Profit from Portfolio Investment not business income

AIT News Network

NEW DELHI. Deciding  a bunch of applications by Fidelity Group vide a landmark ruling  AIT-2007-17-AAR ; the Authority for Advance Rulings(Income Tax) has ruled that the profits from sale of Portfolio Investment is not business income. As a fallout of the ruling FIIs become liable to capital gains tax on such transactions.

T H E   F A C T S

In this batch of forty cases,  thirty applications were filed by Fidelity Group of USA, nine by the Fidelity Group of Canada and one by the Matthews India Fund. The applicant in is a scheme of investment fund organized as a Massachusetts Business Trust under the laws of Commonwealth of Massachusetts (USA). It is set up to provide investors a continuous source of managed investments in securities. It is registered under the Investment Company Act 1940 of USA and is treated as a Corporation for purposes of taxation in USA.  The beneficial interest in the funds is divided into transferable shares of one or more separate and distinct series.  The applicant is being managed by a Board of Trustees, which has the authority and discretion in regard to investment/re-investment of its fund and the power to declare and pay dividends.  It makes investment in different parts of the world including India.  It is registered with the Securities Exchange Board of India (SEBI) as a sub-account of Fidelity Management and Research Company (FMR). Under the Foreign Institutional Investors regime the applicant invests in shares in Indian companies. To comply with the SEBI regulations the applicant appointed Brown Brothers and Harrimon Company as its global custodian who in turn appointed Citibank NA, Mumbai as its correspondent to act as domestic custodian for the applicant.  Both the global custodian and the domestic custodian are acting in the ordinary course of their business and are performing similar custodial services for many other FIIs.  The applicant is regulated by the laws in force in the commonwealth of Massachusetts USA and by the Securities Exchange Commission.  The investment manager of the applicant, FMR, is located outside India and it has no presence in India.  The applicant  does not have any branch office or place of business in India.  It purchases and sells shares/securities in India through brokers and the securities are held by the domestic custodian on behalf of the applicant. 

T H E   Q U E S T I O N:

On these facts the applicant seeks advance ruling of the Authority on the following questions:
  

1.   Whether on the facts and in the circumstances of the case, the profits arising to Fidelity Hastings   Street Trust: Fidelity Discovery Fund (hereinafter referred to as the “Applicant”) from the sale of portfolio investments in India will be treated as business income of the Applicant?

2.    Whether on the facts and in the circumstances of the case, the Applicant can be regarded as having a Permanent Establishment (“PE”) in India in accordance with Article 5 of the Agreement for Avoidance of Double Taxation and Prevention of Fiscal Evasion with Respect to Taxes on Income entered into between the Government of the Republic of India and the Government of the United States of America (hereinafter referred to as the “Treaty”)?  

3.    Whether on the facts and in the circumstances of the case, if the income is found to be in the nature of business income, in the absence of a PE in India and in light of the provisions of Article 7 read with Article 5 of the Treaty, such business income of the Applicant will be taxable in India?

4.   Whether on the facts and in the circumstances of the case, if it is found that the Applicant has a permanent establishment in India under the Treaty and if the income is found to be in the nature of business income, the business income of the Applicant in India from the sale of portfolio investments will be taxable in India at the rate of 20% in light of section 115AD of the Income Tax Act, 1961 (hereinafter referred to as the “ITA”)?

T H E   R U L I N G:

The germane question in all these applications is : whether securities which are the subject matter of purchases and sales by the applicants, are held by the applicant by way of stock-in-trade so as to give rise to business income or investment in capital assets so as to yield capital gains.  Mr. Desai has contended that the term ‘investment’ is not determinative of the nature of the income arising from a transaction and that it would depend on the intention and the circumstances. For the purpose of the income-tax the term “investment or investments” is to be taken in the business sense of laying  out money for profit and the nature of the income has to be considered as per the income tax statute and not in the context of FII Regulations and not with reference to the terminology employed.  The Income-tax Act and FII Regulations are not pari materia therefore, the Regulations cannot be taken into consideration for arriving at the character of income for the purpose of levy of income tax.  The applicants devote their entire resources to the earning of income by trading in securities and do so after study and research in business like manner; merely because some securities are held by the applicant for relatively longer period the income from transactions in securities cannot be considered capital gains. 

We find no force in the contention that for the purpose of classification of income the terminology or the context used in the FII Regulations cannot be used to determine the nature of the transaction as the FII Regulations  are drafted in a generic manner and cannot be determinative of the character of income as the Income Tax Act and the regulations and other enactments are not pari materia.   We are of the view that the classification of income has to be done under the law of the land and once it is classified under any of the heads of income under section 14 of the Act, the relevant provisions of the Act appropriate to that head of income will apply.     

In Fidelity Advisor Series VIII USA , the Authority pointed out that whether a company was an investment company or a trading company or whether any amount received by a person was a revenue receipt or capital receipt was a  mixed question of law and facts which had to be decided on the facts and circumstances of each case.  The Authority noted the following principles:-

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

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

3. ordinarily purchase and sale of shares with the motive of earning a profit, would result in the transaction being in the nature of trade/an 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 etc. then the profits accruing by change in such investment (by sale of shares) will yield capital gain and not revenue receipt.

The whole scheme  meant for FIIs is to invest in securities in India to receive income from them so long as they hold the same and realize capital gains on their transfer.

The circumstances and the framework of the plethora of legislative provisions unmistakably point out that a FII is not registered for carrying on trade in securities; it can only invest in securities for the purpose of earning income by way of dividends and interest and realizing capital gains on their transfer.  Indeed to the same effect is the finding of the Authority in the case of General Electric Pension Trust.  The following observation in that case is material:
“So far as the nature of the income of the applicant is concerned, it is no doubt true that the provisions of the FII investors scheme under both the old guidelines and the amended guidelines suggest that the investment in shares would be to acquire capital assets, the requirement of section 18 of the FII’s regulations also speaks of realization of capital gains of investment from the corpus.  Section 115AD – a special provision in the Act- provides special rates for taxation of short-term capital gains as well as long-term gains”.
In the light of the above discussion, we are unable to countenance plea of the applicant that trading in securities is not prohibited under any Act or Regulation.  

The scheme was meant for the FIIs to invest in securities in Indian companies for the purpose of earning income by way of dividends, interest etc and realizing capital gains on transfer of such securities and indeed they so acted in the first few years and that the first step was not taken in the course of trading transactions. 

From the accounts we would have been in a position to ascertain whether the shares have been entered therein as stock-in-trade or capital assets.  Under the principle of accountancy the stocks-in-trade have to be valued at the end of each year in the case of trading to arrive at the profits of the business whereas in the case of investment in capital assets the gains can be determined only on the sale of such assets.    In spite of being aware of this position  and even though the applicants are required to maintain such accounts under the SEBI Regulations, copies of the accounts maintained  by them are admittedly not filed before the Authority to verify whether the requirements of the first principle is satisfied.   In the absence of accounts we cannot but draw an adverse inference against the applicant, namely, had the accounts been produced before us they would have shown that the securities were not treated as stocks-in-trade but were treated as capital assets and that the investments in securities were for purpose of realizing capital gains. The ratio of sales and purchases are also not noted with reference to each applicant.   The above discussion of the press note containing guidelines and various other provisions of different Acts and Regulations, at the least,  raises a strong presumption that the transactions of purchases and sales of shares in Indian companies by the applicant are for realizing capital gains, which could have been rebutted by the applicant by producing all relevant records including accounts.  It has to be borne in mind that the transactions of sales and purchases as stock-in-trade is a fact known to the applicant but it failed to produce necessary records including the accounts to satisfy the Authority that transaction is nothing but trading.

Even assuming for the sake of argument that it is open to the applicant to trade in securities the material placed on record does not support the claim that the applicant ever intended or indeed has done any trading in securities in India. We are, therefore,  constrained to hold that the facts as disclosed and the material placed before the Authority do not help us to determine the criteria and   therefore, we are unhesitatingly led to the conclusion that the transactions are only in the nature of  investment in capital assets to earn capital gains.

( Click here for full text of ruling  AIT-2007-17-AAR )