2025 (7) TMI 1284 - AT - Income Tax

Income deemed to accrue or arise in India - tax or not to tax the income from Derivatives - whether Derivatives are instruments other than shares and would fall within Article 13(4) of India-Mauritius DTAA to be taxed in Mauritius? - taxability in Host country - definitions of shares and securities under the Companies Act - AR argued Derivatives are separate instruments and just because the underlying asset can be in the form of shares cannot be the reason for denying the applicability of Article 13(4) of India-Mauritius DTAA. Whether Derivatives are shares the alienation of which is taxable under Article 13(3A) or whether Derivatives are other than shares to be taxed as per Article 13(4) of the India-Mauritius DTAA? - HELD THAT - Section 2(84) of the Companies Act defines shares as a share in the share capital of a company and includes stock. . The owner of the shares has various rights including voting right. Though the term Derivatives is not defined anywhere the term securities defined under section 2(81) of the Companies Act as per clause (h) of section 2 of the Securities Contracts (Regulations) Act 1956 (42 of 1956) includes derivatives. Therefore it is clear that as per the Companies Act shares and derivatives are considered as separate assets. Before deciding whether shares and derivatives are difference we will first examine what is a derivative and its salient features. In general parlance Derivative is a financial contract between parties whose value is derived from the changes in the value of underlying assets. The underlying assets can be in the form of shares bonds commodities like gold or silver currencies interest rates and market indices. In layman language a typical derivative contracts is where the parties involved enter into contract to buy/sell the underlying asset at a particular price at an agreed future date in order to mitigate the risk of price fluctuation of the underlying asset. The derivative contract is a complex financial product that gets traded in the exchange or over the counter and the investor earns profits or ends up in making loss without actually buying or selling the underlying asset. We have no hesitation in holding that Derivatives are assets distinct from shares and the gain from the alienation of Derivatives would fall within the purview of Article 13(4) of the India-Mauritius DTAA and cannot be considered under Article 13(3A). Accordingly we hold that the gain arising from the transfer of Derivatives cannot be taxed in India and the addition made in this regard stands deleted. Ground No. 1 raised by the assessee is hereby allowed

Summary

ISSUES:

Whether income from alienation of derivatives qualifies as gains from alienation of "shares" under Article 13(3A) of the India-Mauritius Double Taxation Avoidance Agreement (DTAA) and is taxable in India, or as gains from alienation of property other than shares under Article 13(4) and taxable only in the resident state.Whether the application of the Principle Purpose Test (PPT) and Beneficial Ownership concept by the Assessing Officer (AO) to deny treaty benefits is valid without substantive enquiry into the assessee's substance and business operations.Whether the AO erred in applying the tax rate on dividend income contrary to the Dispute Resolution Panel (DRP) directions under Section 144C(13) of the Income Tax Act, 1961.Whether gains from derivative transactions should be taxed as "Income from Other Sources" at 40% instead of as short-term capital gains at 30% under Section 115AD.Whether the levy of interest under Section 234B of the Income Tax Act is justified.

RULINGS / HOLDINGS:

The Court held that derivatives are distinct financial instruments separate from shares, supported by statutory definitions and judicial precedent, and therefore gains from alienation of derivatives fall under Article 13(4) of the India-Mauritius DTAA and are taxable only in the resident state (Mauritius). The gain from derivatives cannot be taxed in India under Article 13(3A) which applies solely to shares.The AO's blanket application of the Beneficial Ownership concept without enquiry into the assessee's substance, including business transactions, board meetings, investment decisions, and place of effective management, was improper. The Court agreed with the DRP that denial of treaty benefits requires substantive enquiry and cannot be based on "simplistic approach" or "short-cut of Beneficial Ownership."The AO erred in not following the DRP's directions regarding the tax rate on dividend income under Section 144C(13); however, no detailed arguments were presented on this ground during hearing.Grounds relating to taxation of derivative gains as "Income from Other Sources" and the consequent tax rate became infructuous following the decision on the primary issue of treaty applicability.Interest levied under Section 234B was consequential and did not warrant separate adjudication.

RATIONALE:

The Court applied the India-Mauritius DTAA provisions, particularly Article 13, which distinguishes gains from alienation of shares (Article 13(3A)) and other property (Article 13(4)). The term "shares" was interpreted as per Section 2(84) of the Companies Act, 2013, meaning "a share in the share capital of a company and includes stock," whereas "securities" under Section 2(81) include derivatives, establishing derivatives as separate from shares.The Court relied on authoritative clarifications by the Revenue Secretary and judicial precedents including the decision of a coordinate bench in Vanguard Emerging Markets Stock Index Funds, which recognized derivatives and rights entitlements as distinct from shares for treaty purposes.The Court emphasized the necessity of substantive enquiry before denying treaty benefits, rejecting the AO's reliance on the Beneficial Ownership concept without investigation, consistent with the DRP's findings.The principle of consistency was invoked, noting that in the subsequent assessment year, the AO allowed exemption under Article 13(4) for derivative income, underscoring the untenability of taking contradictory positions on the same issue.The Court followed the interpretative rule under Section 90(3) of the Income Tax Act and Article 3(2) of the DTAA that undefined treaty terms are to be interpreted according to domestic law, confirming that derivatives do not qualify as shares under Indian law and thus are not taxable in India under Article 13(3A).No dissent or doctrinal shift was recorded; the Court's approach aligns with established treaty interpretation principles and prior judicial pronouncements.