ILLIQUID STOCK TRADING AND TAX EVASION 

1. The ‘scam’

So a new scam beckons us. That of allegedly executing fraudulent trades in illiquid stock options by committing irregularities in the equity derivative segment.

2. Operation Falcon

Popular belief is that the scam unearthed after the investigation wing of the I-T Department launched ‘Operation Falcon’ in July 2019, and searched 22 brokerage offices in various cities, including Mumbai, Kolkata, Kanpur Hyderabad and the Nation Capital Region(NCR). Truth of the matter is that the tax implications of the transactions were realized in 2019. SEBI was onto it , much earlier.

On the table are financial reports, a pen, a magnifying glass and a notebook with the inscription - Tax evasion

Sample this:

’ early in 2019, the Securities and Exchange Board of India (Sebi) levied a total penalty of over Rs 55 lakh on nine entities for fraudulent trading in illiquid stock options of the BSE. The action had come after the regulator conducted an investigation into the trading activity in the segment from April 2014 to September 2015, after observing large-scale reversal of trades. The regulator had observed that entities repeatedly bought and sold stock options and executed reversal trades with the same set of entities for the same quantity within a short span of time with substantial price difference. Later, these entities had created artificial volume in the contracts, which is in violation of unfair trade practices rules. In April 2018, Sebi announced that it had decided to take action in a phased manner against 14, 720 entities for fraudulent trade in the illiquid stock options segment. So far, the market regulator had passed more than 60-70 orders against such entities. ’’[BUSINESS STANDARD REPORT dated 5. 12. 19][Emphasis and highlight applied].

Financial Express of 29. 10. 2018 says after the investigation, SEBI found that 14, 720 entities violated the provisions of Sebi (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market) Regulations, 2003 by executing manipulative transactions in BSE’s stock options segment between April 2014 and September 2015. Thereafter, the tax agency found out another 6, 000 entities for allegedly executing similar trades in violation of Sebi norms.

2.1 The probe covers trades of the last five years, starting 2014. As many as 21, 900 entities are supposedly under the scanner of Income Tax Department for allegedly evading taxes through non-genuine trades in the illiquid stock options contract segment of the Bombay Stock Exchange (BSE) Ltd.

3. Modus Operandi:Reversal Trading

It is alleged that some share brokers were facilitated either by themselves or by connivance with another broker to generate profits and losses for clients through this market by modus operandi of Reversal trading. This involves buying and selling of stocks from and to the same counterparty during a day which creates artificial trade units of stocks(artificial volume). One party takes losses through buying stock at higher rate and, then, execute reversal trade and sell these stocks to the same counter party at a relatively lower rate thereby resulting in gains for other party in a very short span of time. . Conversly it can be understood as follows: step 1 is to sell options without the corresponding off set position in the underlying scrip. Then selling them at extremely low prices . Step 2 is buying back same options by same entities at a later trading date but at a high price. A loss is obviously created.

Illustration: X wants a manufactured loss of Rs 100 to reduce taxable income. while Y wants to launder Rs 100 untaxed money.

A broker puts X and Y on the opposite SIDE of a series of trades in some options contracts that is in effect substance less. The trades will be matched such that Y makes a profit of Rs 100 and X gets a loss of the same amount. SEBI calls such trades as reversal trades, which were pre-mediated.

Later, money settlement takes place between X and Y clandestinely to settle amounts, by cash or other methods. 

4. SEBI Settlement scheme, 2020

4.1 SEBI has been passing orders against several entities, including those connected to this scam, on options trading in illiquid stocks on the BSE.

Thereafter it introduced the SEBI Settlement Scheme 2020 (end of October 31, 2020), which offers a one-time settlement opportunity for entities that executed reversal trades in the stock options segment of BSE. A one-time settlement to nearly 15, 000 practitioners of the technique, instead of fighting long drawn-out cases in the court.

4.1. 1 In the matter of R S Ispat [adjudication order dated 27. 11. 18, a fine of Rs 25 lacs was imposed u/s 15 HA of SEBI ACT 1992 for indulging in execution of reversal trades in stock options with same entities on the same day , thereby CREATING ARTIFICIAL VOLUME leading to false and misleading appearance of trading in the illiquid stock options.

The scheme seems a fallout of Hon’ble SAT order in this matter:

We are adjourning this matter today, so that SEBI may consider holding a Lok Adalat or adopting other alternative dispute resolution process with regard to the illiquid stock options” [Dated 14th October, 2019 in the matter of R S Ispat Ltd vs SEBI]

4.2 Hence, to settle the proceedings initiated for such entities, SEBI introduced the scheme (supra). The SEBI statement says that a “uniform consolidated settlement factor of 0. 55 in all cases wherein the entities had executed reversal trades, would be applicable while arriving at the indicative settlement amounts. ” So for Rs 10 of notional profit or loss, the involved traders will have to pay Rs 5. 5 as settlement.

5. THE TANGENT OF TAX LAW

5.1 The Settlement scheme puts a spanner in the works for the I. T. Department. For one, Settlement refers to neither admitting nor denying any non-compliance.

Secondly, a 30. 7. 2020 report in Business Upturn [‘’SEBI’s reversal trade settlement causes loss to Income Tax Department’’] says Tax offenders are exploiting a particular loophole in SEBI regulations which allows them to indulge in an unfair trade practice while being able to show that it did not hurt other investors. This shall also provide a lifeline before tax authorities.

Thirdly, SEBI says the trades are not genuine but trader says that his broker put in the trade, so he was not aware of the counterparty. He invested his idle funds for the short term. SEBI imposed a penalty, and the trader challenged the order. While it may seem apparent that the trades were done for tax adjustments, can a case for tax evasion be made out?.

6. Technical aspects

The next set of issue concerns about the technical aspects. The tax agency was supposedly looking to draft a Standard Operating Procedure (SOP) for its assessing officers to assess tax liabilities and to deal with each of these cases as per FINANCIAL EXPRESS ONLINE DATED 29. 10. 2018. The initiation of recent 148 notices confirms that this is probably what has happened.

6.1 These are template driven investigations . But will they create a beneficial standardisation and uniformity of approach or will they do more harm than good ? As we saw in case of bogus purchase scam where such a standardised SOP driven investigation fell flat on its face at appellate level since the department was unable to unravel or appreciate the fine distinctions case to case and failure to appreciate that implementation of tax law is as much an art as it is a science.

6.2 In its excitement of having’’unearthed’’(?)another scam, probably the issue of establishing tax evasion is lost in translation. This is what happened in bogus purchase scam. I strongly believe that genesis or root investigation only can lead to successful assessments. In bogus purchase scam they got enamoured and bound by SOPs that none knew where the issue was coming from. The root there was a decision of hon’ble Bombay High Court  in Mahalaxmi Cotton Ginning Pressing and Oil Industries vs the State of Maharashtra & Others (2012) 51 VST 1 (Bom) (HC) ( SLP dismissed by the Supreme Court). I can bet my bottom dollar that not even 5% of AOs dealing with bogus purchase assessments even heard of this decision, or, if heard, then read it. Prior to that, the lead judgment was years back in case of Suresh Trading Company by hon’ble SC[(1996 (3) SCALE 536, (1997) 11 SCC 378, 1998 109 STC 439 SC]. This was followed by MAHAVAT ACT(2002) which led to the MAHALAXMI judgment. This was root investigation point. But where the department went was a list of some 2059 dealers who have issued tax invoices without actually paying the VAT was displayed by the Sales-tax Department on its website mahavat.gov.in under the title “List of suspicious dealers who have issued false bills without delivery of goods”. Rest is tragic history leading to ‘’12. 5%decisions’’ which every student/practitioner of tax litigation law is well aware of;if not, he/she should be. Huge lesson in legal faux pa and discouragingly dealt with by multiple appellate forums.

6.3 There, at least part tax was recovered. Here , the manner in which 148 notices have been issued on 31. 3. 2021 [ostensibly to avoid the ambit of new s 148A] to book ‘’non-genuine profits/losses on illiquid derivatives on BSE and USE’’ , it makes one wonder. And the apparent unholy hurry to avoid 148A may lead to a case of going from frying pan into the fire.

7. Unfair and fraudulent

SEBI rulings and penalisations center around the law it implements and rules and schemes it follows. Does ‘’unfair’’ trade practice or unethical transactions leverage the taxability of the transaction? Try looking for the terms ‘’fair’’ or ‘’unfair’’ in the Income Tax Act 1961 and do point out in comments and reactions section to this modest effort of mine. !

But ‘’fraudulent and unfair’’ find a pride of place, and probably rightly so, in SEBI Act 1992 in its s. 15HA. Because it’s a different law-with a different purpose.

The closest I find in IT Act 1961 is ‘’impermissible avoidance arrangement’’ in s 95(1), ’’lacks commercial substance’’ and ‘’bona fide’’ in s 96(1), or ’’substantial commercial purpose’’ in s 97(2). But then these are highly contextualized provisions with laser point applicabilities , not admitting of a general conceptual utilization.

8. Issues of interest

To me RT represents but a different shade of CCM. As an officer I would be more concerned about round tripping, circularity and colourable device. But the new gen manning the citadel of revenue (and many of old gen too)have not even seen what McDowell[154 ITR 148 SC]meant for revenue-or should mean. Money has no colour for a taxman and morality, ethics , equity and fairness are alien dimensions for enforcement of the tax law. Surprising? Not my view. See Cape Brandy Syndicate v. IRC [1921] 1 KB 64, 12 Tax Cas 358), where Rowlat J. said it in so many words about equity and picked up favourably by Indian rulings later. As for other aspects, I guess Piara Singh 124 ITR 40(SC) would suffice.

9. Rakhi Trading ruling

The revenue could be enthused by the ruling in SEBI Vs. Rakhi Trading Private Ltd. Civil Appeal No. 1969 of 2011 with C A numbers 3174-3177 & 3180 of 2011 decided on February 08, 2018 (SC) in para 35’’……. . The platform of the stock exchange has been used for a non-genuine trade. Trading is always with the aim to make profits. But if one party consistently makes loss and that too in preplanned and rapid reverse trades, it is not genuine; it is an unfair trade practice…. . ’’

Should this be a cause of cheer for revenue?For now I leave it for the discerning reader to decide and a mouth watering prospect for a student and practitioner of law to delve and debate upon. 

10. CONCLUDING REMARKS:

This is the third alleged stock market scam. The first was CCM (client code modification) way back in 2010 with claimed evasion of Rs. 55, 000 crores. In 2013, the penny stock scam allegedly involved evasion of Rs 70, 000 crores. And this 2019 expose of illiquid derivatives is said to be to the tune of Rs. 8, 200 crores tax evaded. I would add bogus share capital, bogus share premium scam to it as a fourth one.

How many were finally held guilty of tax evasion and how much tax finally came into the kitty after all appellate rounds in first two is not popularly known. What will be the fate of this one? Will the falcon fly?

*****

Source: Business Standard, Financial Express, India Today, Business Upturn, Income Tax And SEBI Case Laws, Newspaper Reports, Self Analysis.

Disclaimer: The contents of this article are for information purposes only and do not constitute an advice or a legal opinion and are personal views of the author. It is based upon relevant law and/or facts available at that point of time and prepared with due accuracy & reliability. Readers are requested to check and refer relevant provisions of statute, latest judicial pronouncements, circulars, clarifications etc before acting on the basis of the above write up.  The possibility of other views on the subject matter cannot be ruled out. By the use of the said information, you agree that Author / TaxGuru is not responsible or liable in any manner for the authenticity, accuracy, completeness, errors or any kind of omissions in this piece of information for any action taken thereof. This is not any kind of advertisement or solicitation of work by a professional.

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