TAXATION OF SHARES AND SECURITIES, DERIVATIVES, FUTURES AND OPTIONS

Dhinal ShahChartered Accountant

National Conference on Direct TaxesNagpur Branch of WIRC of ICAI

12th November 2010

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(1) Capital Gains(2) Business Income vs Capital Gains(3) Derivative Transactions(4) Speculative Transactions(5) Issues relating to Section 14A

TOPICS

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CAPITAL GAINS

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Sec 45 - Gains arising from transfer of capital asset are chargeable as capital gains

Capital Asset Definition of capital asset refers to any property held and not owned

by the assessee Asset must be a capital asset at the time of transfer Includes shares and securities Securities defined in Expl 2 to Sec 2(42A) to mean security as defined

under Section 2(h) of Securities Contracts (Regulations) Act, 1956 Section 2(h) of Securities Contracts (Regulations) Act, 1956

defines security to include: Shares, bonds, debentures or other marketable securities; Derivatives; Units or other instruments issued by any collective investment

scheme or mutual fund; Security receipt as per Section 2(zg) of Securitisation and

Reconstruction of Financial Assets and Enforcement of Security Interest Act 2002;

Government securities; Rights or interest in securities etc.

CAPITAL GAINS

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Transfer Redemption of preference shares involves

transfer – Anarkali Sarabhai (224 ITR 422) (SC) Reduction of share capital is transfer – Kartikeya

Sarabhai (228 ITR 163) (SC) Date of transfer is date of lodging shares with

the company Family arrangement is not a transfer – Kay Arr

Enterprises (299 ITR 348) (Madras) Sec 45(2A) - Income arising from transfer of

shares held in demat form would be taxable in the hands of beneficial owner and not in hands of depository

CAPITAL GAINS

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Period of holding Short term and long term – Sec 2(42A) and 2(29A) Short term if following capital assets held for a period of less than

12 months:i) Share held in a company;ii) Listed security;iii) Units in UTI or Mutual Fund

For remaining assets, short term if capital assets held for a period of less than 36 months

Points to be considered while computing period of holding Period of previous owner to be included for capital assets acquired

through modes specified in Section 49(1) For renouncement of rights – Date when right to acquire rights

shares comes into existence - Navin Jindal v ACIT (SC) (2010-TIOL-03-SC-IT)

For bonus shares – Date of allotment of bonus shares For demat shares – FIFO method to be adopted (Circular No. 704 dt

28 April 1995)

CAPITAL GAINS (CONT.)

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Indexation benefit available for all long term capital asset No indexation benefit available for bonds and

debentures Indexation benefit available from the first year in

which asset was held by the assessee Assets acquired under modes prescribed under Sec

49(1) Indexation benefit available from year of acquisition of

previous owner - Manjula Shah (Mumbai ITAT SB) (2009-TIOL-698-ITAT-MUM-SB)

CAPITAL GAINS (CONT.)

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Long term capital gainsSection 10(38) ► Transfer of long term capital asset being equity shares

of a company or unit of equity mutual fund

► Chargeable to securities transaction tax

► Exempt from tax

Section 112 ► Transfer of any other long term capital asset

► Indexation benefit available

► Taxable @ 20%

Proviso to Section 112

► Transfer of long term capital asset being listed

securities or unit of mutual fund / UTI or zero coupon

bond

► Without indexation of cost, taxable @ 10%

Short term capital gainsSection 111A ► Transfer of short term capital asset being equity shares

of a company or unit of equity mutual fund

► Chargeable to securities transaction tax

► Taxable @ 15%

► Other short term capital gains taxable at normal

rates

TAXABILITY OF CAPITAL GAINS

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CAPITAL GAINS – CONVERSION OF CAPITAL ASSETS INTO STOCK –IN-TRADE Conversion of capital assets into stock in trade – Sec

45(2)

• Shirinbai Kooka’s principle• Sharkey’s principle• Effect of conversion– Sir Kikabhai Premchand, 24 ITR 506(SC)– Dhanuka & Sons 124 ITR 24(Cal)– ALA firm, 189 ITR 285 (SC)• Possibility & proofs• Cost of acquisition– Keshavji Kaarsondas, 207 ITR 737(Bom), – B.K.A.V. Birla (Cal)– Kalyani Exports & Investments, 78 ITD 95 (Pune)• Period of holding– S.2 (42A)– B.K.A.V. Birla 35 ITR 136 (Cal)• Indexation– Kalyani Exports & Investments and other views– Explanation (iii) to s. 48– Harmonious Construction• Part shares and securities as stock in trade and remaining as investment.– Century Builder – 5694/Mum./2000/dt. 30.07.02– Arjun Kapoor (70 ITD 161)(Del)– Circular No. 4/2007 dt. 15-6-2007

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BUSINESS INCOME VS CAPITAL GAINS

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BUSINESS INCOME VS CAPITAL GAINSDesired parameters• Intention - Period of holding• Frequency - Fund utilised• Time devoted - Set-up• Listing - PMS• Occupation – Scale• Owned fund v. Borrowed fund• Alternative occupation - Bank account• Sales/ Purchase - Utilisation• Treatment in books - Statutory requirements• MOA/AOA - Avg. holding period• Group companies - Promoters• No. of script - Genuineness

Applicability of s. 45(2)11

COMPARATIVE ANALYSISBasis Business Income Capital Gains

Taxability u/s 28 u/s 45Computation u/s 48

Types Speculative or Non-speculative

STCG or LTCG

Deduction

allowed

All expenses incurred for carrying on the share trading business.

Only expenses incurred in connection with the transfer.

Indexation No Indexation in any case

Indexation allowed in case of LTCG

Benefit if STT paid

Deduction as an expense u/s 36(1)(xv)

-LTCG exempt u/s 10(36) or 10(38).-STCG chargeable at concessional rate of 15% u/s 111A.

Set-off Non-Speculative loss can be set off against any head except salary

-No loss as per S.14A-LTCL cannot be set-off against any head and has to be carried forward.

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Principles to be adopted for distinction between shares held as stock-in-trade and investment

Assessee to produce evidence for distinction between shares held as stock-in-trade and held as investment – CIT Vs Associated Industrial Development Company (P) Ltd (82 ITR 586), (SC)

Relevant principles for determining capital gains vs business income as laid down by AAR in 288 ITR 641

(i) Where a company purchases and sells shares, it must be shown that they were held as stock-in-trade

(ii) 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 determine the nature of transactions;

(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;

(iv) 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.

Possible to have two portfolios, i.e., an investment portfolio comprising of securities which are to be treated as capital assets and a trading portfolio comprising of stock-in-trade

CIRCULAR NO. 4/2007, DATED 15-6-2007

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BUSINESS INCOME (CONTD.)

Issues 1. Frequency of transactions Smt. Neerja Birla v. ACIT 66 ITD 148 (Mum.) and Arjun Kapoor 70 ITD 161 (Del.) Circular No.4/2007 dt. 15-6-2007.

2. Tax Audit The ICAI has in the Guidance Note on Tax Audit opined

that in case of speculative transactions, total profits and losses shall be taken as turnover.

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(1) Interest on borrowed capital(2) Brokerage, service tax, stamp duty(3) Penalties, bad delivery charges, auction

charges(4) Demat account charges(5) Loss of shares & securities and non

payment by brokers(6) Portfolio Management & advisory fees

DEDUCTION FROM BUSINESS INCOME

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DERIVATIVE TRANSACTIONS

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ISSUES IN DERIVATIVE TRANSACTIONS► Derivative Transaction

► Transactions in futures and options are for a fixed maturity and as per current stock market

regulations are settled by cash either before or at their maturity date

► Accounting Treatment

► As per Guidance Note on Accounting for Equity Index and Equity Stock Futures and Options,

derivative contracts not settled as on balance sheet date should be marked to market.

► Any loss arising from mark-to-market should be recognised in Profit & Loss A/c and gains, if

any, should be ignored

► Tax Treatment

► As per provisions of Section 43(5), amended with effect from 1 April 2006, any income

arising from derivative transaction on recognised stock exchange would not be a

speculative transaction

► Tax Audit

► ICAI in its Guidance Note on Tax Audit has opined that in case of speculative transactions,

total profits and losses shall be taken as turnover. The same view may be taken in respect

of derivative transactions. 17

► Issues

► Whether gains / losses arising in derivative transactions would be

taxable as business income or capital gains

Prior to 1-4-2006 All the derivative transactions are speculative business transactions as amendment in section 43(5) is not retrospective[Shree Capital Services Ltd (Kolkata ITAT) (318 ITR 1)]

Post 1-4-2006 Business Income

► Trading in derivatives is a

business

► High frequency of

transactions

► Taxable as business

income [Morgan Stanley

and Co. 271 ITR 416 (AAR),

Royal Bank of Canada (323

ITR 380) (AAR)]

Capital Gains

► Derivatives are capital

asset

► Settling of derivatives is

transfer

► Income arising from

transfer of derivatives is

capital gains 18

TAXABILITY OF DERIVATIVE TRANSACTIONS

ALLOWABILITY OF MARK TO MARKET LOSS ON DERIVATIVE TRANSACTIONS► Issues

► Whether losses arising in mark to market derivative transactions could be allowable under the Act

► Whether it be considered as business loss or capital loss

Prior to 1-4-2006 All the derivative transactions are speculative business transactions as amendment in section 43(5) is not retrospective[Shree Capital Services Ltd (Kolkata ITAT) (318 ITR 1)]

Post 1-4-2006 Business Loss

► Trading in derivatives is a

business

► Mark to market loss is only

notional loss

► There is no transfer of

capital asset on balance

sheet date

► No consideration is

received for mark to

market loss

Capital Loss

► Derivatives are capital

asset

► Mark to market loss is loss

arising on balance sheet

date

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SPECULATIVE TRANSACTIONS

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SPECULATION BUSINESS

Speculative transaction – S.43(5)

Explanation 2 to S.28

Speculation Loss – S.73

Explanation to S.73

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SPECULATIVE TRANSACTION –S 43(5)

Contract for sale or purchase Any commodity including stock & shares Periodical settlement Without actual delivery or transfer Exceptions

Hedging – to guard loss on price fluctuations Dealer or Investor

Jobbing or arbitrage Member of a Forward market or Exchange

An eligible transaction of dealing in derivatives, with effect from A.Y. 2006-07.

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EXPLANATION 2 TO S.28

‘Speculation transactions’ - ‘business’

Distinct and separate business

Separate computation for I T Act R. Chinnaswamy Chettiar, 96 ITR 353 (Mad.)

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SPECULATION BUSINESS LOSS

Restriction on set-off Jaggannath Mahadeo Prasad, 71 ITR 296 (SC)

Profit of Speculation Business only Any such business Priority of set-off–Cir. No. 23 dt. 12.9.1960 -

72(2) Application to loss as also profit

Samba Trading & Invts. 58 TTJ 360(Mum) Carry forward Period of 8 succeeding years By – legal heirs 24

HEDGING - I Requirements

Two contracts Commodities and scrips Holdings & Contract of delivery Guard against price fluctuations

Purchase- Also sale Different quality-quantity and value

Cir. No. 23D dt. 12.9.1960 Different scrips

Circular 23D Index F & O

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HEDGING - II

Burden of proof Joseph John, 67 ITR 74 (SC)

Co-relation necessary Somasundaram Chettiar, 194 ITR 1 (SC)

Independent treatment Arjan Khimji & Co., 121 ITR 421 (Bom)

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DELIVERY Relevance of intention, payment and delivery

Abdul Gani Haji, Habib, 72 ITR 6 (Cal.) Actual delivery

Blank transfer forms Mangal Chand Bhanwarlal, 255 ITR 329 (Raj)

Delivery Notes Davenport & Co., 100 ITR 715 (SC)

Recalled delivery Clayton Commercial, 67 ITD 118 (Del)

Intended delivery Gandhi Bhandari & Co., 83 ITD 680 (Pune)

Pending delivey Sampath & Iyengar –Ninth Edn. Judicial controversy

No delivery Ramalinga Choodambigal 239 ITR 120 (Mad.) 27

SETTLEMENT Settlement without delivery

S.63 of Indian Contract Act Shantilal (P) Ltd., 144 ITR 57(SC) Kamani Tubes Ltd., 207 ITR 298 (Bom)

F/E Forward contracts Guard against fluctuation

Badridas Gauridu, 261 ITR 251 (Bom) Loss in illegal contract

S.C. Kothari, 82 ITR 794 (SC) Nature of deemed profit u/s. 41(1)

Rajputana Trading Co. Ltd. 72 ITR 286 (SC)

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STRAY TRANSACTIONS

Concerted activity and efforts Treatment under the law

Casual Income Other sources Capital Gains

Plurality of transactions Indian Commercial Co., 106 ITR 465 (Bom) G.P. Birla HUF, 199 ITR 173(Cal)

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DEEMING FICTION – EXPL. TO S.73 Company assessees

All companies Shares Purchase and Sale

Deemed Speculation Business Exceptions

GTI mainly from specified heads Banking Company Loans & Advances Company

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(1) Applicability to shares held as investments Mysore Rolling Mills Pvt. Ltd. 195 ITR 404(Kar) Trade Team Pvt. Ltd. 54 ITD 36(Bom)

(2) Share broking-Whether business of purchase & sale of shares? SRJ Securities Ltd. v ACIT 81 TTJ 484 (Del) DCIT v Frontline Capital Services Ltd. 96 TTJ 201 (Del)

(3) Applicability to securities other than shares Apollo Tyres Ltd. 255 ITR 273 (S.C.)

(4) Loss due to stock valuation is also covered by Expln to Sec 73 Prasad Agents (2009-TIOL-164-HC-MUM-IT) (Bombay HC)

ISSUES RELATING TO EXPLN. TO S.73

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(5) Whether the Expln. Applies to arbitrage, hedging,etc. excluded from the meaning of speculation u/s. 43(5)? Rohini Capital Services Ltd. v DCIT 92 ITD 317 (Del)

(6) Settlement for breach of contract is not a speculative transaction Bhandari Rajmal Kushalraj v ITO 96 ITR 401

(7) Explanation applies to dealing in shares of more than one company

Laxmi Feeds & Export Ltd (62 ITD 315)

(8) Exceptional cases of section 43(5) are also covered by Expl to Sec 73

(9) Speculative loss incurred in earlier years by a company can be set off against profits deemed to speculative under Expln to Sec 73

Lokmat Newspapers Pvt. Ltd (Bom HC)

ISSUES RELATING TO EXPLN. TO S.73 (CONT.)

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Lending /Banking company Exception to general rule Overriding Sec. 43(5)

C.N.M.P. Inv. (P) Ltd., 78 ITD 297 (Del)

GTI ‘mainly’ from Criteria for determination Relevance of other years

Amrutlal & Co., 212 ITR 540 (Bom) Part to include whole

Arvind Investments Ltd., 192 ITR 365 (Cal)

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ISSUES RELATING TO EXPLN. TO S.73 (CONT.)

ISSUES RELATING TO SEC. 14A

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BACKGROUND

► Expenditure incurred for earning exempt income is not allowable as deduction under section 14A

► The Assessing Officer (‘AO’) is empowered to determine the amount of expenditure in accordance with method prescribed under Rule 8D if:► AO is not satisfied with the correctness of the claim

made by assessee or► If assessee claims that no expenditure is incurred to

earn exempt income

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RULE 8D

Disallowance prescribed under Rule 8D is sum of :Direct Expenditure incurred for earning exempt income

A

Proportionate Interest Expenditure= Interest Expense X Average Value of Investments Average Value of Total Assets

B

Administrative Expenditure@ 0.5% of Average Value of Investments

C

Total A+B+C

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RULING OF MUMBAI SPECIAL BENCH – DAGA CAPITAL

► Operation of Section 14A is automatic on earning exempt income

► Computational provisions of Section 14A read with Rule 8D are procedural and clarificatory in nature

► Rule 8D will apply retrospectively to all pending matters

► Rule 8D also applicable for business income

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RECENT RULING OF BOMBAY HIGH COURT IN CASE OF – GODREJ & BOYCE

The key principles laid down by the High Court are as under:

► Section 14A will apply to dividend income although dividend has suffered dividend distribution tax

► The computation method provided by rule 8D is constitutionally valid.

► Rule 8D notified on 24 March 2008 will not have retrospective effect.

► Rule 8D cannot be applied mechanically. ► Only if AO is not satisfied with the claim of tax payer and

has recorded reasons he can compute disallowance under section 14A.

► Upto AY 2007-08, in absence of rule 8D, AO can compute disallowance under section 14A by reasonable method.

► No observation by High Court on applicability of Section 14A to business income

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RECENT RULING OF BOMBAY HIGH COURT IN CASE OF – GODREJ & BOYCE

The facts in Godrej’s case as mentioned by the High Court are as under:

► Major dividend from group companies► 95% consisted of bonus shares► Most of the shares acquired several years earlier► No stage in the past except in last few years has the

Department attributed any interest or expenditure towards dividend

► Reserves of Rs.276 Cr and Capital of Rs.6.55 Cr more than the investments

► In the relevant year no new investments, but disposal of some old investments 39

SCENARIO UP TO AY 2007-08

► Rule 8D notified on 24 March 2008 not to have retrospective effect

► However, disallowance to be on reasonable basis

► Could be argued that basis for disallowance to remain the same as made in the past assessments

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SCENARIO POST AY 2007-08

► Rule 8D to be applied only if AO not satisfied with the disallowance made by the tax payer himself and has recorded reasons

► Responsibility of tax payer to satisfy the AO► Justify its claim by robust documentation and sound

principles of apportionment

► Responsibility will shift on the AO, to justify why disallowance computed by the tax payer should not be accepted

► Could be argued that the basis for disallowance to remain the same as computed in the past

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CONCLUSION

Up to AY 2007-08► Disallowance under section 14A to be computed on a

reasonable basis ► Provide adequate documentation and submissions to

minimize the disallowance to be computed on reasonable basis

Post AY 2007-08► Could be argued that basis of disallowance to remain same as

computed upto AY 2007-08 and not as per Rule 8D► Responsibility will shift on the AO, to justify why

disallowance computed by the tax payer should not be accepted

► Difficult for AO to disregard his own satisfaction with the basis of computation made upto AY 2007-08

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Thank You

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