The Hindu Business Line : Set-off set to rest

India's favourable investment climate, coupled with an increasingly mature and attractive securities market, has attracted significantly high levels of Foreign Institutional Investor investment on a sustained basis. With the surge in FII activity and given that certain investment vehicles compute their Net Asset Value on an ongoing basis, their taxation in India assumes considerable significance. Historically, the FIIs have offered their income from transactions in Indian securities to tax as capital gains underSection 115AD of the Income-Tax Act,1961. An issue faced by the FIIs is the manner of set-off of capital losses incurred before April 1, 2002.

Up to (and including) the financial year ended March31, 2002 (effective April 1, 2002, the Act was amended to provide the manner of set-off of capital losses incurred on or after April1, 2002, inter se short-term and long-term capital assets. As per the amended provisions, short-term capital losses are now eligible for set-off against both short-term capital gains and long-term capital gains. However, long-term capital losses are eligible for set-off only against long-term capital gains) the Act permitted a tax payer to set-off losses from one source against income from another under the same head of income; capital gains constitute a head of income under the Act.

The set-offs

Therefore, a tax payer was required to set-off the capital losses incurred during the year (on transfer of short- and long-term capital assets), against capital gains earned during the year, in the manner prescribed under the Act. Where the net result of the above set-off was a capital loss, the tax-payer was permitted to carry this forward to be set-off against capital gains earned in eight subsequent years. However, where the net result of the set-off resulted in a capital gain, the tax-payer could use the capital losses for past years brought forward, if any, to set-off the net capital gains of that year. The manner of computation of capital gains and tax the liability thereon adopted by most FIIs is illustrated below:

Where an FII earned Rs100 of short-term capital gain (STCG), Rs200 of long-term capital gain (LTCG) and incurred short-term capital loss (STCL) of Rs10 and long-term capital loss (LTCL) of Rs110, the manner of set-off adopted by the FII was:

The total loss of Rs120 (STCL and LTCL) was first set-off against the STCG of Rs100,

The balance capital loss of Rs20 was then set-off against the LTCG of Rs200,

The balance LTCG amounting to Rs180, remaining after the set-off was taxed at 10 per cent (the then prevailing base tax rate) resulting in a tax liability of Rs18.

The Revenue view

The above manner of set-off was not accepted by the Revenue authorities. They contended that as the short-term and long-term capital gains were taxed at different tax rates (30 per cent and 10 per cent respectively), they are to be regarded as distinct sources of income. Thus, the Revenue authorities, in accordance with the Act, held that short-term and long-term gains and losses need to be determined separately before netting-off the net gains/losses interse. The manner of set-off adopted by the Revenue authorities using the same numbers was:

LTCL of Rs110 was set-off against LTCG of Rs200 and STCL of Rs10 was set-off against STCG of Rs100, and

The net capital gains, that is, Rs90 of LTCG and Rs90 of STCG were taxed at 10 per cent and 30 per cent respectively, resulting in a total tax liability of Rs36.

It is evident that while under both the approaches the total capital gain is identical (Rs180), the tax liability differs considerably (Rs18 versus Rs 36).

The Mumbai Income Tax Appellate Tribunal (ITAT), in Ravindra K. Mariwala vs Joint Commissioner of Income-tax [2003] 86 ITD 35 (Mumbai) held that since the Act draws a distinction between short-term and long-term capital gains, net long-term and short-term capital gains are to be worked out separately before netting the short-term and long-term and long-term gains/losses inter se.

When the aforesaid matter came up before the Mumbai ITAT in the case of an FII, counsel for the FII contended that the ITAT's decision in the Ravindra K. Mariwala case was not the correct view in the light of the provisions of the Act prevailing before April1,2002. On hearing the counsel for the FII and the counsel for the Revenue authorities, the Division Bench of the ITAT (two members) referred the matter to the ITAT President, which resulted in the constitution of a Special Bench (of three members).

Not distinct sources

After hearing the substantive arguments of the FII and the Revenue authorities, the Special Bench held that every transaction is a source of income with reference to transfer of an asset, thereby dismissing the Revenue authorities' contention that short-term and long-term capital assets are to be regarded as distinct sources of income. Further, it held that since the Act had not prescribed any order of precedence by which the loss arising from one source has to be set-off against income from any other source, it is the legitimate right of the tax-payer to choose the option which is more favourable to it so that it can avail itself of the benefit of the concessional rate of tax on long-term capital gains.

In the context of the ITAT judgment in the Ravindra K. Mariwala case, the Special Bench noted that the stress of the argument in that case was on the concept of `head of income' rather than on different `sources of income' comprised in a particular head of income. Therefore, the Special Bench noted that the ITAT perhaps did not consider the fundamental distinction between the `head of income' and different `sources' of income falling under a `head of income'.

The above judgment comes as a relief to the FIIs that have been keenly awaiting the outcome of this case before the Special Bench.

With the matter now settled, a number of cases pending with the ITAT and at lower levels, with taxes running into crores of rupees locked in, are expected to be favourably decided. Certainty and clarity in the matter is critical to retaining the attractiveness of India as an investment destination. Proactive clarifications by the Central Board of Direct Taxes on contentious issues would certainly be welcome.

(The authors are senior tax professionals with Ernst & Young.)

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