Copyright vs. Copyrighted Article: Guest Post

( This article is contributed by Megha Mishra. Megha is a final year Charted Accountant Student and is also working as an analyst at PriceWaterHouseCoopers. Needless to state that the views expressed here are personal)

 Payment made for the use of software has been, for sometime now an area of ambiguity and has attracted a lot of controversy. There are various judicial precedents which have held time and again, that the payment made for purchase of “off- the- shelf” software is not a payment for ‘royalty’. However, in a recent ruling in M/s Gracemac Corporation v. ADIT, the Delhi ITAT has held that consideration for the sale/ purchase of “off-the-shelf” software is treated as Royalty.

This ruling in Gracemac is a significant departure from the position laid down by the Indian courts in several cases like Tata Consultancy Services , Motorola Inc, Sonata Information Technology v ACIT, and others, wherein a distinction was drawn between ‘copyright’ and ‘ copyrighted article’. However, in Gracemac, the ITAT held that the term ‘copyrighted article’ has not been defined either in the Income Tax Act, 1961 or under the copyright Act, 1957; the term ‘copyrighted article’ had originated in the US Regulations and then found its way into the OECD commentary. Further, the ITAT observed that the term ‘copyrighted article’ was independently defined only for the sake of drawing out a meaning for the same; hence there was/is no need in importing the expression’ copyrighted article’ for the interpretation of the term ‘royalty’. Alternatively, the Tribunal also stated that as per the definition of the term ‘royalty’ in section 9(1)(vi) of the Income Tax Act,1961, a copyright subsists in a computer programme and therefore any sale of software amounts to ‘royalty’.

However, in my opinion, when a license to use the generalized software is issued by the owner to the end user, the payment made for the same should not be treated as a ‘royalty’, since the end user does not get the right to commercially exploit the said software. Thus, as also held in various judicial precedents, the sale of ‘off-the-shelf’ software should be treated as sale of an article and not as royalty.

GE India Technology: Interesting observation on 'Territorial Nexus'

In GE India Technology v. CIT, the Supreme Court has laid to rest the controversy surrounding the interpretation of s. 195 of the IT Act, 1961. The controversy had arisen through the judgment of the Karnataka High Court in CIT v. Samsung. In Samsung the Karnataka High Court had held that a resident Indian would necessarily have to deduct tax at source u/s 195(1) of the Act while remitting money to a non resident irrespective of the sum eventually not being chargeable to tax in India. The High Court had further held that the only way by which a resident can remit the entire sum to a non resident is by obtaining a “No Objection certificate” (a declaration that the sum in question is not chargeable to tax in India) from the department u/s 195(2) of the Act.

However in GE India the Supreme Court has effectively overruled Samsung and has held that tax has to be deducted at source only when the remitting sum is eventually chargeable to tax in India. The court has further held that s. 195(2) is based on the “principle of proportionality” and it only gets attracted incases of composite payment in which only a certain proportion of payment has an element of “income” chargeable to tax in India. In other words a resident Indian has to make an application when the payment is certainly chargeable to tax but the Resident is unsure about which portion of the payment is chargeable to tax. In case the Resident fails to apply for an application in cases enumerated above, he has to then necessarily deduct tax at source u/s 195(1). In my humble opinion the Supreme Court has arrived at the correct conclusion.

In arriving at the above mentioned conclusions, Kapadia, C.J. has made to an interesting observation:

“The interpretation of the Department, therefore, not only requires the words “chargeable under the provisions of the Act” to be omitted, it also leads to an absurd consequence. The interpretation placed by the Department would result in a situation where even when the income has no territorial nexus with India or is not chargeable in India, the Government would nonetheless collect tax”(emphasis mine)

This observation though an obiter can potentially be used to argue that the principle of “Territorial Nexus” forms an essential element of the Indian Tax jurisprudence. The observation also manifests that the finding in Linklaters (discussed here) and Ashapur wherein the ITAT, Bombay had held that the principle of “Territorial Nexus” is only limited to territorial tax systems, is incorrect. However this observation can also be used to argue that no territorial nexus is required to tax an income of a non resident. Kapadia C.J. above observes that “......even when the income has no territorial Nexus or is not chargeable to tax in India, the government can nonetheless collect tax.” This implies that the Government can collect tax when the income of the non resident has a territorial nexus with India or is specifically chargeable to tax under any of the provisions of the Act (even though the provision is not based on any territorial nexus test).

Concluding, though two contrasting interpretations are possible of the above observation, nonetheless the latter interpretation as stated above would open the doors for a constitutional challenge of the provision  which seeks to tax the income of a non resident without their being sufficient territorial nexus.

Changes Proposed to be Brought by The Direct Tax Code Bill, 2010

The Direct Tax Code is proposed to be brought in to consolidate and amend the regime relating to Direct Taxes in India so as to establish an economically efficient, effective and equitable direct tax system which will facilitate voluntary compliance and help increase the tax-GDP ratio. Also the secondary purpose of the Code is to reduce disputes and minimize litigation. The Code proposes to bring all forms of Direct Taxes under a single code. A Discussion Paper was released in August 2009; subsequently a revised discussion paper was brought out in June 2010 which incorporated certain suggestion made with regard to the Discussion Paper. Finally, the Bill was tabled in the Parliament on 30th August, 2010. The post highlights certain changes which are to be brought by the Direct Tax Code Bill, 2010.

• Tax Rates

The tax slabs have been widened (First Schedule Paragraph A). The lowest tax rate of 10% is applicable to salary income of Rs2-5 lakh, 20% on income of Rs5-10 lakh and 30% on income above Rs10 lakh.

• Residential Status of Individuals

Residential Status of Individual under the Direct Tax Code has undergone a significant change. The requirement of being present in India for 730 days in the preceding seven years, essential for qualifying as an ordinary resident and the categorization of Resident but not ordinary Resident has been done away with (Clause 4).

• Residence of Companies

Under the Direct Tax Code a company would be treated as a Resident if it is an Indian Company or if its place of ”effective management” at any time of the year is in India (Clause 4) in contrast to the requirement of being “wholly” situated in India under the Income Tax Act. 'Place of effective management' under Clause 314(192) is defined as either the place where the Board/Executive directors of a company make their decisions or, in a case where the board of directors routinely approve the commercial and strategic decisions made by the executive directors or officers of the company or the place where such executive directors or officers of the company perform their functions. This has been done to enlarge the scope of taxability of companies by bringing in more number or Companies under the banner or Resident Companies.

• Income from Salary

The broad head of Income from Salary under the Income Tax Act has been renamed to “Income from Employment” under the Direct Tax Code. Clause 23 (e) has removed the cap of 1 lakh towards the Employer’s contribution towards approved Superannuation fund.

• House Property

No taxation on deemed income basis. The concept of fair market value (S.23) for calculation of income from house property has been done away with primarily because computation of notional rent has been a predominant cause of litigation. Income from the letting of house property will be computed on the basis of contractual rent (Clause 26), i.e. the amount of rent received or receivable, directly or indirectly for the financial year less specified deductions (Clause 27). Standard deduction on account of repairs and maintenance has been reduced from 30% to 20% [Clause 27 (1) (b)].

• Branch Profit Tax

The Direct Tax Code introduces a Branch Profit Tax (BPT) on branch profits of foreign companies in addition to the income tax on income attributable to a Permanent Establishment (PE) or an immovable property in India, as reduced by the income tax payable on such attributable income. The Rate of Tax as proposed in the Second Schedule Para D (4) is 15%.

• DTAA

The Direct Tax Code in Clause 291(8) lays down that between the Code and a DTAA the provisions of the Code will apply to the extent that the provisions of the Code are more favorable to the assessee.

• Wealth Tax

The existing exemption limit (30 lakh) for the chargeability of Wealth Tax under the Act has been increased to 1 Crore. (Second Schedule Para E).

• Minimum Alternate Tax

The Direct Tax Code has brought in the concept of Minimum Alternate Tax so as to overcome the problem of excessive tax incentives. Where the normal income-tax payable for a financial year by a company is less than the tax on book profit, the book profit shall be deemed to be the total income of the company for such financial year and it shall be liable to income-tax on such total income (Clause 104 Direct Tax Code).

Daga Capital: S.14A, Rule 8D

The Bombay high court has pronounced the much awaited judgement in Godrej & Boyce v. DCIT, the lead matter challenging the judgement of the ITAT special bench in Daga Capital. The ITAT decision in daga capital has been discussed here.

I will discuss the judgement of the Bombay high court in a subsequent post.

Linklaters: Fiscally Transparent Entities

In my previous post I had discussed one of the findings in Linklaters (one relating to S. 9 and territorial nexus). In this post I shall discuss the finding in linklaters with regard to treaty benefits extended to fiscally transparent entities. The case is extremely important in this respect due to the absence of any specific adjudication on this point in India and very few in other jurisdictions.


The fundamental question before the tribunal was whether the partnership firm (linklaters LLP) which is treated as a fiscally transparent entity in the UK but is taxable as a separate entity in India under the Income Tax Act, 1961 eligible for the India UK treaty benefits. Before discussing the findings of the tribunal it is important to briefly elucidate on why this issue had arisen at the first place. Art. 1(1) of the India UK treaty stipulates that the convention shall apply to “persons who are resident of one or both the contracting states”. Further, Art 3(2) stipulates that a “partnership firm” which is a taxable unit in India shall be “treated as a person” for the purposes of the India UK treaty. It is very clear from the aforementioned provisions that a partnership firm is treated as a person under the impugned treaty. Thus, the only point that needs to be established for a partnership firm to avail treaty benefits is to essentially show that it is a resident of atleast one of the contracting states. For this purpose Art. 4(1) is important and it reads as under:

For the purposes of this Convention, the term "resident of a Contracting State" means any person who, under the law of that State, is liable to taxation therein by reason of his domicile, residence, place of management or any other criterion of a similar nature.

On the basis of this provision the question that the tribunal had to address inorder to answer the larger question of treaty benefits was whether Linklaters meets the test embodied under art.4(1) of the treaty. The tribunal answering in favour of the assesse held that fiscally transparent entities or specifically partnership firms are entitled to treaty benefits. In reaching this conclusion the tribunal adopted two distinct lines of reasoning.

The first line of reasoning was primarily based on the contextual interpretation of art.4(1) of the treaty. The tribunal after citing several authorities on the interpretation of tax treaties stated that if the literal interpretation of a provision in a treaty leads to unreasonable results, the courts or tribunals should resort to contextual interpretation. In this case if art. 4(1) was to be interpreted literally then linklaters would not have qualified as a resident of UK as the income of the firm was taxed at the hands of the firm and the firm was not taxed per se in the UK (resident country). This interpretation in the tribunal’s opinion and correctly so would have been unreasonable as even though there would be no juridical double taxation (same entity taxed twice), there would in substance be an economic double taxation (same income taxed twice). As a result the tribunal adopted a contextual reading of art.4(1) and held that test embodied under the said article was that the “income of the person should be subjected to residence based taxation on account of some locality related attachment” in that contracting state. The following observations are apposite:

“Viewed in the light of the detailed analysis above, in our considered view, it is the fact of taxability of entire income of the person in the residence state, rather than the mode of taxability there, which should govern whether or not the source country should extend treaty entitlement with the contracting state in which that person has fiscal domicile. In effect thus, even when a partnership firm is taxable in respect of its profits not in its own right but in the hands of the partners, as long as entire income of the partnership firm is taxed in the residence country, treaty benefits cannot be declined.”

The second line of reasoning adopted by the tribunal proceeded on the premise that the actual payment of tax in one of the contracting states is not a condition precedent to avail the benefits of the tax treaty in the other contracting state. In light of this principle the tribunal held that the test laid down under art.4(1) is embodied to ascertain the fiscal domicile of an person (see heading to art.4), hence it is sufficient to show that the resident state has a right to tax the income of the partnership firm irrespective of the fact whether such a right is exercised by the resident state. The following observations are apposite in this regard:

“In our humble understanding, as long as de facto entire income of the enterprise or the person is subjected to tax in that tax jurisdiction, whether directly or indirectly, the taxability test must be held to have been satisfied. Of course, the other possible approach to such a situation is that as long as the tax jurisdiction has the right to tax the entire income of the person resident there, whether or not such a right is exercised, the test of fiscal domicile should be satisfied.”

In my view though the final conclusion reached by the tribunal on this point seems to be correct and will surely encourage professional services, the second line of reasoning requires further investigation as it is against the OECD report on partnerships.

Linklaters LLP: Territorial Nexus and International Tax Regime

In Ashapur Minichen ITAT Mumbai had confirmed that Ishikawajima-Harima ([2007] 288 ITR 408) does not continue to be good law in light of the retrospective amendment brought about by the Finance act, 2010.


In another case Linklaters LLP v. ITO the Mumbai ITAT has reiterated that the amendment made by the Finance Act, 2010 has negated the judgment in Ishikawajima. The important point though is that the court in Linklaters has stated that rendering of service in India is no more an essential ingredient for taxability of service in India u/s 9 of the IT Act, 1961. In other words the service can be taxed in India even if it is only “utilized” in India. However some of the observations in Linklaters can also be possibly interpreted to mean that “no territorial nexus” is required at all. For instance the court observes as under:

“It is fallacious to proceed on the basis that territorial nexus to a tax jurisdiction being sine qua non to taxability in that jurisdiction is a normal international practice in all tax systems”- Para. 17

“ ………in consonance with the school of thought discussed above and these amendment unambiguously negate the principle of territorial nexus which is the understructure of the line of reasoning adopted by the honorable courts above”- Para. 18

An interesting point that emerges is again with regard to India’s compliance with the international tax regime. In Ishikawajima Harima the court had noted that territorial nexus (utilized+ rendered) is a well accepted international tax principle. The court had further noted that “having regard to the internationally accepted principle and DTAA, no extended meaning can be given to the words ‘income deemed to accrue and arise’ in India. Considering this observation and the subsequent ruling in Linklaters where the court holds that Ishikawajima Harima is not good law, it is submitted that the impugned amendment in the Finance Act, 2010 is against well accepted international principles. However, this is subject to an investigation whether at the first place the concept of territorial nexus as suggested in Ishikawajima Harima (utilized+rendered) is indeed a well accepted international tax principle.
India’s compliance with the international tax regime has been a matter of previous discussion on this blog here. A further analysis of linklaters and Ashapur is available on the legal developments blog here and here.

Doctrine of Mutuality

In CIT v. Common Effluent Treatment Plant Association the Bombay High Court has reiterated that if an association satisfies the norm of mutuality in respect of some receipts contributed by its members it does not necessarily lead to the conclusion that all the activities of the association satisfies the test of mutuality. I say reiterated because the same principle of law had been enunciated by the Gujrat High Court in Sports Club of Gujrat v. CIT ((1988) 171 ITR 504) .


Before discussing the facts and ruling of the Bombay High Court, it is necessary to briefly elucidate on the Doctrine of Mutuality. The doctrine of mutuality revolves around the hypothesis that “No man can trade with himself’. For e.g., a mutual society, say a club generates a surplus after providing certain privileges such as accommodation, refreshments etc. to its members. This surplus of receipts over expenditure cannot be deemed to be income on the ground of doctrine of mutuality as the club receives the funds from its members and uses it to provide certain privileges to the same members (CIT v. Bankipur Club Limited [ (1972) 82 ITR 831]). In Chelmsford Club v. CIT, the Supreme Court propounded the following tests which would establish mutuality:

(i) The contributors to the fund are the same persons who are also the recipients from the fund.

(ii) The entity is incorporated only for the convenience of the members i.e. the object should not be to earn profit.

(iii) There is an impossibility that the contributors would derive profit from an activity where they are the contributors as well as the recipients of the funds.

In Common Effluent the assesse was an association formed for the purpose of setting up an effluent treatment plant for the members of the assesse who ran industrial units. The income of the assesse consisted of the contribution made by the members for setting up of the effluent plant. The assesse had surplus of receipts over expenditure i.e. the assesse collected more funds than what was needed. The main purpose for maintaining such a surplus as contended by the assesse was to meet any unforeseen circumstances. The assesse further invested the surplus funds in a bank as fixed deposits. In light of this background two issues had arisen before the court, (i) whether the surplus of receipts over expenditure for the purpose of setting up and maintaining the effluent treatment plant is exempt from income tax on the principle of mutuality and (ii) whether the income generated from bank fixed deposits is exempt from tax on the principle of mutuality.

The first question was answered in favour of the assesse. The court relying on Chelmsford held that the surplus income held by the assesse was solely for the purposes of providing common effluent facility to its members and hence was exempt from tax on the principle of mutuality. However, the court answered the second question in favour of the revenue. On this question the court concluded that the interest that is generated on investment of the surplus funds in fixed deposits is not income from the contribution of the members instead it is an income derived from a third party (in this case a bank). The assesse had put forth an interesting submission pursuant to the second issue. The assesse contended that as per S. 35(1) of the Bombay Trust Act, 1950 it was legally mandated to invest the surplus money as deposits in a bank. In essence the contention of the assesse was that the investment made as fixed deposits was a statutory obligation and was not tainted with commerciality i.e. the purpose was not to derive profits. In contrast the court correctly held that the Bombay Trust Act only mandated deposits and not “fixed deposits”. The court further opined that the purpose for investing in “fixed deposits” was to earn interests which would not be available on moneys maintained in ordinary, current or savings account; hence the investment was a prudent commercial decision. In arguendo, the court while relying on the Supreme Court judgment Totgars Cooperative Sale Society Limited v. ITO held that even if their was a statutory obligation to deposit the surplus as fixed deposits, the interests derived from the same would be chargeable to tax under the head income from other sources. However, as the court correctly noticed the question in Totgars was in relation to deduction u/s 80P of the IT Act, 1961 and not on the principle of mutuality.

Direct Tax Code 2009 and GAAR

Although it is fairly well settled under the Indian tax jurisprudence that tax avoidance is legal but tax evasion is not, the dividing line between the two has always been extremely thin and blurred. In Mcdowell v. Commercial Tax officer [AIR 1986 SC 649], Justice Chinappa Reddy while delivering a minority opinion had further blurred the distinction between tax avoidance and tax evasion. However, a smaller bench of the Supreme court in Azadi Bachao Andolan [(2003) 263 ITR 706] correctly did not endorse the minority view in Mcdowell, holding clearly that a man has every right to structure his business in a manner that would reduce his tax liability. Having said that in my humble view Azadi may be per incuriam as in Mcdowell, interestingly the majority might have concurred with some of the findings of Justice Chinnappa Reddy (para. 26&27 of the Mcdowell Judgement is relevant) making the latter a binding precedent.


It is widely believed that both the decisions would be rendered inconsequential if the provisions relating to the General Anti Avoidance Rules (GAAR) as incorporated in the Direct Tax Code Bill, 2009 are brought into force. In this post I shall discuss some of the provisions relating to GAAR in the Direct Tax Code and in some later posts I shall also look into the provisions of GAAR as it exists in some matured jurisdictions such as Canada, Britain, France etc.

The intent of incorporating the GAAR can be best explained by the relying on the discussion paper released by the department last year. The following remarks from the paper may be relevant:

24.1 Tax avoidance, like tax evasion, seriously undermines the achievements of the public finance objective of collecting revenues in an efficient, equitable and effective manner…………………….there is a strong general presumption in the literature on tax policy that all tax avoidance, like tax evasion, is economically undesirable and inequitable. On considerations of economic efficiency and fiscal justice, a taxpayer should not be allowed to use legal constructions or transactions to violate horizontal equity.



The intent echoes the sentiment of Justice Chinappa Reddy in Mcdowells and is in line with the aggressive tax policy undertaken by the department in recent times [See Generally: Geoffrey T. Loomer, The Vodafone Essar Dispute: Inadequate Tax Principles Create Difficult Choices For India, 21(1) NLSI. Rev. 89 (2009)] . Although the intent may be questionable or noble, the actual provisions relating to GAAR seems to be untenable.



S. 112(1) stipulates that the revenue may declare “any arrangement as an impermissible avoidance arrangement”. At first blush this clause seems to be very wide and gives blatant discretionary powers to the revenue. S. 112 not only empowers the revenue to declare “any” arrangement as impermissible but also gives it the power to disregard the arrangement, treat the parties who are connected to each other as one and the same person, re-characterising any equity into debt or vice versa and so on. Further, S. 113 (14) defines impermissible avoidance arrangement as under:


“impermissible avoidance arrangement means a step in, or a part or whole of, an arrangement, whose main purpose is to obtain a tax benefit and it,-

(a) creates rights, or obligations, which would not normally be created between persons dealing at arm's length;

(b) results, directly or indirectly, in the misuse, or abuse, of the provisions of this Code;

(c) lacks commercial substance, in whole or in part; or

(d) is entered into, or carried out, by means, or in a manner, which would not

normally be employed for bonafide purposes;

Conventional wisdom would suggest that S. 113 (14) imposes a limitation on the word “any” in S. 112 i.e. to say that the GAAR only gets triggered when the ingredients of S. 113 (14) are satisfied in a given case. But the interpretation can also be that S. 113 (14) is not exhaustive and the revenue may treat “any” other transaction as an impermissible avoidance arrangement even though it might not expressly fall within the ambit of S. 113(14). The discussion paper supports the former interpretation i.e. S. 113(14) imposes a restriction on the word “any” in S. 112. This interpretation is however rendered meaningless if one refers to S. 114 (1) which stipulates that an arrangement shall be presumed to have been entered for the main purpose of obtaining a tax benefit unless the contrary is shown by the person obtaining such a benefit. The effect of S. 114 (1) is fairly simple; the revenue might deem “any” arrangement to be for the main purpose of obtaining a tax benefit and if the assesse is unable to prove anything to the contrary the revenue would then be free to undertake the consequences as laid down in S. 112 even if the ingredients of S. 113 (14) are not expressly met.

Readers may also refer to a post written by Mihir here.

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?

Taxability of FIIs in India: Part 1

The economic times has stated here that the Bombay High Court has ruled that FII earnings aren’t taxable in India. This view/analysis is erroneous because the Bombay High Court did not have an occasion to consider the question of the taxability of FII earnings in India. In the concerned case, Prudential Assurance Company Ltd. v. DIT the assesse had obtained a ruling from the AAR in its favour i.e. the AAR held that the earnings of the petitioner a FII was not taxable in India. Subsequently there was a ruling by the AAR in Fidelity Northstar fund which stated that the earnings of a FII from selling of shares are taxable in India. Based on the Fidelity ruling the DIT proceeded to tax the petitioner on the ground that there was a change in law. It is in light of this background that the assesse invoked the jurisdiction of the Bombay high court under section 263 of the IT Act. The question before the court was whether the DIT was correct to hold that the AAR ruling obtained by the petitioner was not binding on the revenue as a consequence of a change in law brought about by the fidelity ruling. It is in this regard the Bombay high court held that the ruling obtained by the petitioner was binding on the revenue. The following paragraph of the Bombay high court judgement is apposite:

“Evidently, the Commissioner has ignored the clear mandate of the statutory provision that a ruling would apply and be binding only on the Applicant and the Revenue in relation to the transaction for which it is sought. The ruling in Fidelity cannot possibly, as a matter of the plain intendment and meaning of Section 245S displace the binding character of the advance ruling rendered between the Petitioner and the Revenue.”

It is clear that the question of taxability of FII’s in India had never arisen before the Bombay High Court. The following observation of the court manifests this point:

“We would clarify, in conclusion, that we have had no occasion having regard to the nature of the jurisdiction that was invoked by the Commissioner to inquire into the correctness of the ruling of the AAR in the case of the petitioner and we leave it open to the Revenue to take recourse to such remedies in law in respect of the ruling of the AAR, if so advised.”

Concluding the Bombay High Court does not in any way settle the law on the taxability of FII’s in India. In my subsequent posts I will attempt to analyse the present law (which remains largely unsettled) on the taxability of FII’s in India in light of the existing precedents.