Direct Tax Alert: Delhi Tax Tribunal holds that taxation of sale of Equity-Oriented Mutual Fund units cannot be equated with shares under India-Mauritius tax treaty
BACKGROUND
Foreign Institutional Investments (FII) are foreign institutional entities that invest in the Indian financial markets. FIIs are regulated by the Securities and Exchange Board of India (SEBI), and for the purpose of taxation, they are governed by the provisions of Section 115AD of the Income-tax Act, 1961 (Act).
FII primarily receives capital gains from the transfer of different forms of securities, namely shares, mutual funds, rights entitlement to equity shares, etc. In this regard, the Delhi Tax Tribunal has recently provided clarification on the taxation of capital gains from the transfer of Equity Oriented Mutual Funds under the Act vis-a-vis the relevant tax treaty.
In its recent ruling1, the Delhi Tax Tribunal held that that capital gains on the sale of Equity Oriented Mutual Funds do not tantamount to alienation of Shares (transfer/sale of shares) and hence, they ought not to be taxed in accordance with paragraphs 3A and 3B of Article 13 of the India-Mauritius Tax treaty, instead exemption under paragraph 4 of Article 13 of the said treaty ought to be allowed.
We, at BDO India, have summarised the above ruling and have provided our comments on the impact of this decision hereunder.
FACTS OF THE CASE
-
The taxpayer is an FII entity based in Mauritius, registered under SEBI.
-
The taxpayer basis the investment objective mentioned in the Private Placement Memorandum (PPM) invests in the SEBI-registered Mutual funds for all share classes in the fund.
-
In the fiscal year under consideration, the taxpayer earned income from the sale of equity-oriented mutual funds amounting to INR 5,93,48,24,274. In this regard, the taxpayer claimed the exemption provided in Article 13(4) of the India-Mauritius Tax treaty on such capital gains earned during the year.
-
The case of the taxpayer was selected for scrutiny assessment, and during the course of assessment proceedings, the Tax Officer held that the sale of equity oriented mutual fund shall tantamount to alienation of shares, as such security which has been disposed off has ‘share’ as an underlying asset to derive its income.
-
Accordingly, held that the taxpayer has an underlying asset as shares in the aforesaid transaction, and considering the definition of the equity-oriented fund under the Act, 65% of the total capital gains earned shall be considered as equity element. Thus, the said income shall be covered under the ambit of provisions of Article 13(3A) of the India-Mauritius tax treaty and shall be taxable at 65%.
-
Aggrieved by the said disallowance of exemption claimed, the taxpayer filed an appeal before the Dispute Resolution Panel (DRP) wherein the taxpayer contended that the provisions of Article 13(3A) of the India-Mauritius tax treaty shall not be applicable in the case of the taxpayer as:
-
It expressly covers the alienation of shares, not units, of any mutual funds for the purpose of taxation under the said paragraph of the tax treaty. When the tax treaty has expressly mentioned shares, the meaning of the same cannot be interpreted differently in the absence of the meaning of shares under the Act or the treaty.
-
By placing on the decision of the Hon’ble Supreme Court in the case of M/s Dilip Kumar2 wherein the Supreme Court held that the term share cannot be interpreted as any other securities but share, if the treaty aimed to cover the securities that can be indirectly interpreted as shares, the same should have been expressly mentioned in the treaty.
-
Shares and mutual funds are considered different securities under the provisions of the Securities Contract (Regulation) Act, 1956 (SCRA).
-
Additionally, it was argued by the taxpayer that, the Article 13(3A) was introduced vide virtue of a protocol for taxing the shares acquired on or after 1st April, 2017, thus, the addition of units purchased before 1st April 2017 i.e. amounting to INR 310,80,53,009 cannot be charged to tax under the said clause as the amendment was prospective in nature and not retrospective.
-
-
DRP upheld the decision of the Tax Officer; however, instead of taxing only 65% of such gain, tax shall be levied on the whole amount by considering it as capital gain from shares, based on the principles of the doctrine of purposive construction. Also, with respect to the units sold acquired prior to 1 April 2017, based on the grandfathering rule, the DRP held that the same shall be allowed to be claimed as exempt under the provisions of the India-Mauritius tax treaty.
-
Aggrieved by the said order of the DRP upholding the decision of the Tax Officer, the taxpayer preferred an appeal before the Delhi Tax Tribunal.
DELHI TAX TRIBUNAL’s RULING
The Delhi Tax Tribunal allowed the ground raised by the taxpayer, and the key observations are as under:
-
It is a settled law that for tax treaties, interpretation rules apply only when the language is unclear or open to multiple meanings and thus, the Doctrine of Purposive Construction applied by the DRP cannot be relied upon for the present case.
-
Paragraph to 3A of Article 13 was introduced by virtue of a protocol, which does not intend to disturb the allocation of taxing rights in respect of other fiscal instruments like debentures, hybrid instruments such as compulsory convertible debentures, futures and options contracts, alienation of interests in limited liability partnerships, and participatory notes.
-
‘Shares’ are also not defined under the said protocol; the definition of the same has to be derived from Indian Domestic Law as a whole and not just solely on the Act. Accordingly, it becomes essential to examine whether equity-oriented mutual funds fall within the scope of this definition.
-
The Companies Act, 2013, governs all aspects of shares, i.e., issuance, types, shareholder rights, dividends, and transferability. In contrast, mutual funds in India are basically a collective pool of money contributed by several investors and managed by a professional Fund Manager. It is set up as a trust under the Indian Trust Act, 1882 and regulated by SEBI (Mutual Funds) Regulations, 1996.
-
In mutual fund schemes, dividends are paid when profits are made from selling securities in the fund’s portfolio, unlike stock dividends, which are paid based on the company’s profitability. Mutual fund dividends do not indicate/reflect the profitability of the company.
-
Further, the Tax tribunal also held that SCRA has categorically considered shares and mutual funds as two different securities. Also, reliance was placed on multiple judicial rulings3 held before different appellate authorities, wherein shares have been classified/considered different from securities that are akin to shares in relation to taxability under the provisions of the Act.
-
Based the above, it was held that shares and units of mutual funds are different classes of securities and thus, for the purposes of the tax treaty, gains from the sale of equity mutual funds cannot be considered gains from the alienation of ‘shares’ Thus, it cannot be taxed in accordance with Article 13(3A) of the India-Mauritius Tax Treaty instead shall be eligible for exemption under Article 13(4) of the said tax treaty.
BDO INDIA COMMENTS
This ruling establishes that, for the purpose of taxing income from the sale of different kinds of securities under Indian Tax Treaties, a strict interpretation must be applied. In other words, if a particular security is not explicitly mentioned in the treaty, it cannot, through any legal fiction or purposive interpretation, be treated as equivalent to another type of security that gives rise to taxable income under the treaty.
Under tax treaties and the Act, units of equity-oriented mutual funds are legally and functionally distinct from equity shares. Therefore, the provisions applicable to equity shares cannot be extended to such mutual fund units even if the underlying assets of such mutual funds from which income is derived are equity shares.
Accordingly, capital gains arising from the transfer of equity-oriented mutual fund units cannot be construed as “alienation of shares” and shall be considered for exemption under the provisions of paragraph 4 of Article 14 of the India-Mauritius tax treaty. The ruling is expected to shed some light on the taxation of derivative instruments which have equity shares as underlying.
1 Emerging India Focus Funds, Apex Financial Services (Mauritius) Ltd. Vs ACIT, ITA No.1963/Del/2025, [TS-829-ITAT-2025(DEL)]
2 Commissioner of Customs (Import) vs M/s Dilip Kumar and Company & Ors. (2018) 9 SCC 1
3 Hon'ble Supreme Court in the case of Apollo Tyres Ltd Vs. CIT (2002) 255 ITR 273/122 Taxman 562/174 CTR 521 (SC)
Hon’ble Bombay High Court in the case of CIT Vs. Hertz Chemicals Ltd (2016) 386 ITR 39 (Bom)
Mumbai Bench of this Tribunal in the case of Vanguard Emerging Markets Stock Markets Stock India Fund Vs. ACIT (2025) 172 taxmann.com 515 (Mum-Tri)
ITO Vs. Satish Beharilal Raheja [2013] 37 taxmann.com 296 (Mumbai Trib)
DCIT (International taxation) Vs. K. E. Faizal [2019] 108 taxmann.com 545 (Cochin Trib)