Taxation — how PMS investors are taxed

Why tax sits in a portfolio manager's syllabus

A PMS client does not own "a PMS". The client owns the shares, bonds and units the manager buys in the client's own account. So every rupee of dividend, interest and gain is taxed in the client's hands, exactly as if the client had bought those securities directly.

The workbook teaches the law as it stood under the Income-Tax Act, 1961 (the "ITA"). Section numbers in this lesson are the workbook's.

10.1 Who is a "person"?

Section 2(31) gives an inclusive definition. A person includes:

1. An individual
2. A Hindu Undivided Family (HUF)
3. A company
4. A firm
5. An Association of Persons (AOP) or Body of Individuals (BOI), incorporated or not
6. A local authority
7. Every artificial juridical person not in the categories above

Items 5, 6 and 7 are persons even if they were not formed to earn income or profit.

10.1.1 Residential status decides what gets taxed

Tax is charged on total income. What goes into total income depends on residential status — and citizenship does not matter for this.

• A resident pays tax on world income.
• A non-resident — even an Indian citizen — pays tax only on Indian income.

You cannot compute total income until you know the residential status.

Until recently, status for an individual depended only on days of stay. From Assessment Year 2021-22, it depends on citizenship, period of stay, and Indian income.

The categories:

• Resident, split (for individuals and HUFs) into Resident and Ordinarily Resident (ROR) and Resident but Not Ordinarily Resident (RNOR)
• Deemed resident (new from AY 2021-22)
• Non-resident

The basic test for an individual

An individual is resident if he stays in India for:

• (a) 182 days or more in the previous year; or
• (b) 60 days or more (but less than 182) in the previous year and 365 days or more in the preceding 4 years

The exceptions to condition (b)

Exception 1 — "60 days" becomes "182 days" for:

• An Indian citizen or PIO visiting India whose Indian income is less than Rs. 15 lakh
• An Indian citizen who leaves India for employment during the year
• An Indian citizen who leaves India as a crew member of an Indian ship

So for these people, condition (b) effectively disappears — only 182 days makes them resident.

Exception 2 — "60 days" becomes "120 days" for an Indian citizen or PIO whose Indian income exceeds Rs. 15 lakh. If resident this way, he is deemed Not Ordinarily Resident.

Deemed resident — Section 6(1A)

An Indian citizen is deemed resident, regardless of days in India, if:

• his Indian income (total income excluding foreign-source income) exceeds Rs. 15 lakh, and
• he is not liable to tax in any other country by reason of domicile, residence or similar criteria.

A deemed resident is always Not Ordinarily Resident. And if someone is already resident under the normal tests, deemed residency does not apply.

"Liable to tax" (Section 2(29A)) means a tax liability exists under a country's law — and it still counts if an exemption was granted after the liability was imposed.

Not Ordinarily Resident — any one of four

A resident individual is NOR if any one is true:

If none applies, the individual is Ordinarily Resident (ROR).

A non-resident is simply someone who meets none of the conditions for being resident.

10.1.1.2 HUF

An HUF is resident unless its control and management is wholly outside India. If the decision-makers take even a single decision in India, part of control and management is deemed to be in India, so the HUF is resident. The workbook's example: accounts of a foreign HUF are sent to coparceners in India, and instructions on running the business are sought from and sent by them — that is control and management in India.

A resident HUF is NOR if its manager (karta) was non-resident in 9 of the 10 preceding years, or in India 729 days or less in the preceding 7 years.

10.1.1.3 Companies, firms and others

• An Indian company is always resident — even if it is a subsidiary of a foreign company or controlled from abroad. It can never be non-resident.
• A foreign company is resident if its Place of Effective Management (POEM) is in India during the year.
• A firm, AOP, BOI, local authority or artificial juridical person is resident if any part of control and management is in India. Partners' or members' residence is irrelevant. Substantial control in India is not needed — one decision is enough. It is non-resident only if control is wholly outside India.

10.1.2 Place of Effective Management (POEM)

The Finance Act, 2015 changed the company residency test: a company is resident if it is Indian, or its POEM is in India.

POEM is "a place where key management and commercial decisions that are necessary for the conduct of the business of an entity as a whole are, in substance made."

CBDT issued POEM guidelines in Circular No. 6/2017, dated January 24, 2017. They apply to foreign companies with turnover or gross receipts above Rs. 50 crore in the year.

10.1.3 Scope of total income

Read the RNOR column carefully. That is where the questions are.

10.1.4 Capital gains or business income?

Gains on selling securities are taxed either as capital gains (if held as a capital asset) or business income (if held as stock-in-trade). The workbook's six indicators of capital gains:

1. Intention at purchase was capital appreciation
2. Low transaction frequency
3. Long holding period
4. Shown as investments in the books, not stock-in-trade
5. Bought with own funds, not loans
6. The constitution document's main object is making investments

10.2 The streams of income

The ITA has five heads of income: salaries, income from house property, profits and gains of business or profession, capital gains, and income from other sources. Total income is the sum.

A PMS client may earn:

• Dividends from shares and mutual fund units
• Interest from fixed income securities
• Short- or long-term capital gains or losses — if gains are capital gains
• Business income or loss — if gains are business income

10.2.1 Capital gains — short or long?

Capital gain = sale consideration − cost of acquisition − certain expenses. Whether it is short- or long-term depends on the holding period:

Two special cases are always short-term, whatever the holding period:

• Specified Mutual Fund units acquired on or after 1 April 2023 — a fund with not more than 35% in equity shares of Indian companies
• Market Linked Debentures (MLDs)

10.2.2 Dividends

• Under Section 115-O, companies no longer pay Dividend Distribution Tax. Dividends are taxed in the shareholder's hands at applicable rates.
• A shareholder can deduct interest expense incurred to earn the dividend, capped at 20% of gross dividend.
• Section 80M: an Indian company receiving dividend from another Indian company can deduct it, if it passes the dividend on to its own shareholders at least one month before the due date for filing its return under Section 139.
• TDS: 10% for resident investors (if the amount exceeds INR 10,000); 20% or rates in force for non-residents; for FPIs, 20% under Section 196D (plus surcharge and cess) unless a treaty rate is lower.

Tax rates on dividend and interest for resident investors (the workbook's table):

Notes that come with it:

• Domestic companies with turnover or gross receipts not above INR 400 crore in FY 2022-23: 25%
• Companies opting for Section 115BAA: 22%; Section 115BAB: 15% (conditions apply)
• Under the Section 115BAC(1A) regime, surcharge is capped at 25% (instead of 37%). Someone with business income can opt back into this regime only once; someone without business income can choose every year.

10.2.3 Interest income

Same resident table as dividends. For non-residents, the ITA applies only to the extent more beneficial than a tax treaty. Interest earned by non-residents (corporate or not) is generally taxable at 40% / as per slab, unless conditions are met.

10.2.4 Business income

If gains are business income, tax is on a net income basis:

Buy-back of shares — read both paragraphs

The workbook gives two treatments one after the other:

• First paragraph: gains on buy-back (listed and unlisted) are exempt for investors; the company pays 20% distribution tax (plus 12% surcharge and 4% cess) on the difference between buy-back price and the issue price received.
• Second paragraph: with effect from 01 October 2024, the amount received on a buy-back under Section 68 of the Companies Act, 2013 is taxable as dividend in the shareholder's hands under Section 2(22)(f). No expense deduction is allowed under Section 57. Under amended Section 46A, sale consideration is taken as nil, and the cost of the shares becomes a capital loss, available for set-off and carry forward.

The workbook does not say in words that the first regime stopped. Read the date: the second treatment applies from 01 October 2024.

10.3 Section 9A — the safe harbour for offshore funds

The SEBI (Portfolio Managers) Regulations, 2020 let Indian fund managers serve overseas funds. The risk for such a fund: being managed from India could make it resident or give it a business connection in India.

Section 9A, inserted after the Union Budget 2015-16, provides a safe harbour. An eligible investment fund is not treated as having a business connection or as resident in India just because an eligible fund manager in India manages it — provided both meet the conditions.

The fund's conditions

Conditions (e), (f) and (g) do not apply to funds set up by a foreign government or central bank, a sovereign fund, or a Category I FPI under the SEBI (FPI) Regulations, 2019.

The fund manager's conditions

1. Not an employee or connected person of the fund
2. Registered as a fund manager or investment adviser under the PM Regulations 2020, the IA Regulations 2013 or the MF Regulations 1996
3. Acting in the ordinary course of business as a fund manager
4. With connected persons, not entitled to more than 20% of the fund's profits from transactions carried out through the manager