Hierarchy of STCL Set-Off Against STT and Non-STT Gains: ITAT Mumbai Rules in Favour of Assessee

The Income Tax Appellate Tribunal, Mumbai Bench, in a landmark decision concerning Florida Retirement System Vs ACIT, has clarified the permissibility of setting off short-term capital losses (STCL) first against non-STT gains taxable at thirty percent before applying the remaining loss to STT gains taxable at fifteen percent. This ruling reinforces the principle that Section 70 of the Income Tax Act, 1961, does not impose any mandatory sequence for loss adjustment when dealing with capital gains computed under identical provisions.

Background and Factual Matrix

The appellant in this matter is Florida Retirement System, an Artificial Juridical Person constituted under the laws of the United States of America. The entity operates as an investor in Indian securities markets through a multi-manager investment framework, wherein various investment managers holding registration as Foreign Portfolio Investors (FPIs) with the Securities and Exchange Board of India execute transactions on its behalf.

For the assessment year 2022-23, the appellant submitted its return of income on 20th July 2022, declaring total income amounting to Rs. 6,00,22,42,100. The case was subsequently picked up for comprehensive scrutiny under the Computer Aided Scrutiny Selection mechanism. Pursuant to this selection, a notice under Section 143(2) dated 31st May 2023 was duly issued to the appellant.

Following detailed enquiries and examination of the records, the Assessing Officer (AO) issued a Draft Assessment Order under Section 144C on 23rd March 2024, proposing to assess the appellant's income at Rs. 9,12,70,56,580. The proposed assessment incorporated two primary adjustments:

1. Rejection of the manner in which the appellant had arranged the set-off of short-term capital losses against different categories of short-term capital gains
2. Addition of dividend income received on American Depository Receipts (ADRs) and Global Depository Receipts (GDRs) to the taxable income, premised on the argument that the underlying securities represent shares of Indian companies

The appellant, dissatisfied with the proposed adjustments, filed objections before the Dispute Resolution Panel (DRP). The DRP, through its directions dated 5th December 2024, sustained the AO's position on both issues. The Panel upheld the action of taxing the gross non-STT short-term capital gains at thirty percent by rearranging the order of loss set-off. Similarly, the DRP confirmed the addition of ADR/GDR dividend to total income while directing that tax deducted at source (TDS) credit should be granted only upon strict compliance with Rule 37BA of the Income Tax Rules, 1962.

Consequent to these directions, a final assessment order under Section 143(3) read with Section 144C(13) dated 27th January 2025 was passed, prompting the appellant to approach the Tribunal.

Core Issue: Hierarchy of Short-Term Capital Loss Set-Off

Appellant's Computation Methodology

During the relevant previous year, the appellant earned net short-term capital gains aggregating Rs. 2,05,55,03,809 after adjusting current year and brought forward losses in the manner reflected in its return of income. The granular breakup of short-term capital gains and losses, as computed by the appellant, may be summarized as follows:

The appellant's approach proceeded on the foundation that all short-term capital losses should first be aggregated. Thereafter, in the absence of any statutory prescription regarding the sequence of adjustment, the assessee is entitled to adopt a tax-efficient method of loss absorption. In practical terms, the current year short-term capital loss was first applied to extinguish the non-STT short-term capital gains (taxable at thirty percent). Only the surplus loss was thereafter applied against the STT-paid short-term capital gains (taxable at fifteen percent). Subsequently, the brought forward short-term capital loss was adjusted against the remaining STT-paid gains. This methodology ensured that losses were utilized first against gains bearing a higher tax rate, before being applied to concessionally taxed gains.

Revenue's Counter-Computation

The Assessing Officer, however, adopted a different internal sequencing mechanism. Under the Revenue's recomputation, the current year short-term capital loss was first set off against the fifteen percent short-term capital gains (STT-paid transactions). Only thereafter was the brought forward loss allowed to be adjusted, thereby leaving the non-STT gains of Rs. 35,45,943 entirely intact and subjected to taxation at the rate of thirty percent.

The Revenue's computation, which was endorsed by the DRP and incorporated in the final assessment order, may be represented as follows:

Statutory Framework: Section 70 of the Income Tax Act, 1961

The legislative foundation for this dispute rests on Section 70 of the Income Tax Act, 1961. Sub-section (2) of this provision permits the set-off of short-term capital loss against income arrived at under a "similar computation" in respect of any other capital asset. The provision reads as follows:

"Where in respect of any assessment year the net result of the computation under the head 'Capital gains' is a loss and the assessee has income assessable under any other head of income, such loss shall be set off against income under that head."

Critically, the statute does not bifurcate capital gains for the purpose of set-off into those taxable at differential rates. Nor does it prescribe any mandatory hierarchy or compulsory internal order in which an assessee must apply its losses to different streams of short-term capital gains. The legislative emphasis is on the "similarity of computation," that is, both gains and losses must be computed under Sections 48 to 55 of the Income Tax Act, 1961, and not on the similarity of the eventual rate of tax.

Interpretation of "Similar Computation"

It is essential to appreciate that Sections 48 to 55 deal exclusively with the mechanism by which capital gains or losses are computed. These provisions do not venture into the domain of the rate of tax. The rate at which capital gains may ultimately be taxed is dealt with separately under provisions such as Section 111A (concessional rate for STT-paid equity transactions) and Section 115AD (taxation of FPI income). Accordingly, the expression "similar computation" in Section 70 refers solely to the computational mechanism and not to the rate of tax that may subsequently be applied under charging provisions.

The scheme of the Income Tax Act, 1961, therefore, permits the aggregation of all short-term capital gains and losses computed under the same machinery provisions. In the absence of any contrary legislative mandate, it does not compel the assessee to follow a sequence that is favorable to the Revenue or that maximizes tax liability.

Judicial Precedents Supporting Appellant's Position

The Tribunal has rightly noted that the appellant's interpretation finds robust support in a series of judicial pronouncements by coordinate benches and higher courts.

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