Tax cloud over foreign investors' co-location servers

Ambiguity over whether use of these by FPIs can be construed as evidence of permanent establishment, experts say

Attempts by foreign investors to trade at ever-increasing speeds might be up against a tax hurdle. Foreign institutional investors (now called foreign portfolio investors, or FPIs) use co-location servers for faster trade on exchanges. To cut the time taken for signals to travel to a bourse, such servers are located on the exchange premises. The fraction of a second saved through this helps algorithms, or programmes that execute orders more efficiently than a human dealer. These can execute thousands of orders in a second.

However, these can also open the door to tax ambiguity. It is felt the use of co-location servers by FPIs might be construed as evidence of having a permanent establishment in India, resulting in tax woes, according to Rajesh Gandhi, director, Deloitte Haskins & Sells. “Let’s say a Mauritius-based FPI trades in Indian markets through co-location servers. There is some uncertainty over whether such servers located in India could be construed as a permanent establishment,” he says.

"There is ambiguity in the Indian tax law on whether co-location services created a Permanent Establishment (‘PE’) for an FII in India....Hence, if the intent of the Indian Government is to make co-location a success, it would be good if they could clarify that a co-location arrangement in India will not trigger PE implications for an FII in India.  For example, in the case of Japan, the Japanese tax authorities have issued a circular which clarifies that co-location arrangements would not trigger PE implications in Japan."  said Russell Gaitonde, Partner at BMR & Associates.

If co-location is construed as a permanent establishment, investors could be subjected to tax of up to 40 per cent.

“Whether it means a permanent establishment for a foreign investor will have to be evaluated on a case-to-case basis. The recent Budget amendment that classifies all income as capital gains dilutes the risk,” said Pranay Bhatia, partner, BDO India. Gaitonde agreed.

However, Gandhi of Deloitte says, “It is unclear whether FPIs could rely on the 2014 amendment and continue to claim exemption under the treaty despite having a permanent establishment in India’.

The proportion of algorithmic trading as percentage of overall trading has been on the rise. In December last year, it accounted for 30.82 per cent, against less than 20 per cent a year earlier, according to BSE data. Historical data for the National Stock Exchange (NSE) wasn’t immediately available. For December, algorithmic trading and co-location accounted for 38.5 per cent of overall NSE trade, while co-location accounted for 22.6 per cent.

This translates into average volumes of Rs 58,975 crore through co-location. If one assumes the same proportion for the BSE, it means an additional Rs 23,229 crore. Thus, co-location could account for up to Rs 82,204 crore of daily volumes on stock exchanges.

Naveen Kumar, managing director of QuantXpress Financial Technologies, which provides algorithmic trading solutions, estimates 20-30 per cent of the co-location volume is accounted for by foreign investors. This translates into Rs 16,000-25,000 crore of volume a day.

A source says the Securities and Exchange Board of India had raised this issue with the tax department. However, there hasn’t been a clarification in this regard.An email sent to the capital markets regulator on the matter wasn’t immediately replied to.