Recently, the Authority for Advance Rulings (AAR) in the case of Royal Bank of Canada1 has held that the profits / losses on futures and options contracts (derivative transactions) carried out by Canadian entity would be in the nature of ‘Business Income’. Further since the entity did not have a Permanent Establishment (PE) in India, as per Article 5 of the India-Canada tax treaty (the tax treaty), the Business Income of the applicant would not be taxable in India.
While pronouncing the ruling, the AAR has also made some important observations on the taxation of income earned by Foreign Institutional Investors (FII) in India.
Facts of the case
The applicant, a public company incorporated under the Bank Act of Canada, is engaged in the business of banking and other financial services. It also trades in securities (including derivatives) in various parts of the world including India. In India, the applicant is registered as a FII with the Securities and Exchange Board of India (SEBI) since March 2008 and is mainly dealing in the derivatives segment of the Indian Stock Exchanges, where stock / index futures and stock / index options are traded. The derivative transactions undertaken by the applicant are part of its trading activity.
Issue before the AAR
- Whether the profits/losses from derivative transactions carried out by the applicant are to be treated as ‘Business income’ or ‘Capital gains’ under the Income-tax Act, 1961 (the Act) and the tax treaty?
If profits from derivative transactions are characterized as business income then in absence of PE of the applicant in India, whether such business profits are taxable in India?
- The applicant contended that the derivative transactions undertaken by it are part of its trading activity. The object in purchasing derivative is to resell the same at appropriate time and earn income. At times, the applicant sells derivatives first and then purchases them.
- The profits or loss arising from derivative transactions will be reflected as business profits in the financial statements and it will be taxed in Canada accordingly. Accordingly, the profits earned/or loss from derivative transactions should be characterised as business profits or loss.
- Further, the applicant did not have fixed place of business in India. Therefore, the applicant claimed that it does not have PE in India. Hence, in view of Article 7 of the tax treaty, the business income earned by the applicant from trading in derivatives is not taxable in India.
Tax department’s contentions
- The tax department contended that in terms of SEBI and Foreign Exchange Management Act Regulations, the applicant is only allowed to make ‘investments’ in the capital market in India. Therefore, the trading of derivatives on stock exchanges would also amount to an investment activity and the income earned from such activity would be in the nature of ‘Capital gains’.
- The tax department further contended that that the applicant’s income from dealing in derivatives has necessarily to be brought within the purview of section 115AD of the Act which is a self contained code applicable to the FIIs. It was argued that, for the FIIs, section 115AD contemplates income from dividend, interest and capital gains only. Therefore, the applicant could only have earned ‘capital gains’ from the transfer of securities which would be taxable in India under the provisions of section 115AD of the Act.
- The AAR observed that the issue of the character of income relating to exchange traded derivative contracts having a maximum of three months trading cycle has been considered by the AAR in the case of Morgan Stanley & Co2. In this case, the AAR held that the income earned by a UK company from exchange traded derivatives in India was to be regard as ‘business profits’ as per the provisions of India-UK tax treaty and it cannot be regarded as income in the nature of capital gains.
- Accordingly, after considering the decision of its own in the case of Fidelity North Star Fund3, the AAR held that income arising from the ‘derivative transactions’ is to be regarded as ‘business income’ and in the absence of PE in India of the applicant such ‘business income’ was held not liable to be taxed in India as per Article 7(1) of the tax treaty.
- The AAR also made some significant observations in the context of FII taxation which are given below:
- Tax department’s contention that there is a prohibition of trading in Derivatives under the FEMA or SEBI Regulations is unsustainable.
- Investment in Derivatives does not necessarily exclude trading transactions.
- Giving an undertaking for abiding by SEBI Rules and Regulations, would have no bearing on the characterization of income.
- The purpose and purport of section 115AD of the Act is to provide for special or concessional rate of taxation in relation to securities received or arising from the income of FIIs. The contention of the tax department that for FIIs there cannot be any income outside section 115AD is not sustainable.
- The observation of AAR in Fidelity North Star that there was no prohibition in law as far as the exchange traded derivatives were concerned cannot be faulted.
- Irrespective of the provisions of the Act, the applicant can seek the benefit of tax treaty provisions. If the income derived can be characterised as business income, such income cannot be taxed in the absence of a PE in India.
- A special provision in the Act cannot be pressed into service to deny the benefit which is otherwise due to FII under the tax treaty provisions notwithstanding their conflict with the domestic law of income tax.
In line with the earlier ruling in Morgan Stanley & Co. the AAR has once again ruled that FIIs income from trading in derivatives is ‘business income’ and not capital gains. Further in the absence of a PE in India, the business income would not be subject to tax in India.