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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.

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.

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)

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.

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)

3. 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.

4. 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.

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.

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.

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.

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.

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