The Hindu Business Line : Is the FM keen on joining the Sensex party?

Friday is all red. And tickers tell the story: `Sensex sinks 452 points,' `No respite from falling market,' `The beginning of the end or just a blip?', `Sensex crash course', and so on. All this, despite the Finance Minister jamming the brakes on Thursday, and terming the crisis a `manufactured' one based on `uninformed reporting'.

At the heart of the crisis is an otherwise innocuous document, `draft instructions' posted on www.incometaxindia.gov.in (see accompanying story, The fifteen commandments). The FM was aghast that people were reacting to `uninformed reports in newspapers', and therefore advised everybody to take `informed decisions'.

To be better informed, therefore, let us listen to what the experts say about the latest missive from the Central Board of Direct Taxes (CBDT).

"The move to lay down a set of guidelines to determine share transactions that would constitute `business' seems to have been motivated by the current hype in terms of both prices and volume," opines V. Ranganathan of Ernst & Young. "It appears as an effort to sensitise the tax officers to more consciously review transaction in shares, than passively accept the STT (securities transactions tax) dispensation."

What does he think of the historic dive of 826 points on Thursday? "The response of the FM that FIIs (foreign institutional investors) would not be affected by the proposed regime seems out of place and causing greater concern among non-FIIs, essentially small share investing community." How so? Because a ruling of the AAR (Authority for Advance Ruling) sometime back had categorised FII activity of shares as `business' on a given set of facts, points out Ranganathan. "The rather precipitate view of the FM on this looks more as a way of supporting the market than a valid legal clarification."

STT = Sensex Trading Tax?

Worryingly, the proposed guidelines are bound to raise the stakes of battle between the taxpayer and the officials on what constitutes capital gains or business income, says Ranganathan. "While some of the celebrated cases noticed in the existing clarification issued in 1989 by the CBDT provide good guidance, the temptation to convert the STT regime into a Sensex Trading Tax may be hard to resist, given the way the stock market has behaved over the last year or so." STT in new avatar!

If the guidelines come through, the punters have yet another imponderable on the their investments to contend with, alerts Ranganathan. "They would've to decide the amount of tax to pay when the gains are booked.

Is the FM keen on joining the Sensex party, asks Ranganathan. "When in mid-2004 the FM brought in a sea change in the taxation of gains from listed shares, he must have worked on the premise that it makes more sense to have an assured revenue on turnover (through STT) than rely on the vagaries of taxing the gain per se." Did it pay off? Yes, "Post this generous gesture, the markets have climbed to historical (hysterical) levels and he now seems seduced to join the party and take a greater share of the cake!"

He adds, "When the law was amended in 2004 to treat long term and short term capital gains as tax exempt and taxable at 10 per cent respectively (Sec 111A), upon payment of STT, it should have been quite obvious to lawmakers that the assessees would take it for granted that this dispensation was consciously ushered into the law, and that if there were an intention to bypass this scheme and treat the transaction as trading in shares, the rules for the same would have been very clearly laid out, contemporaneously."

Sameer Gupta, Director, Ernst & Young, adds, "It is pertinent to highlight that the instructions are not specifically in the context of FIIs or Funds, as widely believed. In the absence of a specific clarification from the CBDT, the same would apply to all categories of taxpayers." That widens the damage base, doesn't it?

New worries for FIIs

Kamdin Bahroze of KPMG feels that market swings are a cause for concern for the small investors. He says that FIIs from Mauritius are neutral whether the shares are characterised as business income or capital gains, as generally FIIs lack permanent establishment (PE) in India. "FIIs from the US and the UK are eligible to claim treaty benefits. They should have rejoiced since they'd benefit if the tax officer were to treat the shares held as stock-in-trade; for, the same would not be taxable in India if the FII lacks PE in India."

According to Bahroze, the new worries of FIIs would be whether they need to draw up books of account in India, whether they would have to obtain tax audit report here, and whether they have to undergo the hassle of engaging in a dialogue with the tax officer to prove that they don't have a PE in India.

"FIIs from non-treaty countries like Luxembourg and Hong Kong or FIIs which are not able to claim treaty benefits (e.g. transparent funds), would be adversely affected, as the profits earned on their activity in India may be characterised as business income and not capital gains, and so taxable at 33.66 per cent/41.82 per cent on net income basis after deduction of expenses." Watch out, therefore!

"The legislative history of FII taxation and the regulatory intention of allowing FIIs to invest in India appears to treat the shares held by FIIs in India as investment and not as stock-in-trade," states Bahroze. He sees the current controversy as arising out of the AAR ruling in the case of Fidelity Advisors Series VIII and General Electric Pension Trust.

There, it had been ruled that the FIIs had earned business income from their activity in India and not capital gains. "It was held that Fidelity's business income was not taxable in India as it lacked PE in India. However, in the case of GE Pension Trust, the AAR ruled that the fund was not eligible to claim treaty benefit as it did not satisfy the criteria of `residence'," informs Bahroze. The way forward, according to him, would be to make FII activity an exception in the final instruction that will be issued by the CBDT.

Why unsettle settled issues

R. Anand, a Chennai-based chartered accountant, finds that the `new' guidelines have been applied by the Assessing Officers (AOs) routinely to decide whether shares held by an assessee are investment or stock-in-trade. "Already, there is Instruction No.1827 dated August 31, 1989, crux of which dealt with principles laid down by the Supreme Court in the G.Venkata Swami Naidu & Co vs CIT (1959)," he informs.

Does the draft instruction provided clarity on the issue? No, says Anand. "It has only given a new twist to what was already settled. It has reiterated the stand taken by the CBDT on the subject. It also advises the AO that no single test is decisive and a sum total of various tests listed in the instruction should be considered to determine the nature of activity." Anand finds it strange that settled issues on a subject such as this should be unsettled all of a sudden.

What is the financial/commercial effect of the instruction, were it to become law? "Currently, an assessee holding shares as investment and retaining it for more than 12 months, and thereafter selling the shares is liable to long term capital gain," explains Anand. "If the share is a listed security and STT is paid, the long-term capital gain is nil. If the shares are sold before 12 months, and STT is paid, the assessee will pay short-term capital gain at 10 per cent."

In the proposed regime, a transaction of this nature could be categorised as business income, subject to the guidelines spelt out in the draft instruction. "Then, the business profits would be taxable at the effective maximum marginal rate of 33.66 per cent. This is the core issue, which has led to panic in the stock market, with FIIs unwittingly brought into the picture." Anand has a wry statement to wrap: "As a saying goes, `we always introduce a problem and then try to find a solution'."

Aren't we better informed now?

Tailpiece

"When you manufacture a crisis... "

"Yes, you should pay excise duty!"

http://Detaxification.blogspot.com

D. Murali

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