Rider in new ruling makes FII income tax-free

In a landmark ruling on taxing of income from derivative transactions by foreign institutional investors, the Authority of Advance Ruling has said such income will be classified as "business income". However, to tax a business income, the laws require a permanent establishment of the FIIs in India.

Tax experts say it is a big relief for FIIs, since most of them operate from offshore with the help of local banks which act as custodians of such transactions.

The ruling, announced early this week, was for Royal Bank of Canada, a registered FII in India with Citibank as its settlement agent here. RBC had sought an advance ruling for a clarification on taxing the profit earned/losses incurred from transactions in future and option contracts traded on Indian stock exchanges. The experts say the ruling now overrides Section 115AD of the Income Tax Act which deals with taxation of income by FIIs from securities or capital gains arising from transfers.

The revenue department in its appeal to AAR had stated that there could not be any income outside the purview of Section 115AD as far as FIIs were concerned. Besides, Section 115AD classified all such income as "capital gains".

To this, AAR stated that this section was just to facilitate special or concessional rate of taxation on income of FIIs and could not be used as a blanket provision to deny any other classification of income of the FIIs.

In India, while business income for local companies of foreign entities is taxed at 55 per cent, capital gains is taxed at 20 per cent or less, depending on whether they have a double taxation avoidance treaty and rates specified therein. However, to tax a business income, the company has to have a permanent establishment in India. RBC, in its filings, had showed that it had a representative office in India but was engaged in core banking activities and did not play any role in FII related activities.

"Derivatives have a short life. They do not yield any income like dividends and, therefore, investment with a view to derive income is not feasible. Besides, volume of transactions is huge to justify that the trading is for business purposes and not for investment," the ruling said.

RBC had also sought an advance ruling on taxation of profit and losses arising from transaction on purchase and sale of equity shares or other tradable securities on Indian stock exchanges. To this, AAR reserved its ruling and stated that classification of such income depended on the fact that whether such transactions were in the nature of index arbitrage trading or for hedging activity.

Index arbitrage trading is simultaneous purchase or sale of equities and reverse (sale or purchase) of index futures. Such activity seeks to capitalise on difference between equities and index future prices.