Stockbrokers, the major stakeholders of capital markets, have lately been facing critical issues on the income tax front which have arisen from their own type of business activities. This has resulted in a manifold increase in litigation for stockbrokers. Section 14(a) of the Income-tax Act, 1961, was introduced to cover cases where expenditure in relation to tax-exempt income such as agricultural income, income from dividend, etc, were being claimed as deductible expenses by the assessees.
Section 14(a) read with rule 8(d) of the Income-tax Rules, 1962, prescribes a formula for determining the quantum of disallowance of expenses incurred against the earning of exempt income, in cases where the tax officer is not satisfied with the correctness of claims of expenditure made by the assessees. This rule makes provision for disallowance of not only direct expenditure incurred against the earning of exempt income but also for disallowance of proportionate indirect expenditure. This goes against the main objective mentioned in the explanatory memorandum to the Finance Bill, 2001. Further, the application of rule 8(d) at times results in an exorbitant disallowance exceeding the exempt income. On top of this, the tax officers arbitrarily disregard the disallowance calculated by the assessees and invoke the method provided by rule 8(d) without examining into the correctness or otherwise of the suo motu disallowance calculated by the assessees. But recent judicial precedents on the subject matter have provided a sigh of relief.
Cash and future arbitrage transactions comprise purchases in cash segment and corresponding sales in the futures & options (F&O) segment. Upon settlement of F&O, stock price and future price are equal or close to equal. At that point, the arbitrageur reverses the trades. Upon completion of this stage, income from cash and future arbitrage is determined.
The tax authorities tend to view these transactions as involving two separate business activities that is the cash segment and the F&O segment, instead of a single integrated business activity. Generally, tax officers consider the loss in the cash segment as the difference of sale and purchase made in the cash segment, and see the loss incurred on the cash segment of the transaction as a loss from speculation business. So, they consider that the losses or profits in the cash segment cannot be related to the transactions in the F&O segment. These losses from the cash segment are not allowed to be set off against the profits from the F&O segment, on application of explanation to section 73 to the losses arising from the cash segment of such business activity.
In order to avoid the above-mentioned risk of denial of adjustment of speculative loss on cash segment against profit on F&O segment, some of the industry players have started considering gain on F&O segment of the arbitrage transaction as a speculative gain on a technical ground.
Dividend stripping
As stated in section 94(7), if the shares are purchased and sold within a period of three months from the record date, then any losses incurred (to the extent that such a loss does not exceed the amount of dividend income) shall be ignored for the purposes of calculating the income chargeable to tax. A plain reading of section 94(7) of the Act does not provide for any exceptional treatment for either capital loss or business loss. Thus, in the cases of the stockbrokers undertaking proprietary trading, losses pertaining to shares which have been purchased and sold during the stipulated timeframe may be ignored in calculations of the income chargeable to tax.
Generally, stockbrokers provide direct market access (DMA) to the FII fund for trading in India. In DMA, a fund manager can place the orders in the broker?s trading systems directly from abroad and the orders will be executed without any manual intervention from the broker?s end. Under this arrangement, the investor can have access to the real time position, current order, etc.
Certain investors also like to trade on the Indian stock markets using the strategy/algorithmic software. This software processes market information to identify the best available trading opportunities. An order is generated when the algorithmic software detects certain trigger conditions based on preset parameters.
Under this system, the stockbroker would hire a rack at the stock exchange in India where both these servers and software would be installed. The co-location server allows brokers to place their servers in the same place as the stock exchange?s trading engine, giving them faster access to order book data streamed from the exchange. Generally, the non-resident investment manager of the fund would own and control the server and the software for trading in derivatives in India on behalf of the fund.
In this case, considering India?s reservations towards the OECD commentary, it appears that a non-resident investment manager would have a permanent establishment (PE) exposure in India even if they were to use the infrastructure or services provided by a separate service provider. It follows that a fund using an investment manager?s services or infrastructure in India could also be said to have a PE in India.
In such case, the Indian broker can be considered to be a representative assessee of the fund under section 163(1) of the Act. Once a person is treated as an agent of a non-resident, he is treated as an assessee for the purpose of the Act. The representative assessee of the non-resident, as regards the income in respect of which he is a representative, is subject to the same duties and responsibilities as that of the non-resident.
In addition to these, there are instances of disallowances on account of loss on error trade, disallowance of expenses in connection with busted deals, etc. There is no end to the list. We hope that the new government will pay heed and work towards resolving these tax troubles.
(With inputs from Snehal Mehta, manager, PwC India)
The author is executive director, Tax & Regulatory Services, PwC India
