taxation matters relating to securities and derivatives

Taxation matters relating to securities and derivatives

Updated on :7th December 2010

Index1. Transactions relating to securities and derivatives1.1. Difference between Delivery in cash, Intraday trading in cash segment and Derivatives (F&O) segments

2. CGs on shares held as investment 3. Investment Vs. Trading3.1. Investment Vs. Trading (CBDT Circular) 3.2. Investment Vs. Trading (Case laws)

4. Hedging 5. Case Law on: Part I Difference between hedging and speculative transaction Part II Difference between trading income and business income 6. Derivatives

Index7. Futures and Options7.1.Futures and Options Difference 7.2.Taxation of Futures and Options

8. Speculative transaction8.1.Exclusion of Derivatives from definition of Speculative Transaction 8.2.Case Law: Income from trading of shares will be speculative business within meaning of provision of Explanation to section 73

9. CBDT Circular on Notional losses on forex hedge not tax deductible

Transactions relating to securities and derivatives Transactions relating to securities and derivatives can be of three types: Cash delivery Intraday trading Derivatives (F&O Segment)

Difference between Delivery in cash, Intraday trading in cash segment and Derivatives (F&O) segments For Tax purpose the Income tax act distinguishes between Delivery, Intraday trading in cash segment and F&O segments. Consequently the tax treatment for profit/loss in all three are different. CASH DELIVERY Delivery based income can be capital gain or business income. If, Delivery is deemed as investment in an asset. Then Capital gains rules apply. On short term investment i.e. shares bought in cash segment and sold before completion of 1 year from date of purchasing, you have to pay 15% of profits as STCG Tax. On long term investments i.e. shares sold after 1 year of holding the long term tax applies which currently is NIL. Any loss is allowed to be carry forward and set off for 8 years.

Difference between Delivery in cash, Intraday trading in cash segment and Derivatives (F&O) segments (Continued ) CASH INTRADAY Intraday trading in Cash segment is deemed as speculation, same as lottery or betting on horse racing. The tax rate applicable on profits from speculation income is flat 30%. Any loss is allowed to be carry forward for 4 years, to be set off against future speculation profits.

DERIVATIVES/F&O Dealing in FnO is treated as Business. Thus normal business taxation rules apply as they would to any other business. The rate of Tax is as per Slab applicable in the respective year.

NOTE: TAX AUDIT IS ONLY REQD FOR BUSINESS INCOME I.E FOR INCOME FROM DERIVATIVES/FUTURES AND OPTIONS. Not from Income from Capital Assets or Speculation Income.

CGs on shares held as investment Short term Capital Gains: Gains arising from the sale of shares held for less than 12 months Taxability of short term capital gains: Section 111A of the Income tax Act - equity shares or equity oriented funds which have been sold in a stock exchange and securities transaction tax is paid on such transaction then the short term capital gain arising from such transaction will be chargeable to tax @10% upto assessment year 2008-09 and 15% from assessment year 2009-10 onwards.

CGs on shares held as investment (Continued ) If an assessee does the business of selling and purchasing shares he cannot take advantage of section 111A or section 10(38). In this case income will be treated as business income. The deduction u/s 80C to 80U can be taken from the income from short term capital gain apart from the short term capital gain u/s111A

CGs on shares held as investment (Continued ) Long Term Capital Gains : The gain arising from the sale of shares held for 12 months or more is termed as long term capital gain. Taxability of Long term capital gains: Section 112(1) - any capital gain arising from a long term capital asset being the listed securities which are sold outside the stock exchange the long term capital gain shall be calculated on such securities as below: a) Tax arrived at @ 20% on such long term capital gain after indexation u/s 48 or b) Tax arrived at @ 10 % on such long term capital gain without indexation Whichever is less. The long term capital gain on equity shares or units of equity oriented mutual fund which are sold in the stock exchange and on which securities transaction tax is paid, is exempt u/s 10(38). No deduction is allowed from the long term capital gains from section 80C to 80U.

Investment Vs. Trading The tax liability depends upon whether the person is carrying on an activity of investing or is carrying on a business of share trading. To differentiate between the two, there are several factors to be considered:1. The motive for the original purchase as perceived at the time of sale If at the time of sale, it is seen that the original motive of purchase was to earn a quick profit, this would support the presumption that the transactions represent a business.

Investment Vs. Trading (Continued )2. The period of holding of the shares The shorter the period, the greater the presumption that the transactions are in the nature of a business. One indicator of this is the definition of long term capital asset vis--vis shares - any shares held for more than 12 months are regarded as long term capital assets. Generally, shares bought with the intention of holding them for more than 12 months would be an indicator that the transaction was intended as an investment. 3. The frequency of sale of shares The more frequent the transactions, the greater the presumption that it amounts to a business.

Investment Vs. Trading (Continued )4. The circumstances responsible for the sale of shares If the sale is necessitated by the need for funds for other personal purposes, such as for payment of taxes or family functions, the presumption would be that it is merely a realisation of investments. The presence of a clearly discernible motive for the purchase of the shares Investors invest in business of the company and traders invest in stock of the company. Investors go by fundamentals of the business and traders go fluctuations in a stock price. For instance, where the purchase of shares was with an intention to acquire controlling interest in the company, such purchase of shares would be in the nature of an investment. Similarly, the shares acquired by the promoter of a company are generally in the nature of investments.

5.

Investment Vs. Trading (Continued )6. The relation of the share transactions to the normal business of the assessee In the case of a sharebroker or an underwriter, acquisition of shares would generally be regarded as an extension of his sharebroking or underwriting business. On the other hand, shares acquired by a professional such as a chartered accountant, lawyer or doctor would generally be considered to be investments. The treatment of the shares and profit or loss on their sale in the accounts of the assessee The treatment of the shares as stock-in-trade by the assessee would be one of the indicators of his intention to treat it as a business. The source of funds out of which the shares were acquired - borrowed or own Investment out of borrowed funds would generally support the presumption of existence of a business activity. On the other hand, acquisition of shares by liquidation of another investment would support the presumption that the transaction is one of change of investment from one form to another.

7.

8.

Investment Vs. Trading (Continued )In the case of a company, the existence of an objects clause permitting it to trade in shares Since a company cannot carry on any business unless permitted by the objects clause of its Memorandum of Association, its acquisition of shares would normally not be regarded as a business activity in the absence of an objects clause permitting share trading. Since a partnership firm can carry on any activity mutually agreed upon by its partners, the absence of a clause in the partnership deed to carry on the business of share trading would not make any difference. 10. The manner of acquisition of the shares Where the shares were not purchased voluntarily but were inherited or received as a gift, the presumption would generally be that the sale of such shares is a capital gain. Similarly, shares acquired from the primary market for long term holding would generally support the presumption of an investment activity, while acquisition of shares from the secondary market could indicate either investment or business activity. 9.

Investment Vs. Trading (Continued )11. The infrastructure employed for the share transactions If the assessee employs people to assist him in his share activities, such as analysts, dealing assistants, or acquires various assets such as computer hardware and software, etc. for this purpose, it indicates an organized activity, supporting the presumption of a business. On the other hand, investing through a discretionary portfolio manager is indicative of an investment activity, since the investor does not have to be involved with the activity of investment on a regular basis, but is merely concerned with the rate of return on his funds employed. 12. Marketability of the shares If the shares acquired are not readily marketable, generally the presumption would be that they are held as investments. The very purpose of acquisition of shares held as stock-in-trade is to make a quick profit, and the acquisition of non-marketable shares is not consistent with such a purpose. 13. Delivery If STT is paid and delivery is taken then its investment, and if no delivery and settled on same day then trading income.

Investment Vs. Trading (CBDT Circular) There is no clarification in this regard in Income Tax Act, it all depends on the intention of the assessee how he wants to treat the same in the books of accounts. However circular has been issued by CBDT in this regard specifying that the assessee can have two portfolio one is Investment in shares and second one is of Business Stock. Enclosed herewith circular and Questionnaire given by ITAT in various case laws. A. Principles laid down by CBDT in circular 04/2007 dated 15.06.2007(i) Where a company purchases and sells shares, it must be shown that they were held as stock-in-trade and that existence of the power to purchase and sell shares in the memorandum of association is not decisive of the nature of transaction; (ii) the substantial nature of transactions, the manner of maintaining books of accounts, the magnitude of purchases and sales and the ratio between purchases and sales and the holding would furnish a good guide to determine the nature of transactions;

Investment Vs. Trading (CBDT Circular) continued(iii) ordinarily the purchase and sale of shares with the motive of earning a profit, would result in the transaction being in the nature of trade/ adventure in the nature of trade; but where the object of the investment in shares of a company is to derive income by way of dividend etc. then the profits accruing by change in such investment (by sale of shares) will yield capital gain and not revenue receipt .

A. Details as per decision given by ITAT (Mum) in the case of Management Structure & Systems Pvt. Ltd. (ITA No. 6966/Mum/2007 AY: 2004-05) What is the intention of the assessee at the time of purchase of the shares (or any other item) ? This can be found out from the treatment it gives to such purchase in its books of account. Whether it is treated as stock-in-trade or investment ? Whether shown in opening/closing stock or shown separately as investment or non-trading asset ? Whether assessee has borrowed money to purchase and paid interest thereon ? Normally, money is borrowed to purchase goods for the purposes of trade and not for investing in an asset for retaining.

Investment Vs. Trading (CBDT Circular) continued

What is the frequency of such purchases and disposal in that particular item ? If purchase and sale are frequent, or there are substantial transactions in that item, it would indicate trade. Habitual dealing in that particular item is indicative of intention of trade. Similarly, ratio between the purchases and sales and the holdings may show whether the assessee is trading or investing (high transactions and low holdings indicate trade whereas low transactions and high holdings indicate investment). Whether purchase and sale is for realizing profit or purchases are made for retention and appreciation in its value ? Former will indicate intention of trade and later, an investment. In the case of shares whether intention was to enjoy dividend and not merely earn profit on sale and purchase of shares ? A commercial motive is an essential ingredient of trade. How the value of items has been taken in the balance sheet ? If the item in question are valued at cost, it would indicate that they are investments or where they are valued at cost or market value or net realizable value (whichever is less), it will indicate that items in question are treated as stock-in-trade. How the company (assessee) is authorized in memorandum of association/articles of association ? Whether for trade or for investment? If authorized only for trade, then whether there are separate resolutions of the board of directors to carry out investments in that commodity ? And vice versa .

Investment Vs. Trading (CBDT Circular) continued These principles of law have to be applied to the following facts (or answer to the below 8 question): Treatment given in the Books of Accounts by the assessee, whether treated entire Investment in shares as an investment and not as stock-in-trade Whether aseessee is share broker or registered with any stock exchange Proportion of Long Term Capital Gain in Total Gain Whether any derivative transaction carried out by the assessee Whether any transaction without delivery carried out by the assessee Whether assessee has borrowed money for making investment or used own surplus fund Whether the disclosure made by assessee in past in filing the return has been accepted by the Income tax Dept Has assessee received substantial amount of dividend on the investment

Investment Vs. Trading (Case laws)CASE LAWS

Mere possibility of realisation of enhanced value will not render the transaction a business venture

The question whether transactions of sale and purchase of shares were trading transactions or whether these were in the nature of investment is a fixed question of law and fact. That depends on the question whether the excess is an enhancement of the value by realising a security or a gain in an operation of profit-making. The assessee might invest his capital in shares with the intention to resell these if in future their sale brings in a higher price. Such an investment, though motivated by a possibility of enhanced value, will not necessarily render the investment a transaction in the nature of trade. The totality of all the facts will have to be borne in mind and the correct legal principles applied to these - Raja Bahadur Visheshwara Singh v. CIT [1961] 41 ITR 685 (SC). The surplus realised on the sale of shares would be capital if the assessee is an ordinary investor realising his holding; but it would be revenue, if he deals with them as an adventure in the nature of trade. The fact that the original purchase was made with the intention to resell if an enhanced price could be obtained by itself is not enough, but in conjunction with the conduct of the assessee and other circumstances it may point to the trading character of the transaction. For instance, an assessee may invest his capital in shares with the intention to resell them if in future their sale may bring in higher price. Such an investment, though motivated by a possibility of enhanced value, does not render the investment a transaction in the nature of trade. The test often applied is, whether the assessee has made his shares and securities the stock-in-trade of a business - Raja Bahadur Kamakhya Narain Singh v. CIT [1970] 77 ITR 253 (SC).

Investment Vs. Trading (Case laws) continued Element of carrying on of business must be present When an owner of an ordinary investment chooses to realise it and obtains a higher price for it than when he originally acquired it, the enhanced price is not a profit assessable to income-tax, but where what is done is not merely a realisation or a change of investment but an act done in what is truly the carrying on of a business, the amount recovered as appreciation will be assessable - Raja Bahadur Visheshwara Singh v. CIT [1961] 41 ITR 685 (SC).

Where purpose is acquisition of managing agency, transaction is not a business venture If the shares were acquired for obtaining control over the managing agency, the fact that the acquisition of the shares was integrated with the acquisition of the managing agency would not affect the character of the acquisition of the shares. Subsequent disposal of some of the shares could also not convert what was a capital acquisition into an acquisition in the nature of trade Ramnarain Sons (P.) Ltd. v. CIT [1961] 41 ITR 534 (SC)/Rameshwar Prasad Bagla v. CIT [1973] 87 ITR 421 (SC).

Investment Vs. Trading (Case laws) continued Where initial intention itself is to make profit by resale, transaction is a business venture It is no doubt correct to say that the principal consideration in determining whether income from sale of shares is revenue income or capital gain is to find out what was the purpose of purchase of those shares and, if the purpose was investment, the fact that in varying the investment, the sale of those shares resulted in a profit will not make that profit revenue income. However, this principle is not applicable to cases where it is found that even the initial purchase of shares by the assessee was not for the purpose of investment; for earning income from dividends, but was with a view to earn profit by resale of those shares - Dalhousie Investment Trust Co. Ltd. v. CIT [1968] 68 ITR 486 (SC).

Mere fact that assessee is a big land-holder is not relevant The fact that the assessee was, at the material time, a land-holder of a large estate, would not mean that his transactions in shares, securities and bullion could not be transactions in the nature of trade. They had, therefore, to be examined in the light of all the facts and circumstances to ascertain whether they had been entered into in pursuit of a trading activity - Raja Bahadur Kamakhya Narain Singh v. CIT [1970] 77 ITR 253 (SC).

Investment Vs. Trading (Case laws) continued Acquisition out of borrowed capital, and source of acquisition, are relevant factors In the case of purchase and sale of shares the relevant consideration would be whether the shares have been purchased with borrowed capital and they are speculative in nature, and whether they have been purchased in the open market or from the company at the time of its incorporation or expansion of its capital - CIT v. Sugar Dealers [1975] 100 ITR 424 (All.)

Later stages of operations must also be looked into In order to determine whether an assessee is a dealer in shares or an investor, the real question is not whether the transaction of buying and selling the shares lacks the element of trading, but whether the later stages of the whole operation show that the first step the purchase of the shares is not taken as, or in the course of, a trading transaction - CIT v. H. Holck Larsen [1986] 160 ITR 67 (SC).

Hedging Hedging is defined as to enter in to transactions that will protect against loss through a compensatory price movement . A hedging transaction is one which protects an asset or liability against a fluctuation in the foreign exchange rate. Hedging contracts can be undertaken to protect investments as well as stock in trades. Thus income from it can be either of the nature of capital gains or income from business. Whatever it is, the cost of it will form part of the cost of the product, to hedge which it is undertaken. Hedging contracts entered into by merchants to guard against future losses through price fluctuation and derivatives transactions, and trading in the F&O market are exceptions to this section 43(5) of the Income Tax (IT) Act, 1961, and are not considered as speculative transactions from assessment year (AY) 2006-07.

Case Law on: Part I Difference between hedging and speculative transaction Part II Difference between trading income and business income

Assessee in garb of entering hedging transaction cannot seek to enter into speculative transaction in any stocks or shares other than one held by him as inventory CASE DETAILS ITAT, MUMBAI BENCH D ACIT v. Dinesh K. Mehta (HUF) ITA No. 976/Mum/2009 RELEVANT PARAGRAPH If all speculative transactions will be claimed as hedging transactions, very purpose behind the provisions of section 73 not permitting set off of speculative loss against business income will become redundant. The first part of Case law describes the difference between hedging transaction and speculative transaction, whereas, the second part of it describes the difference between trading income and business income

Case Law on: Part I Difference between hedging and speculative transaction Part II Difference between trading income and business income (Continued ) ORDER PER N.V. VASUDEVAN, JM :This is an appeal by the revenue against the order dated 28.11.2008 of learned CIT(A)-XII, Mumbai for A.Y. 2005-06. Conclusion of the case law: Hedging transactions, to fall under exception under section 43(5)(b) of the Act, should be equal to the inventory of the shares held by the assessee in its business of dealing in shares and securities and only to this extent, transactions can be said to be hedging transaction which fall within exception. An assessee who is a dealer in shares can also hold shares in investment portfolio by demarcating the same in his books of accounts. The ruling of consistency should apply when the facts are identical.

Case Law on: Part I Difference between hedging and speculative transaction Part II Difference between trading income and business income (Continued )

The case law is detailed as below: Part I Ground No.1 raised by the revenue reads as follows :On the was 1. justifiedfacts and circumstances of the case law, learned CIT(A) as in treating the transactions in derivatives and futures 2.business (hedging) transactions and not speculative transactions and thereby allowing the loss on account of the transaction in derivatives as business loss instead of speculation loss. The assessee is a HUF. It is engaged in the business of dealing in shares and securities. In the profit and loss account, the assessee had debited loss on account of Nifty hedging transactions of Rs. 1,30,41,270/-. Generally, in transaction of purchases in Nifty Futures, which is a derivative instrument, there is no actual delivery of shares. The transaction of purchase at a particular price on a future date is entered into.


On the specified date, the difference between the agreed price and price prevailing on the specified date is settled and there is no Shri Dinesh K. Mehta HUF actual transaction of purchase of the security. On such settlement there could be a loss or profit.

The assessee explained that the loss had occurred on account of purchase of Nifty Futures and these transactions were purely hedging transactions meant to minimize the loss due to fluctuation of price of shares which the assessee does on delivery basis in the usual course of business and held by him as stock-intrade of his business. They are primarily to be regarded as speculative transactions. Loss arising on account of speculative transactions cannot be set off against income from regular business.

Case Law on: Part I Difference between hedging and speculative transaction Part II Difference between trading income and business income (Continued ) Speculative transactions have been defined in section 43(5) of the Act to mean transactions in which, contract for purchase and sale of any commodity, including stocks and shares, is periodically or ultimately settled otherwise than by actual delivery or transfer of commodity or script. There are certain exceptions to the above definition. Under clause (b) of section 43(5) of the Act, a contract in respect of stocks and shares entered into by a dealer or investor therein to guard against loss in his holdings of stocks and shares through price fluctuations shall not be deemed to be speculative transactions.3.

According to the Assessing Officer, transaction of derivatives trading in the form of purchase of Nifty futures was in the nature of speculative transaction. In this regard the Assessing Officer called for the details of transactions of purchase of Nifty futures, which resulted in the loss debited to the profit and loss account.


According to the Assessing Officer, to fall under exception under section 43(5)(b) of the Act, hedging transactions should be equal to the inventory of the shares held by the assessee in its business of dealing in shares and securities and only to this extent, transactions can be said to be hedging transaction which fall within exception. The Assessing Officer noticed that on the date on which the assessee entered into transactions of purchase of Nifty futures, position of inventory of shares held by the assessee on that particular day was less than the value of purchase of Nifty futures. In this regard, Assessing Officer has analyzed 38 transactions given by the assessee. Shri Dinesh K. Mehta HUF The Assessing Officer thereafter referred to Circular No. 23 dated 12.9.1960; wherein CBDT had clarified as follows:Hedging sales can be taken to be genuine only to the extent the total of such transactions does not exceed the ready stock.


Hedging contract is a contract where the person dealing with the actual commodity ensures himself against the adverse price fluctuations in that commodity in future. The transaction in the future market corresponds to an earlier transaction in the ready market. The future transaction is basically to off-set any loss that may arise on the earlier transaction.

The Assessing Officer thereafter referred to certain judicial pronouncements in the case of M.G. Brothers Vs. CIT, 154 ITR 695 (AP); Pankaj Oil Mills Vs. CIT, 115 ITR 824 (Guj). The Assessing Officer thereafter pulled out following principles : Thus the basic principles which emerge from the above case laws are follows :(i) the test of whether a Futures transaction is for hedging or for speculation hinges on whether there already exists a related commercial position which is exposed to risk of loss due to price fluctuation. Hedging can be taken to be genuine only to the extent the total of such transactions does not exceed the ready stock.

Case Law on: Part I Difference between hedging and speculative transaction Part II Difference between trading income and business income (Continued ) (ii) In the case of pure speculator, as distinguished from a hedger, futures transaction is a business by itself, as he has no off-setting commercial position. The assessee would bear the onus to prove that the forward contract of purchase entered into by it was to safeguard it against the loss through future price fluctuations in respect of any specific contracts of sale for actual delivery of shares. (iii) The basic material required to identify hedge would be as under:(a) Details of original position and details of delivery and payment for original position. (b) Details of the hedging transaction (c) Details of the final settlement of the transaction.

Case Law on: Part I Difference between hedging and speculative transaction Part II Difference between trading income and business income (Continued )Analysis of assessee s arguments and conclusion:

4.

In view of the principles which emerge from discussion of the above judicial precedents, it is clear that the onus is on the assessee to prove that the transaction is not speculative, and it is Shri Dinesh K. Mehta HUF a hedging transaction. In discharge of this onus, the assessee has also to prove that he has in his stock in trade shares which required to be hedged by taking position in the futures market. To do this, the assessee has to prove at least that the total value of his stock exceeds the money invested in purchase of Nifty Futures. The Assessing Officer thereafter examined the inventory position of the assessee on various dates on which the assessee entered into transaction of purchase of Nifty Futures. Wherever the value of purchases of Nifty Futures were more than the value of inventory, they were treated as speculative transactions. For example on 17.6.2004, the value of inventory was Rs. 38.18 lakhs. The value of Nifty purchases were Rs. 1.49 crores. The loss on this transaction of purchase of Nifty Futures on settlement was treated as speculation loss by the Assessing Officer and disallowed. On the above basis and analysis of transactions, the Assessing Officer arrived at a sum of Rs. 98,66,738/- as the loss on account of speculative transactions and this loss was not allowed as a deduction. In respect of the remaining loss the Assessing Officer found that the value of stock was more than the value of purchase of Nifty Futures and these transactions were accepted by the Assessing Officer as Hedging transactions and loss to that extent was allowed as deduction.

Case Law on: Part I Difference between hedging and speculative transaction Part II Difference between trading income and business income (Continued ) Circular of CBDT dated 12.9.1960 gives a general guideline with regard to different kind of speculative transactions. the value and volume of a dealer or investor holding hedging transactions should be in equal proportion and hedging transactions can never be in excess. It is further a condition that hedging transaction should be in respect of very same script held by an assessee as inventory in the business of stocks and shares. In the present case, the Assessing Officer has not gone by script-wise tally but has gone by value of overall inventory. To this extent, the Assessing Officer has been very reasonable. There is no doubt truth in the plea of the assessee that Nifty futures and index futures are the only available form of derivatives trading through which the assessee could hedge the value of inventory held by him. In such trading there cannot be any identification of shares and tally the same with the inventory of shares held. This aspect has been taken care by the Introduction of clause (d) of section 43(5) of the Act; therefore, from A.Y. 2006-07, the assessee may not face this difficulty. But in A.Y. 2005-06 as per the law as it stands, the claim of the assessee cannot be accepted. We therefore reverse the order of CIT(A) and restore the order of the Assessing Officer on this issue.

Case Law on: Part I Difference between hedging and speculative transaction Part II Difference between trading income and business income (Continued ) Learned counsel for the assessee, however, submitted that the Board Circular itself says that only excess of the assessee s position in forward market over actual stock held in ready market should be considered as speculative. For e.g. on 17.6.2004, the inventory of stock held by the assessee was Rs. 36.18 lakhs and purchases in Nifty Futures was Rs. 1.49 crores. In Nifty Futures purchase if the assessee incurs loss on the settlement day, the loss proportionate to the value of inventory i.e. Rs. 36.18 lakhs should not be considered as speculative loss. To that extent, the loss should be considered as hedging transaction. We have already observed that the shares held as inventory and the shares in which hedging transactions are entered into should be the same. The Assessing Officer has however gone by overall value of inventory without individual script wise tally. The plea of the assessee that to the extent of the value of inventory held by the Assessee on a particular day, the loss in purchase of Nifty Futures should not be considered as speculative while working out the loss is an acceptable plea

Case Law on: Part I Difference between hedging and speculative transaction Part II Difference between trading income and business income (Continued ) To this extent, plea of the assessee is accepted and the Assessing Officer is directed to work out speculation loss by taking excess of the assessee s position in forward market over actual stock in ready market and work out the speculative loss proportionately. Thus, Ground No. 1 of the revenue is partly allowed.

Part II Ground No. 2 raised by the revenue reads as follows : On the facts and circumstances of the case and in law, learned CIT(A) was justified in reversing the action of the Assessing Officer of treatment of the short term capital gains of Rs. 16,02,739/- as income under the head profits and gains from business and profession .

Case Law on: Part I Difference between hedging and speculative transaction Part II Difference between trading income and business income (Continued )5. The assessee declared short term capital gains of Rs. 16,02,739/. The Assessing Officer was of the view that since, the assessee was dealer in shares and was having huge volume of share transactions in such business, it was hard to believe that the assessee held shares as investment also, the Assessing Officer therefore treated the short term capital gain declared by the assessee also as income from business. 6. On appeal by the assessee, learned CIT(A) held that gain in question was capital gain and not business income for the following reasons : I have carefully considered the submissions made for the appellant and the assessment order. It is true that when a dealer in shares holds shares, the first presumption would be that the shares held by him constitute stock in trade. But, at the same time, it is not impossible that there cannot be a situation in which the assessee, who is dealer in shares also hold some shares as investment. This proposition is supported by the decision of Mumbai Tribunal in the case of J.M. Share and Stock Brokers Ltd., relied by the appellant. As such, I am not inclined to accept the Assessing Officer s line of reasoning that a dealer in shares cannot hold shares as investments.

Case Law on: Part I Difference between hedging and speculative transaction Part II Difference between trading income and business income (Continued ) In fact, the very decision relied by the Assessing Officer in Motilal Oswal has been reversed by the same Tribunal on rehearing. The fresh decision on rehearing supports the appellant s case. An assessee who is a dealer in shares can also hold shares in investment portfolio by demarcating the same in his books of accounts has also been upheld by the Delhi Tribunal in the case of Arjun Kapur Vs. DCIT, 70 ITD 161 (Del) and the Chandigarh Tribunal in Vesta Investments & Trading Co. P. Ltd. Vs. CIT, 70 ITD 200 (Chd).

The onus will be of course on the assessee to show that the shares have been correctly so held as investments notwithstanding the fact that he is a trader in shares. In my view, the manner in which the assessee holds the shares will determine whether the shares are investment or stock in trade. Generally, if the volume and frequency in dealing in shares is large, the period of holding is low, the conduct of the assessee should point towards that of a trader. If this also coupled with the use of borrowed capital the Shri Dinesh K. Mehta HUF presumption in favour of trading would be strengthened. The manner in which the transactions are accounted whether a trading transaction or as investment would also be a relevant indicator as this would manifest the intention of the assessee in dealing with the shares.


The role of the assessee as an investor should be more passive in comparison to that of a dealer, whose role would be aggressive. The words passive means that the role of the investor would be less in frequency and volume, more use of own capital and larger period of holding. In short, it is the conduct of the assessee that should be the determining factor. In the assessee s case, its allocation of shares as stock in trade and investment appears to be justified by its manner in dealing with the shares. Whereas the shares involved in high frequency in dealing large volumes etc. have been treated as stock in trade, the ones in which the period of holding is larger and volume of holding is small has been demarcated as investments. This method of accounting has been followed consistently by the assessee and this lends credibility to the assessee s allocation of shares as investments and stock in trade.


The Supreme Court in its decision in the case of Karam Chand Thapar Bros. P. Ltd. Vs. CIT, 82 ITR 899 (sc) has observed that the circumstances that the assessee has shown particular shares in its books as well as balance sheet as investments is a relevant factor in deciding whether the shares are investment or stock in trade. The assessee has reasonably discharged its onus of showing that it is in dual role of both investor and dealers of shares by cogent evidence and reasoning. The Assessing Officer is therefore directed to treat the income of Rs. 16,02,739/- as income from short term capital gains and not as business income. This ground of appeal is allowed.

7. We are of the view that the order of learned CIT(A) does not call for any interference. Admittedly, the assessee had treated the shares in question as investment in his books of accounts.

Case Law on: Part I Difference between hedging and speculative transaction Part II Difference between trading income and business income (Continued ) In fact, in A.Y. 2004- 05, the assessee had declared short term capital gain on sale of investments (shares held as investment) the same was accepted by the Assessing Officer in assessment u/s. 143(3) of the Act. The Hon'ble Bombay High Court in the case of CIT Vs. Gopal Purohit, ITA No. 1121 of 2009 dated 6.1.2010 has held that ruling of consistency should apply when the facts are identical. In view of the acceptance of the assessee s stand by the revenue in the past and other circumstances considered by the learned CIT(A), we see no reason why a different treatment should be Shri Dinesh K. Mehta HUF given in the present assessment year. For the reasons given above, we uphold the order of learned CIT(A) and dismiss Ground No. 2 raised by the revenue. In the result, appeal by the revenue is partly allowed.

Derivatives Definition:International Accounting Standard 39 defines a derivative in paragraph 9 as under: A derivative is a financial instrument or other contract with all three of the following characteristics: (a) its value changes in response to change in a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices of rates, credit rating or credit index, or other variable, provided in the case of a nonfinancial variable that the variable is not specific to a party to the contract (sometimes called the underlying ); (b) It requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors; and (c) it is settled at a future date. The Exposure Draft issued by the Institute of Chartered Accountants of India (ICAI) on the proposed Accounting Standard on Financial Instruments Presentation also uses the same definition as used in IAS 39.

Futures and OptionsToday, futures and options based on individual stocks or based on stock indices are the major derivatives traded on the exchanges.

OPTIONSDefinition: The ICAI Guidance Note on Accounting for Equity Index and Equity Stock Futures and Options describes options as under: An Option is a type of derivative instrument whereby a person gets the right to buy or sell at an agreed amount an underlying asset on or before the specified future date. He is not under any obligation to do so. The specified price at which the option can be exercised is called the strike price .

Futures and Options (Continued ) FUTURESDefinition The ICAI Guidance Note on Accounting for Equity Index and Equity Stock Futures and Options describes futures as: A futures contract, like a forward contract, is an agreement between two parties to buy or sell an asset at a certain time in future for an agreed price. Futures contracts are normally traded on an exchange. To make trading possible, the exchange specifies certain standardised features of the contract. The exchange may also provide for guarantee mechanism to ensure that each party to the contract meets its obligations and, consequently, risk from default by parties is minimised.

Futures and Options - Difference

The difference between futures and options is also highlighted by the Guidance Note. Futures and options are both standardised derivative instruments traded on a stock exchange. The difference between these two types of derivative instruments is in respect of the rights and obligations of the parties involved in such contracts. In case of a futures contract, both the parties are under obligation to complete the contract on the specified date. However, in case of options contract, the buyer/holder has a right, but no obligation to exercise the Option, whereas the seller/writer has an obligation but no right to complete the contract. Like options, futures are also for a maximum maturity of 3 months, expire on the last Thursday of the month and have to be cash settled on maturity. Unlike options, where the premium fluctuates for a particular strike price, the price of the futures itself fluctuates for a particular maturity. On maturity, the purchaser of a futures contracts receives (or pays) the difference between the market price of the underlying share/index on the maturity date and the purchase price of the futures, while the seller of a futures contract receives (or pays) the difference between the sale price of the futures and the market price of the underlying share/index on the maturity date.

Taxation of Futures and Options Till Assessment Year 2005-06, the Income Tax Act, 1961 did not have any special provisions dealing with taxation of derivatives transactions in general, and dealing with futures and options in particular, though derivatives contracts have been traded on Indian stock exchanges since 2000. The Finance Act 2005 has amended the proviso to section 43(5), with effect from Assessment Year 2006-07, to provide that derivatives trading transactions would not be regarded as speculative transactions, subject to the fulfilment of certain conditions. To understand the taxation, one also needs to understand the accounting treatment. The ICAI Guidance Note on Accounting for Equity Index and Equity Stock Futures and Options provides guidance as to how such transactions are to be accounted for.

Taxation of Futures and Options (Continued ) In substance, the Guidance Note provides that the profit or loss on the transactions is to be recognised only on expiry of the future or option or on squaring up of the position. Till such time of expiry or squaring up, the initial margin, premium paid and mark-to-market margin is to be accumulated and shown as a current asset. Taxable as business income In most cases, derivatives transactions are regarded as business transactions on account of the following factors: 1. The purpose behind entering into most derivatives transactions is to earn profit from short-term fluctuations in market prices. 2. The period of any derivatives transaction cannot exceed 3 months, and such transactions are invariably short-term transactions. 3. Often, the sheer volume of trades in derivatives transactions entered into by a person on an ongoing basis indicates that it amounts to a business. There can be situations where derivatives transactions may not amount to a business.

Taxation of Futures and Options (Continued ) Taxable as capital gains: Derivatives transactions can even be carried on by an investor to hedge his investment portfolio. A derivative, the transaction in the nature of hedging of investments, being a security and a right under a contract, is certainly a valuable right, and can be regarded as property and therefore as a capital asset. When the transaction is squared up by an opposite corresponding transaction, there is certainly a transfer. Where the squaring up is on expiry of the contract, whether a transfer is said to be taken place, is ruled by section 2(47) and Supreme Court case of CIT vs. Grace Collis 248 ITR 323. Definition of transfer as per section 2(47) is, the expiry of such a contract can possibly be regarded as an extinguishment of the rights in the asset . As held by the Supreme Court in the case of CIT vs. Grace Collis 248 ITR 323, the definition of transfer in section 2(47) clearly contemplates the extinguishment of the rights in a capital asset distinct and independent of such extinguishment consequent upon the transfer itself.

Taxation of Futures and Options (Continued ) A view is therefore possible that on expiry of the derivatives, there is a transfer of the capital asset. The gains or losses arising from such derivatives would accordingly be taxable under the head Capital Gains . Though such income would be taxable under the head Capital Gains , and the derivatives transactions would be subject to Securities Transaction tax, such gains would not be entitled to the concessional tax treatment for short-term capital gains under section 111A, since the benefit of that section is available only to equity shares in a company or a unit of an equity oriented mutual fund. Taxable as Interest Another common practice in the stock markets is arbitrage between the cash market and the futures market. It is a well known fact that the difference in prices between the futures market and the cash market is primarily dictated by the short-term interest rates, and such difference is normally equivalent to the interest that one would earn on short term lending.

Taxation of Futures and Options (Continued ) Therefore, a person having surplus funds may buy shares in the cash market, while simultaneously selling an equal amount of futures of the same share in the futures market. He would take delivery of the shares bought in the cash market. On maturity of the futures, the shares bought in the cash market would be sold in the cash market. Since the futures would be squared off at the cash market price, the profit on the transaction would normally consist mainly of the difference between the initial purchase price in the cash market and the initial sale price in the futures market, with small adjustments for expenses such as brokerage, securities transaction tax, service tax and the market spread between the buying and selling quotes in the cash market. If one looks at the substance of these transactions, they are not motivated by a desire to earn profits, but just to avail of the benefit of the short term interest rates.

Taxation of Futures and Options (Continued ) The income element in the transactions is determined right at the outset, and does not fluctuate to any material extent, even if there is substantial volatility in the market. Going by the principle of the substance of the transaction, a view is possible, as was being taken in the past in the case of vyaj badla transactions, that such transactions are in the nature of earning of interest, though they take the form of arbitrage transactions. It may be however noted that other factors, such as frequency of transactions, nature of other business carried on, etc., would also determine whether such transactions are business transactions or investment or interest.

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 commodity or scrips . Hence, two important criterions are necessary for any transaction to be categorized as speculative transaction viz.; Purchase or sale of any commodity including stocks and shares, and It is periodically or ultimately settled otherwise than by the actual delivery or transfer of commodities or scrips.

Both the conditions are cumulative and must be fulfilled for the transaction to be qualified as a "Speculative Transaction".

Speculative transaction (Continued ) Taxability of speculative transaction: Losses will not be eligible for set off against any other income of the assessee and will be carried forward and set off against speculative income only up to maximum of four years.

Exclusion of Derivatives from definition of Speculative Transaction A new clause (d) had been added to the proviso to section 43(5), excluding certain derivatives trading transactions from the definition of speculative transaction . Such exclusion of derivatives transactions is however subject to certain conditions. These conditions are: a. The transaction should have been carried out electronically on a screen-based system. b. The transaction should have been carried out through a stock broker or sub-broker or other intermediary registered under section 12 of the SEBI Act, 1992 in accordance with the Securities Contracts (Regulation) Act, 1956, the SEBI Act, 1992 or the Depositories Act, 1996 and the rules, regulations or bye-laws made or directions issued under those Acts, or by banks or mutual funds.

Exclusion of Derivatives from definition of Speculative Transaction (Continued )c. The transaction has to be carried out on a recognised stock exchange. d. The transaction has to be supported by a time-stamped contract note issued by such stock broker, sub-broker or other intermediary. e. The contract note has to indicate the unique client identity number allotted under SCRA, SEBI Act or Depositories Act and the permanent account number of the client. SEBI had made such unique identity number mandatory for all investors for transactions exceeding Rs.5 lakhs. According to Circular No 3/2006, dated 27-2-2006, trading in derivatives of securities carried out on a recognised stock exchange shall not be deemed as speculative transaction.

Case Law: Income from trading of shares will be speculative business within meaning of provision of Explanation to section 73 Where assessee is engaged in trading in share of other companies, the business carried on by the assessee will be in nature of speculative business and profit or loss arising therefrom will be the speculative profit/loss. CASE LAW DETAILS Decided by: ITAT, DELHI BENCH `B , DELHI, In The case of: ITO v. Ethno Financial Research Pvt. Ltd., Appeal No.: ITA No. 2743(Del) of 2008, Decided on: October 30, 2009 RELEVANT PARAGRAPH We have heard both the parties and perused the material on record. In this case there no dispute that trading in shares is not the business of the assessee as authorised by memorandum of association. It is also a fact that the assessee had dealt in futures and as well as traded in shares of other companies. Therefore, we have to see the applicability of the Explanation to section 73 of the Act to the share trading activities carried on by the assessee.

Case Law: Income from trading of shares will be speculative business within meaning of provision of Explanation to section 73 (Continued ) As per Explanation to Section 73. where any part of business of the company an assessee whose gross total income is not consisted 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 banking or the granting of loans and advances ; consists of the purchase and sale of shares of other companies, such company shall, for the purposes of section 73, be deemed to be carrying on a speculation business to the extent to winch the business consists of the purchase and sale of such shares. The provisions of Explanation to section 73 do not distinguish between the transaction of trading in shares on actual delivery or without delivery basis. Admittedly the assessee does not fall under any of the exceptions provided in the Explanation and hence, the purchase and sale of shares traded during the year under consideration is in nature of speculation business within the meaning of proviso to section 73 of IT Act, 1961.

CBDT issued Instruction No. 03/2010, dated 23-3-2010 to assessing officersNotional losses on forex hedge not tax deductible A company that makes a notional loss on a forex derivative because of a fall in its value cannot deduct the loss from its taxable income since it still owns the derivative. This has been clarified by Central Board of Direct Taxes (CBDT), the apex body that administers direct taxes in the country. The tax body has made it clear that if no sale or settlement has actually taken place and the loss on mark-to-market basis has resulted in reduction of book profits, such a loss would not allowed to be offset against income.

CBDT issued Instruction No. 03/2010, dated 23-3-2010 to assessing officers (Continued ) Going one step further, the tax body has said that if a loss arises on actual settlement of such contracts and is not a notional or marked to market book entry, the assessing officer would have to determine whether such a loss is on account of a speculative u/s 43(5) or an eligible transaction. A speculative loss can only be offset against a speculative profit and can be carried forward for only four years. However, an eligible transaction is one that is carried out electronically on a screen-based system through a stock broker or a sub-broker on a recognised stock exchange. This means that if companies buy or sell dollars or pounds on NSE and MCX-SX, the losses or profits arising out of such transactions can be offset against business gain or losses and can be carried forward for eight years. The CBDT has said that after due diligence by the assessing officer, such losses or gains may be offset against taxable income.

CBDT issued Instruction No. 03/2010, dated 23-3-2010 to assessing officers (Continued ) Thus, MTM losses provided for in the books in compliance with AS-30 may be disallowed pursuant to specific instruction from the CBDT. However, the Special Bench of ITAT in the case of DCIT v. Bank of Bahrain and Kuwait, has held that these losses are allowable.

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