1. Taxing portfolio management services

Taxing portfolio management services

The intention of the taxpayer in appointing a PMS provider is key to taxation.

Published: November 7, 2014 1:40 AM

Portfolio Management Services (PMS) has emerged as a popular investment scheme over the past few years. PMS typically offers the investors customised investments in equity markets with an objective to earn high returns. This portfolio is managed by a portfolio manager keeping track of the equity markets. The PMS could either be discretionary or non-discretionary, depending on whether the investment is at the discretion of the fund manager and whether the client can intervene in the investment process. This has higher transparency of information and, unlike the mutual fund manager, the manager has higher flexibility in controlling the downside of the portfolio value.

Taxation of gains from PMS under the I-T Act has been a matter of debate.Various courts/tribunals have had conflicting views on the taxability of gains from PMS. There is a difference of opinion on characterisation of gains from PMS as business income or capital gains. The tax laws do not prescribe any specified duration of holding or frequency of trading for tax characterisation and tax officers use their own best judgment to arrive at a decision. This has been a source of dispute between investors and the taxman.

The Mumbai Tribunal, in the case of Salil Shah Family Pvt Trust, held that all decisions regarding investments, its timings, etc, are made by the PMS provider and not by the taxpayer, though the gain/loss is on the account of the taxpayer’s investment. Accordingly, the Tribunal held, the gains from PMS are taxable as capital gains and not business income. Further, the Tribunal, in the case of Radha Birju Patel, observed that the share transactions carried out by the PMS manager were in the nature of transactions for maximisation of wealth rather encashing the profits on appreciation in value of shares. Since the taxpayer was engaged in systematic activities of holding portfolio through the PMS manager, it could not be said that the main object of holding the portfolio was to make profit by sale of shares during the course of maintaining the portfolio investment over the period. The Pune Tribunal, in the case of ARA Trading & Investments P. Ltd, also held on a similar line.

On the other hand, if at the time of the deposit of the amount, the intention of the taxpayer was to maximise the profit and not create any wealth then such income could be taxable as business income and not capital gains. It is pertinent to refer to the decision of the Delhi Tribunal in the Radials International case where the Tribunal took a different view and observed that the purchase and sale of the shares under PMS was not in the control of the taxpayer at all. Therefore, it could not be said that the taxpayer had invested money under PMS with the intention to hold shares as investment. Since the portfolio manager, in the capacity of an agent, had traded in shares on behalf of the taxpayer, the resulting profits would be in the nature of business profits. Therefore, profits on share transactions carried through PMS scheme are taxable as business income. Subsequently, the matter went to the Delhi High Court, where the decision of Delhi Tribunal was reversed and the Court held that income from sale of shares invested through a discretionary PMS is taxable as capital gains and not as business income under the I-T Act. The Court also observed that while the portfolio manager had the discretion to invest on behalf of the taxpayer, he did not provide any guarantee about the appreciation of the securities invested in or that he would be responsible for any loss from the deficiency. From the terms of the PMS agreement, it does not emerge that the intention was to make profits. In a discretionary PMS, intention of the taxpayer ought to be evaluated post the fact of investment and not at the time of depositing the money with the PMS.

Generally, at the time of appointing the PMS provider, the taxpayer spells out the ‘Investment Objective’ in the discretionary PMS agreement. If the intention is to achieve a reasonable return over a long-term by investing in a focused portfolio stocks with good growth prospects across various sectors, then the income from PMS may result into capital gains and not business income. Therefore, it is important to understand intention of the taxpayer in appointing the portfolio manager, whether the intention is to invest a corpus in shares and securities for wealth creation or to maximise the profit. This will decide the characterisation of such income, i.e., business income or capital gains. Further, it is also important to take into consideration that the decision regarding investments, its timings, etc, are made by the PMS provider or by the taxpayer and the fact that such decisions taken by the PMS provider are not client-specific, but is taken for a whole range of clients in his portfolio.

The above discussion clearly shows that the characterisation of income from PMS either as business income or as capital gains has been a matter of debate, mainly since it is a fact-based analysis. While the courts/tribunal have laid down the principles to differentiate between the two kinds of transactions, there are still grey areas that have left room for interpretation. In order to reduce this litigation, it is desirable to have more clarity from CBDT to attain some element of certainty in the tax treatment. Clarification with respect to period of holding, volume, etc, would be welcome to avoid litigation.

By Punit Shah
Co-authored by Mrugen Trivedi, technical director-Tax, KPMG in India
Shah is Co-head of tax, KPMG in India.
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