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August 28, 2012 Fees Paid to Portfolio Managers Is Tax deductible: Tax Tribunal The Pune Bench of the Income Tax Appellate Tribunal (“Tribunal”) in its recent judgment in the case of KRA Holding and Trading Pvt. Ltd. (“Taxpayer”)1 has held that the fee paid to a portfolio manager, allowable under the Securities and Exchange Board of India (Portfolio Manager) Regulations, 1993 (“SEBI Regulations”), was deductible while computing the capital gains accruing from the sale of securities in the hands of the Taxpayer. The ruling assumes significance given the prevailing uncertainty regarding deductibility of fees paid to portfolio managers. This hotline contains a brief overview of the Tribunal’s judgment and the analysis of the same. Background In relation to its activity during the Assessment Year (“AY”) 2007-08, the Taxpayer had declared short term and long term capital gains on sale of shares and units of mutual funds. The tax officer, following its own orders for AY 2004-05, 2005-06 and 2006-07 in the Taxpayer’s own cases, considered the income declared by the Taxpayer as its business income from dealing in shares and securities, since in his view, the Taxpayer had carried out such transactions on a large scale in a systematic and continuous manner. The Taxpayer also claimed a deduction, from its income, of the performance fees and fees for maintenance paid to its portfolio manager (“Fees”) under the terms of the investment management agreement executed with the portfolio manager. The Fees paid by the Taxpayer was a ‘return based fees’, calculated as a percentage of the NAV of the securities. However, the tax officer rejected the claim of the Taxpayer and added the Fees paid to the portfolio manager to the income of the Taxpayer. On appeal from the order of the tax officer, the Commissioner of Income Tax, Appeals (“CIT-A”) held, following the judgment of the Tribunal in the Taxpayer’s own case, that for AY 2004-05 the income of the Taxpayer arising from the activity of dealing in securities was to be treated as capital gains and not as business income. However, on the second issue of deductibility of the Fees, the CIT-A held that the Fees could not be allowed as a deduction from either the business income or capital gains earned by the Taxpayer, since the said payments were not in accordance with the SEBI Guidelines, and further because the payments were made for different services, which were distinct from the act of purchase or sale of the shares. Aggrieved by the order of the CIT-A, the revenue department and the Taxpayer filed cross appeals before the Tribunal on the aforesaid two issues. Proceedings before the Tribunal: The Tribunal considered the cross appeals filed by the revenue and the Taxpayer on both issues. First, in respect of the appeal filed by the tax department, considering the nature of the income of the Taxpayer, the Tribunal observed that it had in the Taxpayer’s own case accepted the claim of the Taxpayer that its income from sale of shares and units of mutual funds was in the nature of either short term capital gains or long term capital gains, depending upon the period of holding of such assets. The Tribunal noted that although the tax department had appealed from the judgment of the Tribunal to the Bombay High Court; the High Court had not rendered any decision on the issue and hence the judgment of the Tribunal stood effective as on date of the judgment. Accordingly, it dismissed the appeal of the revenue department on the first issue. In reference to the appeal filed by the Taxpayer seeking allowance of deduction of the Fees, the Tribunal observed that Regulation 14(3)(a) the SEBI Regulations provided that the fees charged by a portfolio manager could be a ‘fixed fee’ or a ‘return based fee’ or a combination of both, and hence the Fees paid by the Taxpayer was in accordance with the stipulations of the SEBI Guidelines. Accordingly, the tax authorities were not justified to rejecting the claim of the Taxpayer on this ground alone. The next issue considered by the Tribunal concerned the deductibility of the Fees under Section 48 of the Income Tax Act, 1961 (“ITA”). Section 48 of the ITA provides that while computing income chargeable under the head ‘capital gains’ the amounts which may be classified under any of the following categories would be deductible: 1. Expenditure incurred wholly or exclusively in connection with the transfer of capital asset under Section 48(i); or 2. The cost of acquisition of the capital asset and the cost of improvement thereto under Section 48(ii). Hence, any amount which may be classified under either of the above mentioned categorizes of Section 48 would be available for deduction from the consideration accrued or received by a taxpayer. In order to determine whether the Fees could be deducted under Section 48 of the ITA, the Tribunal first referred to the case of CIT v. Shakuntala kantilal2 wherein the Bombay High Court had opined that as long as the expenditure in question is genuine and incurred in connection with the transfer of the relevant capital asset, the same may be deducted from the full value of the consideration received or accruing to a taxpayer by virtue of the provisions of Section 48. The Tribunal observed that the genuineness of the Fees payment was not challenged by the tax department before it. Further, for the purposes of interpreting the expression ‘wholly and exclusively in connection with the transfer’ as appearing in Section 48 (i) of the ITA, the Tribunal referred to a judgment of the Supreme Court of India3 wherein the terms ‘wholly’ and ‘exclusively’ were considered. In that judgment, it was held that the first adverb ‘wholly’ refers to the quantum of the expenditure and the second adverb ‘exclusively’ refers to the purpose behind the expenditure. Regarding the ‘purpose’ of the payment of the Fees to the portfolio manager, the Tribunal had observed in its earlier judgment (for the AY 2004-05) that this expenditure was incurred for the twin purpose of acquisition and sale of the Taxpayer’s securities and hence could be considered as ‘exclusively’ incurred for the share transfer under the terms of Section 48 of the ITA. The Tribunal also noted that the payment of Fees to the portfolio manager was a percentage of the NAV of the securities only, and not any other component of the income, and hence could be considered as incurred ‘wholly’ in connection with the share transfer under Section 48. Interestingly, the Tribunal refrained from ascertaining the portion of such Fees would be deductible under Section 48 (i) as expenditure incurred wholly and exclusively in connection with the transfer of the securities, and under Section 48(ii) as the cost of acquisition and the cost of any improvement of the shares, since in its view this attribution was purely an academic exercise. Analysis The above summarized judgment of the Tribunal is particularly relevant to the clients of SEBI registered portfolio managers acting under the SEBI Guidelines. The Tribunal in this case has held that to the extent the fees paid to a portfolio manager is linked to the NAV of the shares or securities of a taxpayer, the same should be permitted to be deducted from the capital gains of the taxpayer from transfer of such shares or securities by virtue of Section 48 of the ITA. Notably, there are certain other decisions, including that of Tribunal (Mumbai Bench)4, wherein the fees paid by taxpayers to portfolio managers have been held as not deductible from capital gains accruing to the taxpayer. These judgments are not in consonance with the above analyzed decision of the Tribunal. In our view, where there are two interpretations possible in respect of a provision of the ITA, the one which is beneficial to the taxpayer should be adopted. The decision of the Tribunal is a welcome ruling on the grounds that it is only reasonable to give the benefit of the expense incurred by investors in form of Fees paid to the portfolio managers. However, given divergent view of the various benches of the Income Tax Appellate Tribunal, there is an urgent need for clarity and finality on the issue which could possibly be achieved either through legislative action or the matter coming up for hearing before the Supreme Court. If the subject decision of the Tribunal, is ultimately held to be good law, in our view the principals laid down in the judgment would also apply to a situation where income of a taxpayer arising from dealings in shares and securities is held to be in the nature of business income (as opposed to capital gains), and it should be possible for the taxpayer to claim a deduction of the fees paid to the portfolio manager so long the fees is wholly and exclusively for the purpose of the business as mandated by relevant provisions of the ITA. Additionally, once this issue is clarified, it would also be interesting to see if the same benefit could be granted in respect of fees paid to managers of private equity funds and other investments managers.
__________________ 1 KRA Holding and Trading Pvt. Ltd. v. DCIT Circle 11(1) Pune, ITA No. 356/PN/ 2011 2 190 ITR 56 (Bom) 3 Sasoon J David & Co Pvt. Ltd. v. CIT, 118 ITR 261 (SC) 4 Shri Homi K Bhabha v. The Income Tax Officer (International Taxation) 3(1), ITA No.3287/Mum/2009
- Vivaik Sharma & Abhay Sharma You can direct your queries or comments to the authors
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