In income tax law, capital gains are taxed at a lower rate compared to business income, which is taxed at normal rates, usually 33.99%.
Capital gains are taxed at 22.66% (long term) and 33.99% (short term), with holding period of up to one year being considered short term. For listed shares sold on the stock exchange, long-term capital gains are completely exempt.
In relation to investments by overseas entities, such as Foreign Institutional Investors (FIIs), the distinction is equally crucial.
If the gains derived are in the nature of capital gains, then the FII tax rate is 10.33% (if short term), and nil (if long term) where sold through the stock exchange.
If the FII is registered in Mauritius, then capital gains, whether short term or long term, are exempt as per the India-Mauritius treaty, subject to certain—and usually straightforward—residence criteria.
If the income is business income, it doesn’t necessarily mean that it will be taxed in India, but more on that later.
The determination of the nature of income depends on whether the shares are held as capital assets or as trading assets (as in an investment vs. stock in trade). The issue of whether an asset is held as capital asset or trading asset is contentious, and given the significant gains involved in the light of the continuing bull run in India, the distinction is even more crucial.
Recently, the Central Board of Direct Taxes (CBDT) issued Circular No. 4/2007 dated 15 June, 2007, giving further guidance to both “assesses as well as for the guidance of the assessing officer.”
Those who keep track of these matters might recall that a draft circular was issued in May 2006 as well and led to a huge decline in stock prices, from which some mid-cap stocks have still not recovered fully. Several judicial precedents have been referred to, to bring out the distinction between capital asset and stock in trade.
The new circular has been issued as a supplement to an earlier circular of 1989 and reiterates the earlier judicial principles. It recognizes that a taxpayer could have an investment portfolio and a trading portfolio and hence income from shares could be in two baskets: capital gains and business income.
It also refers to certain judicial precedents, including an advance ruling in the case of Fidelity (8 January, 2007), in which the Authority for Advance Ruling laid down certain characterization principles.
These include the substantial nature of transactions, the manner of maintaining books of accounts, the magnitude of purchases and sale, among others. The authority also laid down another principle saying that when the object of investment is to derive income by way of dividend, the profits on the sale of such investments would be capital gains and not business income.
The 1989 circular and the 2006 draft had also laid down similar principles, though the 2006 draft was more elaborate and mentioned criteria, such as whether purchases were made out of own funds or borrowings, whether a transaction is by promoters of the company, both of which seem not really relevant.
For a non-resident seller, such as an FII, if the shares are trading assets, it does not mean that these would be taxed in India, since only business income attributable to an Indian permanent establishment is taxable in India.
Such an establishment is not necessarily a fixed place of business, but could also be business done through an agent who has the ability to conclude contracts, say, a broker, who has the power to conclude contracts on his own. This would usually not be the case, but questions relating to the role of a broker or an investment advisor, and whether there is a permanent establishment, could arise. However, the significant uncertainty and potentially long-winded litigation involved is something that an assessee has to reckon with.
The dividend-earning objective has been mentioned as a criterion in determining the characterization. But, let’s look at the reality: given the dynamic nature of the business landscape and associated risks, capital appreciation is normally a predominant motive of investment, getting dividends is usually secondary if that. In fact, the dividend yield ratio of the Sensex stocks is only 1.15 % and that of the Bombay Stock Exchange 100 is only 1.11%. As a result, this criterion can create considerable litigation and needs review, since, if this criterion were to be strictly applied, virtually all income from investment in shares would become business income, which cannot have been the intent.
Clearly, there is a need to recognize that the burden of proof is on the assessee. Additionally, a variety of circumstances would be taken into account, including the number and magnitude of transactions, the period of holding and the manner of accounting.
As far as accounting is concerned, it is important that the accounting classification should also be consistent with the stand taken. One important note of caution: while the circular has come into effect now, a taxpayer may need to reconcile the position that is being adopted versus the past position and some clarity on this would also be welcome.
Another dimension is the need to clarify the situation vis-à-vis private equity. In relation to private equity, the shares are normally held for a long period, but again not for earning dividends.
There have been judicial precedents that have concluded that shares held by a private equity fund in the circumstances of those case, should be considered as trading assets.
However, a private equity situation should more appropriately be treated as investments and not as stock in trade,and this needs to be clarified.
Ketan Dalal is executive director of PricewaterhouseCoopers. Your comments and feedback are welcome at firstname.lastname@example.org