulations allow FIIs to trade in Securities?

(3) What is the correct scope and application of S. 115AD of the IT Act, 1961?