Derivatives Vs Shares: Tax Clarity On The Horizon

As we continue to witness the upward trajectory in the Indian financial markets, one cannot skip the multifold rise in the volume of derivative transactions. This traction in the derivative segment involves equivalent interest from global investors. For these investors, it is imperative that they factor in the applicable tax cost in India while charting their growth strategies to assess the net impact.

Derivatives are financial instruments - such as futures and options - which track the value of the underlying assets (including shares and commodities). For foreign portfolio investors in India, the derivative income is treated as capital gain and taxed at the rate of 30% (plus applicable surcharge and cess). However, taxability of a foreign entity is subject to beneficial provisions under the applicable tax treaty. Several tax treaties that India has entered (including with Mauritius, Singapore, Luxembourg, Ireland) extend an exemption from Indian taxes on the derivative income. 

On the other hand, gains on sale of shares in an Indian company are taxable in India at a rate ranging from 12.5% to 35% (plus applicable surcharge and cess), depending on the period of holding of such shares. Unlike derivatives, most tax treaties do not provide for any tax exemption on capital gains from sale of shares in an Indian company.

This differential treatment has resulted in the tax department claiming that derivatives are akin to shares and hence, the tax treaty exemption should not be available for them either. 

In one such recent case, Sigma Global Fund, a Mauritius based Fund claimed the tax exemption on derivative income under the India-Mauritius tax treaty. The tax department denied the exemption by claiming that derivatives are closely related to shares. However, the Income Tax Appellate Tribunal noted the difference in the features of derivatives and shares, including the fact that holding a share grants certain rights in the company whereas a derivative is only a contract which derives value from the performance of the underlying share. The Tribunal also considered another ruling which held that units in mutual funds are not shares. Ruling in favour of the fund, the Tribunal concluded that derivatives cannot be equated to shares and affirmed the tax exemption claimed under the India-Mauritius tax treaty.

What Next?

The courts have time and again acknowledged the legal and economic reality of these transactions while adjudicating on tax matters. So far, the courts have accepted that derivatives, mutual funds and rights entitlements are not equivalent to owning a share and affirmed tax exemptions claimed by the investors under relevant tax treaties. These rulings should assist the investors who are eligible for tax treaty benefits, in evaluating their respective tax positions.

Interestingly, the aforesaid position has been coded under the Indian tax law itself with respect to certain GIFT City Funds. To elaborate, a GIFT City Fund which is set up as a Category III Alternative Investment Fund and comprised of only overseas investors (except for the sponsor / manager) is exempt from tax on derivative income. Additionally, distributions by such GIFT City Funds to its investors are also tax exempt. Noting that GIFT City is set up as an International Financial Services Centre, the tax regime for these funds has been kept on par with an overseas fund investing directly in India (and more favourable in certain instances). These amendments also reflect that the legislature treats derivatives as different from shares for the purpose of taxability in India which further strengthens the tax position for overseas investors.