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Loss on derivative transactions incurred by FIIs is in the nature of capital gains and not business income

12 December 2013

Background

Recently, the Mumbai Bench of the Income-tax Appellate Tribunal (the Tribunal), in the case of

Platinum Asia Fund1 and Platinum International Brand

Fund2 (jointly referred as taxpayers), held that the loss

from derivative transactions incurred by Foreign Institutional Investor (FII) cannot be treated as business loss and is in the nature of capital gains.

Facts of the case

The taxpayers are the sub-accounts of the FII Platinum Asset Management Ltd., registered in Australia and operating in India, registered with the Securities and Exchange Board of India (SEBI). The taxpayers are involved in purchase and sale of securities in India and trading in derivatives.

For Assessment Year (AY) 2006-07, the taxpayers filed NIL return of income respectively and claimed carry forward of short term capital loss after setting off losses from index derivative transactions against short term and long term capital gains respectively.

____________ 1 Platinum Asset Management Ltd, A/c Platinum Asia Fund, v. DDIT (ITA No.

2787/M/2012) dated 4 December 2013 2 Platinum Asset Management Ltd, A/c Platinum International Brand Fund v.

DDIT (ITA No. 2788/M/2012) dated 4 December 2013

The Assessing officer (AO) held that the loss arising from index derivative transactions were business losses and assessable under the head business income and could not be claimed as capital loss. Accordingly, the AO taxed the capital gains earned by the taxpayers. The Commissioner of Income-tax (Appeals) [CIT(A)] upheld the AO’s order.

Issues before the Tribunal

Whether loss from index derivative transactions is in the nature of business loss or capital loss?

Whether loss arising on derivative transactions can be set off against capital gains arising on sale of shares and if balance loss can be allowed to be carried forward?

Tax department’s contentions

Reliance was placed on the decision of the Bombay High Court in case of Bharat R. Ruia (HUF)

3 which

held that exchange traded derivative transactions carried out in AY 2003-04 were speculative in nature.

_____________ 3 CIT v. Bharat R. Ruia (HUF) [2011] 337 ITR 452 (Bom)

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Prior to amendment made by the Finance Act, 2005 in Section 43(5) of the Income-tax Act, 1961 (the Act), trading in derivatives was speculative transaction. After insertion of clause (d) in Section 43(5) with effect from 1 April 2006, transaction of trading in derivatives carried out on a recognised stock exchange is not speculative in nature, but is a business transaction and cannot be considered as an investment.

Taxpayers’ Contentions

Reliance upon earlier decisions of Platinum Investment Management Ltd, A/c Platinum International Fund

4,

wherein the Tribunal has held that gain/loss arising from derivative transactions is to be treated as capital gain/loss and not as business profit /loss.

The decision of Bharat Ruia was not applicable, since in the present case the taxpayers were FIIs.

The taxpayers, being FII, were not allowed to do business in the security market capital market. Derivative was a security as per Section 2(h)(ia) of the Securities Contracts (Regulation) Act, 1956. In case of the taxpayers, derivatives were capital asset and not business/trading asset.

The taxpayers were allowed to invest in Indian capital market and income arising from transfer of security was to be considered as capital gains as per Section 115AD

5 of the Act.

Reliance was also placed on LG Asian Plus Ltd.6

wherein the Mumbai Tribunal held that income earned by FIIs from exchange traded derivative transactions shall be taxable as capital gains in view of special provisions of Section 115AD of the Act.

Tribunal’s ruling

The decision of Bharat Ruia is not applicable in the present case.

The issue is squarely covered by the decision of Platinum Investment Management Ltd, A/c, Platinum International Fund that relied on LG Asian Plus Limited, wherein the following observations were made:

On a close scrutiny of the SEBI (FII) Regulations, 1995 together with Section 115AD of the Act, seen in the light of the Memorandum explaining the provisions of the Finance Bill, 1993, a FII is allowed to invest only in the `securities’ and further the income from securities, either from their retention or from their transfer, is to be taxed as per this section alone.

___________________ 4

Platinum Investment Management Ltd, A/c, Platinum International Fund vs. DDIT – ITA No. 3598/Mum/2010, dated 5 December 2012 (refer KPMG Flash News dated 28 January 2013)

5 Section 115AD of the Act provides concessional tax treatment in respect of long-

term capital gains and short-term capital gains arising to FIIs from transfer of shares and securities 6 LG Asian Plus Limited. v. ADIT [2011] 11 taxmann.com 414 (Mum.)

Once it is noticed that a FII can only ‘invest’ in `securities’ and tax on the income from the transfer of such securities is covered by a special provision contained in Section 115AD of the Act, the natural corollary which follows is that tax should be charged on income arising from transfer of such securities as per the prescription of this section alone, which refers to income by way of short term or long term capital gains.

If the tax authorities venture to make a distinction between such securities as constituting capital asset or stock in trade, which is not contemplated by the Central Government, as is evident from SEBI (FII) Regulations and the definition of FII in Explanation (a) to Section 115AD of the Act, then this provision will become otiose.

If FII receives any income in respect of securities or from the transfer of such securities, the same can be considered under Section 115AD(1) of the Act alone and Section 115AD(2)(b) of the Act cannot be invoked to construe it as `Business income’.

From the earlier Press Note7 issued by the

Ministry of Finance, it is abundantly clear that FIIs have been considered as ‘investors’ (and not traders). Secondly, income from the transfer of securities has been viewed as chargeable to tax under the head ‘capital gain,’ as long-term or short-term capital gain, depending upon the period for which such securities are held.

It is noticed that Section 115AD of the Act falls in Chapter XII of the Act which deals with determination of tax in certain special cases. It is a well settled legal position that specific provisions override the general provisions. In other words, if there are two conflicting provisions in an enactment, the special provisions will prevail and the subject matter covered in such a special provision shall stand excluded from the scope of the general provision.

Further Section 43(5) of the Act defining a ‘speculative transaction’ is relevant only in the context of income under the head `Profits and gains of business or profession’. It has no application to FIIs in respect of securities as defined in explanation to Section 115AD of the Act, income from whose transfer is considered as short term or long term capital gains.

_____________________________

7 F No. 5(13) SE/91-FIV dated 24 March 1994 issued by Ministry of Finance,

Department of Economic Affairs (Investment Division), New Delhi

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Income arising from the derivative transactions to the taxpayer, being a FII cannot be treated as business profit or loss, whether speculative or non-speculative, but the same has to be capital gain or loss. Further, loss from derivative transactions is to be considered as short term capital loss on sale of securities eligible for adjustment against short term capital gains on sale of shares.

Following the decision of the Co-ordinate Bench of the Tribunal, the Tribunal held that income from derivative transactions in case of the taxpayers cannot be treated as business profit or loss.

Our comments

The decision is the latest in a series of Tribunal rulings (as discussed above) which have held that owing to Section 115AD of the Act, derivative income for FIIs would be Capital Gains/ Loss and not Business Income, irrespective of whether such securities constitute capital asset or stock in trade.

It needs to be noted that earlier the Authority for Advance Ruling in case of Royal Bank of Canada

8, relying on

Morgan Stanley & Co. International Ltd.9, has held that

classification into capital gains or business income for the purpose of Treaty is necessary and that such income is not liable to tax under Article 7 of the India-Canada Tax Treaty in the absence of a Permanent Establishment in India.

However, based on the recent rulings, the tax officer is likely to strongly challenge any claim of the taxpayer that such income is business income and not capital gains/ loss. Taxpayers who had taken a position, based on the Advance Rulings or otherwise, that such income would be business income may possibly need to re-visit the position in view of the Tribunal rulings.

______________

8 Royal Bank of Canada, In re [2010] 189 Taxman 466 (AAR)

9 Morgan Stanley & Co. International Ltd, In re [2005] 142 Taxman 630 (AAR)

© 2013 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.

The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we

endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue

to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation.

© 2013 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative

(“KPMG International”), a Swiss entity. All rights reserved.

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