Mr. Ramesh Narain Parbat, IRS (IT: 1989)
Pr. CIT (Central), Bengaluru
[email protected]
Ramesh Narain Parbat is an Indian Revenue Service (IRS) officer of 1989 batch currently posted as Principal Commissioner of Income Tax (Central), Bengaluru. He has done B.Tech (Civil) from IIT, BHU and LL.B. from Mumbai University and has worked in I.T. Deptt at various levels dealing with assessment, Investigation, ITAT, appeals and Central etc.
Executive Summary
Assessment of income from transaction in shares and securities under the Income-tax Act 1961 involves multiple issues. Such transactions give rise to income assessable under different heads of income e.g. business income, capital gain and income from other sources. This article is an attempt to discuss some major issues involved in assessment of such income under the head income from business. Speculative income, non-speculative income, trading, contract, derivatives, setting off losses 43(5), 10, 24(1), 24(2), 28, 73.
INTRODUCTION
Assessment of income from transaction in shares and securities under the Income-tax Act 1961 involves a plethora of issues. Such transactions give rise to income assessable under different heads of income e.g. business income, capital gain and income from other sources. This article is an attempt to discuss some of the major issues involved in the assessment of such income under the head ‘Income from Business’.
Business income earned through trading in shares and security can either be speculative income or non-speculative income. Determination of the nature of income as speculative or non-speculative goes to the root of the assessment of such income. Hence, in the first part of the article, speculative income has been discussed. In the second part, the enquiries to be conducted while assessing the business income from shares and securities have been considered.
PART 1
SPECULATIVE INCOME
Income-tax provision has not defined speculative income but has defined ‘speculative transaction’. Therefore, it can be said that income that is derived from the speculative transaction is speculative income.
MEANING OF ‘SPECULATIVE TRANSACTION’
Section 43(5) of the Income-tax Act defines ‘Speculative transaction’ as a transaction in which a contract for the purchase or sale of any commodity, including stocks and shares, is periodically or ultimately settled otherwise than by the actual delivery or transfer of the commodity or scrips. For example, intra-day trading in shares.
EXCEPTIONS
Clauses (a) to (e) of sub_Section 5 of Section 43, following are certain transactions which have been specifically excluded from being treated as ‘Speculative Transactions’. These include:
a. Hedging contract in respect of raw materials or merchandise.
b. Hedging contract in respect of stocks and shares.
c. Forward contract.
d. Trading in derivatives.
e. Trading in commodity derivatives.
Now we will discuss some of these exceptions relevant for the subject at hand:
Trading in Derivatives
An eligible transaction in respect of trading in derivatives referred to in Clause (ac) of Section 2 of the Securities Contracts (Regulation) Act 1956 carried out in a recognized stock exchange is not a speculative transaction.
Prior to the insertion of Clause (d) in proviso to Sub-section 5 of Section 43, the Bombay High Court in its decision in the case of 199 Taxmann 87 (Bom.), Bharat R. Ruia (HUF), has held that exchange traded derivative transactions carried on by assessee before 24.1.2006 were speculative transactions. Further, it is also to be kept in mind that along with the insertion of Clause (d) to Section 43(5), an explanation has also been inserted, which defines the term ‘Eligible Transaction used in Clause (d)’. As per this explanation, only certain type of transactions in trading in derivatives carried on by recognized stock exchanges are eligible for being treated as non-speculative transactions. The notification under this section was made only by Notification No. S.O. 89(e) dated 25.1.2006 with effect from the same date recognizing Bombay Stock Exchange and National Stock Exchange for this purpose. Thus, the transactions in trading of derivatives carried on by following the conditions mentioned in the explanation to Section 43(5) after this date on BSE and NSE or other exchanges from the date of their notification under this section only can be treated as non-speculative transaction.
As on date, the recognized stock exchanges are:
1. National Stock Exchange of India Limited, Mumbai.
2. Bombay Stock Exchange Limited, Mumbai.
3. MCX Stock Exchange Ltd.
4. United Stock Exchange of India Limited.
5. India International Exchange (IFSC) Limited, Gandhinagar, Gujarat.
6. NSE IFSC Limited, Gandhinagar, Gujarat.
Trading in Commodity Derivatives
An eligible transaction in respect of trading in commodity derivatives carried out in a recognized association, which is chargeable to commodities transaction tax under Chapter VII of the Finance Act 2013 is not a speculative transaction. As on date, the recognized associations are:
1. Universal Commodity Exchange Limited, Mumbai.
2. Multi Commodity Exchange of India Limited, Mumbai.
3. Ace Derivatives and Commodity Exchange Limited, Ahmedabad.
4. Indian Commodity Exchange Limited.
5. BSE Limited Mumbai.
6. National Stock Exchange of India Limited, Mumbai.
The other points discussed in respect of derivative in shares are also applicable here. From AY 2019-20, in respect of trading in agricultural commodity derivatives, the requirement of chargeability of commodity transaction tax has been removed.
Hedging Transaction
A hedge is an investment that protects one’s finances from a risky situation. Hedging is done to minimize or offset the chance that assets will lose value. It also limits loss to a known amount if the asset does lose value. The Circular no. 23D (XXXIX) [F. NO. 412/(4)60/TPL], Dated 12.9.1960 explains the applicability of the provisions of the Section 43(5) to hedging transactions. Its provisions can be summarizied as follows:
1. The intention has always been that where bona fide forward sales are entered into with a view to guarding against the risk of raw materials or merchandise in stock falling in value, the losses arising as a result of such forward sales should not be treated as speculation losses. Accordingly, ITOs should not treat such transactions as speculative transactions within the meaning of Explanation 2 to Section 24(1). It is to be noted in this connection that hedging sales can be taken to be genuine only to the extent the total of such transactions does not exceed the total stocks of raw materials or merchandise in hand. If the forward sales exceed the ready stock, the loss arising from the excess transactions should be treated as loss arising from speculative transactions and not from genuine hedging transactions.
2. Referring to Board’s Letter No. 13(102) IT/53, dated 8.9.1954 in which it was stated that as regards hedging in raw materials, the Income-tax Officers should not be too particular about the quantities and timing so long as the transactions constitute genuine hedging. It has been explained that similarly, Income-tax Officers should not treat genuine hedging transactions in connected commodities as speculative transactions though the transactions may not be incidentally the same commodity. Thus, hedging transactions in one type of cotton against another type of cotton, one variety of oil seed against another, one type of grain against another, should not be treated as speculative transactions provided the other conditions of Explanation 2 to Section 24 are satisfied. It has been reiterated again that hedging sales can be taken to be genuine only to the extent the total of such transactions does not exceed the total stocks of raw materials or merchandise in hand. If the forward sales exceed the ready stock, the loss arising from the excess transactions should be treated as loss arising from speculative transactions and not from genuine hedging transactions.
3. It has been held that as a general rule, it is not acceptable that where a transaction contemplating actual delivery is ultimately settled (wholly or partially) by paying differences and without actual delivery due to any reasons and where there was no intention to speculate, the transaction should be excluded from the purview of speculative transactions. It is already provided, if on the facts of any case it can be demonstrated that the forward transaction has been entered into only for safeguarding against loss through future price fluctuations, such a transaction should not be treated as a speculative transaction but as a case of hedging. However, in case of a bona fide ready delivery contract being settled by delivery to a substantial extent and by payment of differences for the balance is exceptional and, in such a case, the difference paid need not be treated as a loss arising in a speculative transaction.
4. It cannot be accepted that a dealer or investor in stocks or shares can enter into hedging transactions in scrips outside his holdings. The material words in Clause (c) of the proviso to Explanation 2 to Section 24(1) are ‘to guard against loss in his holdings of stocks and shares through price fluctuations’. Therefore, hedging transactions having reasonable relations to the value and volume of dealer’s or the investor’s holdings are exempted from the ambit of speculative transactions; but transactions in scrips outside his holdings are not excepted.
5. For the purpose of set-off under Sections 10 and 24(1), the speculation loss of any year should first be set-off against the speculation profits of that year and the remaining amount of speculation profit, if any, should then be utilized for setting off any loss of that year from other sources. For the purposes of Section 24(2), the Income-tax Officer may allow the assessee:
a. either to first set-off the speculation losses carried forward from an earlier year against the speculation profits of the current year and then to set-off the current year’s losses from other sources against the remaining part, if any, of the current year’s speculation profits;
b. or to first set-off the current year’s losses from non-speculation business and other sources against the current year’s speculation profits and then to set-off the carried forward speculation losses of the earlier year against the remaining part, if any, of the current year’s speculation profits, whichever is advantageous to the assessee.
The Mumbai Tribunal in its decision in the case of Araska Diamond (P.) Ltd. vs. Assistant Commissioner of Income-tax, 5 (1), Mumbai [2014] 52 taxmann.com 238 (Mumbai-Trib.),, has explained the applicability of Section 43(5) to hedging transactions. The AOs can refer to this decision to have a better understanding of the issue.
Speculative Business to be Treated as Distinct Business
As per Explanation 2 to Section 28 of the I-T Act 1961 where speculative transactions carried on by an assessee are of such a nature as to constitute a business, the business to be referred to as ‘speculation business’, shall be deemed to be distinct and separate from any other business.
Allocation of Expenses
Where a part of business being carried on by an assessee is to be treated as speculation business, then all relatable expenses are to be compulsorily allocated to such speculation business too on a rational basis.
SOME OTHER IMPORTANT CASE LAWS RELATING TO SPECULATIVE TRANSACTION Davenport & Co. P. Ltd.
[1975] 100 ITR 715 (SC)
This decision gives the meaning of ‘actual delivery’ for the purposes of I-T Act 1961. In this case, the Court has held that the words ‘actual delivery’ in Explanation 2 (Sub-section 5 of Section 43 of the Income-tax Act 1961) mean ‘real’ as opposed to ‘notional delivery’. For income-tax purposes speculative transaction means what the definition of that expression in Explanation 2 says. Whether a transaction is speculative in the general sense or under the Contract Act is not relevant for the purpose of this Explanation. The definition of ‘delivery’ in Section 2(2) of the Sale of Goods Act which has been held to include both actual and constructive or symbolical delivery has no bearing on the definition of speculative transaction in the Explanation.
Commissioner of Income–tax vs. Joseph John [1968] 67 ITR 74 (SC)
In this, the court has held that the burden of proof was upon the assessee to show that the transactions were merely hedging transactions within the meaning of proviso (a).
Commissioner of Income–tax vs. Shantilal (P.) Ltd. [1983] 14 Taxman 1 (SC)
The Court held that Section 43(5) speaks of a settlement of the contract, and, consequently, where there is a breach of the contract resulting in a dispute between the parties and culminating in award of damages as compensation by an arbitration award, the transaction cannot be treated as a ‘speculative transaction’ within the meaning of Section 43(5).
TREATMENT OF LOSS FROM SPECULATIVE BUSINESS
Treatment of speculative business as a distinct and separate business is necessary for the purpose of setting off the loss provisions. As per Section 73, losses from speculation business can be set-off only against profits from speculative business unlike loss from other businesses which can be set-off against the profits of any business. Further, loss from a speculation business carried forward to a subsequent year can be set-off only against the profit and gains of any speculative business in the subsequent year. Along with treating speculative business as separate and distinct business, profits and losses resulting from speculative transactions must also be treated as separate and distinct from other profits and gains of business and profession.
Further, above provisions will apply also to allowance on account of depreciation or capital expenditure on scientific research, if any, incurred in speculative business.
Loss from speculative business cannot be carried forward for more than 4 assessment years succeeding the year in which loss is incurred.
EXPLANATION TO SECTION 73
Explanation to Section 73 States
‘Where any part of the business of a company [other than a company whose gross total income consists mainly of income which is chargeable under the heads “Interest on securities”, “Income from house property”, “Capital gains” and “Income from other sources”], or a company [the principal business of which is the business of trading in shares or banking] or the granting of loans and advances) consists in the purchase and sale of shares of other companies, such company shall, for the purposes of this section, be deemed to be carrying on a speculation business to the extent to which the business consists of the purchase and sale of such shares.’
Thus, if the provisions of this explanation are applicable, the delivery based share transactions of a corporate assessee would also become speculative transaction.
Applicability of explanation to Section 73 has always been a complex and highly litigated issue. Assessees have been taking pleas on several occasions to escape the dragnet of provisions of this explanation. Over the period, several decisions of courts and tribunals have been delivered on issues relating to this explanation, however, the issues have not attained finality. Brief analysis of the issues is as follows:
The first issue which goes to the root of the applicability of the provisions of this explanation is, as to whether the provisions are applicable to all sources of losses in share transaction or they are only applicable to the transactions involving sale and purchase of shares of group companies. The Hon’ble Bombay High Court in the case of Prasad Agents Pvt. Ltd., reported in 180 Taxman 178, has held that in view of the clear language of Explanation to Section 73, a company carrying on business of purchase and sale of shares shall be deemed to be carrying on speculation business. It was held that the explanation is applicable even if the sale and purchase of shares of companies outside the group companies of the assessee have been made.
Another issue is whether loss or profit on account of valuation of closing stock in trade in shares would be covered by the provisions of this explanation. The Hon’ble Bombay High Court in the above mentioned decision in the case of Prasad Agent Pvt. Ltd. has held that loss on account of valuation of closing stock of shares would also be covered by this explanation.
The other issue is as to whether explanation is applicable only to the losses in share transactions or it covers the profit also. The Hon’ble Bombay High Court in the case of Lokmat New Paper P. Ltd., reported in 189 Taxman 370 has held that once the provision is applicable to an assessee’s company, both losses and profit in share transaction will have to be treated as arising from a speculation business. But subsequently, the Hon’ble Gujarat High court in its decision in the case of Commissioner of Income-tax–VI vs. Appollo Vikas Steels (P.) Ltd. [2013] 32 taxmann.com 329 (Gujarat), has held that the explanation is attracted only if there is any loss from share trading. Thus, if there is carried forward speculation loss and the assessee has positive income from delivery based share trading and derivative transactions, then no set-off can be allowed as the income from share trading in the current year is not hit by the explanation and hence is to be treated as non-speculative income.
Another important issue is as to whether only the profit is to be considered for the purposes of determining the applicability of this explanation or losses are also to be considered. The High Courts in the decisions given below have held that losses are negative profits and hence they are also to be considered for this explanation.
Another issue is as to whether trading in units of mutual funds are covered by this explanation or not. In Apollo Tyres Ltd. vs. Commissioner of Income-tax [2002] 122 Taxmann 562 (SC),the apex court held that buying and selling of units by the assessee-company cannot be treated as a speculative business as per Explanation to Section 73, because units of mutual funds are not shares. The same was followed by the Bombay HC in its decision in the case of CIT vs. Hertz Chemicals Ltd. [2016] 69 taxmann. com 338/239 Taxman 431 (Bom.). But SLP filed by the Revenue against this decision has been admitted in the Supreme Court as reported in Commissioner of Income-tax-8 vs. Hertz Chemicals Ltd. [2017] 78 taxmann.com 165 (SC).
Similarly, another issue is as to whether derivative transactions are covered by this explanation or not. In the decision in the case of Commissioner of Income-tax, Delhi–IV vs. DLF Commercial Developers Ltd. [2013] 35 taxmann.com 280 (Delhi), it has held that the explanation covers derivative transactions too. But in the decision in the case of Asian Financial Services Ltd. vs CIT [2016] 70 taxmann.com 9/240 Taxman 192 (Cal.), the High Court ruled that loss incurred on account of derivatives would be deemed business loss under proviso to Section 43(5) and not speculation loss and, hence, Explanation to Section 73 could not be applied. However, SLP against this decision of the Calcutta High Court has been admitted as reported in, Commissioner of Income-tax-3, Kolkata vs. Asian Financial Services Ltd. [2016] 75 taxmann.com 68 (SC).7.2.7 The most important aspect of this issue is to determine as to whether this explanation is applicable to a particular company or not on the basis of analysis of incomes under different heads comprised in the gross total income. For this purpose, it is to be determined whether the assessee is a company whose gross total income consists mainly of income which is chargeable under the head: interest on securities, income from house property, capital gain and income from other sources; or a company whose principal business is business of banking or the granting of loans and advances (and from AY 2015-16 business of trading in shares also). In case of such companies, the provisions of explanation are not applicable, whereas in case of rest of the companies these provisions would be applicable.
The above analysis has to be made on case-to-case basis for every year. There are following three decisions of Special Bench of ITAT on this issue:
1. The decision in the case of Concord Commercial Pvt. Ltd., reported in 95 ITD
2. The decision in the case of AMP Spinning Mills Pvt. Ltd., reported in 100 ITD 142.
3. The decision in the case of Venketeshwar Investment and Finance Pvt. Ltd., reported in 93 ITD 177. This case relates to analysis of the facts to find out whether the principal business of assessee is of granting loans and advances.
Besides the decision of Hon’ble High Court of Bombay in the case of Commissioner of Income-tax-3 v. Darshan Securities (P.) Ltd. [2012] 18 taxmann.com 142 (Bom.), is also very important in which the court has held that in order to determine as to whether exception carved out in form of bracketed portion by Explanation to Section 73 applies, firstly one has to compute gross total income of company under normal provisions of Act and it is only thereafter, it has to be determined as to whether gross total income so computed consists mainly of income which is chargeable under any of heads referred to in Explanation.
Here, the AOs should consider the following situation:
- Business loss: Rs. 1,00,000
- Income from other sources: Rs. 50,000
In such situation, assesses normally contend that a positive figure howsoever small it is, is always greater than a very big negative number and hence, in such circumstances the Explanation to Section 73 will not be applicable. This, one must understand, is a situation not covered by the Mumbai Special Bench decision of Concord Commercial. In such a situation, and in the example taken above, the figures in absolute terms should be seen and the Explanation is invoked as Rs. 1,00,000 is greater than Rs. 50,000.
Besides these, some other important decisions are as follows:
a. Commissioner of Income-tax vs. Arvind Investments Ltd. [1991] 58 Taxmann 216 (Cal), [1991] 58 Taxmann 216 (Cal), held Explanation to Section 73 will apply even where share dealing was company’s sole business.
b. Commissioner of Income-tax-I, Indore vs. Intermetal Trade Ltd. [2006] 156 Taxman 21 (MP).: It was held that since objects of memorandum and articles of association of company clearly showed that main business of assessee was trading in metal and shares and not granting advances/ loans, no benefit of excepted category could be granted to assessee.
c. Commissioner of Income-tax vs. Parkview Properties (P.) Ltd. [2004] 139 Taxman 38 (Cal.) held that: In speculation business, speculation loss cannot be set off except against a speculative profit permissible of being carried forward for being set-off in subsequent years stretching to a period of eight years and not otherwise, unless test of Explanation is satisfied.
d. Aryasthan Corpn. Ltd. vs. Commissioner of Income-tax [2002] 124 Taxman 516 (Cal) held that: since assessee could not be said to be a company whose gross total income consisted mainly of income which was chargeable under heads ‘interest on securities’, ‘income from house property’, ‘capital gains’ and ‘income from other sources’ as business loss exceeded income computed under head ‘income from other sources’, Section 73 was clearly applicable.
e. Assistant Commissioner of Income-tax, 4(2)(2), Mumbai vs. Sonal Share & Stock Brokers (P.) Ltd. [2006] 6 SOT 218 (Mum) held that: Section 73(1) requires loss from shares to be computed in respect of speculation business and in computing said loss, expenses incurred on purchase and sale of such shares have to be taken into account.
f. Mafatlal Securities Ltd. vs. Joint Commissioner of Income-tax, Special Range 32, Mumbai [2009] 119 ITD 444 (Mum) held that: business loss being negative profit cannot be ignored in determining applicability of exception clause of Explanation to Section 73.
g. Torrent Finance (P.) Ltd. vs. Joint Commissioner of Income-tax, (Asstt.) Special Range [2008] 110 ITD 315 (Ahd) held that: since dividend income was earned by assessee for holding shares and not by transfer thereof, it could not be treated to be an income from speculation business and, consequently, speculative business loss of assessee could not be set off against dividend income.
h. Yucca Finvest (P.) Ltd. vs. Deputy Commissioner of Income-tax, Circle 3(3), Mumbai [2006] 101 ITD 403 (Mum.) held that: it is absolute figures of two incomes either under head ‘Business’ or under head ‘Other sources’ without sign, i.e., irrespective of whether it is positive income or loss, which should be taken for comparison for deciding as to whether a case falls in first exception of Explanation to Section 73 or not. Therefore, where loss due to trading in shares had greater figure than figure of income from dividend, Explanation to Section 73 was rightly invoked. Besides, provisions of Explanation would be applicable even if whole of business is that of sale and purchase of shares and to attract provisions of Explanation, it is immaterial whether an assessee deals in shares of a single company, or in shares of several companies.
i. AMP Spg. & Wvg. Mills (P.) Ltd. vs. Income-tax Officer [2006] 100 ITD 142 (AHD) (SB) held that: loss arising from sale of shares acquired by a dealer by making application for allotment of shares in public issue is a speculative loss in view of Explanation to Section 73.
j. ALFA Tie-up (P.) Ltd. [2013] 31 taxmann. com 277 (Cal.) held that: where less than 50 per cent funds of assessee were invested in granting loans and advances, it could not be treated as assessees principal business; and therefore, share trading loss would be treated as speculative loss.
K. S [2012] 23 taxmann.com 377 (Bom.) held that: Explanation to Section 73 does not operate in respect of a company whose gross total income consists mainly of income which is chargeable under heads of ‘interest on securities’, ‘income from house property’, ‘capital gains’ and ‘income from other sources’.
l. Savi Commercial (P.) Ltd. [2015 ] 60 taxmann.com 295 (Cal) held that: since activity of granting loans and advances was on a larger scale than business of buying and selling shares, granting loans and advances was to be treated as principal business of assessee.
m. Snowtex Investment Ltd. vs. Principal Commissioner of Income-tax, Central-2, Kolkata [2019] 105 taxmann.com 282 (SC), held that: the amendment which was brought by the Parliament to the Explanation to Section 73 by the Finance (No. 2) Act, 2014 was with effect from 1 April, 2015. In its legislative wisdom, the Parliament amended Section 43(5) with effect from 1 April, 2006 in relation to the business of trading in derivatives, the Parliament brought about a specific amendment in the Explanation to Section 73, insofar as trading in shares is concerned, with effect from 1 April, 2015. The latter amendment was intended to take effect from the date stipulated by the Parliament and we see no reason to hold either that it was clarificatory or that the intent of the Parliament was to give it retrospective effect.
PART 2: ENQUIRIES DURING ASSESSMENT
In this part, the enquiries to be made at the time of assessing the business income on account of transactions in share and securities are discussed.
ANALYSIS OF TRADING ACCOUNTS OF TRANSACTIONS IN SHARES
1. First of all, the AO should ask the assessee to furnish trading accounts of delivery-based share transactions, non-delivery based share transactions and derivative transactions separately. Assessees may resist this on the ground that they are carrying on a composite business or carrying on arbitrage activity and hence all such transactions are common to same business. But it should be remembered that, as already discussed in the first part, for Income-tax purposes all these transactions are separate activities and the treatment to profits or losses earned on them would vary from situation-to-situation. Explanation 2 to Section 28 deems speculation activity as separate business. Provisions of Section 43(5) defining ‘speculative transaction’ should also be kept in mind. These days due to computerization, the software at the brokers’ back-office can give separate reports for each activity; namely, delivery based, non-delivery based, derivatives etc. giving the details of scrip-wise profit/ loss.
2. Now, depending upon the fulfilment of different conditions, the income will be determined as follows:
a. In case of corporate assesses:
i. If the Explanation to Section 73 is applicable, then the losses from delivery-based share transactions and non-delivery based share transactions as well from derivative transactions will be treated as speculative loss and hence will not be set-off against any other income which is non-speculative in nature like brokerage income etc
Here, it must be kept in mind that if in the pending appeals, it is held by the Supreme Court that derivative transactions doesn’t come within the ambit of the Explanation to Section 73, even then derivative transactions done on non-recognized stock exchanges will remain speculative transaction only. But in that case, the losses from delivery-based share transactions and non-delivery based share transactions will not be set-off against any profit from derivative transaction done on recognized stock exchanges after 24.1.2006 as after this date, derivative transactions carried out on BSE and NSE are not to be treated as speculative transactions.
ii. If Explanation to Section 73 is not applicable, then losses from non-delivery based transactions and losses from derivative transactions carried out on non-recognized stock exchanges will not be set-off against any other income which are non-speculative in nature, including profits from delivery-based share transactions and derivative transactions carried on recognized stock exchanges.
a. In case of non-corporate assesses:
The treatment will be the same as in the case of a corporate assessee in whose case Explanation to Section 73 is not applicable i.e. losses from non-delivery based transactions and losses from derivative transactions carried out on non-recognized stock exchanges will not be set-off against any other income which are non-speculative in nature, including profits from delivery based share transactions and derivative transactions carried on recognized stock exchanges.
ALLOCATION OF EXPENSES
Now the next step will be to allocate the expenses over speculative transactions and non-speculative transactions. Where a part of business being carried on by an assessee is to be treated as speculation business, then all relatable expenses are to be compulsorily allocated to such speculation business too on a rational basis. Such allocation has been approved by the Bombay and Gujarat high courts in the decisions in the cases of Sind National Super Mills P. Ltd vs. CIT (121 ITR 742) (Bom), [2013] 35 taxmann.com 374 (Gujarat), High Court of Gujarat; Anjalee Exim (P.) Ltd. [1966] 61 ITR 214 (Allahabad); Makhanlal Ram Swarup vs. Commissioner of Income-tax. Hence, the AOs should on some rational basis e.g. turnover, etc. determine the expenses incurred to earn profit in speculation business, reduce it from the profits (or add to the loss) and then determine the profit or loss from speculation business and non-speculation business. By doing this, it may so happen that profit in speculation business may turn into loss and by invoking the provisions of Section 73 this may not be allowed to be set-off against other incomes.
VERIFYING THE NATURE AND GENUINENESS OF DERIVATIVE TRANSACTIONS
Another point of verification is, as to whether the derivative transactions have taken place over notified stock exchanges or not and thus they are eligible transactions or not. This is because as per stand taken by the department in the past, such transactions are considered to be speculative in nature till 25.1.2006 and after that day, these are non-speculative only if carried out on a notified stock exchange. Transactions on other non-recognized exchanges are still speculative.
Besides, as per Section 18A of the SCRA 1956, a derivative contract can be legal and valid only if such contracts are:
a. Traded on a recognized stock exchange.
b. Settled on the clearing house of the recognized stock exchange.
in accordance with the rules and bye-laws of such stock exchange.’
Thus, any transaction in derivatives not carried on a stock exchange is illegal. If loss is claimed on such transactions, it cannot be allowed, being an illegal loss. Many assessees try to claim such bogus losses on the basis of forged contract notes.
Bogus losses created on account of derivative transactions can be detected by investigating as to whether these have been done on recognized stock exchange or not. The AOs should invariably, in case of loss in derivatives, call for the details and contract notes of the broker. From the contract notes, the genuineness should be examined by communicating with the Exchange where the transactions purportedly have been claimed to be executed. In case of a denial from the Exchange, the details as submitted by the Exchange together with the letter of the AO to the Exchange asking for the details, should be immediately informed to the assessee and his explanation must be called for. If the assessee asks, cross-examination should also be provided to him.
SET-OFF OF BROKERAGE INCOME AGAINST SPECULATION LOSS
The AOs assessing the share brokers should keep in mind that the brokerage income of the share-brokers are not to be adjusted against their speculative loss as per ratio of the decisions of the apex court in the case of Pangal Vittal Nayak and Co. P. Ltd. 74 ITR 754 (SC) and of ITAT Delhi bench in Frontline Capital Services Ltd. 96 TTJ (Del) 201.
SET-OFF OF DIVIDEND INCOME AGAINST SPECULATION LOSS
Similarly, the dividend income cannot be treated as speculation income as this is earned on account of holding of shares and not on account of their sale and purchase as decided in Torrent Finance (P.) Ltd. vs. Joint Commissioner of Income-Tax, (Asstt.) Special Range [2008] 110 ITD 315 (Ahd).
VERIFICATION OF OFF-MARKET TRANSACTIONS
Many-a-times, the assessees claim loss on account of sale and purchase of listed securities carried out privately and outside the stock exchange. Besides making enquiries regarding purchasers and sellers and ascertaining the genuineness of such transactions, the provisions of the Security Contract Regulation Act 1956 also must be kept in mind while assessing such loss. This is because under certain circumstances, such loss would be illegal loss.
Therefore, once it is foun that the purchase and sale transactions are off-market transactions conducted through a person who is not a share-broker, then the legality of such transaction is to be verified as per the provisions of the Securities Contract (Regulations) Act 1956 as discussed below:
a. As per Section 13 of this Act, the Central Government is empowered, to apply the said Section by a notification in the Official Gazette, and, upon such declaration, every contract in securities in the State or area which is entered into after the date of such notification, otherwise than between members of a recognized stock exchange, in such State or area, or through or with such member, is rendered illegal.
b. The exception to this is the spot delivery contract, i.e. a contract which provides for the actual delivery of securities and the payment of a price there for either on the same day as the date of the contract, or on the next day.
c. Similarly, as per Section 18A, contracts in derivative shall be legal and valid only if such contracts are:
1. 2. Traded on a recognized stock exchange;
Settled on the clearing house of the recognized stock exchange, in accordance with the rules and bye-laws of such stock exchange.
d. Section 16 of the SCRA provides that:
e. ‘16(1) if the Central Government is of the opinion that it is necessary to prevent undesirable speculation in specified securities in any state or area, it may by notification in the official gazette declare that no person in the state or area specified in the notification shall, save with the permission of the Central Government (or SEBI/ RBI), enter into any contract for the sale or purchase of any security specified in the notification except to the extent and in the manner, if any, specified therein.
f. In accordance with the above, a Notification No. SO 184(E) was published in the Gazette of India on March 01, 2000 stating that no person in the territory to which the said Act extends, shall, save with the permission of the Board (SEBI here as all powers under Sections 13 and 16 of the SCRA have been delegated to SEBI), enter into any contract for sale or purchase of securities other than such spot delivery contract, or contract for cash, or hand delivery, or special delivery, or contract in derivatives as is permissible under the said Act or the Securities and Exchange Board of India Act 1992 and the Rules and Regulations made under such Acts and Rules, Regulations and Bye-laws of a recognized Stock Exchange.
g. Thus, outside stock exchanges, only spot delivery contract, or contract for cash, or hand delivery, or special delivery, or contract in derivatives, as is permissible under the said Act, or the Securities and Exchange Board of India Act can be entered. Hence, all the back-dated share purchases in which the deliveries have not been given within 48 hours of the purchase are illegal and hence do not confer any right on the purchaser.
h. In the decision dated 11.7.2016 in the case of Securities and Exchange Board of India…..Appellant VERSUS M/s. Opee Stock-Link Ltd. & Anr …..Respondents in CIVIL APPEAL NOS. 2285, 2286, 2294 & 2303 OF 2010, related to IPO scam, the Supreme Court of India has also held that: considering the facts and circumstances of the present case, the transfer of shares did not comply with the requirements of the provision of either Section 13 or Section 2(i) of the SCRA. Therefore, the off-market trading indulged into by the Respondents was rightly held to be per se illegal by the Whole Time Member. Similar finding has also been given by the apex court in the decision in the case of Bhagwati Developers Pvt. Ltd. vs. Peerless General Finance and Investment Company Ltd. & Anr. (2013) 9 SCC 584.
Thus, if the transactions made outside stock exchange are not ‘Spot Delivery’ contracts, then the resultant loss would be illegal and cannot be allowed to be set-off against other legal incomes of the assessee.
DIVIDEND STRIPPING
Another aspect is to examine the losses as per the provisions of Section 94(7) to detect any disallowance on account of dividend stripping. For this, the assessee should be asked to give date-wise details of purchase and sale of shares and dividend received along with record dates. In many cases, good disallowances under Section 94(7) have been detected.
VERIFICATION OF OTHER EXPENSES INCLUDING UNDER SECTION 14A
The AO is required to verify all other expenses which are common to all types of business activities like administrative expenses, finance expenses, commission expenses etc. The disallowance under Section 14A is also to be examined by the AO as per relevant laws and rules applicable to the assessment year. The Supreme Court in its decision in the case of Maxopp Investment Ltd. vs. Commissioner of Income Tax, New Delhi [2018] 91 taxmann.com 154 (SC) has upheld the applicability of this Section on the exempt dividend income earned from shares held as stock in trade too.
LOSS CLAIMED ON ACCOUNT OF ‘MARK TO MARKET’ OF OPEN DERIVATIVE CONTRACTS
Another point of verification is as to whether the assessee has claimed any loss on account of ‘Mark to market’ of open derivative contracts as on 31st March. Assesses should be asked to furnish the details of provision made of notional loss on account of open contracts in derivatives and Interest Rate Swap (IRS) on the last day of the financial year and debited in the P&L account. Such losses being contingent losses are to be disallowed. As per circular of CBDT Instruction No. 03/2010, Dated 23.3.2010, the MTM losses on forex derivatives are notional loss in nature and hence are not allowable as a deduction in computation of income. The same is applicable to MTM loss in share and security derivatives too.
Further, Clause 4 of Income Computation and Disclosure Standard I relating to accounting policies provides that marked to market loss or an expected loss shall not be recognized unless the recognition of such loss is in accordance with the provisions of any other Income Computation and Disclosure Standard. Further, Clause (xviii) of Section 36 also provides that only marked to market loss or other expected loss as computed in accordance with the income computation and disclosure standards notified under Sub-section (2) of Section 145 are allowable as a deduction in computation of income. No such ICDS is in place as on date which allows such notional losses on share and security derivatives.
Only as per ICDS VI, exchange differences on a forward exchange contract shall be recognized as income or as expense in the previous year in which the exchange rates change provided the contract is not intended for trading or speculation purposes. Even if the assessee claims that the same should be applied to share and security derivatives too, since the derivative transactions in shares and securities are for trading or speculation purposes only; hence, any mark to market loss of such derivatives would not be allowable in computation of income.
The provisions of ICDS and Section 36(xviii) are applicable from AY 2017-18. For assessment years prior to that, there are decisions in favour of allowing as well as disallowing such notional losses. In the case of Edelweiss Capital Ltd in ITA no 5324/Mum/2007, Mumbai ITAT has allowed such losses on the presumptions that derivatives are stock-in-trade. The same has been followed in some other decisions. But this is a wrong presumption as explained below:
i. As we know, derivatives contracts are of two types: ‘Futures’ and ‘Options’. The assessees are debiting in P&L A/c, provisions for loss on equity index/ stock futures account but the profits are ignored on the basis of prudence principle. This loss is arrived at, on account of adverse price differences, in the future contracts, open i.e. unsettled as on 31st March i.e. the date of preparation of balance sheet.
ii. The ICAI Guidance Note on Accounting for Equity Index and Equity Stock Futures and Options describes ‘futures’ is like a forward contract. As futures do not have any cost of their own at the time of execution of the contract, no asset or liability is created on purchase or sale of the futures and the futures contract is not recognized as such at inception in the books of account, unlike when security is purchased in cash market, where an asset is recorded in the books irrespective of the payment made for it. No such accounting takes place for futures.
In case of options, if any premium is paid that remains in the nature of advance, the mark to market adjustments also are in the nature of advances.
iii. On final settlement of futures contract, parties pay the difference between the final settlement price as on the expiry date and the contract price, which is recognized as income or loss by debiting or crediting the P&L A/c in the year the contract is settled. The margin accounts are appropriately adjusted and closed.
iv. As the derivative contracts are not accounted for in the books of account at the inception thereof at the time of purchase, they do not, and cannot, form a part of stock-in-trade. Any contract to acquire a derivative at a future date is a forward contract to acquire a commodity. This contract, as such, is not a stock-in-trade and hence it cannot be valued at the time of preparation of balance sheet as stock in trade.
v. Even for the argument sake, if it is assumed that the futu is re contract for the derivative itself is a stock-in-trade and can be valued at cost or market price whichever is lower, in cases where mark to market results in a loss, the cost of acquisition being NIL, the valuation of such a contract will be a negative figure. By its very nature, the value of stock-in-trade cannot be negative. Hence, this argument is not correct. The mark to market loss at best can be an unascertained liability or a provision for loss which may or may not be incurred at the time of settlement of the contract at a future date.
The above position has been rightly appreciated and applied by the Bengaluru bench of ITAT in its decision in the case of, Shankara Infrastructure Materials Ltd. [2015] 53 taxmann. com 429 (Bangalore-Trib.).The observations of the bench are worth reading for the purpose of understanding this issue.
VALUATION OF CLOSING STOCK
The valuation of stock-in-trade of securities except derivatives has to be checked as per the provisions of the Revised Income Computation and Disclosure Standards (ICDS) Notified Under Section 145(2) notified vide Notification No. SO 3079(E) [NO. 87/2016 (F.NO.133/23/2015-TPL)], Dated 29.9.2016.
The Income Computation and Disclosure Standard VIII relating to security is applicable for computation of income chargeable under the head “Profits and gains of business or profession” or “Income from other sources” and not for the purpose of maintenance of books of account. Part A of this Income Computation and Disclosure Standard deals with securities held as stock-in-trade except following cases:
a. The bases for recognition of interest and dividends on securities which are covered by the Income Computation and Disclosure Standard on revenue recognition;
b. Securities held by a person engaged in the business of insurance;
c. Securities held by mutual funds, venture capital funds, banks and public financial institutions formed under a Central or a State Act or so declared under the Companies Act 1956 or the Companies Act 2013.
d. For the purposes of this ICDS, ‘Securities’ shall have the meaning assigned to it in Clause (h) of Section 2 of the Securities Contracts (Regulation) Act 1956 and shall include share of a company in which public are not substantially interested but shall not include derivatives referred to in Sub-clause (ia) of that Clause (h). Thus, it is not applicable to derivatives. As already discussed, it is not allowed to claim deduction on account of mark to market of security derivatives at the year end, hence the valuation of such derivatives is not required to be done.
The relevant parts of the ICDS are as follows:
‘Recognition and Initial Measurement of Securities’
1. A security on acquisition shall be recognized at actual cost.
2. The actual cost of a security shall comprise of its purchase price and include acquisition charges such as brokerage, fees, tax, duty or cess.
3. Where a security is acquired in exchange for other securities, the fair value of the security so acquired shall be its actual cost.
4. Where a security is acquired in exchange for another asset, the fair value of the security so acquired shall be its actual cost.
5. Where unpaid interest has accrued before the acquisition of an interest-bearing security and is included in the price paid for the security, the subsequent receipt of interest is allocated between pre-acquisition and post-acquisition periods; the pre-acquisition portion of the interest is deducted from the actual cost.
SUBSEQUENT MEASUREMENT OF SECURITIES
At the end of any previous year, securities held as stock-in-trade shall be valued at actual cost initially recognized or net realizable value at the end of that previous year, whichever is lower.
For the purpose of para 9, the comparison of actual cost initially recognized and net realizable value shall be done category-wise and not for each individual security. For this purpose, securities shall be classified into the following categories, namely:
a. shares.
b. debt securities.
c. convertible securities.
d. any other securities not covered above.
The value of securities held as stock-in-trade of a business as on the beginning of the previous year shall be:
a. The cost of securities available, if any, on the day of the commencement of the business when the business has commenced during the previous year; and
b. The value of the securities of the business as on the close of the immediately preceding previous year, in any other case.
Notwithstanding anything contained in paras 9, 10 and 11, at the end of any previous year, securities not listed on a recognized stock exchange; or listed but not quoted on a recognized stock exchange with regularity from time-to-time, shall be valued at actual cost initially recognized.
For the purposes of paras 9, 10 and 11 where the actual cost initially recognized cannot be ascertained by reference to specific identification, the cost of such security shall be determined on the basis of first-in-first-out method or weighted average cost formula.’
The ICDS defines ‘Fair value’ as the amount for which an asset could be exchanged between a knowledgeable, willing buyer and a knowledgeable, willing seller in an arm’s length transaction.
Hence, while assessing the income of a trader in share and securities, the closing stock valuation must be checked as per provisions of this ICDS. This will prevent the assessee from evading due taxes by valuing the unquoted shares at lower than cost of acquisition. Such checks will also detect as to whether the assessee has claimed any loss on account of valuations of open contracts in derivatives at market value at the year end.
Another method of claiming lower profit is by way of bogus purchases which are valued at a much lower prices than the alleged cost of acquisition. Most of the time, such practice is resorted to after the end of the financial year. Hence, the assessee can neither show any acceptance of delivery of shares, nor can he make any payments by cheques. Therefore, purchase is shown on credit side and the assessee is also without any evidence of delivery.
Hence, the list of closing stock should be obtained and tallied with the demat statement of the assessee as on 31st March. If any share is not found reflected in the demat statement and loss on account of valuation of the same at market value has been claimed by the assessee, then the assessee should be asked to give details of purchase of these shares like date of purchase, details of persons from whom purchased, whether purchase was on-market or off-market, when was the payment for purchase made.
If the purchase was through stock exchange, the shares must be transferred to the demat account of the assessee within 2 days as per SEBI circular on transfer of share by broker to its client MRD/ DoP/SE/Dep/Cir-30/2004. If it has not been done, the assessee cannot claim any benefit on account of such purchases.
If the assessee claims that the shares were purchased off- market, then the delivery of shares and payment of consideration has to be completed either on the same day as the date of the contract, or on the next day. If it has not been done, then again the purchase is illegal as per the provisions of SCRA 1956, as already discussed. Hence, again the assessee cannot claim the valuation loss of such shares in computation of his income.
In case of unquoted shares, as per ICDS VIII, the closing stock valuation has to be done at cost of acquisition. So, again, no such valuation loss can be claimed for such shares.
CONVERSION OF STOCK-IN-TRADE TO CAPITAL ASSET
Many assessees resort to this practice to take benefit of lower rate of taxes on capital gain. Till AY 2018-19, the Act was silent on this issue. Hence, the most important aspect of this issue was the analysis of the nature of transactions done by the assessee after the alleged conversion. The AO should find out whether after the alleged conversion, the assessee’s transactions were in the nature of an investor, or he continued to act as a trader only. This fact should be clearly brought on record. This was to be done in the year of conversion itself. Refer: Clauses 12 and 12A of Form No. 3CD attached to the Tax Audit Report which give such details.
In the judgment in the case of Wallfort Financial Services Ltd. vs. Additional Commissioner of Income-tax, Range 4(2), Mumbai, reported in [2010] 41 SOT 200 (Mum.), the ITAT has analyzed this issue in detail. In this case, the assessee, a share-broker, tried to pass off his trading transactions in shares after 1.10.2004 as investment in order to take advantage of the lower tax rate. The AO and the CIT(A) had passed detailed order bringing out the fact that the assessee continued to behave as a trader even after such conversion. After analyzing all the facts, the ITAT has decided the issue in the favour of the Revenue. Again, it should be noted that in this case, in the assessment order and the appellate order, all the facts had been well marshaled and fully analyzed.
Besides, in Abhinandan Investment Ltd. [2015] 63 taxmann.com 263 (Delhi),, it has been held that where stock in trade is converted into capital asset, the holding period for the purposes of classifying it as long-term or short-term capital asset shall be reckoned while excluding the period for which it was held as stock-in-trade prior to conversion.
Now from AY 2018-19, a new Clause (via) has been inserted in Section 28 as per which the fair market value of inventory as on the date on which it is converted into, or treated as, a capital asset determined in the prescribed manner is to be taxed as business income of the previous year in which such transaction took place.
TAXATION OF GAINS FROM DEALING IN SHARES–WHETHER CAPITAL GAIN OR BUSINESS INCOME
In view of the differential rate of taxation between income received from trading and capital gains in shares, there is a tendency on the part of the assesses to camouflage the trading receipts as short-term capital gains.
The Instruction No. 1827, dated August 31, 1989 of CBDT sets out guidelines to the Assessing Officers for determining whether a particular assessee is a trader in shares, or the shares are held as capital assets. This instruction was updated on the basis of subsequent judicial pronouncements by Circular No.4/2007 dtd.15.06.2007 issued by the CBDT. After this, the CBDT has issued another circular vide Circular No. 6 of 2016 dated 29.2.2016. The AO has to consider all these instructions/ circulars while framing assessment orders.
The ratios to be considered by the AO as laid down by these instructions/ circulars as well as judicial pronouncements can be summarized as follows:
1. The income shown as capital gain is to be examined on case-to-case basis to find out whether business income is being shown as capital gain or otherwise. No single factor can be termed as conclusive and totality of the facts has to be considered.
2. Intention should be ascertained–the determinants of intention are: (these are only indicative and not conclusive)– frequency and volume of transactions, period of holding, continuity and regularity of the transactions, magnitude of transactions, nature of entry in the books of account, object clause in the Memorandum of Association, organized efforts, loans and borrowings used for investment, profit motive, reasons of sale and the nature of investment of the sale consideration etc.
3. Now, as per the latest CBDT circular, where the assessee itself, irrespective of the period of holding of the listed shares and securities, opts to treat them as stock-in-trade, the income arising from transfer of such shares/ securities would be treated as his business income.
4. Furthermore, in respect of listed shares and securities held for a period of more than 12 months immediately preceding the date of its transfer, if the assessee desires to treat the income arising from the transfer thereof as Capital Gain, the same shall not be put to dispute by the Assessing Officer. However, this stand, once taken by the assessee in a particular Assessment Year, shall remain applicable in subsequent Assessment Years also and the taxpayers shall not be allowed to adopt a different/ contrary stand in this regard in subsequent years.
5. To have a better understanding of the issue, the AO is recommended to read the following orders of various courts:
i. Pari Mangaldas Girdhardas vs. CIT 1977 CTR (Guj.) 647.
ii. Gopal Purohit 122 TTJ (Mum)87. Later, the Bombay High Court has approved this decision. In this aforementioned order, after analyzing all the facts, the delivery based transactions were held assessable as capital gain and non-delivery based transactions as business income.
iii. Dr Rajeev Choudhary [2019] taxmann. com 438 (Madhya Pradesh): The income was held to be business income on account of high frequency of transactions.
iv. Ramilaben D. Jain [2018] 97 taxmann.com 217 (Bombay): held that profit from sale and purchase of shares was business income due to short period of holdings.
v. Ratanlal J. Oswal [2015] 63 taxmann.com 57 (Bombay): Since the assessee borrowed funds for purchase of shares, transactions was carried out with many brokers and transactions had resulted in crores of rupee of income, the income on such on such transactions was held to be assessable as ‘business income’.
vi. Manoj Kumar Samdaria [2014] 45 taxmann.com 394 (Delhi): Where assessee was selling shares very frequently, volume and magnitude was very high and he earned only a meagre amount of dividend, income arising from sales of shares was assessable as business income.
vii. PVS Raju [2012] 18 taxmann.com 3 (AP.): where assessee had not purchased shares as an investment, but with intention to trade in such scrips – it was held to be assessable as business income.
viii. Rakesh J. Sanghvi [2010] 7 taxmann. com 40 (Mum): this decision has discussed multiple issues.
Further, if the assessee is utilizing the services of a Portfolio Management Services (PMS), even then the same principles are to be applied to determine whether the income is business income or trading income. For this, reference can be made to decisions in the cases of:
a. Radials International [2012] 18 taxmann. com 20 (Delhi.)
b. Tash Investment (P.) Ltd. [2019] 106 taxmann.com 190 (Ahmedabad-Trib.).
c. Nalin Pravin Shah, [2014] 49 taxmann. com 319 (Mumbai-Trib.).
Source- Taxalogue 3- April to June 2020
