Fresh tax troubles brewing for FPIs

Local tax laws permit FPIs to set off losses made in one transaction against gains made in another to reduce their tax burden. However, this adjustment comes with a crucial rider that such a set-off is allowed only when both transactions fall under the same income category.

For many years, FPIs have been offsetting gains made on the derivatives market with losses made on listed shares. However, in some recent assessments, the tax department has taken the stance that such adjustments cannot be allowed since the nature of income is different. The divergence arises due to the distinction made in the nature of income, where derivatives’ profit or loss is considered business income or loss and can only be offset against business gains or losses, while cash market trading income or loss is categorized as capital gain or loss. Resident Indians are barred from offsetting the loss from cash market trades against profit from derivatives, since for them equity market gains/loss is considered capital gains/loss while derivative market gains/loss is considered business income/loss. But for FPIs it is allowed since both equity market and derivative market gains/loss for them is considered capital gains/loss. Such adjustment helped FPIs who used substantial derivative exposure as hedge against cash market trades. Hedging, a risk mitigation strategy, involves taking opposite positions on the same asset in cash and futures markets.

Without any relief, FPIs will be forced to pay up to 40% tax on derivative gains they made. The capital losses, however, can be carried forward to the next financial year. This interpretation may adversely impact the hedging strategies of foreign funds, which take exposure to derivatives as a risk management practice. Some of them typically take exposure to derivatives to offset equity risks.

An email sent to the spokesperson for the income tax department remained unanswered.

Tax experts say there have been numerous judgements by tax tribunals that have upheld such adjustments between income made in equity and derivative markets as valid.

“In a recent case of an American fund, a Mumbai tribunal has held that short-term capital loss from equities can be offset against short-term capital gains from other securities since there is no prohibition in the law for such loss offset. This ruling follows several previous rulings on this matter and allows gains from derivatives to be offset from loss on sale of equity shares,” said Rajesh Gandhi, a partner at Deloitte India. “A specific clarification from CBDT in this regard would, however, be welcome since it will provide certainty to investors and would reduce unnecessary litigation,” he added.

According to Section 70(4) of the Income Tax Act, a taxpayer is entitled to set off any loss against income made from any other source provided they fall under the same head in terms of tax code.

Now, resident Indians file any stock market gains under the head of capital gains during tax filings, while income from the derivatives market is filed under business income. Hence, they are not eligible to claim any adjustments between equity market gains and derivative market profits.

In contrast, both stock market gains and derivative market profits are considered capital gains for FPIs. Even in tax filings, they file both gains under capital gains. Hence, FPIs have been able to claim such a set-off.

“This stance being taken by the income tax department is a major concern for foreign funds, especially the ones who are active in the derivative market segment,” said one of the people cited above. “Also, in derivative trades made for hedging, there is a high possibility of derivative gain and equity loss. Such funds would directly be impacted.”

As a hedging strategy, funds often offset their exposure in Nifty 50 company shares by taking opposing positions in the derivatives market. This approach aims to mitigate potential losses from a substantial decline in the share price by capitalizing on gains achieved through contra positions in the derivatives market.

The second person cited above said the view being taken by the tax department needs to be upheld by the tax tribunals.