TaxTMI 
TaxTMI 
2007 (1) TMI 545
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....resentative of the facts in all other cases. The applicant in AAR Nos. 694 of 2006 (for short " the applicant" ) is a scheme of investment fund organized as a Massachusetts Business Trust under the laws of the Commonwealth of Massachusetts (USA). It is set up to provide investors a continuous source of managed investments in securities. It is registered under the Investment Company Act, 1940 of the USA and is treated as a corporation for purposes of taxation in the USA. The beneficial interest in the funds is divided into transferable shares of one or more separate and distinct series. The applicant is being managed by a board of trustees, which has the authority and discretion in regard to investment/reinvestment of its fund and the power to declare and pay dividends. It makes investment in different parts of the world including India. It is registered with the Securities and Exchange Board of India (SEBI) as a sub-account of Fidelity Management and Research Company (FMR). Under the Foreign Institutional Investors regime the applicant invests in shares in Indian companies. To comply with the SEBI regulations the applicant appointed Brown Brothers and Harrimon Company as its global....
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....ome, the business income of the applicant in India from the sale of portfolio investments will be taxable in India at the rate of 20 per cent. in the light of section 115AD of the Income-tax Act, 1961 (hereinafter referred to as the " ITA" ) ? 2. In the comments of the Commissioner it is not disputed that the applicant is a trust registered under the provisions of the Investment Company Act 1940, of the USA ; that it is set up to provide investors a continuous income from managed investment in securities and it principally invests in equity shares. The applicant, it is stated, makes investment in India under the FII regime and for this purpose it is registered with the SEBI as a subaccount of FMR which was registered as a FII under the SEBI regulations. In compliance with the regulations, the applicant appointed J. P. Morgan Chase Bank (JPMCB) which in turn appointed Hongkong and Shanghai Banking Corporation (HSBC) as domestic custodian of the applicant. 3. The Commissioner raised a preliminary objection with regard to the jurisdiction of the Authority to pronounce ruling on the questions formulated by the applicant. Referring to the definition of " advance ruling" in section 245....
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.... income of FII in respect of securities or by way of long-term capital gain or short-term capital gain arising on transfer of securities and provides that no deduction under sections 28 to 44C and 57 of the Act would be allowed. Had the intention of Parliament been to allow a FII to trade in securities the business income would have been allowed to be computed under sections 28 to 44C of the Act. Further, any income payable to a non-resident is subject to deduction of tax at source but section 196D of the Act, a special provision meant for FIIs, provides that in the case of a FII Income-tax has to be deducted at source in respect of income from securities but not from capital gains in regard to which a FII has to specify an agent for the purpose of section 163 of the Act to obviate the need for deduction of tax at source from the capital gains. 4. It is noted that non-resident entities from jurisdictions where capital gains are exempted from taxation, are claiming the yield from transactions of sales and purchases of securities on Indian stock market as capital gains while in respect of identical transactions some others treat the income arising therefrom as business profits. The ....
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....account of the FII. Both of them receive their fees and commission. The activities of the fund manager and the custodian are not akin to the activities of a business venture but are in the nature of investment and management of properties. In view of the objectives of the trust, the special status of the applicant as a FII, the SEBI guidelines under which it is allowed to operate and the special provisions of the Income-tax Act, it can be inferred that the applicant has been engaged in investment activities and not in trading activities. Therefore the income from those securities by way of interest and dividends will be taxable under the head " Income from other sources" and profits from the transfer of such securities are taxable as capital gains. 7. It is, further, pleaded that having regard to articles 1 and 4(b) of Indo-US treaty (for short " the treaty" ) the applicant, being a trust, has placed no material to show that it is subject to tax in USA and therefore it cannot be treated as tax resident of USA so as to derive the benefit of the treaty. Even if it is entitled to the benefit of the treaty capital gains arising from transfer of securities are taxable in India. In rega....
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....es which are the subject matter of purchases and sales by the applicants, are held by the applicant by way of stock-in-trade so as to give rise to business income or investment in capital assets so as to yield capital gains. Mr. Desai has contended that the term " investment" is not determinative of the nature of the income arising from a transaction and that it would depend on the intention and the circumstances. For the purpose of the Income-tax the term " investment or investments" is to be taken in the business sense of laying out money for profit and the nature of the income has to be considered as per the Income-tax statute and not in the context of FII Regulations and not with reference to the terminology employed. The Income-tax Act and FII Regulations are not pari materia therefore, the Regulations cannot be taken into consideration for arriving at the character of income for the purpose of levy of Income-tax. The applicants devote their entire resources to the earning of income by trading in securities and do so after study and research in a business like manner ; merely because some securities are held by the applicant for relatively longer periods the income from transa....
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....capital gains is being raised before the Authority from time to time. We can with advantage refer to the following observation of the hon' ble Supreme Court in CIT v. H.Holck Larsen [1986] 160 ITR 67 (headnote) : " that the question whether the transactions of sale and purchase of shares were trading transactions or were in the nature of investment was a mixed question of law and fact." 13. In Fidelity Advisor Series VIII, In re [2004] 271 ITR 1, the Authority pointed out that whether a company was an investment company or a trading company or whether any amount received by a person was a revenue receipt or capital receipt was a mixed question of law and facts which had to be decided on the facts and circumstances of each case. After discussing the decisions of the hon'ble Supreme Court in Raja Bahadur Visheshwara Singh v. CIT [1961] 41 ITR 685, Dalhousie Investment Trust Co. Ltd. v. CIT [1968] 68 ITR 486, CIT v. Sutlej Cotton Mills Supply Agency Ltd. [1975] 100 ITR 706, A. V. Thomas and Co. Ltd. v. CIT [1963] 48 ITR 67 CIT v. P. K. N. Ltd. [1966] 60 ITR 65 and CIT v. Associated Industrial Deve....
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....rs-are of infinite variety. They do not fit neatly into categories or classes. Innominate contracts and transactions are of frequent occurrence, and I would not expect to find appropriate names to denote new kinds of operations devised for the sole purpose of gaining tax advantages. In the present case the question is not what the transaction of buying and selling the shares lacks to be trading, but whether the later stages of the whole operation show that the first step-the purchase of the shares-was not taken as, or in the course of, a trading transaction.' The real question as Lord Reid said was not whether the transaction of buying and selling the shares lacks the element of trading, but whether the later stages of the whole operation show that the first step-the purchase of the shares-was not taken as, or in the course of, a trading transaction." 15. In order to ascertain whether the first step-the purchase of the shares-was not taken as, or in the course of, a trading transaction we shall commence our discussion by making a survey of the legal framework and circumstances prevailing at the time when India extended the invitation to financial investors abroad for investme....
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....is scheme will benefit from a concessional tax regime of a flat rate tax of 20 per cent. on dividend and interest income and a tax rate of 10 per cent. on long-term (one year or more) capital gains. Necessary legislative amendment giving effect to this will be brought at the time of the 1993-94 Budget. All FIIs investing under the scheme even in 1992-93 will be covered." 17. The Modified Guidelines for FIIs (Taxation Aspect) [1994] 206 ITR (St.) 295 were issued by Press Release dated March 24, 1994. The following extracts are material for the present discussion : " Modified Guidelines for Foreign Institutional Investors (Taxation Aspect) The following modifications of FII Guidelines dated September 14, 1992 (See [1992] 197 ITR (St.) 173 ) in general, and paragraph 9(f) and paragraph 18 of those guidelines in particular, are issued by way of clarification in the light of the enactment of section 115AD of the Income-tax Act through the Finance Act, 1993 : The taxation of income of Foreign Institutional Investors from securities or capital gains arising from their transfer, for the present, shall be as under : (i) The income received in respect of securities (other than unit of o....
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....ee [2000] 99 Comp Cas (St.) 301 (for short " the FEMA" ) ; the Foreign Exchange Management (Foreign Exchange Derivative Contracts) Regulations, 2000 See [2000] 101 Comp Cas (St.) 217 (for short the " the FEM Regulations (Derivatives) of 2000" ) and the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations 2000 See [2000] 101 Comp Cas (St.) 152 (for short " the FEM Regulations (Security) of 2000 See regulation 1(1)" ). These regulations were framed in exercise of the powers conferred under the FEMA. Regulation 5 of the FEM Regulations (Security) of 2000 deals with permission for purchase of shares by certain persons resident outside India. Sub-regulation (2) of regulation 5 provides that a FII may purchase shares or convertible debentures of an Indian company under the Portfolio Investment Scheme, subject to the terms and conditions specified in Schedule 2 of the said Regulations. Schedule 2 deals with, inter alia, maintenance of account by a registered FII for routing transactions of purchase and sale of shares/convertible debentures and remittance of sale proceeds of shares/convertible debentures. Para 3 of Schedule 2 speaks of ....
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....hapter III (comprising of regulations 14 to 15A) which deals with " investment conditions and restrictions" . Regulation 15(1) enumerates securities in which a FII may invest. Further, the SEBI regulation 15(7) declares that the investment of the FII shall also be subject to the Government of India Guidelines (referred to above). Sub-regulation (1) of regulation 15A provides that a FII or sub-account may issue, deal in or hold, off-shore derivative instruments such as participatory notes, equity linked notes or any other similar instruments against underlying securities, listed or proposed to be listed on any stock exchange in India, only in favour of those entities which are regulated by any relevant regulatory authority in the countries of their incorporation or establishment, subject to compliance of " know your client" requirement and sub-regulation (2) thereof, requires a FII or subaccount to ensure that no further downstream issue or transfer of any instrument referred to in sub-regulation (1) is made to any person other than a regulated entity. The SEBI Regulation 18 enjoins every FII to maintain proper books of account, records etc. and reads as under (see [1996] 85 Comp Ca....
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....India and by the Reserve Bank of India from time to time under the provisions of the Act or any other law for the time being in force." 23. Mr. Desai has placed reliance on the SEBI Regulations 3(1) ; 15(3)(a) ; 15(3)(c) and Circular No. FITTC/CUST/23920/2002 dated December 6, 2002 issued by the FITTC department of the FII Division, SEBI and pleaded that trading activities are not prohibited under the scheme. The circular states that the SEBI has introduced the facility to directly upload these FII trades/ investments by local custodians. The regulations referred to above read as follows (see [1996] 85 Comp Cas (St.) 84, 85, 89) : " Regulation 3 (1) No person shall buy, sell or otherwise deal in securities as a foreign institutional investor unless he holds a certificate granted by the Board under these regulations. Regulation 15 (3) in respect of investments in the secondary market, the following additional conditions, shall apply : (a) the foreign institutional investor shall transact business only on the basis of taking and giving deliveries of securities bought and sold and shall not engage in short selling in securities ; . . . (c) the transaction of business in securit....
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....ed derivative is specifically permitted. In contrast there is no provision in the aforementioned Acts, Regulations or Guidelines of the Government of India, permitting trading in other securities. The obvious inference is that trading in other securities is not permitted ; in other words trading in securities other than exchange traded derivatives is prohibited. 27. From a careful reading of the above provisions, it becomes evident that the whole scheme meant for FIIs is to invest in securities in India to receive income from them so long as they hold the same and realize capital gains on their transfer. 28. We shall now turn to section 115AD of the Act. In so far as sub-sections (1) and (2) thereof are relevant for the present discussion, they are extracted as under : " 115AD. Tax on income of Foreign Institutional Investors from securities or capital gains arising from their transfer.-(1) Where the total income of a Foreign Institutional Investor includes- (a) Income other than income by way of dividends referred to in section 115-O received in respect of securities (other than units referred to in section 115AB) ; or (b) Income by way of short-term or long-term capital gain....
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....expenditure in obtaining loan, pay interest thereon, or incur expenditure of like nature. In our view it is against such deductions that Parliament guarded by providing in clause (a) of sub-section (2) of section 115AD of the Act stating that no deduction shall be allowed in computing income in respect of securities referred to clause (a) of sub-section (1). If we read section 115AD in conjunction with regulation 12(3) of the SEBI Regulations whereunder a subaccount of a FII is registered as a FII for the limited purpose of deriving benefit under section 115AD, it becomes clear that this is for the purpose of deriving the benefit of reduced rates of tax. 30. The circumstances and the framework of the plethora of legislative provisions unmistakably point out that a FII is not registered for carrying on trade in securities ; it can only invest in securities for the purpose of earning income by way of dividends and interest and realizing capital gains on their transfer. Indeed to the same effect is the finding of the Authority in the case of General Electric Pension Trust, In re [2006] 280 ITR 425. The following observation in that case is material (page 431): &nbs....
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....ted in the first few years and that the first step was not taken in the course of trading transactions. 33. We shall revert to the aforementioned principles. The first principle requires us to ascertain whether the purchase of shares by a FII in exercise of the power in the memorandum of association/trust deed was as stockin-trade as the mere existence of the power to purchase and sell shares will not by itself be decisive of the nature of transaction. We have to verify as to how the shares were valued/held in the books of account i.e. whether they were valued as stock-in-trade at the end of the financial year for the purpose of arriving at business income or held as investment in capital assets. The second principle furnishes a guide for determining the nature of transaction by verifying whether there are substantial transactions, their magnitude, etc., maintenance of books of account and finding the ratio between purchases and sales. It will not be out of place to mention that regulation 18 of the SEBI Regulations enjoins upon every FII to keep and maintain books of account containing true and fair accounts relating to remittance of initial corpus of buying and selling and reali....
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....vestment in capital assets the gains can be determined only on the sale of such assets. In the case of Fidelity Advisor Series VIII, In re [2004] 271 ITR 1 the Authority while laying down the aforementioned principles, noted the criteria to determine the said question. In spite of being aware of this position and even though the applicants are required to maintain such accounts under the SEBI Regulations, copies of the accounts maintained by them are admittedly not filed before the Authority to verify whether the requirements of the first principle are satisfied. In the absence of accounts we cannot but draw an adverse inference against the applicant, namely, had the accounts been produced before us they would have shown that the securities were not treated as stock-in-trade but were treated as capital assets and that the investments in securities were for the purpose of realizing capital gains. The ratio of sales and purchases are also not noted with reference to each applicant. The above discussion of the press note containing guidelines and various other provisions of different Acts and Regulations, at the least, raises a strong presumption that the transactions of purchases and....
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....companies are noted. From the perusal of the same it is not clear as to how the purchase and sales of shares were transacted in US dollars if the transactions were conducted in the stock exchange of India. In all other respects this application also suffers from the same deficiency of not producing the accounts and other relevant particulars to show that the transactions were in the nature of trade in securities. Therefore, the same result will also follow in this case also. 38. We shall now discuss the cases which dealt with this aspect earlier. In XYZ/ABC, Equity Fund, In re [2001] 250 ITR 194 (AAR) the then learned Chairman dealt with a similar question and observed that there was little doubt that the purchase of shares of the company in India was part of the company' s business operation. On that basis it was ruled that the income from the sale of shares would have to be treated as trading profit as and when the shares were sold. In Fidelity Advisor Series VIII, In re [2004] 271 ITR 1 (AAR) one of the questions which the Authority considered was, whether the income of portfolio companies arising from the sale of portfolio investments in India would be treated as busines....
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....also the income arising from purchase and sale of shares is business profit. 40. Questions Nos. (1) to (4) are common in all the applications of the US group. Question No. 1 is the main question. Questions Nos. (2) to (4) are consequential and need to be answered only if the Authority were to come to the conclusion that the transactions of sales and purchases of shares in Indian companies by the applicants amount to trading and the income arising therefrom would be taxable as profits and gains of business or profession. Inasmuch as we have held above that the aforementioned transactions of purchases and sales in securities were investment in capital assets leading to realizing of capital gains, questions Nos. (2) to (4) need not be answered. 41. In the Canada group of cases also question No. (1) is common in all the applications and is the main question. Questions Nos. (2) and (3) are consequential. They need to be answered only if the Authority were to come to the conclusion that the transactions of sales and purchases of shares in Indian companies by the applicants amount to trading and the income arising therefrom would be taxable as profits and gains of business or profession....