This Article summarizes a recent ruling of the Special Bench (SB) of Kolkata Income Tax Appellate Tribunal (ITAT) in the case of Shree Capital Services Ltd. (Taxpayer) vs. ACIT (ITA No. 1294 (Kol) of 2008) in which the SB held that, prior to financial year 2005-06 (assessment year 2006-07), derivative transactions in shares were covered by the definition of speculative transactions (ST). The SB further held that the exception to the definition of ST, from tax year 2005-06, in respect of eligible derivative transactions carried out on recognized stock exchanges, is not clarificatory in nature and does not have a retrospective effect for earlier years.
Background and Facts
- Section 43(5)(Section) of the Indian Tax Law (ITL) defines ST 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’. Under the ITL, the characterization of a transaction as ST is relevant, as loss from such transactions is not permitted to be set off against any other income (including regular business income). Further, the period of carry forward for such losses is restricted to 4 years instead of the normal period of 8 years.
- Up to tax year 2004-05, the Section carved out an exception for certain specified hedging contracts from the scope of ST.
- From tax year 2005-06, a further exception was added to the definition in terms of which, eligible derivative transactions on recognized stock exchanges, which fulfill certain conditions, are also excluded from the scope of ST.
- The Taxpayer is engaged in the business of financing and investments in shares and securities. In the tax year 200304 (i.e. prior to the amendment from tax year 2005-06), it suffered loss on account of derivative transactions, in respect of shares of companies.
- The Tax Authority treated the derivative transactions as ST and denied set off of such loss. The first appellate authority confirmed the decision of the Tax Authority. The Taxpayer further appealed to the ITAT. The Division Bench of the ITAT referred the issue to the SB of the ITAT.
Contentions of the Taxpayer
- The definition of ST contemplates actual delivery of commodity or scrips. As per the rules of the Securities & Exchange Board of India (SEBI), the regulatory authority for securities transactions in India, it is mandatory to settle the derivative transactions only in cash and actual delivery is not possible.
- There was no option to the Taxpayer to give or take delivery of the derivatives so as to attract the applicability of the definition. The definition applies only to those transactions which are capable of being settled by actual delivery.
- Derivative transactions cannot be regarded as purchase or sale of any commodity or stocks or shares.
- The insertion of exception for derivative transactions from tax year 2005-06 is clarificatory in nature and has a retrospective effect.
- The Taxpayer also relied on certain decisions of the Supreme Court (SC) to support the submission that a provision which is inserted to supply an obvious omission to a parent provision takes effect from the date of insertion of the parent provision.
Contentions of the Tax Authority
- Referring to the meaning of ‘derivative’ as per Securities Contract (Regulations) Act (SCRA) and SEBI’s website, the Tax Authority contended that the derivative transactions derive their value from the underlying assets which can be securities, commodities, bullion, currency, livestock or the like. Hence, derivative transactions take their color from the underlying assets, being commodity or stocks or shares, and will fall within the ambit of the definition of ST.
- The Tax Authority placed reliance on the SC’s decision in the case of CIT vs. B. Suresh [313 ITR 149], in which it was held that the telecast rights of films or TV programs are goods, eligible for export profit deduction. Since the meaning of commodity is wider than that of goods, it needs to be construed widely to include derivatives also.
- As the exception for derivatives has been inserted in the ITL prospectively from tax year 2005-06, the same cannot be applied to earlier years.
Ruling of the SB
The SB held that the derivative transactions fell within the definition of ST and were not covered by the exception inserted from tax year 2005-06, for the following reasons:
- The meaning of ‘derivative’, as explained on SEBI’s website, makes it clear that derivatives derive their value from the underlying assets. The definition of derivatives, as per SCRA, also makes it clear that it is (i) A security derived from, inter alia, shares or (ii) A contract which derives its value from the prices of the underlying securities. In the instant case, the underlying assets in derivative transactions of the Taxpayer, were shares of companies.
- The SB relied on SC’s decision in the case of B. Suresh (supra), in which the SC held that, with technological advancement, one has to change the thinking regarding concepts like goods, merchandise and articles. It held that, under the wide meaning of such items, telecast rights of films would fall in the category of articles of trade and commerce and, hence, it can be regarded as goods. The SB held that, the observation of the SC in the context of goods, would squarely apply to commodity also.
- Although, in common parlance. commodity does not include stocks and shares, which are in the nature of securities, the Legislature has consciously given the term ‘commodity’ a wider meaning for the purpose of the Section, by including them within its scope.
- Since, in the instant case, the derivatives represent the underlying assets, being shares, it should be given the same treatment as shares. Hence, like shares, derivatives will also fall within the meaning of commodity, for the purposes of the Section.
- Any other interpretation will render the exception for eligible derivatives, inserted from tax year 2005-06, redundant. If the Section did not cover derivatives within its scope, there was no need for the Legislature to insert the exception with effect from tax year 2005-06.
- The amendment made by inserting the exception for eligible derivatives is not clarificatory in nature and does not have any retrospective effect. The Explanatory Memorandum to the Finance Bill 2005, which introduced the amendment, makes it evident that the derivatives were exempted from the purview of ST because of the recent systemic and technological changes introduced by the stock exchanges, which provide transparency in such dealings. Hence, the amendment was not intended to provide for an obvious omission but was made in view of the changed circumstances.
- Further, the exemption does not apply to all derivative transactions but only to eligible derivative transactions which fulfill the conditions prescribed in the exception and which are carried out on recognized stock exchanges, which were notified after the amendment. Hence, the amendment is prospective in nature and does not apply to tax years prior to 2005-06.
An SB is generally constituted when there are conflicting decisions of the Tribunals or the matter pending for adjudication is of considerable importance. It is also a well-settled convention to consider the SB’s decision as binding on the division benches of the Tribunal .
The current ruling of the SB provides guidance that, prior to tax year 2005-06, derivative transactions in shares were covered within the meaning of ST.
The ruling provides guidance that, from tax year 2005-06, eligible derivative transactions, which are carried out on recognized stock exchanges, are not covered within the scope of ST and the loss incurred in such transactions would be available for set off against other income.