New Delhi: A few weeks ago, investors riding on the India Inc growth story had nothing to complain. The Indian economy was buoyant.
The Sensex stood at 12,200, an all time high, and a tax regime where tax on gains made by investors on sale of equities on the stock exchanges and redemption of equity oriented mutual funds were exempted in case the shares / units were held for more than a year.
Besides, in cases where these shares / units were held for less than 12 months, the applicable tax had been only 10 pc (plus education cess and surcharge of course).
Further, in case of Foreign Institutional Investors (FII)- the tax residents of a country with which India has entered into a Double Taxation Avoidance Agreement (DTAA), the gains on their investments were not be taxable in India.
However, the upbeat mood was not to last. On Thursday, May 18, 2006, there was a bloodbath on the bourses.
A convergence of global and domestic factors knocked the market off the cliff and sent it crashing.
One of the factors triggering the mayhem was said to be the draft circular by the Central Board of Direct Taxes (CBDT) - the apex Indian tax administration body.
Whether the transactions were entered into continuously and regularly during the Assessment Year.
The stated objects in the Memorandum and Articles of Association in the case of a corporate taxpayer.
Ratio of sales to purchases and holding.
The characterization of securities in the books of account and in balance sheet as stock in trade or investments.
Whether investment is in sister/related concerns or independent companies.PAGE_BREAK
The said draft circular proposed principles for determining whether a person was a 'trader' in shares or an investor.
The market read this as a move to change the tax structure of gains from equities.
In case gains from sale of shares are categorized as 'trading' gains, the above mentioned tax regime would not apply and these gains would be taxed at the existing tax rates applicable under the Indian Income-tax Act, 1961 (‘the Act’), i.e. typically 30 pc plus education cess and surcharge (the rate would be 40 pc, plus applicable education cess, and surcharge for non resident companies).
Reacting to this, the indices started spiraling southwards, recording one of the largest absolute declines in the Bombay Stock Exchange’s recorded history.
The Indian stock markets have been on a bull run on the India Inc story and fundamentally strong economic indicators since the last couple of years.
A huge amount of wealth has been created as a result of the stock market boom.
No wonder, the tax authorities have trained their guns on the manner of taxing gains being made on the stock market.
Previously, the tax authorities had denied some FIIs the benefits under the India-Mauritius tax treaty inter alia, on the basis that such FIIs were not tax residents of Mauritius.
This had led to an outcry against the action of the revenue authorities. The CBDT had to issue instructions clarifying the position of the tax administration in this regard.
However, this too was challenged in public interest litigation. It was finally, the Apex Court judgment that laid the controversy to rest.
Mindful of the situation, and to allay apprehensions, the revenue authorities recently stepped in to clarify the intentions around the draft circular.
The authorities mentioned that this was not a move to change the basis of taxation of FIIs (however, there is no clarity on whether it would then apply to 'individual' investors).
They also mentioned that the draft circular was intended only to ‘elicit public views’.
As per the existing provisions of the law, the profits of trade (or business) and gains made on investments are taxed differently.
The characterization of income between the two has always been a bone of contention between the tax authorities and the taxpayers.
The issue has been the subject matter of judicial scrutiny, historically.
The indicia discussed by the Apex court to distinguish trading from investment income, largely relies on the intention surrounding the transaction, while the enormity and frequency of transactions is also a critical factor.
However, even solitary transactions have been regarded as 'adventure in the nature of trade'.
Based largely on these principles, the CDBT issued instructions way back in 1989, to distinguish between shares held as stock-in-trade and shares held as investment.
In case the gains on sale of equities are categorized as business income or trading gains, these would be taxed at the applicable rates of 30 pc to 40 pc (plus education cess and surcharge) as mentioned earlier.
However, for non-residents, tax treaties, if applicable, may provide succor.
Non-residents from a country with which India has a tax treaty that may be able to argue that such business income is not taxable in India, in case they do not have a 'permanent establishment' in India.
No such technical arguments may be available to residents, for whom, coupled with the higher taxes, the securities transaction tax, (that was introduced when capital gain tax rates were brought down) would prove to a be a double whammy.
Further, in case such gains were taxed as business income, there would additional compliance and documentation issues.
These include the requirement to furnish a tax audit report, in case receipts are above a certain threshold limit, maintenance of books of accounts, etc.
Although, the proposed circular is only a draft to 'elicit public views', it would not be surprising if the tax authorities, especially at the lower levels, use the parameters mentioned in the circular to categories the gain on sale of equities as business gains.
Mindful of the obduracy of the tax authorities, till such time the legislation provides specific and objective criteria distinguishing between trading and investing income, the issue may go through protracted litigation.
All in all, the jury is still out on the subject and investors need to relook at their investment strategy in the backdrop of the above proposed draft circular.
The authors, Gaurav Taneja and Rakesh Dharawat, are senior tax professionals with Ernst & Young
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