Circular No. 768-Income Tax Dated 24-6-1998

420. Determination of ‘date of transfer’ and the ‘period of holding of securities’ held in dematerialised form under section 45(2A) qua transactions in securities

1. At present trading in securities is done through the physical movement of the scrips. Transactions are settled through the endorsement and delivery of the certificates which are also the proof of ownership of the security mentioned therein. This system is fought with many difficulties caused due to bad deliveries and loss of share certificates. In order to remove these difficulties faced by the investors, a system of holding securities in the electronic mode at the option of an investor has now been intro­duced in India. The object of this system is to eliminate prob­lems which are normally associated with settlement through physi­cal certificates, like tearing/mutilation of share certificates due to careless handling, loss of certificates by postal authori­ties or registrars or investors, problems of bad delivery, for­gery of certificates, etc. The new system is devised to ensure faster and hasslefree settlement of trade with shorter settlement cycles.

2. Under the new system, the movement of the scrips physically from one person to another is totally done away with by introducing certain intermediaries, chief among them being a Depository and a Participant. In order to implement the system of holding and transferring securities through the electronic media, firstly the Depositories Act, 1996, has been enacted. The object of this Act is to regulate the working of the depositories in securities and matters incidental thereto. A depository is an organisation where the securities of a shareholder are held in the electronic form on the request of the shareholder, through the medium of a Depository Participant. The depository is com­parable to a bank where an investor who desires to utilise its services can open an account with it through a Depository Partic­ipant. However, a Depository is not merely a custodian but is in fact the registered owner of the security and it is the Deposito­ry whose name is entered as such in the register of the issuer. The person actually entitled to the security becomes the benefi­cial owner, whose name is recorded as such in the books of the Depository.

3. The salient feature of this new system is that it is optional and would operate in inconjunction with the existing system of holding securities in physical form. Where an investor opts to hold a security with a Depository, i.e., not in physical possession of a certificate, the Depository shall be intimated of the details of allotment of securities and, accordingly, the depository shall enter in its records the name of the allottee as the beneficial owner of that security. Under this system, physical share certificates are surrendered to the issuing agency and the account maintained with the depository is the only evi­dence of the ownership of the securities. This conversion of physical certificates into the electronic holdings at the request is called dematerialisation. Whenever purchase/sale, i.e., any transfer of such securities held in dematerialised form is ef­fected, delivery is given or taken by making adjustments in the accounts maintained with the Depository by the two parties. The significant feature of the dematerialised securities is that they are fungible, i.e., all the holdings of a particular security will be identical and inter-changeable and they will have no unique characteristic such as distinctive number, certificate number, folio number, etc. As the holdings of any securities in dematerialised form is represented only by the account with the depository and all transfers are effected through book entries in the accounts maintained by the depository, under this system it is not possible to link the purchase of a security with its sale by means of its distinctive number, etc. It is for this reason that sub-section (2A) has been inserted in section 45 to provide for the computation of capital gains in respect of securities held in dematerialised form. This sub-section provides that for the purposes of calculating the date of transfer and period of hold­ing in respect of shares held in dematerialised form, the FIFO method would apply. Clarifications have been sought on the manner of application of the FIFO system for the determination of the date of transfer and the period of holding.

4. The primary issue under the Income-tax Act in the case of securities whether held in physical form or in the dematerialised form remains the determination of cost of acquisition and the period of holding. The Board had earlier issued Circular No. 704, dated 28-4-1995, which explains the manner in which the ‘date of transfer’ and ‘period of holding’ may be determined. This primary position as regards the ‘date of transfer’ and ‘period of hold­ing’ does not change even when the securities are held in the dematerialised form. The only problem when securities are held in dematerialised form is that the distinct trail linking every share to a certificate and its unique distinctive number linking it with its subsequent sale is not available.

5. Section 45(2A) stipulates that in the case of securities held in dematerialised form, for determining ‘date of transfer’ and ‘period of holding’, the FIFO method would be applicable. FIFO method is generally used to determine the value of any item moving out of a stock account and those remaining in stock at any point of time. When applied to an account holding dematerialised stock, it implies that, out of the existing holdings, the item that first entered into the account is deemed to be the first to be sold out. However, once a sale is linked with an earlier purchase, for determination of their ‘date of transfer’ and ‘period of holdings’, Board’s Circular No. 704 would be applica­ble. That is to say that the relevant contract notes as explained in Circular No. 704 will have to be referred to, for ascertaining the cost of the security sold and the date of transfer.

When actually operating an account of dematerialised stock by applying FIFO system, certain other issues can arise. For instance, an investor can hold part of his holdings of a security in physical form and the remaining in dematerialised form. Further, he may hold his dematerialised holdings in more than one account with one or more depositories. In such a situation, there can be doubts whether the FIFO system is to be applied globally on the entire holdings of physical and dematerialised holdings or not. In this connection, it is clarified that :

    (a)   FIFO method will be applied only in respect of the dematerialised holdings because in case of sale of dematerialised securities, the securities held in physical form cannot be construed to have been sold as they continue to remain in posses­sion of the investor and are identified separately.

    (b)   In the depository system, the investor can open and hold multiple accounts. In such a case, where an investor has more than one security account, FIFO method will be applied accountwise. This is because in case where a particular account of an investor is debited for sale of securities, the securities lying in his other account cannot be construed to have been sold as they continue to remain in that account.

    (c)   If in an existing account of dematerialised stock, old physical stock is dematerialised and entered at a later date, under the FIFO method, the basis for determining the movement out of the account is the date of entry into the account. This is illustrated by the following examples :

If say, 2500 shares were sold from out of this account, then the period of holding and the cost of acquisition of the first 2000 shares should be as from 25-5-1997 and the cost thereof, whereas the balance 500 shares will be treated as having been acquired in November 1985, at the relevant cost. This is the effect of the FIFO method.

Circular : No. 768, dated 24-6-1998.