The Hindu Business Line : Losses when profits are seen as capital gains

THE Comptroller and Auditor General (CAG), in its recent report tabled before Parliament, has expressed concern over, if not castigated, the cavalier attitude of the tax administration in taxing the profits of the foreign institutional investors (FIIs) from their operations in the stock exchanges. It has expressed the view, shared and endorsed by many, that what is earned by FIIs from buying and selling shares is their business profit and not capital gains.

This view, and by extension the view of the C&AG, has been repelled by critics on the ground that the line dividing the dealer and investor is often blurred. A dealer's income according to them is admittedly taxable as business income while that of an investor is, of course, a capital gain. Their disingenuous argument, however, is that since the line dividing trade and investment is thin and diffused, the benefit of doubt must be given to the FIIs.

This is a dangerous proposition, the one that would consign the tax administration to passivity and fatalism. And going off at a tangent, some of them have even questioned the jurisdiction of the C&AG in the realm of policymaking. This too is wrong, for the role of the C&AG is not merely to attest the accounts as being done by auditors of the private sector. The C&AG does not wash its hands off with mere expression on truth and fairness of accounts.

It goes into the efficiency and effectiveness aspects of an organisation whose accounts are audited. In the event, it was perfectly justified in commenting adversely upon the tax administration's abject and pusillanimous surrender to the machinations of the FIIs. After all, FIIs have been accounting for a lion's share of the stock market volumes for around a decade now. While it is difficult to put a figure, they must have made considerable profits during this period.

That the tax administration has remained a mute spectator even as these worthies thumbed their noses at it is shocking, to say the least. Hopefully, it would be chastened by the slap on the wrist administered by the C&AG, and swing into action by going up to the apex court level if warranted. The tax that has gone abegging by the supine executive behaviour in this regard won't be inconsiderable.

For a variety of reasons capital gains has got the indulgence of Parliament, especially if they are of the long-term hue — sold after holding the capital asset after 12 months or 36 months according as it is share or other instrument traded in stock exchange or other assets. They are taxed with kid gloves after allowing a host of tax shelters. The Finance (No. 2) Act, 2004 did the unthinkable by going overboard and completely abolishing tax on long-term capital gains emanating from stock markets and replacing it with an apology of tax in the form of securities transactions tax (STT).

If anything, the STT should have been in addition to and not in substitution of capital gains tax. The capital gains of short-term variety similarly earned from stock exchanges is let off with a small 10 per cent tax. The mollycoddling capital gains has naturally tempted one, including FIIs, to jump into the capital gains bandwagon.

After the abolition of tax on long-term capital gains from stock market, the FIIs do not have to go through the rigmarole of channelising their investments into the Indian bourses through Mauritius with which India has an obnoxious treaty that completely exempts capital gains earned by residents of Mauritius.

Income is income. There should be no discrimination between any two types of income when it comes to taxation. The apologists of capital market speak with forked tongue when they lap up the tax sops to it but pontificate smugly when other segments of the society are given any tax concession. Ideally, therefore, the tax laws must be amended to give a parity of treatment to dealers and investors. But this is unlikely to happen in the conceivable future.

The tax administration should, therefore, gird its loins to pin down the FIIs as well as others who camouflage their business income as capital gains. The Supreme Court has shown the way by laying down a series of alternative guidelines or litmus tests to tell a dealer from an investor:

In order to determine whether one was a dealer or an investor, the real question is not whether the transaction of buying and selling the shares lacks the element of trading, but whether the later stages of the whole operations show that the first step — purchase of shares — is not taken as, or in the course of, a trading transaction (CIT vs H. Holck Larsen 1986 160 ITR 67).

Where on proper appreciation of evidence transactions in shares were aimed at nursing investments, the assessee must be treated as investor and not a dealer in shares (Larsen supra).

The mere fact that shares were not sold with any amount of frequency is not sufficient to establish that shares were held as investment and not as stock-in-trade (CIT vs Associated Industrial Development Co (P) Ltd — 1971 82 ITR 586).

Where from the very beginning purchase of shares is made with intention of selling them at profit, it is an adventure in the nature of trade (Rajputana Textiles (Agencies) Ltd vs CIT (1961 42 ITR 743).

Purchase and sale of shares for substantial amounts at frequent intervals cannot be treated as change in investments but treated as dealings in shares.

The tax administration should seek solace from these judgments. It has a strong case. FIIs are avowedly here to make profits. They make no bones about it. They are not here for a long haul. They make no bones about it either. They have no sentimental attachment to any scrip. They dump the shares without any qualms like any trader when the time is ripe to do so.

A careful reading of the apex court view would render bulk of the players in the stock market traders or dealers. Only the promoters and their associates would qualify as investors. Implicitly, the Supreme Court view also negates the legislative perception that mere holding for 12 months makes an investment long-term.

Be that as it may, the short point is the tax administration should bestir and act. It is no use wringing one's hands helplessly and cry resource crunch. Opportunities such as these must not be passed up. Certainly not without a fight.

(The author is a Delhi-based chartered accountant.)

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