Many people invest in the stock markets through portfolio managers. Funds are given to portfolio managers, generally on a discretionary basis, with the portfolio manager taking the decision and carrying out the transactions of buying or selling shares on behalf of the investor. The portfolio manager is paid a fee according to the agreement signed when the funds are given. At times, the fee is a fixed annual amount, at times a percentage of the value of the portfolio at the end of the year, at times a percentage of the appreciation in the value of the portfolio during the year, and very often, a combination of these.
Generally, these transactions are treated as being in the nature of investments and the income from sale of such investments is treated as capital gains of the investor. Are such fees paid to the portfolio manager deductible in computing capital gains?
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The issue has been controversial with some tax authorities taking the view that such fees are not deductible. Even at the appellate level, the Mumbai bench of the Income Tax Appellate Tribunal has held that such fees are not deductible, while the Pune bench of the Tribunal has recently held that the fees are deductible.
The tax laws provide that capital gain on transfer of an asset is to be computed by deducting expenses incurred in connection with transfer of the asset, cost of acquisition of the asset and cost of improvement of the asset. No other type of expenditure is allowable as a deduction. The portfolio management fees are certainly not a cost for improvement of the asset as there is no improvement in the asset on account of such expenditure. Can they be regarded as cost of acquisition or expenditure in connection with the transfer of shares?
To understand the deductibility, one needs to understand the nature of the services rendered by the portfolio manager in relation to which fees are paid. The role of the portfolio manager is primarily to formulate a suitable investment strategy for the client, identify suitable investments based on such strategy, purchase such investments, and monitor and sell investments based on the strategy. Incidentally, the portfolio manager also keeps an account of the shares so acquired and held in the portfolio. If one looks at the substance of the services provided, the portfolio manager is charging for services connected with the acquisition of the shares and services connected with the sale of shares, and all other services are incidental thereto.
Irrespective of whether the fee charged is a flat fee, a percentage of the value of the portfolio, or a percentage of the appreciation, the portfolio management fees being charged are for purchase and sale of the shares, and it is only the manner of quantification of the fee that differs. As rightly held by the Pune Tribunal, the expression “in connection with such transfer” has a wide meaning as interpreted by the Bombay high court, and all expenditure having a nexus with the transfer is allowable. Further, the payment of the fee to the portfolio manager is for the twin purposes of purchase of shares and sale of shares, which shows that the portfolio management fee has a direct nexus with the transfer of shares. Further, there is no need for bifurcation of the fee between purchase and sale because the part of the fee paid for purchase would form a part of cost of acquisition, while the portion paid for sale would be expenditure in connection with the transfer—in either case, it would be allowable.
It is interesting to note that in the case before the Mumbai tribunal, the taxpayer was unable to allocate the fees paid for portfolio management services between the shares sold and the shares held as investment on the last day of the previous year, nor was he able to give a definite basis on which such allocation could be made. It was on the basis of this fact that the tribunal held that no nexus was established between the portfolio management fees and the sale of shares.
It is, therefore, important to note that when the fees are being paid as a percentage of the appreciation, the fees paid in relation to the shares sold (whether the fees are paid in the current year or earlier years) should be computed and such fees alone should be claimed as a deduction and not the fees attributable to appreciation in the value of shares which remain unsold till year-end. Also, it needs to be kept in mind that long-term capital gains on sale of shares on a stock exchange is exempt from tax and accordingly the fees paid in relation to such long-term capital gains cannot be claimed as a deduction. It is only the fees attributable to short-term capital gains which can be claimed as a deduction in computing short-term capital gains on the sale of shares.
Of course, for the moment, the controversy as to the deductibility of portfolio management fees will continue till the matter is decided by the courts. Therefore, considering the cost of likely litigation, for most taxpayers where the amount of fees involved is small, it may not be worthwhile claiming such fees as a deduction, though it appears that such fees may be an allowable deduction in computing short-term capital gains on sale of shares.
Gautam Nayak is a chartered accountant
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