Taxing rights under the Tax treaty for rights entitlement, vis-à-vis, underlying shares

The Mumbai Income Tax Appellate Tribunal (ITAT) in the said case of an Assessee, being an Irish company registered as a Foreign Portfolio Investor (FPI) with SEBI, primarily addressed two key claims of the assessee which were being denied by the Tax authorities:

Taxability of Gains from Rights Entitlement: Rights Entitlement vs. Shares

The core of the first dispute revolved around whether capital gains from the sale of “rights entitlement” should be taxed as gains from “shares” under Article 13(5) of the India-Ireland DTAA, or as “other property” under Article 13(6). The latter would mean taxability only in the resident country (Ireland), while the former would allow India to tax the gains. The Assessing Officer (AO) had treated the gains on rights entitlement as taxable under Article 13(5), considering it akin to shares. However, the ITAT relied on its own coordinate bench’s previous decision to laid out several arguments to establish that rights entitlements are distinct, independent and separate right, capable of being transferred independently of the existing shareholding.

• Companies Act, 2013: Section 62 of the Companies Act, 2013, highlights that a shareholder receives an “offer” to subscribe to shares, implying an exercisable right that is different from the shares themselves. The shareholder has the option to accept, renounce, or transfer this right.
• SEBI Regulations and ISIN: SEBI Circulars mandate that rights entitlements (REs) are credited to demat accounts with a separate International Securities Identification Number (ISIN). This separate ISIN signifies that REs are distinct assets, different from the company’s shares.
• Securities Transaction Tax (STT) Treatment: The National Stock Exchange of India Limited (NSE) circulars clarify that trading in dematerialized REs is chargeable to STT at a rate specified for “Sale of an option in securities” (0.05%), which is different from the STT rate for purchasing equity shares.
• Income Tax Act Provisions: Sections 2(42A) and 55(2)(aa) of the Income Tax Act, 1961(ITA), treat the “right to subscribe to any financial asset” distinctly from the financial asset or shares themselves.
• DTAA Interpretation (OECD/UN Model and MLI): The Tribunal noted that while the UN Model Convention was amended to include “other comparable interests” in Article 13(4) and 13(5), the India-Ireland DTAA, even after amendment in 2019 following MLI introduction, did not include “comparable interests” in Article 13(5). This indicates a clear intention to restrict Article 13(5) to shares only.
• Right entitlement akin to Derivatives: Rights entitlements, being distinct assets that can be sold, lapsed, or subscribed, should be treated akin to derivatives (which derive value from underlying equity but are considered distinct assets).

Based on these comprehensive arguments, the ITAT concluded that rights entitlement is not the same as shares, and therefore, the gain on transfer of rights entitlement falls within the purview of Article 13(6) of the India-Ireland DTAA, rendering it taxable only in Ireland. The addition made by the AO in this regard was deleted.

Flexibility in Set-off of Short-Term Capital Losses

The second issue concerned the Assessee’s action of setting off Short Term Capital Loss (STCL) arising from the sale of Securities Transaction Tax (STT)-paid shares which are taxed at a lower rate against Short Term Capital Gain (STCG) arising from the sale of non-STT paid shares which was rejected by the  AO on the premise that the applicable provision only permits set-off for income and losses arrived at under similar computation. However, ITAT relied on judgements to hold that that the AO was incorrect in denying this benefit on the findings below:

• No Statutory Prohibition: While different tax rates (e.g., under Section 111A and 115AD) might apply to STT-paid gains in juxtaposition to non-STT-paid gains, Section 70 of the ITA does not prescribe a specific chronology for set-off of losses and there is no prohibition under regarding the hierarchy of set-off of STCL.
• Assessee’s Right to Choose: In the absence of any specific prohibition or prescribed chronology for set-off under the Act, the assessee is entitled to choose the chronology of set-off that is most beneficial to them including set-off of STCL arising out of STT paid shares against STCG arising out of non-STT paid shares.

Conclusion

This judgment is significant for FPIs and other non-resident investors as it clarifies the non-taxability of gains from rights entitlements in India under the applicable Tax treaties and the underlying principle can be sought to be extrapolated to other instruments. Furthermore, it provides comfort regarding the flexibility in setting off short-term capital losses, affirming that taxpayers can optimize their tax position by choosing the most beneficial chronology of set-offs in the absence of any explicit statutory prohibition.