Applicability of 44AD and 44AB in case of Derivative (F&O) transactions:

Para 5.14 of Guidance Note on Tax Audit under Section 44AB of the Income-tax Act, 1961 provides for method of calculating the turnover or gross receipts to ascertain whether tax audit will be applicable or not. The same is reproduced as under:

Derivatives, futures and options: Such transactions are completed without the delivery of shares or securities. These are also squared up by payment of differences. The contract notes are issued for the full value of the asset purchased or sold but entries in the books of account are made only for the differences. The transactions may be squared up any time on or before the striking date. The buyer of the option pays the premia. The turnover in such types of transactions is to be determined as follows:

  • The total of favourable and unfavourable differences shall be taken as turnover.
  • Premium received on sale of options is also to be included in turnover.

Whereas actual turnover will be determined based on accounting entries passed in the books of account, in case of derivative transactions one will pass entry in books for differential amount only and the same will be regarded as turnover of the business for the purpose of Income tax.

  • Section 44AB(a) of Income tax Act, 1961 (“the Act”) provides that if the turnover or gross receipts exceeds Rs. 1 Crore then he is liable to get his books of accounts audited under Income tax. First Proviso to section 44AB provides that section 44AB will not be applicable in case the person declares profits and gains from business as per provision of section 44AD(1) and his total sales or turnover as the case may be doesn’t exceeds Rs. 2 Crore.
  • Section 44AD(1), starts with non-obstante clause with regards to section 28 to section 43C, provides that a sum equal to 8% of the total turnover or a sum higher than the 8% claimed to have been earned by the eligible assessee shall be deemed to be the profit and gains of such business and chargeable under the head “PGBP”. Explanation to section 44AD doesn’t specifically exclude transactions in derivatives – F&O as not eligible business.
  • Explanation 2 to section 28 provides that speculative transactions are of business nature then the same will be distinct transactions from any other business of the assessee.
  • Section 43(5) defines speculative transactions and specifically excludes derivative (F&O) transactions from the definition of speculative transactions.
  • Combined reading of section 28 and section 43(5) provides that derivatives (F&O) transactions will be treated as business and profit or loss will be taxable as business income only.
  • In case of Nand Lal Popli vs D.C.I.T. (ITA No.1161/Chd/2013 & ITA No.1162/Chd/2013) the Hon’ble ITAT, Chandigarh has held that asking the assessee to prove to the satisfaction of the Assessing Officer, the expenditure to the extent of 92% of gross receipts, would also defeat the purpose of presumptive taxation as provided under section 44AD of the Act or other such provision. Since the scheme of presumptive taxation has been formed in order to avoid the long drawn process of assessment in cases of small traders or in cases of those businesses where the incomes are almost of static quantum of all the businesses, the Assessing Officer could have made the addition under section 69C of the Act, once he had carved out the case out of the glitches of the provisions of section 44AD of the Act.
  • In case of Pawa Industries Pvt. Ltd. vs ITO-14(2) (ITA No.1161/Chd/2013 & ITA No.1162/Chd/2013) the Hon’ble ITAT, Delhi has held that e.f. assessment year 2011-12, the choice available with the assessee of choosing the option, has been taken away and now, the assessee is required to declare the income whichever is higher, out of estimated income or the amount claimed to have been actually earned from such vehicle.

The said ruling is with regards to section 44AE of the Act and is in line with the Circular No. 5/2010 – Explanatory notes to the provisions of the Finance (No. 2) Act, 2009 wherein it is specifically mention that “Further an anti-avoidance clause is provided to state that a prescribed fixed sum or a sum higher than the aforesaid sum claimed to have been earned by the assessee shall be deemed to be profits and gains of such business.” However such clause doesn’t exist for section 44AD.

Example:

Purchase value of lot as per contract note – 14 Crore and sale value of lot as per contract note is 15 Crore, then there is net favourable difference is of 1 Crore which will be regarded as turnover for the purpose of section 44AB and the same will be accounted as sales in the books of account of the assessee.

As per provision of section 44AD it is at the option of assessee to offer 8% or actual profit that he claims to have been earned from the said F&O transactions. If profit is offered at 8% then there will be addition to asset at actual profit that was earned by the assessee. It may possible that AO add differential amount as unexplained investment under section 69C of the Act, however there is decision of Chandigarh ITAT (supra) in which similar addition was directed by ITAT to be deleted.

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4 Comments

    1. hiteshkothari says:

      If it is regularly carried out then you continue the practice of offering of 8% and of course AO will not accept the stand, fight will have to be done

    1. hiteshkothari says:

      total of favourable and unfavourable differences shall be taken as turnover means total in absolute terms. Favourable (Profit) difference is 100 and unfavorable (loss) is 90 then total turnover as per GN will be 190.

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