India Tax: AAR rules FII income from derivatives trading is business income

In a taxpayer-favorable ruling issued 22 March 2010, the Indian Authority for Advance Rulings (AAR) concluded that income derived by a Canadian company from derivatives transactions is business income and is not subject to tax in India in the absence of a permanent establishment (PE) in India (M/s Royal Bank of Canada).

The case involved the Royal Bank of Canada (RBC), which is engaged in the business of banking and other financial services and also trades in securities, including derivatives, in various parts of the world. RBC is registered as a Foreign Institutional Investor (FII) with the Securities Exchange Board of India (SEBI) and mainly deals in the derivatives segment of Indian stock exchanges. RBC has no fixed place of business in India through which its business is fully or partly carried on; RBC does have a representative office in India that is engaged in certain preparatory and auxiliary activities relating to the banking business, but it does not play a role in carrying out derivatives transactions.

According to RBC, derivative transactions are undertaken as a part of its trading activities, i.e. the object of purchasing derivative is to resell them at an appropriate time and earn income, and the number of these transactions is substantial. The Indian tax authorities argued that SEBI and the Foreign Exchange Management Act, 1999 restrict RBC to making investments in the India capital market, and as the derivative transactions constitute an investment activity, the income derived therefrom would be in the nature of capital gains rather than business income. The tax authorities also argued that section 115AD of the Indian Income Tax Act, the provision that sets out the tax treatment of FIIs, contemplates only income from dividends, interest and capital gains, so that the income from the derivatives could not constitute business income.

RBC requested a ruling from the AAR as to whether income from the derivatives transactions and the trading in equity shares and other securities is business income under the India-Canada tax treaty and whether, in the absence of a PE in India, such income would be taxable in India.

The AAR agreed with RBC and held that profits from the derivative transactions are in the nature of business income and are not taxable in India in the absence of a PE and, further, that special provisions under domestic law (i.e. section 115AD) do not preclude an FII from earning business income in India.

In reaching these conclusions, the AAR first said that the term "investment" should be interpreted in a broad sense and that an investment in derivatives does not necessarily exclude trading transactions.

The AAR emphasized the importance of classifying the income for purposes of obtaining benefits under the India-Canada tax treaty (i.e. if characterized as business income, it cannot be taxed in India in the absence of a PE, but if characterized as capital gains, the income is liable to be taxed under the ITA). The AAR stated that the classification must be made "in accordance with the ordinary and well settled principles," and special provisions in the ITA cannot be used to deny benefits that are otherwise due to an FII under the treaty, notwithstanding their conflict with the domestic law.

The characterization of income as capital gains or business income is essential in determining the tax treatment of derivatives income. This determination is highly fact based and, once such income is classified as business income, benefits available under a relevant treaty cannot be denied.

TAX NEWS - may 2010

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