Foreign
Institutional Investors (Resident of Countries with which India has DTAA) (FII)
– Taxability on gains on transactions in Shares of Indian Companies & on Derivative.
1.
FII are incorporated in their respective
countries with an objective to trade in shares, bonds, securities etc.
2.
An argument is raise that since FII are carrying
on business in securities and in the absence of PE in India, their income from
dealing in shares is not taxable in India.
3.
Attempt is being made to understand what correct
legal position is.
For taxability of
Non-resident, deep analysis of provisions of DTAA is must. The basic purpose of
DTAA is to allocate the taxing rights among the contracting states on the
various types of Income. Here the UN Model Double Taxation convention is
considered for captioned issue, since most of DTAA, India has entered into with
various countries is based on UN Model.
For subject under
consideration, two relevant Articles of DTAA needs further examination.
1.
Article –
7 - Allocate taxability rights
on profits of ENTERPRISE of resident
Contracting state (Hereinafter referred to as Foreign state) with other
Contracting state (Hereinafter referred to as India). As per Article 7, India
get right to tax profit of Enterprise of foreign state, only if business in
carried through PE in India and that too only profits which are attributable to
PE.
2.
Article 13
– Allocate taxability rights on income from alienation of Property. Allocation
of taxing right between Foreign state and India has varied in various DTAA
entered into by India.
Further little elaboration of
Article 3(2) at this juncture is also required. It provides as under:-
“As regards the application of the Convention at any time by a
Contracting State, any term not defined therein shall, unless the context otherwise requires, have the meaning that it has
at that time under the law of that State for the purposes of the taxes to which
the Convention applies..”
Thus for interpretation of any
term not defined in treaty, reference shall be made to domestic tax law of
country but only if the meaning of said term is not coming out from context of
treaty (DTAA).
With reference income of FII arising from sale of shares of Indian
companies, the question for consideration is whether India gets taxability
right on such income under Article 7 or under Article 13.
Analysis of Article 7
1. Article
7 deals with allocation of profit of Enterprise of resident contracting state.
2. “Enterprise
of resident contracting state” is defined under Article 3 as ENTERPRISES carried on by person resident
of contracting states.
3.
However
the word “ENTERPRISES” is neither defined DTAA nor in India Taxation laws and
as a result profits of Enterprise is matter of Interpretation.
4.
One Interpretation is that all income accruing
to person from activities carried on as business would fall under the purview
of words “Profits of Enterprise”. Consider the following cases:-
a)
Owning immovable properties across Globe and
giving then on hire (Income for which Article 6 gives distribution rights
between the states involved)
b)
Purchasing shares and earn Dividend thereon only
(Income for which Article 10 gives Distribution rights between the states
involved)
c)
Lending money and earning Interest thereon
(Income for which Article 11 gives distribution rights between the states
involved)
d)
Developing patents , copyrights etc. and earn
royalty & Technical fees thereon. (Income for which Article 12 gives
Distribution rights between the states involved)
e)
Capital gain alienation of Properties (shares
etc.) (income for which Article 13 gives distribution rights between the states
involved)
5. Thus if person is carrying on either of
above activities in the nature of business, whether it will be right to state
that person is carrying on enterprise. It should not be, otherwise such
interpretation will render all other distributive Article (6, 10, 11, 12, 13)
will render useless.
6.
Thus
enterprise can be interpreted to mean any business activity pursue by person,
the income therefrom is not covered under the other distributive Article. In the treatise on Double taxation
convention by professor Klaus vogel, with reference to enterprise it is stated
that if a person is engaged in different gainful activities, to which different
distributive rules are applicable, then each activity will be subject to
respective distributive rule.
The next question for
consideration is whether shares come under the definition of property as
contemplated by Article 13.
Analysis of Article 13:-
Article 13(4)
Gains from the alienation of shares of the capital stock
of a company, or of an interest in a partnership, trust or estate, the property of which consists directly or
indirectly principally of immovable property situated in a Contracting
State may be taxed in that State.
Article 13(5)
Gains, other than those to
which paragraph 4 applies, derived by a resident of a Contracting State from
the alienation of shares of a company
which is a resident of the other Contracting State, may be taxed in that
other State if the alienator, at any time during the 12-month period preceding
such alienation, held directly or
indirectly at least ___ per cent (the percentage is to be established through
bilateral negotiations) of the capital of that company.
Article 13(6)
Gains from the alienation of
any property other than that referred to
in paragraphs 1, 2, 3, 4 and 5 shall
be taxable only in the Contracting State of which the alienator is a resident.
Article 13(4) deal with
alienation of shares of company, the property of which consist principally of
immovable property
Article 13(5) deals with
alienation of shares of company, where resident of contracting state held
prescribed % in capital of said company
Article 13(6) – Deals with any
property not covered in Articles 13(1),13(2), 13(3), 13(4) & 13(5).
From afore-said it is clear that context of treaty (Article 13(4) &
13(5)) required shares to be come under purview of 13. As a result, gains from alienation of shares, not forming part of
criterion specified in 13(4) & 13(5), would fall under the Article 13(6).
At this juncture, it is
necessary to look at relevant clause relating to Distributive rights on gain
from alienation of shares, in various DTAA entered into by India.
All DTAA entered into are either based on OECD model or UN Model
(Mostly) or US model (Only for US). All these models have relevant clauses as specified in
above-mentioned Articles 13(4) & 13(5). So unless DTAA entered into by
India, contains a specific clause, excluding shares from definition of property
contemplated in Article 13 of DTAA, it can be interpreted that intention of
Contracting states to include shares as a part of Property.
|
State
|
Relevant Clause
|
Remarks
|
|
Mauritius
|
Article 13(4)
Gains derived by a resident
of a Contracting State from the alienation of any property other than those
mentioned in paragraphs (1), (2) and (3) of this article shall be taxable
only in that State.
|
1. There
are no clauses as specified in model Article 13(4) & 13(5)
2. No
specific exclusion to Shares as a part of property
3. Thus
Shares can be interpreted as a part of property as specified in Article
13(4).
|
|
Singapore
|
Same as above
|
Same as above
|
|
USA
|
Article 13
Except as provided in Article
8 (Shipping and Air Transport) of this Convention, each Contracting State may
tax capital gains in accordance with the provisions of its domestic law.
|
Shares can be interpreted as
part of Article 13, since no specific exclusion is provided.
|
|
UK
|
Article 14
Except as provided in Article 8 (Shipping and Air Transport) of this
Convention, each Contracting State may tax capital gains in accordance with
the provisions of its domestic law.
|
Shares can be interpreted as
part of Article 14, since no specific exclusion is provided.
|
|
Canada
|
Article 13(2)
Gains from the alienation of any property, other than those referred
to in paragraph 1 may be taxed in both Contracting States.
|
Shares can be interpreted as
part of Article 13(2), since no specific exclusion is provided.
|
Thus
afore-said a conclusion can be drawn the gains from alienation of Shares are
covered Article dealing with Capital gains – Article 13.
Conclusion – India’s Distributive
Rights to tax gains from Alienation of shares.
1.
Though FII are engaged in the business of
trading in Shares, the income from Alienation/transfer of shares is covered by
Article 13, as discussed above, to the exclusion of provision of Article 7. Hence to examine the taxability right of
India under DTAA, the relevant Article is Article 13 not Article7.
2. Thus it cannot be argued that since FII are
carrying on business and they don’t have
PE in India, their Income cannot be taxed in India under Article 7. Rather it
is Article 13 which governs the taxability right of India over income of FII
from sale of Shares of Indian companies, for that PE presence is immaterial.
3.
As per OECD commentary on Article 13, if a state
gets a right to tax under Article 13, the taxability working is left to that
state, which may tax then as business profit or capital gains and levy tax
accordingly.
India Rights under Article
dealing with Capital Gain under various DTAA.
1.
India has entered DTAA with several countries
and aspect of Article 13 dealing with
sale of shares can be broadly divided into following categories:-
a)
Right to tax gain from transfer of Shares in
Indian companies executed by resident of foreign state, is with foreign state only (DTAA with Mauritius , Singapore).
b)
Right to tax gain from transfer of Shares in
Indian companies executed by resident of foreign state, is with both the states (DTAA with UK, USA)
2.
FII’s
Taxability when under DTAA right to tax is with only State of which FII is
resident – Under this case, India cannot levy any tax on Income of FII
arising from sale of their shares, irrespective of quantum of shares dealing
and irrespective whether FII has PE in India or not.
3.
FII’s
Taxability when under DTAA right to tax is with
both India and State of which FII is resident- In this scenario, the
questions for considerations are following:-
a)
What should be nature of Income – Business
Income or Capital Gains
b)
Whether FII are entitled to beneficial rates of
taxation u/s 115AD, if their income is treated as Business Income, since apparently
beneficial taxation rate is given for short term capital gains or long term
capital gains.
c)
Whether FII’s are entitled exemption u/s 10(38),
if their income is treated as business Income.
4.
The FII main business purpose is to deal in
shares, bonds, securities etc. and their volumes and frequency of trade
indicates that they are doing business and income therefrom be taxed as
Business Income.
5.
If FII’s income is taxed as business income, the
apparently they will be will not be entitled to following benefits, as the same
is available in the case of Capital gains only:-
a)
Exemption u.s 10(38) on long term capital on
sale of shares subject to Securities transaction tax (STT)
b)
Beneficial rate of tax @ 15% on short term
capital gain on sale of shares subject to STT
c)
Beneficial rate of tax @ 10% on long term
capital gain on sale shares subject to STT.
6.
In Most of the cases, the objective of FII are
to deal in shares etc. and they trade in India with objective to earn profit
and with large volume. If that be case, every FII income will be subject to tax
as business income and they will be denied the benefit u/s 115AD. In that
scenario, section 115AD will be rendered otiose and useless, which is not the
correct way of interpretation.
7. Thus in my view where under DTAA, India get
taxability right under Article 13, FII should be taxed at the rate specified in
section 115AD
FII”s Taxability on
Derivative Dealings
With above stated background in mind,
following issues merit attention in the context of Derivatives
1. Whether Derivative is a “PROPERY” covered
by Article 13?
a)
Derivative is a contract whereby the person gets
rights to buy or sell specified numbers of securities in future Date. In Indian
context, the contract expires on pre-specified expiry Date. On expiry date, the
Derivative contract is cash settled, with no transaction in buy or sell of
underlying security/index of securities.
b)
Context of Article 13 does not provide any
indication whether Derivative is ‘Property” or not.
c)
Going by Article 3(2) for interpretation of term
property with reference to Derivative, we need to refer Indian taxation laws.
d)
Under Income Tax Act 1961, Capital gains are
defined as transfer of Capital asset. Further Transfer is defined u/s 2(47) to
include any extinguish of rights in Capital assets.
e)
As per decision of Supreme court in Grace Collis 248 ITR 323, the expression ‘Extinguishment”
does include the extinguishment of rights in a capital asset independent of and
otherwise than on account of transfer.
f)
Going by above-said decision, it can be concluded
that since rights under derivative gets extinguished on expiry date, the gain therefrom
is a capital gain.
g)
Thus from Indian Taxation laws, an interpretation
can be drawn that “Derivative” is a property and hence covered under Article
13.
h)
If afore-said conclusion is sustained, then
taxability of FII on derivative will be governed by provisions as stated in
case of Shares above.
2.
Where
income from derivative is not covered under Article 13, then Article 7 will
deal with said income.
a)
Accordingly FII’s income from Derivative will be
taxable in India, only when FII’s has PE in India. If FII’s does not have PE in
India, then no Income from Derivative will be taxable in India.
b)
As a corollary of point (a) above, if FII’s
sustain loss in Derivative transaction, the same will also not be available for
set-off against Income from alienation of shares.
