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Tax Evasionthrough

Shares

How to catch them !

Prashant Kumar ThakurIncome Tax Officer

Author

Prashant Kumar Thakur

Udita, Flat 50203i, 1050/1 Survey Park

Santoshpur, Kolkata-700075

Email: [email protected]

Mob: 9831096533

Ist Edition, : 2008

2nd Edition : 31/12/2011

Note :

The views expressed in this book are solely of the author .Income Tax Department has

nothing to do with the content of this book.

All rights reserved.

Dedication

One man, other than the author, responsible for this book is Sri R .S. Upadhyay, CIT(Training). A chance meeting with him flared up the desire to pen the book.

One woman behind successful completion of this book-Alka, my better half.

One couple without whom this book was impossible-my parents!

Five officers who played

silent role in my learning and training - Sri Samir Mukhopadhya, CIT –thanks

for his great mentorship, Sri B.B.Mohanty, CIT– learned from him fast deci-

sion and smooth management style, Sri A.K. Bala, CIT- inculcated from him

his simple, open and firm approach, Sri J.R. Singh, CIT-for his friendly and

fatherly teachings and Sri R.N.Bhatacharya-Addl. CIT-(retired)-who taught

me how to be a good boss. Thanks to all of them.

Preface to Second Edition

Overwhelming response from officers and professionals ,spread across the coun-try to the first edition is the reason for this updated second edition .

So what is new in the second edition? Almost entirely the topics are rewritten with fair amount of sprinkling of case laws and circulars issued by authorities. A few topics have been deleted . Newly added topics relate to tax evasion practice through Futures & Option trades” and use of mergers for tax evasion .

Readers should note that case laws referred under various topics are not neces-sarily in favour of income tax department. Many are in favour of tax payers. The purpose to include all relevant case laws, whether favourable to department or not , is to broaden the idea of readers on a provision of law.

I hope the book will serve its purpose .

Suggestion, criticism & comments are welcome at [email protected]

Kolkata-31/12//2011 Prashant Kumar Thakur

Preface to First Edition

Some of the questions bothering me from the time I joined the department

“Why do we refer the books written by “outsiders” only-who have their

own reasons to give a perspective in the larger interest of their readers-the

assessees? Why is there absolute dearth of books written by officers for the

officers of the department ?”.

While the books writen by “outsiders” definitely enhance knowledge on Income

Tax Act, such books can not teach-how to enquire or investigate a case. This

can be taught by an officer only, who has rich experience of investigation,

enquiry and assessments. Not getting in-house experts on income tax is a

big irony because, we are supposed to study the I T Act for more than thirty

years, but still junior officers are compelled to search for guidance on income

tax from books written by “outsiders”. I am quite hopeful that other officers

of the department will also share their expertise like the one great effort

of past- a five volume compilation named “Techniques of Investigation for

Assessment”. That is a superb guide book

For the last fourteen years, I am in search of a guide book on shares’ related

cases. I could not find any. So, I pen this book. Suggestion, criticism, comments

& case studies which will be incorporated in future editions are welcome at

[email protected]

Kolkata-11/3/2008 Prashant Kumar Thakur

Part-I

Evasion Practices 1. Bogus Purchase Of Shares to Reduce Business Profit. 2

2. Unquoted Shares & Tax Evasion 14

3. Evasion Through Reverse Conversion Of Shares? 27

4. Speculation Loss And Tax Evasion? 37

1. Mix Speculation Loss With Trading Income.

2. Claiming Speculation Loss As Hedge Loss

5. How To Detect Closing Stock Undervaluation? 47

6. How To Detect If Short Term Is Claimed

As Long Term Gain? 50

7. Why Should You Scrutinize Transactions Statement? 52

8. How Family and Private Companies Are

Used For Evasion? 55

9. Use of Mergers for Tax Evasion 61

10. How To Decide If Share Transaction Is Business Or

Investment Activity? 70

11. Why Should You Scrutinize Transactions

Of Last Seven Days ? 84

12. How To Handle Cases Of Evasion Through Penny Stocks? 86

1. When Bogus LTCG On Penny Stock Created Legally.

2. When Bogus LTCG On Penny Stock Created By

Using False Documents.

12. Tax Evasion through Futures & Option Trades 102

13. Tax Evasion by Changing Client Codes 107

Part II

Don’t Forget These Points

1. Why Should You Keep An Eye On Warrant? 113

2. How Preference Share Creates Capital Gains? 118

3. Can Scrutiny Of Security Deposit Bring Tax? 123

4. Why Knowledge Of SCRA Is Important For Share Cases? 125

5. How To Easily Apply Explanation To Section 73? 134

6. ESOP, Phantom Stock Option & A flash back on FBT ! 142

Part IIIBack To Basics

1. What Are The Procedure For Share Transactions In Dematerialized Form? 153 2. How Internet Can Bring You Information You Always Wanted For ? 155 3. Important Circulars/Instructions Issued By CBDT 156 1. Period of holding in case of dematerialized shares. 2. Determination of the ‘date of transfer’ and holding period for the purpose of capital gains. 3. Distinction between shares held as stock-in-trade and shares held as investment 4. What is the meaning of ‘hedging’ with respect to

Explanation to section 73 ? 4. Important Circulars Issued By SEBI. 169 1. Transfer of shares from pool account to clients account. 2. Time duration for transfer of funds and securities from member to client. 3. What is the definition of ‘negotiated deal’ ? 4. Circular regulating negotiated deal. 5. Circular regulating broker-client relationship. 6. MAPIN abolished 7. NSE Circular on Penalty for Client Code Modification 5. Certain Important Judgments You Must Refer To 183 1. What are the views of different courts on the issue “business or investment income” 2. Are illegal expense or losses allowable? 3. Is surplus on “sale as going concern” taxable as capital gains? 4. Are bonus shares or rights to shares capital asset? 5. Does exchange of shares fall within the meaning of transfer? 6. Does reduction of share capital give rise to capital gains? 8. Whether trading in units and govt. securities fall within the ambit

of the word “commodity” as given in section 43(5) of the IT Act? 9. Whether the sale of warrants received against debentures held as

stock-in-trade give rise to taxable revenue receipt? 6. What Is A Contract Note? 187 7. Why Is Demat Transaction Statement Important For Share Investigation? 189 9. What Is A Private Limited Company And What Are Its Privileges? 19110. What does “Beneficial Owner” mean in context of share ownership ? 192 11. What Are Derivatives? 19312. Books Maintained By The Broker & Stock Exchanges? 196 13. The Addresses of Different Stock Exchanges? 197 14. Address of Six Regional Directors (RD) under Ministry Of Corporate Affairs 202 15. Terms Every Assessing Officer Must Know 203

1

Evasive Practices

Part 1 of the book is devoted to evasive techniques of tax avoidance

used by some unscrupulous share dealers. This part of the book

consists of 11 topics. Each topic has been discussed at length

and an endeavour to give step wise guidance has been made. The

views of higher judicial fora as well as circulars of CBDT & SEBI,

wherever needed, have been incorporated.

Bogus Purchase Of Shares to Reduce Business ProfitBogus purchase of shares means showing share purchase without actually

purchasing shares. Since the actual purchase is not made, there can be no

question of sale of such shares. Therefore, those shares are carried to closing

stocks. One of the most popular methods of valuation of closing stock-cost

or market price, whichever is lower1, is then followed by the assessee. The

devaluation in share price i.e difference between purchase price of shares

and the closing price of same shares , is used to adjust the profit of other

business carried by the assessee.

Let us take an example to understand this technique. Mr X is a share dealer

and during FY 2009-10, he found that he had earned profit of Rs 60 lakhs.

However, he wanted to file return for Rs 5 lakhs. Therefore, his problem was

to reduce 55 lakhs of income. Finally when his profit and loss account was

prepared, it showed profit of Rs 5 lakhs only. He prepared profit and loss

account as under :

Profit & Loss Account Of Mr X

Opening Stock Rs. 22,00,000 Sale Rs.2,47,10,000

Purchase Rs. 2,60,00,000 Closing stock Rs.60,00,000

Interest Rs. 12,00,000

Other expense 8,00,000

Net Profit 5,10,000

3,07,10,000 3,07,10,0001 Chainrup Sampatram v. CIT [1953] 24 ITR 481 (SC), A.L.A. Firm v. CIT [1991] 189 ITR 285 (SC

2

The problem of Mr X–the tax evader was solved without giving even a small

hint as far as his P & L account was concerned.

Can you detect such cases?

Two reasons why such cases can be detected with a little work are :

First is that he woke up very late to evade tax. This casual approach brings

him face to face with two genuine problems. After 31st March, he can neither

show any acceptance of delivery of shares nor can he make any payments by

cheques. Therefore, purchase is shown on credit side and he is also without

any evidence of delivery.

Second reason is that share trade in India is fully computerized and requires

involvement of third parties like stock exchange or depository participants or

banks. These third parties can be helpful in gathering evidences to prove the

wrongs perpetrated by the tax evaders.

Steps to Catch Them !

Therefore, one can detect such tax evasion cases by following steps :

1. Ask for certain details in a particular format.2. Analyse the details.3. Enquire & collect evidences.4. Dealing with different scenarios.

5. Summing up & assessments

First two steps are required to identify such cases, third step is necessary for

collecting evidence and the last two to counter alibis of assessee and finalise

the findings.

3

4

Tax Evasion Through Shares

Let us say, in response to such a query u/s 142(1) Mr X–the businessman submitted following details about transactions in shares Value in ‘000

Share Opening Purchase Sale Closing Name Stock Stock

Qnt Value Qnt Value Qnt Value Qnt Value

RIL 1000 700 3000 2100 2000 1600 2000 1700

TISCO 800 320 30000 9540 28000 15800 2800 1097

GAIL 1000 100 0 0 0 0 1000 100

Infosys 100 100 0 0 100 260 0 0

Petronet 900 18 100000 4620 80000 4800 20900 827

TV Today 1000 82 0 0 0 0 1000 70

Simplex 0 0 1000 300 1000 320 0 0

Arvind Mills 0 0 5000 200 5000 250 0 0

Step 1: Ask for certain details in a particular format

The easiest method to detect cases of bogus purchases is to ask assessee to

submit details in following format u/s 142(1) of the IT Act. The reason for

invoking section 142(1) is that under this provision, an A.O is legally entitled

to ask for information in the format he desires.

i) Details of closing stock of shares

Share Opening Purchase Sale Closing Name Stock Qnt Value Qnt Value Qnt Value Qnt Value

ii) List of trade creditors with details of purchases made for which payments are due.

iii) Copies of demat transaction statement for the period under consideration.

5

Bogus Purchase Of Shares to Reduce Business Profit

Ballarpur 10000 380 0 0 10000 480 0 0

Mukta Arts 5000 500 0 0 5000 300

SmkayConsultant 0 0 10000 1200 0 0 10000 110

Zircon 0 0 12000 1840 0 0 12000 103

Shyam Tele 1000 100 2000 110 0 0 3000 300

Biocon 5 350 1000 500 1005 1200 0 0

Guest Financial 0 0 20000 2000 0 0 20000 240

Rel Petro 1000 50 20000 1250 0 0 21000 1050

Step 2 : Analyse the details

(i). Concentrate on big purchases

Segregate data related to all big purchases of shares which have not

been sold or only a very small percentage of total purchase is sold.

For example, in the aforesaid chart, shares which have been purchased

during the year and not sold are :

Values in Thousands(‘000)

Share Opening Stock Purchase Sale Closing Name Stock

Qnt Value Qnt Value Qnt Val Qnt Value

Mukta Arts 5000 500 0 0 5000 300

Smkay Consultant 0 0 10000 1200 0 0 10000 110

Zircon 0 0 12000 1840 0 0 12000 103

Guest Financial 0 0 20000 2000 0 0 20000 240

Rel Petro 1000 50 20000 1250 0 0 210000 1050

6


(ii) : Try to find out answers of following questions

1. Are these shares listed on NSE, BSE or regional stock exchanges? [Refer to Part III for more on listing of shares]

2. Are these shares well known?

3. Whether diminutions in the value of these shares as on the last day of the year are very high?

4. Are these shares purchased on credit?

A share listed on regional stock exchange on which there is very high diminution in value and if such share is purchased on credit, it is most likely to be a bogus share purchase.

The aforesaid chart shows that out of five shares, two of them are well known, i.e., Mukta Arts and Reliance Petro and both are listed companies. Even the closing stocks value of those two shares have reduced only marginally. Therefore, both these shares have to be left out of scrutiny angle. Rest of the three shares have to be taken up for further enquiry & investigation because it is apparent that total devaluation on account of these three shares totals to Rs 45,87,000.

Value in Thousands (‘000)Share Opening Purchase Sale Closing Deva- Stock Stock lua- tion

Qnt Val Qnt Val Qnt Val Qnt Val

Smkay Consultant 0 0 10000 1200 0 0 10000 110 1090

Zircon 0 0 12000 1840 0 0 12000 103 1737

Guest Financial 0 0 20000 2000 0 0 20000 240 1760

5040 453 4587

7

Once you filter out the shares fit enough for deep investigation, concentrate all

your efforts to find out answers to the genuineness of purchase of those shares

Step 3: Steps to enquire into & collect evidences

Enquiry and collection of evidences involve following steps

i. Analyse demat transaction statement.

ii. Write a letter to the stock exchange

iii. Send a letter to the broker

iv. Have peep into broker’s demat account

v. Examine books of account of the Broker.

i. Analyse demat transaction statement.

Demat transaction statement is like a passbook of shares. (Read more about

demat transaction statement in Part III of the book). If the assessee has done

any mischief, he will not submit the transaction statement and will always pray

for more time. Therefore , in the very first notice u/s 142(1), you must ask for

demat account number and name with address of the depository participant

(DP) with whom he maintains demat account. The details furnished can be

utilised at this stage. If you know the DP address, send a letter u/s 133(6)

and ask for transaction statement related to the assessee for financial year.

Peruse the transaction statement of the assessee to find if the shares were credited

in his account, three or four days after the date of purchase (i.e ,transaction

date) shown in the contract note. If you do not find entry of shares on the

date or even in any month of the relevant financial year, then this is the 1st

evidence on record that no transaction in those shares had taken place. Now,

your work has increased manifold


8


(ii) Write a letter to the stock exchange

Stock Exchange is a prime witness to the transaction in shares through broker.

Therefore, a confirmation from stock exchange is of great help. Note that,

since no person can transact without Broker filling his /her PAN in order form,

PAN is the single most important data to establish authenticity of the trade.

Here is a suggested format for writing a letter to stock exchange

“Please confirm that M/s XYZ broker has purchased shares of …………………

On……………for his client named ……………………having PAN……………………

in settlement number ………………… vide Trade No ………………………………….

Please also confirm if the transaction was done on delivery basis. If

yes, please furnish date, quantity, demat account number in which such

delivery was made.

In case the broker has made the transaction for any person other than

mentioned above, Give name and PAN of that person. You are also

requested to give the demat account number along with DP name &

address of the aforesaid broker, both for his client A/c/pool a/c and self

account .(iii) Send a letter to the broker

Send a letter u/s 133(6) to the broker who issued contract note asking following question :

1. Have you purchased shares for …………… having address ……………………….. on date ………….. If yes, please furnish ledger copies of the assessee for the FY ………

2. Did you purchase shares through stock exchange or through Off market?

9

3. If shares have been purchased from any person other than stock exchange, give name, address, details of payment, the date of delivery taken in your accounts.

4. When did deliver of shares to assessee and in which demat account?

5. Enclose your Demat Transaction Statement for period under consideration.

In all probabilities, if the broker has done some mischief, he will not answer the notice u/s 133(6) or he may shirk from answering In that case, issue him notice u/s 131 of the I T Act and ask questions given above including documents required for investigation.

(iv) Have peep into broker’s demat account

1. Write a letter u/s 133(6) to the depository of the broker for the demat transaction statements of the broker-personal as well as pool account,related to the impugned shares for the relevant financial year.

2. Peruse the demat transaction statement of the broker.If you do not find any incoming shares or any credit in brokers account on that day or even within few days after the date, an additional evidence will be on record that no purchase was made by the broker even off-market.1

3. Also note the balance of shares being shown in broker’s demat accounts in impugned share. If you do not find any balance before the date on which the assessee claimed to have transaction, this finding would be very useful against the broker’s alibi that the transaction was executed off-market.

1 Read SEBI Circular MRD/DoP/SE/DEP/Cir-3/2004 dt 24.08.2004


10


Step 4 : Dealing with different scenarios

The result of the letter u/s 133(6) to the stock exchange has to be properly analysed. There may be different types of confirmations from the stock exchange. For example, stock exchange may confirm that :

Scene (i): The said transaction had taken took place.

In that case, just check that demat transaction statement also shows the credit or debit of such quantity of shares. If the shares are indeed reflected according to the contract note details, close the chapter. There is nothing to find out, as far as genuineness of the transaction is concerned. If you wish, go ahead and do what is generally required for PENNY stock. But this is certainly not falling under this technique “Evasion Through Bogus Purchase Of Shares?”

Scene (ii): The broker had transacted in that share but not for the person mentioned in the letter.

In this case, you have just brought 2nd evidence on the record that broker did not purchase the impugned shares for the assessee. It is clear that the assessee in connivance with the broker tried to hoodwink the department by producing fake contract note. You can strengthened your investigation by calling the broker u/s 131 of the IT Act bt following these steps :

1. Match the name and the client ID/PAN reflected in stock exchange’s letter with the name and client ID reflected in Broker’s ledger account of shares .You will certainly get the name reflected.If that is true, you have just unearthed 3rd evidence. Impound the share ledger or get the copies of the share ledger duly signed by the broker , because that page will be used as an evidence for your conclusion.

2. Record the statement of broker/his manager/staff member who appears as an authorized person, asking him to show the entry of the assessee’s transaction.

11

Evasion Through Bogus Purchase Of Shares.

Scene(iii): Broker deal t wi th those shares on that day but deal was squared off.

If the deal was squared off and the client ID of both the squared off trades match, it means that the assessee can not get the shares as it were never delivered. Just a speculative transaction was made. Therefore, the assessee can not show following things in his account in absence of actual delivery of shares

1. Business gain or loss

2. Capital gain or loss.

3. Closing stock out of such purchase

Scene(iv): No transaction took place in broker’s account.

Clear denial by the stock exchange is a great evidence in itself for proving the contract note as false, but the assesee and the broker can still make some alibi as a last resort to save themselves. How to deal with such alibis has been described later in this chapter.

Step 5. Summing up & assessments

Copies of all the evidences collected from different sources should be given to the assessee with a show cause notice as to why the share purchase shown by him/her/it should not be regarded as a sham/bogus purchase and that the losses on account of such / bogus purchase should not be disallowed. However, the assessee and the broker may make following arguments as last ditch efforts to save themselves.

12


How to counter last ditch efforts of evaders who may argue as follows:

The shares are not reflected in his demat transaction statement because he(the assessee) did not take the delivery from the broker and kept the shares with the broker only, so that whenever he wanted to sell, he would just tell his broker to sell and order will be executed.

He does not know what broker has done. He purchased shares from the broker and he is not responsible for any misdeed of broker.

Similarly, broker may say “the stock exchange has not confirmed the transaction because he had made “off market” deal which was not routed through stock exchange.”

There is no reason for accepting the arguments of the assessee or the broker on following grounds :

1. There are clear evidences on record that authenticity of the contract note is not proved.

2. Burden of proof1 of purchase is on the assessee. No proof was produced by the assessee or the broker to show that there was actual purchase.

3. Even broker’s demat account on examination does not show that he had purchased the impugned shares. It is also to be noted that there was no balance of shares in his pool account before transaction dates.

4. The broker could not show from which party he made the off market purchase and when those shares were delivered to him.

5. The broker is supposed to transfer the shares from pool account to his client within two days under SEBI’s rule. Why did he not do so? 2

1 CIT v. Calcutta Agency Ltd. [1951] 19 ITR 191 (SC)/2 SEBI circular on transfer of share by broker to its client MRD/DoP/SE/Dep/Cir-30/2004 (go to Back to Basics)

13

6. The assessee could not convince the extraordinary need for authorization

to the broker to keep the shares on behalf of him.

7. The broker could not say under what law he acted as “caretaker of the

share” ,if any.

8. Even the payment was not made by the assessee for the purchase and the

delivery was also not made. Therefore, there was no purchase and sale at

all.

Case Laws Reference

Bogus Capital gains : Assistant Commissioner Of Income ... vs Smt. Ranjit Kaur

on 11 August, 2005. 99 TTJ 568

Burden of proof : Lakshimaratan Cotton Mills Co. Ltd. v. CIT [1969] 73 ITR 634 (SC)/ , Dalmia Jain & Co. Ltd. v. CIT [1958] 33 ITR 294 (Pat.)/Dey’s Medical

Stores Mfg. (P.) Ltd. v. CIT [1986]

–End–


14


Unquoted Shares & Tax Evasion Common ways of routing back the black money (earned profits on which no

tax is paid) in business are :

1. Unsecured loan receipt

2. Using the concealed income for purchase and showing purchase on

credits, i.e ,creating fictitious creditors,

3. Gifts from someone

4. Investment in immovable properties and undervaluing it.

5. Earning tax exempt income like agricultural income, etc

However, this chapter deals with two methods ,both involve shares of private

limited companies for converting black money into white

Readers may note that after amendment in section 56(2) of the I T Act

effective from 1st October 2009 , practice of conversion of black money into

white by using the two methods described below has almost died down .

Method 1: Create your own private limited company

Say, a contractor Mr X has two crores of unaccounted money which he wants

to convert in white without giving a single penny as tax. He converts these

two crores of black money easily into tax exempt money in the following

five steps:

1. He creates a private limited company ABC P Ltd having authorsied

capital of Rs 20 lakhs. He along with his wife invests Rs 10 lakhs

as capital required to set up a company.

2. Let us say the authorsied and issued share capitals are as follows

Authorised 2,00,000 shares of Rs 10

15

Issued 1,00,000 shares of Rs 10 face value

Initial subscriber: Mr X 50000 shares

Mrs X 50000 shares

3. The assessee, Mr X wants to convert Rs 2 Crore in FY 2008-09. Therefore, he will issue 1,00,000 shares of the company ABC Pvt Ltd , to others for Rs 200 at a premium of Rs 190 per shares.

4. Nobody will subscribe to the shares of ABC P Ltd at such high premium in the absence of any substantial business or future prospect. Mr X contacts a broker specialized in arranging fake subscribers to such premium issues. The broker manages many investment companies. He gets the cheque for Rs 2 Crore issued from five or six of these investment companies. The broker gets cash equivalent of cheques and the commission from Mr X.

5. When the money arrives in ABC Ltd’s bank account, Mr X immediately transfers the application money to his other companies or concerns. The balance sheet of the company ,after the shares are issued and subscribed by those companies may be as under:

Capital 20, 00,000 Investments 40, 00,000

Reserve 1,90,00,000 Loans &Advances 1,70,00,000

2, 10,00,000 2,10,00,000

[the aforesaid balance sheet is simplified for clarity purpose]

6. The return for the Asst Yr 2009-10 is filed and there is chance that this return may not be scrutinized. Even if it is scrutinized, if the A.O is not alert, he may not investigate the origin of capital .

Unquoted Shares & tax Evasion

16


company. The merged subscribed capital actually helps in masking the money which has been routed through different companies.

7. In FY 2008-09 or to be on safer side, in FY 2009-10, Mr X and Mrs Y will purchase back 1,00,000 shares issued at premium of Rs 190 for a mere Rs 15 per share. So, they will issue cheques for Rs 15 lakhs to those share holders and purchase all the shares.

8. The effect would be that investment companies will claim capital loss which may be adjusted with other capital gains. Mr X receives back Rs 1,90,00,000 in form of capital of the company by paying Rs 15 lakhs by cheque. How clever !

9. The company’s balance sheet does not reflect any purchase or sale by individual shareholders ; as such these transactions go unnoticed.

10. An illustration of the method is given below

For this, he uses his company wherein

there are 1,00,000 of shares left

to be issued.

Mr X wantsto convert Rs

2 Crore ofblack money.

This way, Xgets backwhite moneyof Rs 2 Cr ascapital by using cash.

After one ortwo years, X

buys backsame share for

Rs 15

X pays Rs2 crore cash +

fees, Brokerarranges cheques for Rs. 2 Crore issued by 3 or 4

companies.

He issuesshares for Rs200. A brokerarranges share

subscibers

17

Method 2: Buy a private limited company

This method is , in fact , a business proposition for a bunch of people who have specialised in creation of companies and believe in perseverance and luck. Simply put, the process of creating a company is as under:

1. A company is created with a small capital and with very big amount of share premium.

2. All those share application moneys are used to buy investments in private limited companies , which are also created by same person for the same purpose. For example, their balance sheet will show as under

Capital

Shares Issued 20000 Rs 2,00,000

Reserve Premium Rs 2,00,00,000

Assets

Investment in shares Rs 2,00,00,000

(The list of investments may be in 10-20 private limited companies created in the same way

Each company holds investments the other companies )

3. Now , let us say, someone wants to convert black money into white. He will approach the person who is controlling these companies, who will transfer the 20000 shares on very low price. Say Rs 2,00,000 in this case. That person will pay , say Rs 2,00,000 by cheque ,as a price for shares to be transferred and commission /fee for buying such company , say 5 % of total capital ( Rs2.2 Crore) in cash.


18


4. After the company is bought, the new controlling person will start selling the shares shown as investment , usually on same price on which it was bought . The purpose is simple. Bring cheque for equivalent cash . The person who created those companies , has the responsibility to buy those shares.

Now the new company is flush with real money which was black money of the unscrupulous person. He uses that money for whatever purpose he wants it to be.

How to catch such an evasion?

The modus operandi of the persons who indulge in creating such companies and selling them to prospective tax evaders is that they disperse all these companies in different wards , so that no one A.O will have grip over them. Their operations are also covered in different years , so linking of each case is also difficult. In author’s opinion ,Investigation wing is more suitable for such enquiry and getting the whole chain of links exposed in this “black to white operation” on the ground of better resources of intelligence, lack of burden of time limited work ,wide area of operation and unlimited power into things to enquire into things. All these help in investigation of source of application money, in examining the intention of the parties involved and in piercing the layers of funds movement are required.

Anyway, however hard that task may be, it is not beyond the capabilities and abilities of the A.O. In fact, in many cases, one can catch the culprits at the first stage itself , when money in the form of application amount is received by the tax evader company.

19

Steps involved for achievement of success by the A.O for investigating and assessing such cases are :

1. Identify the cases.

2. Examine application money

3. Go deep into layers of fund movements.

4. Collect evidences.

5. Record statements under oath.

Step1 : Identify the cases :

A company’s annual report contains balance sheet and P & L accounts for two years. Get hold of the earlier two years balance sheets and P & L accounts and compare the share capital of the company with respect to its activities. If you find that :

i) The company is not very profitable

ii) It is not carrying any major business

iii) It is earning some interest and dividend only.

iv) Most of its funds are used for giving loans and advances.

If such a company suddenly issues shares at a very high premium and also

gets subscriptions for such issue, then you have just got the perfect case

for questioning the receipt of the capital.

Let us take an example, a typical case where capital of the company for fours years is compared and can be as under :

Capital 2003-04 2004-05 2005-06 2006-07

Authorsied (Nos) 2,00,000 2,00,000 2,00,000 2,00,000

Authorised capital (Val) (Rs.) 20,00,000 20,00,000 20,00,000 20,00,000

Issued & Subscribed (Nos) (Rs.) 100000 100000 100000 2,00,000


20


Issued & Subscribed (Value) (Rs.) 10,00,000 10,00,000 10,00,000 20,00,000

Net Profit (Rs.) (24000) 100000 110000 85000

Reserve(Premium) (Rs.) 0 0 0 1,90,00,000

One can see from the aforesaid chart that the net profit earned by the company is very dismal. Even then such a company is able to get the capital at a very high premium. The natural question would be “Why will anybody be interested in such a company?”

Step 2: Examine application money. Call for details of all the shareholders who subscribed to the “premium

issue” and work on each subscriber as if you have got a case to verify the unsecured loan from such shareholdes. The analogy between an unexplained loan and unexplained application money for subscribing to shares is perfect, because in both cases money is first credited to the books of the receiver ,i.e , the assessee. Therefore, try to find out the truth about application money on three legally settled parameters :

1. Identity of the person subscribing to the shares

2. Creditworthiness of the subscribers

3. Genuineness of the transaction

Step 3: Go deep into the layers

Generally most of share applicants in such cases will be companies. Their

identity may not be suspect as it is easily verifiable these days. The modus

operandi of the Operators (the person who are in business of creating capital

companies ) is to bring subscription by depositing cash and issuing cheques. But

21

the cash is not deposited in the bank account of the subscribing company. The

deposit of cash is generally made in different companies’ or persons’ accounts

and from those accounts, cheques are issued to the subscribing companies. The

subscribing company, once money reaches to its account, issues cheques to

the share issuing company. The operator of such schemes makes it sure that

the money passes through more than one layer. That is why, when you check

the bank account of subscribing company, you will invariably find that the

company has also received the money from somebody else and issued cheque

either on the same day or after a few days to the share issuing company.

Let us take an example. Say, we are investigating into subscription of shares

worth Rs 25 lakhs issued by a company, named ABC P Ltd . Let us say

LMN P Ltd has subscribed to the shares by paying a cheque for Rs 25 lakh.

In that case, you may find fund movements as given below :

ABC P Ltd received Rs 25 Lakhs of share application money from LMN P Ltd.

LMN P Ltd says that it received Rs 25 Lakhs from XYZ P Ltd as advance.

Bank account of XYZ P Ltd. shows deposit of three cheques from three persons/companies totalling to Rs 25 Lakhs just before the date of issuing cheques

Bank account of these three persons shows deposits of cash equivalent to the amounts deposited

1st Layer

2nd Layer

3rd Layer

ÔÔ

Ô


22


The A.O will have to go at least up to the 3rd layer, only then the real picture will emerge. This is the reason that I stated in the beginning that to break the chain, investigation wing is most suitable. The A.O has to go deep up to the third layer where one will find that the there is no explanation for such cash deposit. The scrutiny up to such level will certainly be helpful in bringing out the real story.

Step 4: Collecting evidences

While going deep into the layers of fund movements, one should get following data :

1. Shareholders list of those companies ,e.g, LMN P Ltd and XYZ P Ltd.

(You may even find that there are common shareholders)

2. Capital, Loans, and Advances. (You may find that these companies have also issued the shares at

premium and advanced loans or used the money to purchase shares of other private limited companies) 3. Addresses of all those companies.

(You may find that all addresses are same or within same city)

4. Name of auditors of these companies. (It may just happen that auditors are also found to be same)

5. Place where they are being assessed. (It is likely that they are being assessed at the same station)

6. Net profits (All these companies have only income from other sources and

very small profits)

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7. Business these companies are carrying on. (Generally these are investment companies)

8. Investments in different companies. (The investment by these companies is generally in related companies

which they sell after a year or two.)

Step 5 : Banks are the real places for investigation

The modus operandi of the people is such that the name of the game is getting a cheque for cash. The cash is certainly deposited somewhere down the chain. Therefore, investigation is a matter of time devotion with the bank managers. That is the reason I stated, that compared to an A.O , investigation department which has wide powers of enquiry , is much more suitable for such an enquiry.

In fact , the greatest tool in the hands of the investigation department , now is the information collected by Financial Intelligence Units who monitor funds transfer through banking channel in real time basis.

Step 6 : Recording of statements u/s 131

Deep enquiry will certainly bring out instances of cash deposits at certain layers. In that case it is very important that the person in whose account such cash deposits have been made are examined in details. Apart from the questions based on the facts and circumstances which come on the record at the time of an enquiry, following questions ought to be asked to everybody whose involvement in chain circulation of subscription amount comes on record.

1. What is the source of cash deposit?

2. Why did he pay the cheque to the company immediately after depositing cash?


24


3. What is the relationship between company/person in whose account cash has been deposited and the company to which the loan was

issued? 4. Who received the cheque of application money

and how the delivery of that cheque was made?

5. Who are the auditors of the company?

6. If it was loan, how come the company or the person came to know

about the need of the loan by that person?

7. What were the net profits of the company for the last three years?

8. What is the ratio of total loans taken and given by the company?

Most important decision of the Supreme Court on the issue of addition of money shown as share application moneyWhen an A.O is successful in getting to the bottom of the chain and finding

cash deposits somewhere down the chain , should he add the share capital

amount in the hands of the assessee whose case he was scrutinizing or

unexplained amount should be added in the hands of person in whose bank

account cash got deposited.

In other words, let us say the A.O is investigating into the case of ABC P

Ltd in which Rs 2 Crore share application was received from two companies,

FGH Pvt Ltd and TQL P Ltd. On further investigation , he found that cash

was deposited in two individuals accounts - X and Y- who transferred the

amount by cheque to two companies ZYZ and WTU P Ltd , who transferred

the money as share application to FGH & TQL who , in turn , transferred

money as share application to ABC P Ltd , whose case was being investigated .

The question is in whose hand the unexplained cash deposits should be

added . In ABC Pvt ltd or in hands of individual Mr X or Mr Y in whose

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account cash was deposited or XYZ P ltd or WTU Pvt ltd who were the

first recipients of the unexplained cash deposits in individual account.

Fortunately, the controversy regarding the point of addition of unexplained

cash which travelled to different accounts , has been settled by Hon’ble

Supreme Court while dismissing the Special Leave Petition of the Income Tax

Department. Perhaps , it is one of the tiniest order from the Apex Court which

clearly spells out the point where those unexplained cash deposits should be

added. Since it is very small order , full order is given below

Supreme Court of India

CIT vs Lovely Exports (P) Ltd.

Special Leave to Appeal No. 11993 of 2007

S.H. Kapadia and B. Sudershan Reddy, JJ

11 January 2008

V. Shekhar with Chinmoy Pradip Sharma and B.V. Balaram Das for the Petitioner

ORDER

By The Court :

Delay condoned.

2. Can the amount of share money be regarded as undisclosed income under

s. 68 of IT Act, 1961 ? We find no merit in this Special Leave Petition for

the simple reason that if the share application money is received by the

assessee company from alleged bogus shareholders, whose names are

given to the AO, then the Department is free to proceed to reopen their

individual assessments in accordance with law. Hence, we find no infirmity

with the impugned judgment.

3. Subject to the above, Special Leave Petition is dismissed


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In author’s opinion, the law is now settled that addition u/s 68 of the I T Act can be done in the hands of person in whose account money is deposited provided he files return of income and is very much identifiable ; else addition should be done in hands of the first beneficiary company/person who is identifiable and files return of income with the department.

Therefore, in the aforesaid example ,addition u/s 68 of the I T Act in the hand of ABC Pvt Ltd will not sustain judicial scrutiny when finding is that XYZ or WTU Pvt Ltd were the first beneficiary companies which received money out of cash deposits .

Case law reference

CIT v. Divine Leasing & Finance Ltd. (2008) 216 CTR (SC) 195Bharti Syntex Ltd. vs DCIT 125 TTJ 484Midas Golden Distilleries (P) Ltd. vs CIT 137 TTJ 82CIT vs GP International Ltd ; 229 CTR 86CIT vs Oasis Hospitalities (P) Ltd. 238 CTR 402

–End–

27

Evasion Through Reverse Conversion Of Shares?The reverse conversion means that the stock-in-trade is being converted into investments to claim the benefit of lower or nil tax on capital gains.

Let us start with an example. Mr. X is a share dealer who has prepared his computation of total income, P & L account and balance sheet for FY 2008-09 (Asst Yr 2009-10 ) as under :

Computation of total income

Net Profit As per P & L A/c 1,82,00,000Less Capital gains 1,80,00,000A) Business Income 2,00,000B) Income from Capital GainsSale of BEML on 1/1/2009 2,00,00,000Lesscost of share purchased on 1/9/2005 20,00,000Long term capital gains(exempt) 1,80,00,000C) Income from other sources 1,00,000 Gross Total Income 3,00,000LessFixed deposit for 5 years(u/s 80C) 1,00,000Total Income 2,00,000

The Profit & Loss account of Mr X was as follows Opening stock 75,00,000 Sale 3,15,00,000Purchase 2,87,00,000 Closing Stock 62,00,000Expenses 13,00,000 Capital Gains 1,80,00,000Net Profit 1,82,00,000

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Balance Sheet of Mr X was drawn as follows

Capital 45,00,000 Investment 1,20,00,000

Net Profit 1,82,00,000 Stock-in-trade 62,00,000

Sundry Creditors 20,00,000 Bank Balance 56,00,000

Debtors 1,00,000

2,47,00,000 2,48,00,000

When the case was selected for scrutiny, the A.O asked for the evidence of purchase

and sale of shares on which capital gains were claimed. It was found that the shares

were transacted through the National Stock Exchange. The assessee also furnished

payment evidence regarding the sale. The A.O test checked the computation, tallied

purchase and sale quantity, value and date with the contract note submitted by the

assessee and was satisfied with the claim of the assessee. Therefore, the A.O did

not press on the capital gains issue and passed the assessment order without further

scrutinising the case.

Was there something more to be seen?

The case related to FY 2008-09. When his return for FY 2007-08 was perused, the balance sheet enclosed with the return was as follows :

Balance Sheet for FY 2007-08

Capital 42,50,000 Investment 12,00,000

Add Net Profit 2,50,000 Stock-in-trade 95,00,000

Sundry Creditors 70,00,000 Bank Balance 5,00,000

Debtors 3,00,000

1,15,00,000 1,15,00,000

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A careful scrutiny of the balance sheet for FY 2007-08 shows that closing stock-in-trade was Rs 95,00,000 whereas the opening stock in FY 2008-09 was shown at Rs 75,00,000. This is certainly a discrepancy because closing stock of a year is opening stock of the next year. Enquiry revealed that the decrease in the value of the closing stocks of shares was on account of shifting the shares of BEML from stock-in-trade to investment account. The assessee had done this window dressing of his balance sheet with an ultimate objective that the gain of Rs 1.82 Crore should be shown as long term capital gain to evade tax.

The aforesaid example was a simplistic one regarding the reverse conversion of stock-in-trade. You may come across even more innovative scheme of reverse conversion.

Evasion Through Reverse Conversion Of Shares?

Why such craze for reverse conversion?In the past, businessmen used to convert the investment into stock-in-trade for simple reason that in case of long-term capital gain, the rate of tax was fixed at 20% but there was limitation for charging expense against such capital gains. The I .T. Act allow very specific types of expenses as cost of acquisition of capital asset whereas in case shares are treated as stock-in-trade, one has the infinite possibilities to charge every kind of expense against income from sale of shares. One of the favourite claims of expense is interest on unsecured loan. These unsecured loans in many cases, are unaccounted moneys, routed back to the assessee’s business as unsecured loans. Thus,the double benefit using black money as well as claiming interest on it for reduction of tax liabilities could be availed if the shares were stock-in-trade.

However, the time has changed now. Two major factors which have encouraged unscrupulous persons to adopt reverse conversion of stock tactics for tax evasion are:

1. The phenomenal rise of the stock market.

2. The provision of nil tax on long term gains and 15 % tax on short

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term gains.

Let us understand the reason for such reverse conversion with the help of stock price chart of BEML, a public sector company listed on NSE and BSE is given below :

1745.90

1572.55

1399.20

1225.85

1052.50

879.15

705.80

532.45

359.10

185.75

12.40

Price : 1026.55 14.11.2006

BEML

29.03.1995 16.09.1997 10.01.2000 03.05.2002 13.08.204 29.12.2006Left click and drag mouse to select range, release to zoom in. Right click to zoom out.

In 1995, the shares of BEML were quoting at Rs 185 which touched Rs 12.50 during FY 1999-00 and towards the end of FY 2005-06 went up to Rs 1514. So somebody who purchased 1 lakh shares of BEML for Rs 185 as stock-in-trade in 1995 had incurred huge losses in next five years because of the drop in price of shares of BEML. However, the loss in value was utilized to reduce other profits as the stock-in-trade is valued at market or cost whichever is lower.As the scenario completely changed towards the end of FY 2005-06 ,if he sells the shares , let us say, on 28/02/2006 when the price reached Rs 1514, he earns huge profits and also pay staggering amount of tax as computed below :

Sale Value 1514 x 1,00,000 shares = 15,14,00,000Less Cost of the shares Rs 185* x 1, 00,000= 1,85,00,000Gain reflected in P & L account = Rs 13,29,00,000Tax @ 30 % = 3,98,70,000

(* For simplicity, price as on 1.4.05 is taken at Rs 185)

Compare it with the situation that if he would have kept shares as investment,

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tax would have been nil, as the rate of tax in case of long-term gains on shares is nil. The situation like this has created a desire among the tax evaders to adopt innovative approach to evade tax.

The arguments of assessee & implication.The pet replies of the assessee in cases of reverse conversion of stock-in-trade into investment will be as follows :

1. There is no bar under the I.T.Act for such conversion ;

2. The shares were held for quite some time and

3. He was free to change the nature of holding ,i.e, he was free to treat his holding as an investment with the logic that the shares which had been converted into investment were those which had been held for a longer period.

To understand how to counter the aforesaid arguments, find the facts and then draft the assessment order, we have to understand first of all why the conversion of investment into stock-in-trade was brought within the meaning of transfer in relation to capital asset.

The provision regarding conversion of investment into stock-in-trade was not in existence until 1/4/1985. Sub-section 2 to section 45 was inserted with effect from 1/4/1985 in following words

“(2) Notwithstanding anything contained in sub-section (1), the profits or gains arising from the transfer by way of conversion by the owner of a capital asset into, or its treatment by him as stock-in-trade of a business carried on by him shall be chargeable to income-tax as his income of the previous year in which such stock-in-trade is sold or otherwise transferred by him and, for the purposes of section 48, the fair market value of the asset on the date of such conversion or treatment shall be deemed to be the full value of the consideration received or accruing as a result of the transfer of the capital asset.”


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This amendment was brought by Finance Act 1984 to nullify the effect of judgment of Supreme Court in case of CIT vs Shirinbai K Kooka [1962] 46 ITR 86. The brief facts of the case was

:“The assessee is a Parsi lady who held by way of investment a large

number of shares of different companies. These shares were purchased before

the end of and after 1939-40 at a cost price which was much less than

their market value on April 1, 1945. Her dividend income was assessed to

income-tax for several years prior to April 1, 1945 ; but in the assessment

year 1946-47, the relevant accounting year being financial year 1945-46,

the Income-tax Officer found that the assessee had converted her shares

into her stock-in-trade and carried on a trading activity, viz., a business in

shares. Her income for the assessment year 1946-47 was therefore computed

on the basis of the profits which she made by the sale of her shares as

a trading activity, the profits being calculated on the difference between

the ruling market price at the beginning of the account year and the sale

proceeds. For the assessment year 1947-48, the relevant accounting year

being the financial year 1946-47, it was found by the Income-tax Officer

that the sale proceeds of the shares which the assessee had sold amounted

to Rs. 5,49,487.

The assessee then appealed to the Appellate Assistant Commissioner who

enhanced the income of the assessee by a sum of Rs. 2,91,307 including a

capital gain of Rs. 37,590. The Tribunal agreed with the view of the income

tax officer. On being approached by assesse for a reference to High Court,

the Tribunal framed the question of law in the following terms :

“Whether, the assessee’s assessable profit on the sale of shares is

the difference between the sale price and the cost price, or the

difference between the sale price and the market price prevailing

33

on April 1, 1945?” The aforesaid question of law was then referred to the High Court of Bombay under section 66(1) of the Indian Income-tax Act, 1922 (XI of 1922). The High Court answered the question in favour of the assessee and held that the assessee’s assessable profit on the sale of shares was the difference between the sale price and the market price prevailing on April 1, 1945. The Supreme Court upheld decision of High Court and dismissed petition of department.

To overcome effect of such judgment sub-section 2 was inserted in section 45 of the I T Act. Further, section 2(47) which defines ‘transfer’, was also amended to include such conversion. The subsection (iv) of section 2(47) thus states :

2(47) “transfer”, in relation to a capital asset, includes,- (iv) in a case where the asset is converted by the owner thereof into, or is treated by him as, stock-in-trade of a business carried on by him, such conversion or treatment; or

Similar situation has now arrived. The assessee finds fruit in converting the stock-in-trade into investment, because that is more beneficial to him. The department can not allow reverse conversion, if the sole reason for resorting to such conversion by the assessee is to evade tax. So, A.O has to

i. Detect such cases,

ii. Bring out the facts associated with such conversion,and

iii. Then disallow the conversion and assess the gain under “business head”


34


How to detect reverse conversion?

Write down the opening stock and closing stock of last three or four years. If you find that closing stock is not matching opening stock of the next year the most probable reason is reverse conversion.For example, have a look on the table of opening and closing stock below:

Financial Year Opening Stock Closing Stock

2003-04 A B

2004-05 B C

2005-06 X D

2006-07 D E

In the aforesaid chart you see that closing stock of FY 2004-05 is C. Therefore, C should be opening stock next year i.e FY 2005-06. But the opening stock is a different number X.

It is a great pointer for investigation to see if there was a case of reverse conversion.

You can also closely examine tax audit report to find if the tax auditor has mentioned any thing on this.

What should A.O do in such cases?

Once it is established that assessee has converted stock in trade into investment, first thing A.O should do is to ask an explanation from assessee for such conversion. Following arguments, in my opinion, should be utilized for disallowing such creative conversion of stock-in-trade into investments.

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i) The intention of the assessee is mala fide in the sense that there is no

cogent reason for such conversion other than saving on tax.

ii) In the past, the loss on account of devaluation of closing stock-in-trade was always adjusted with the income as the valuation is done as per market value or cost whichever is lower. Now suddenly, assessee has changed its method of accounting from the stock-

in-trade into investment, the loss of revenue on account of such

conversion can not be sustained on account of clever accounting.

iii) Stock-in-trade is not a capital asset. Simply changing the

nomenclature can not change the character of the asset. The shares

which were carried in accounts book for so long as stock-in-trade

can not be rechristened as investment simply because one day,

one changes its treatment.

iv) Such conversion is against the regularly followed method of

accounting and u/s 145(3) the A.O is empowered to make the

account in the manner provided in section 144 of the I T Act.

How to determine period of holding in case of converted asset ?The issue of determining the period of holding will certainly arise to determine

whether the converted asset is short term or long term. The problem comes

when the stock-in-trade which is being held for say 6 years and converted

to investment and after one year , say it is sold. The question arises from

which date the period of holding should be counted. Let us take an example:

Mr X bought certain private limited companies shares on 01/06/2003 and

was showing it as stock-in-trade. On 01/04/2006 , he convert the shares as


36


investment in his balance sheet. Let us say , he sells the shares on 01/10/2010.

When he computes capital gains, he takes indexation from the date of original

buy i.e 01/06/2003 (FY 2003-04) . Is he correct?

In author opinion, which is based on settled case laws, the date on which a

stock in tade is converted is the date on which that capital asset has taken birth.

So the age of the asset should be counted from that date. In the example stated

above, the indexation should be from 01/04/2006 and not from 01/06/2003

ITAT, Delhi in case of Splendor Construction (P) Ltd v. ITO (2009) 20

DTR (Del) (Trib) 282 a similar issue came up before the tribunal. The

assessee converted stock in trade into investment in April 2002 and was sold

subsequently in December 2002. The stock-in-trade -lands- were acquired

during the financial year 1998-99. The assessee claimed the capital gain as long

term on the reasoning that it was owned by it for more than 36 months. The

tribunal held that the period of holding as stock in trade is to be ignored

and only the period for which the asset was held as capital asset will be

determinative of the capital gain as to whether short term or long term.

In the case of Commissioner of Income-tax Vs. Santosh L. Chowgule

[1998] 234 ITR 0787 , Bombay High Court held that it is only “the life of

the converted asset which should be considered in reckoning whether it is a

short-term or long term capital asset.

Further Case Law Reference !• ACIT vs Bright Star Investment Pvt. Ltd. on 2/7/2008 (Assessee Favour )

• CIT Vs. Chunilal Khushaldas [1974] 093 ITR 0369(Guj)

• Manecklal Premchand (Decd.) Vs. CIT [1990] 186 ITR 0554(Bom)

–End–

37

Speculation Loss And Tax Evasion!

A share trader does not distinguish between speculation loss and business loss. For him both are trades-one with delivery and the other without delivery. When he prepares his business P & L account, he finds the actual profit or loss.

For example a trader earning Rs 10 lakh in delivery based trade and incurring speculation loss of Rs 10 lakh, in practical sense, earned nothing. However, Income Tax Act treats speculation loss differently. Section 73 of Act provides that speculation loss can be adjusted only with the speculation gain. So when the computation of total income as per I.T. Act is done, he finds that he will have to pay tax with interest on Rs 10 lakh of business income and speculation loss of Rs 10 lakh has to be carried forward.

Thus, he starts devising ways to save himself from financial burden which he feels is purely out of technical reasons. Add to this is the fact that method of evasion of tax in such situation is very easy to implement. He does not have to make any fake documents but a simple twist to computation of total income in a particular manner can save him tax.

Following two methods are being adopted by the share dealers.

I. Mix Speculation Loss With Trading Income.

II. Claiming Speculation Loss As Hedge Loss

The first method is very crude method of evading tax whereas the second method is sophisticated.

Mix Speculation Loss With Trading Income.

Let us start with an example. Following are the P & L account and computation of total income of Mr X for FY 2008-09 (Asst Yr 2009-10).

38


Opening 1,39,60,000 Sale 8,40,00,000

Purchase 7,56,00,000 Closing stock 1,20,33,000

Speculation Loss 6,00,000

Expense 34,37,000

Net Profit 20,36,000

Computation of total income of Mr X

Income from business 24,00,000

Add Income from other sources 2,50,000

Gross Total Income 26,50,000

Deduction u/s 80 C 1,00,000

Total Income 25,50,000

Perusal of P & L account shows that speculation loss of Rs 6,00,000 has been

treated by the assessee as business loss since he has not added it to his total

income. The A.O passed the assessment order adding the speculation loss

and allowed it to be carried forward.

Are we satisfied with the disallowance of the speculation loss debited in P &

L account in this case? If you go deeper in the case, you may just find that

the assessee has actually adjusted very large speculation loss. The explicit

speculation loss shown in the P & L account was a kind of bait to A.O by the

shrewd tax evader to entangle him on somewhere else so that actual misdeed

remains hidden.

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How to unearth cases of such tactics?Step 1: Call for details of purchase and sale of shares in following format u/s 142(1)

Share Opening Purchase Sale Closing Name Stock


Alternatively, you can also call for share ledger or general ledger of the

assessee and find out big volume transactions in aforesaid manner. For example,

when Mr X was asked to give details of share purchase and sale in aforesaid

performa, he furnished following details

Value in Thousand (‘000)



RIL 10000 6000 30000 21000 30000 24000 10000 7000

TISCO 8000 3200 30000 15000 36200 15800 1800 1200

GAIL 10000 1000 0 0 0 0 10000 1000

Infosys 1000 1000 0 0 1000 260 0 0

Petronet 90000 1800 400000 12000 490000 14800 0 0

TV Today 10000 820 0 0 0 0 10000 700

Satyam 0 0 50000 20000 50000 22000 0 0

Arvind Mills 0 0 5000 200000 5000 250000 0 0


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Ballarpur 10000 380 0 0 10000 480 0 0

Mukta Arts 0 5000 500 0 0 5000 300

TELCO 0 0 10000 1200 0 0 10000 1100

Maruti 0 0 12000 1840 0 0 12000 1730

M & M 1000 100 2000 110 0 0 3000 100

Biocon 1000 350 1000 500 2000 1200 0 0

MRF 0 0 20000 2000 0 0 20000 1800

Rel Petro 1000 50000 20000 1250 0 0 21000 1050

Step 2: Segregate those shares in which despite very high volume of transactions (i.e highest purchase & sale value wise), the gain is not very high.

If you analyse the aforesaid table, you can see that higher volume of purchase & sale are in following cases



RIL 10000 6000 30000 21000 30000 24000 10000 7000

TISCO 8000 3200 30000 15000 36200 15800 1800 1200

Petronet 90000 1800 400000 12000 490000 14800 0 0

Satyam 0 0 50000 2000 50000 22000 0 0

Step 3: Ask for the demat transaction statement from the assessee of these

four shares. Alternatively, you can also fetch yourself the demat transaction

statement from the depository participant of the assessee by invoking provision

u/s 133(6).

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Step 4 : Compare the total numbers of shares incoming (credited) with the numbers of shares shown as purchased by the assessee in response notice u/s 142(1). If numbers match, there is no speculation.

However, if the number of purchase shown in the details of purchase furnished by the assessee is more than numbers shown in demat transaction statement, there is every possibility that speculative transaction are mixed with the delivery based transactions.

In the aforesaid example, when the transaction statements of RIL and TISCO were tallied with the figures shown in details filed by the assessee, the numbers credited in the transaction statement were less by 8000 and 9000 respectively. Further, shares of Satyam were not reflected in transaction statement at all.

Step 5 : Ask the assessee to produce the contract notes related to purchase and sale of those shares of the company in which you have found out mismatch in numbers. If assessee has done what you caught, assessee will either fail to produce or will furnish fake contract note.

When the relevant contract notes were perused, it was found that extra numbers of shares of RIL, TISCO and Satyam reflected in the details furnished by the assessee were actually of speculation. The contract notes related to those transactions clearly showed that trade was squared off and had resulted in losses as under:—

RIL 7, 60,000

TISCO 8, 00,000

Satyam 20,00,000

Total speculative loss adjustment 35, 60,000

Thus the assessee had mixed non-delivery based trades(speculative) with delivery based trades, so that speculative losses get adjusted with delivery based trade. That way it hides !


42


How to find out the sign of speculation from contract note?1. In case, speculative transactions are performed by a broker on behalf

of assessee, the transactions are, in most cases, squared off same day. Therefore, in all probability, you will find in the same contract note both the debit and credit entries of all details of share transactions.

2. Another way is to ask details of share transactions from the brokers of the assessee. Two separate details should be asked – one for share transaction where delivery was made and one for share transactions without delivery.

3. Write to the stock exchange for confirmation of the trade and ask specifically whether the shares were purchased on delivery basis.

4. Ask the assessee to explain why so many numbers of shares are not reflected in demat transaction statement.

Shortcut to catch the quantum of speculation business!In the very beginning, you must ask for details of all the brokers with whom the assessee had an account. This trick is easier to implement if number of brokers are not many. Send letter u/s 133(6) to all those brokers asking following details about assessee

1. Easiest way to know is ask for Form 10DB which is for declaration of STT deducted at source. Code 3 of the Form 10 DB related to day trading i.e sale of shares without taking delivery (speculative).

2. Details of shares which were purchased on delivery and sold on delivery.

3. To give statement of accounts of all those transaction for which no delivery was made. i.e. assessee squared off dealings through him.

4. Ask for payment details.

The details sent by the brokers should be tallied with the details procured from the assessee and any mismatch should be identified & enquired into.

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Claiming Speculation Loss as Hedge Loss

This method is quite sophisticated as the assessee tries to evade tax under the garb of innocence that his case falls under exceptional circumstances which allows speculation loss to be treated as business loss. Let us go by an example.

The P & L account of assessee, say Mr X is as under

Opening 1,39,60,000 Sale 8,40,00,000



Expense 34,37,000


The computation of income of Mr X shows that the assessee has adjusted the

speculation loss of Rs 60 lakhs as business loss. At the time of scrutiny, the

A.O asked him why speculation should not be added back to his income as

the speculation loss can not be adjusted with the business income.

The assessee replied very shrewdly as under

“Sir,

With due respect to you, I would like to bring in your attention that the said

speculation loss of Rs 60 lakhs were actually business loss in terms of section

43(5) (b) which says

“Speculative transaction” means 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 :


44


Provided that for the purposes of this clause-

(a) ……………………….

(b) 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; or

©……..

shall not be deemed to be a speculative transaction;

The speculation loss of Rs 60 lakhs was incurred in course of speculation of shares of MRF to guard against my holding of shares of MRF which you can see from closing stock of shares.”

The A.O. however did not agree with the reply of the assessee. He disallowed the speculation loss to be adjusted as business loss.

What was the actual trick?

Assessee brought following facts on record in support of his claim –

There is speculation loss of Rs. 60,00,000,

The speculation loss was incurred on the shares of MRF.

There was holding in shares of MRF in assessee’s stock in trade.

However, most important fact is not on the record–i.e. whether the speculation was really for minimizing the risk of investment in MRF shares. In the instant case, the A.O found that

The date of speculation was 1/5/2010.

There were no shares of MRF before 1/5/2010.

The shares of MRF shown in stock in trade were purchased on 1/9/2009.

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Thus, the transactions in MRF shares were purely speculation and were not incurred with intention to minimize the risk on investment in MRF shares, because there were no holdings in shares of MRF as on the date of speculation in MRF. Had the speculation were done after 1/9/2009, the argument of assessee could be authentic, not otherwise.

Crucial test

The crucial fact for determination in these types of case is “whether the assessee had holdings in the same shares in which the speculation losses were incurred”. The issue whether same share should be held at the time of speculation in the share was clarified even by CBDT vide circular No 23D (XXXIX) [F No 412/(4)60/TPL dated 12.9.1960 in point 4 which is reproduced below

“Point 4: Bona fide hedging transactions by a dealer or investor should be allowed provided that the hedging transactions are up to the amount of his holdings even though these transactions may extend to other types of shares not held by him.

Board’s decision

The Board are unable to accept this suggestion. It cannot be accepted that a dealer or investor in stocks or shares can enter into hedging transactions in scripts outside his holdings. The material words in clause C of the proviso to Explanation 2 to section 24(1) are “to guard against loss in his holdings to stocks and shares through price fluctuations”. Therefore, hedging transactions having reasonable relations to the value and volume of dealer’s or the investor’s holdings are excepted from the ambit of the speculative transactions; but transactions in scrip outside his holdings are not.”

[Full circular is given in Part III of the book]


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Lessons learnt !

If assessee claims that a speculation transaction is actually business transaction

within the meaning of section 43(5)(b) of the I T Act, following steps must

be taken to confirm if the speculation falls within the exception provided u/s

43(5)(b) of the I T Act.

1. Note the names of share and respective dates of speculation

transactions.

2. It must be confirmed if the assessee possessed those company’s shares

on the date when he made speculation transaction resulting in

loss.

3. It should also be noted that if the numbers of shares held by assessee

as on the date (s) of speculation is very small in comparison to

speculative transactions done, such speculation transaction should

also not be considered covered u/s 43(5) read with CBDT’s circular.

Case Law Reference

1. ACIT vs Dinesh K Mehta [ITAT Mumbai] 2010 39 SOT 488- [Revenue Favor ]

2. CIT v. Hotz Hotel Pvt. Ltd. [2003] 128 Taxman 160 (Delhi)

3. Davenport & Co. P. Ltd. V/s. CIT reported in 100 ITR 715 (S.C.)

4. CIT v. Joseph John [1968] 67 ITR 74 (SC)

–End–

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How To Detect Closing Stock Undervaluation ?The closing stock under valuation is a very common trick to reduce the profit. This method is applied in all kinds of business. But in case of shares, it can be applied very easily on account of sheer number of closing stock items. In many cases one may find the numbers of closing stock of shares as many as 400 or even 600 shares. If the A.O is not vigilant to check the market price of closing stock, tax evaders can quite easily reduce taxable profits without much effort.

Method of valuation

The accounting standard AS 2 issued by ICAI is prescribed for valuation of inventory but AS-2 is not valid for valuation of stock-in-trade in relation to shares, debentures and other financial instruments. Therefore no accounting standard is prescribed for valuation of closing stock of shares. Three common methods for valuation of closing stock are :

1. At cost

2. At lower of cost or market value ;

3. At average cost

The time tested and legally settled method is “cost or market value whichever is lower”. This method is beneficial to traders as the notional loss in valuation of stock-in-trade with respect to cost is allowed to be adjusted with the current years’ profits. As such, it is most accepted method of valuation of closing stock-in-trade. That the diminution in the value of closing stock is allowed under this method, also make it a tool to evade tax. If you refer the chapter “Evasion Through Bogus Purchase Of Shares”, the tax evasion is possible because of this method. This chapter, however, is not on the merits or demerits of method of valuation, but on the subject of undervaluation trick adopted by some unscrupulous share traders.

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Let us take an example. The P & L account of Mr X, a share dealer, for FY 2009-10 was as follows :

Opening 1,39,60,000 Sale 8,40,00,000



Expense 34,37,000


Details of closing stock as on 31/3/2009

Share Name Opening Qnt Value RIL 10000 4100000TISCO 8000 3200000GAIL 10000 1000000 Infosys 1000 1000000 Petronet LNG 90000 1800000 TV Today 10000 82000 Satyam 0 0 Arvind Mills 0 0 Ballarpur 10000 351000 Mukta Arts 0 TELCO 0 0 Maruti 0 0 M & M 1000 100000 Biocon 1000 350000 MRF 0 0 Rel Petro 1000 50000 12033000

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This is only an example, that’s why, the list of closing stock is kept very small.

Let us say, in the aforesaid case, the average purchase cost of RIL shares is Rs 500. However the valuation of closing stock has been done at average price of Rs 410 per share. It means that if assessee is following “cost or market price whichever lower” method, Rs 410 should be the market price as on last date when the stock exchange was open. If you took the trouble to confirm with the rate on NSE or BSE, it might be found that rate was actually 480. What it means that assessee, reduced its income by Rs 7 Lakhs.

This is very crude method for the tax evasion, but A.Os should be vigilant to get the confirmation of the closing rate on major stock exchange concerned and verify valuation done by assessee.

How to check the closing stock price?

There are two ways to confirm the stock rate :

1. By consulting certain books which publishes closing rates of stocks.

2. Visit the internet sites of NSE, BSE or CSE or any regional stock exchange. Website addresses are given in Part III of the book.

And check the price on the last day of the year which may not necessarily be 31st March but last day means the last day stock exchange was open. One can verify the price of the share on a particular day by visiting web site of the stock exchange.

[Read how internet helps you in investigation of share cases in Part III of the book.]

Which Stock Exchange’s Price?

In author’s opinion the stock exchange from which such transaction was done, should be taken for valuation of the closing market rate.

–End–

How To Detect Closing Stock Undervaluation ?

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How To Detect If Short Term Is Claimed As Long Term Gain?

This method is the easiest to implement. Shares held for 12 months are short term capital asset and for one day more, shares become long term capital asset. Long term gains on shares sold through stock exchanges are exempt u/s 10(38) and short term gains on shares chargeable to STT are taxed @10% (15% proposed by Budget 2008). Therefore, an unscrupulous investor tries to disguise a short term as long term gains for the stupendous tax savings

Let us take an example. A share dealer showed long term capital gains of Rs 50 lakhs and claims it as tax free as per law. The computation of capital gain was as under

Sale of RIL 10,000 on 28/12/2010 @ Rs 1200 for Rs 1,20,00,000

Less

Purchase 10,000 on 26/12/2009 @ Rs 700 for Rs 70,00,000

Long Term Capital Gains Rs 50,00,000

At the time of scrutiny, he submits demat transactions statement to show that shares were credited and debited in his accounts on that date. Still, A.O did not allow him the tax exemption. Why?

The reason

It was found by the A.O that there was no discrepancies as far as numbers, value of shares purchased and sold were concerned. But the contract notes furnished by the assessee reflected dates of transaction as under :

Contract note Transaction Date

Purchase 28/12/2009

Sales 16/12/2010

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How To Detect If Short Term Is Claimed As Long Term Gain ?

As per the contract note, shares were sold within 12 months. As such shares were short term capital assets and the gain on it was also short term capital gains. The A.O invoked the circular 704 issued by CBDT dated 28th April 1995 which states in para 2 of the circular that date of transfer is the date of transaction given on the contract note.Here is excerpt :

“2. When the securities are transacted through stock exchanges, it is the established procedure that the brokers first enter into contracts for purchase/sale of securities and thereafter, follow it up with delivery of shares, accompanied by transfer deeds duly signed by the registered holders. The seller is entitled to receive the consideration agreed to as on the date of contract. The Board are of the opinion that it is the date of brokers note that should be treated as the date of transfer in cases of sale transactions of securities provided such transactions are followed up by delivery of shares and also the transfer deeds.

Similarly, in respect of the purchasers of the securities, the holding period shall be reckoned from the date of the brokers note for purchase on behalf of the investors. In case the transactions take place directly between the parties and not through stock exchanges the date of contract of sale as declared by the parties shall be treated as the date of transfer provided it is followed up by actual delivery of shares and the transfer deeds.”

The delivery of shares may, for many reasons, may take time. As per CBDT circular cited above, the date of transaction reflected in the contract note is the date from which period of holding is to be ascertained in case shares are transacted through brokers. That was the reason, the A.O found that total period of holding of shares was less than 12 months. Therefore, the shares were only short term capital asset and the gain was short term capital gains to be taxed @ 10%.

Lessons learnt!Always ascertain the date of transactions from the contract note and not from any other documents like broker’s bill or demat account balance statements. The holding period is reckoned from the contract note.

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Why Should You Scrutinize Transaction Statement?

Let us take the example of Mr X, an investor-cum-share dealer whose case

was being scrutinized. His computation of total income was as under

Net profit from share business 4,00,000

Short Term Capital Gains

Sale of 10,000 TISCO share For Rs 35,00,000

Less

Purchase of 10,000 TISCO share Rs 30,00,000

5,00,000

Income From other sources 1,00,000


The A.O asked for evidence of purchase & sale of shares like contract notes,

demat statements, payment details and bills issued by the broker, and which

were furnished by the assessee.

It was observed by the A.O that contract notes were issued by a renowned

broker and transactions were done on National Stock Exchange. It was further

noted by the A.O that the date and price reflected in the contract note tallied

demat holding and found that the assesse had those shares. Therefore, the A.O

did not make any further enquiry on the issue of capital gains. The assessment

was passed with some addition on other points under business head,with the

date and price taken for computation of capital gains.

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Why Should You Scrutinize Transaction Statement?

What A.O forgot to enquire?

The A.O verified the purchase date and price of the share with the contract note. He did not go further. Had he gone a bit more, the result would have been startling. Actually, there was no fault as far as purchase or sale of shares were concerned. The fault was only in computation.

The demat transaction statement was showing following entries

TISCODate Credit Debit Balance1/4/2009 NIL2/5/2009 purchase 10,000 10,0004/8/2009 purchase 10,000 20,0005/3/2010 Sale 10,000 10,000

The contract notes reflected following details regarding purchase & sale of TISCO shares Purchased Date 1/5/2009 @ 170 10,000 17,00,000 Date 1/8/2009 @ 300 10000 30,00,000Sold 1/3/2010 @ 350 10,000 35,00,000Assessee computed capital gains by assuming that shares purchased on 1/8/2009 were sold on 1/3/2010. This way capital gain of Rs 5,00,000 was computed. But, as per section 45(2A) of the I T Act, he was actually required to follow FIFO i.e First in First Out method. As per FIFO, 10000 shares purchased on 2/5/’09 have to be first considered as sold. Had he followed that method, the short term capital gains would have been Rs.18,00,000 (35,00,00- 17,00,000). Therefore, he was able to suppress income of about Rs. 13 lakhs.

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Lessons learnt1. Always verify if the capital gains are computed by following FIFO method

in case of dematerialized shares which is prescribed under section 45(2A) of the I T Act. In this regard the CBDT’s circular No 768 dt 24/4/1998 is very clear. The relevant portion of the circular is reproduced below :

“The FIFO method will be applied only in respect of the dematerialized holdings because in the case of sale of dematerialized securities, the securities held in physical form cannot be construed to have been sold as they continue

i. to remain in the possession of the investor and are identified separately.

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

iii. If in an existing account of dematerialized stock, old physical stock is dematerialized and entered at a later date, under the FIFO method, the basis for determining the movement out of the account is the date of entry into the account.”

[Full circular is given in Back to Basic part of this book]

2. Whenever, A.O finds any capital gains or loss, he must ask for transaction statement and verify from there whether the FIFO method has been applied for computing the capital gains.

3. Ask for transaction statement in case of shares you find discrepancies and try to find out which share has entered demat account first. Those shares have to be “Out” first and not those shares which were purchased first but not entered in demat account.

–End–

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How Family And Private Companies Are Used For Evasion? Let us start with an example. Mr X has shown his computation of income for Asst Yr 2009-10 as follows

A) Income from Business

Business Income 2,00,000

B) Income from Capital Gains

Short Term Capital Gains 43,00,000


Total Income 45,00,000

Tax on Rs 45,00,000

On Rs 2,00,000 Rs 15,000

On Rs 43,00,000 @ 10% Rs 4,30,000

Tax 4,45,000

At the time scrutiny assessment, assessee also submitted the details of short term capital gains as under

BEML ST Gain

Sale value 2,00,00,000

Less cost of share 20,00,000 1,80,00,000

Rasoi P Ltd

Sale 50000 shares 7,00,000

Purchase 5,000 shares 50,00,000 -( 43,00,000)

Sanjay P Ltd

Sale 100000 shares 600000

Purchase 100000 shares 1,00,00,000 -(94,00,000)

Net short term capital gains 43,00,000

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Obvious question in A.O’s mind was that in one of the shares dealt by the assessee, huge gains were earned, whereas in other two transactions huge losses were incurred. While the gain and loss are common in share dealing, the strange point to note in the aforesaid case is that the losses were incurred in transactions of private limited companies’ shares. Naturally, the A.O got curious about the genuineness of the purchase and sale of private limited company shares. He asked the assessee to submit confirmation certificate from the purchaser and payment evidence. The assessee furnished all evidences as asked by the A.O and also stated that the shares sold were already shown in his balance sheet. So, what should be seen in this case?

Let us see, what A.O did. He concentrated on three aspects of the transactions related to private limited companies’ shares.

1. Enquired about the purchaser

2. Enquired about sale.

3. Enquired about the private limited companies.

4. Examined valuation of the shares.This is what the A.O found out.

1. It was found by the A.O that the assessee had purchased these shares from a company in which the directors of the company were substantially interested. The company issued shares on premium which were susbcribed by the assessee.

2. The purchaser is none other than a close relative of the assessee. The close relative is a house wife and her husband is carrying an agency of the main business of the assessee.

3. It was also found out that the purchase was done on credit. 4. The A.O collected the balance sheet of the company and found

that almost all the shareholders of the company are assessee’s relatives.

5. It was seen that the said companies have income from rent and also earns some interest income.

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6. The balance sheet reflected that one of the company- Sanjay P Ltd - was created to construct commercial building and employing it on rent. The enquiry revealed that the commercial building is situated at prime place in the city.

7. It was found by the A.O that the pricing of the shares were done according to choice of the assessee and not according to the standard valuation methods. A rough computation of the value of share by the A.O showed much higher value of shares than the price on which it was sold.

The re-computation of the capital loss by the A.O showed that out of two private companies’ shares transaction, there was actually gain in one shares and there was very small loss in the other share sale. The result was that the assessee could not get the benefit of adjustment of created loss and he had to pay the evaded tax.

Lessons learnt!

Whenever you find that the capital gain or loss has arisen on account of purchase and sale of shares of a private limited company, one must find out answer of following questions :

1. Who was the seller?

2. What was the relationship between assessee and the seller?

3. Who is the purchaser?

4. Is he/she/it having capacity to purchase?

5. What are the ownership / membership details of the private limited companies?

6. Is there close relationship between the assessee and the purchaser or seller of the shares?

7. Is the sale price based on the right valuation of the share?

How Family And Private Companies Are Used For Evasion?

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Point 1 to 6 is easy to find out, the 7th question is a bit laborious and technical, is being discussed below

How to value the unquoted shares?

The Income Tax Act has now tackled the problem by inserting sub-clause (vii) under section 56(2) effective from 01/10/2009 under which receipt of shares by Individual or HUF either for inadequate consideration or no consideration , is treated as “income from other source” in the hands of recipients. However, the provision was not applicable with respect to firm and company as recipients. This was a loophole in the I T Act which was plugged from 01/06/2010 from which date sub-clause (viia) was inserted in section 56 (2) . The value of shares, thus , received either for no consideration or inadequate consideration by a firm or company is regarded as “income from other source” .

For the purpose of valuation of shares , Rules are also framed . The said rule for valuation of unquoted shares are contained in Rule 11UA(c)(b) of It Rule 1957 as under :

b) the fair market value of unquoted equity shares shall be the value, on the valuation date, of such unquoted equity shares as determined in the following manner namely:-

The fair market value of unquoted equity shares =

(A-L) x (PV)

_____________

(PE)

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Where,

A= Book value of the assets in Balance Sheet as reduced by any amount paid as advance tax under the Income-tax Act and any amount shown in the balance sheet including the debit balance of the profit and loss account or the profit and loss appropriation account which does not represent the value of any asset.

L= Book value of liabilities shown in the Balance Sheet but not including the following amounts:-

(i) the paid-up capital in respect of equity shares;

(ii) the amount set apart for payment of dividends on preference shares and equity shares where such dividends have not been declared before the date of transfer at a general body meeting of the company;

(iii) reserves, by whatever name called, other than those set apart towards depreciation;

(iv) credit balance of the profit and loss account;

(v) any amount representing provision for taxation, other than amount paid as advance tax under the Income-tax Act, to the extent of the excess over the tax payable with reference to the book profits in ac-cordance with the law applicable thereto;

(vi) any amount representing provisions made for meeting liabilities, other than ascertained liabilities;

(vii) any amount representing contingent liabilities other than ar-rears of dividends payable in respect of cumulative preference shares.

PE = Total amount of paid up equity share capital as shown in Bal-ance Sheet.

How Family And Private Companies Are Used For Evasion?

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PV = the paid up value of such equity shares.

(c) the fair market value of unquoted shares and securities other than equity shares in a company which are not listed in any recognized stock exchange shall be estimated to be price it would fetch if sold in the open market on the valuation date and the assessee may obtain a report from a merchant banker or an accountant in respect of such valuation

Case Law Reference1. CIT v. L.N. Dalmiya [1994] 207 ITR 89 (Cal.).-Revenue favour- In this case the assessee had purchased shares to acquire the controlling interest in a company. Thereafter those shares were sold at a lower rate to other companies which were owned by the assessee himself. It was held that these transactions were to avoid tax, as the assessee still retained the controlling interest of that company and thus the loss was held as not allowable.

2. Kameshwari Finance and Leasing (P) Ltd. vs DCIT 109 ITD 173 (Delhi)

3. CIT Delhi (Central) vs Bharat Nidhi Ltd 133 ITR 447

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Use of Mergers For Tax EvasionRestructuring -merger or demerger - of business is an important necessity Therefore , myriad of laws including tax laws which governs a business environment in the country recognize such needs and incorporate relevant provisions to facilitate reorganization of business. Therefore, Income Tax Act also contains benevolent provisions by which mergers & de-mergers exercise are made tax neutral.

However, as it happens everywhere, unscrupulous persons abuse these benevolent provisions related to restructuring of business for evading tax. This chapter is going to discuss two such methods of tax evasion which involve mergers of companies. These are :

1. Merger of companies to convert black money to white.

2. Create artificial loss for adjusting with real income.

3. Merger of private companies after revaluation of its assets.

Merge Companies to convert Black Money

This was not a very popular way to convert black money to white until 01/10/2009 . Why ? Because from that date , a new clause © under sub-clause (vii) of sub-section 2 to section 56 of the I T Act became effective. In simple terms, from that date , shares and securities received by an individual or HUF either without any consideration or inadequate consideration , shall be regarded as income if it exceeds a specific amount .

This , new provision , scared the black money rich individuals to buy the companies “manufactured” for this purpose only. (Read Method 2: Buy a

private limited company under Chapter Unquoted Shares & Tax Evasion )

From 01/06/2010, a new sub-clause (viia) was inserted under sub-section 2 to section 56 , by which it was provided that a firm or company receiving

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shares of closely held companies (read private limited company and limited company in which public are not substantially interested) either without cost or on inadequate consideration , shall have to include the difference in amount paid and fair market value of shares as income from other sources.

Thus , the ways in which unquoted shares were being used to bring in black money as legitimate sales consideration of investment or stock-in-trade of shares of private limited company , evaporated . The business of creating private companies and selling it to perspective customers really got jot as the buyers fled the scene on account of section 56(2)(vii) of the I T Act.

So, have those creatures stopped functioning. No. Now they have taken the route of mergers . The reason is that the assets transferred under merger and amalgamation are not treated as transfer. The newly inserted Clause (viia) provided that it is not applicable to receipt of any property (read share in instant case) by a company by way of transaction not regarded as transfer under

1. Clause (via)

2. (vic) , or

3. (vicb) or

4. (vid) or

5. (vii)

Of section 47 of the I.T Act.

Clause (via) & (vii) of sec.47 of I.T.Act relate to merger and amalgamation.

What it means , in simple words, is that if the shares are transferred to another company under scheme of amalgamation , such transfer , shall be out of purview of capital gains and even from newly inserted section 56(2)(viia) of

63

the I T Act. Therefore,assets transferred under merger does not suffer either capital gains tax in hand of transferrers or can be charged under section 56(1)(viia) as Income from Other Sources” in hand transferees.

How they do it?

Let us take an example. A person has a private company TUV Pvt LTD in which he and his wife are shareholders. He has 2 crores of cash (Please note

that the small figure is used just for example , in reality the conversion is on a very large

scale ). He can bring this cash in form of loan or other form , but each form is open for scrutiny. So , in order to hoodwink the agencies, he will first approach the person who creates companies for this purpose .

Let us say , this manufacturer offer two private limited companies similar to the objects of the company in which black money of Rs 2 Crore ( Rs 20 million ) is to be routed as white .Share capital and investments in offered two companies are as under:

Company Issued Capital Share Premium Investments in shares

(On Asset Side)

ABC P Ltd 4,00,000 96,00,000 1,00,00,000

XYZ P Ltd 5,00,000 95,00,000 1,00,00,000

There are specialists who takes the burden of getting amalgamation of aforesaid two private companies with the TUV P Ltd successfully done and they do whatever needed for getting approval of High Court .

Once the merger becomes effective, the investments of Rs 20 million (Rs 2 crore, say in four companies Rs 50 lakhs each ) are now asset under the new merged company TUV Pvt Ltd and shown as investments.

The company then sells these private limited shares by paying cash against the cheque which comes to assessee’s bank as sales consideration. No capital

Use of Mergers For Tax Evasion

64


gains also arises , as the sale is done at par value.

How to prevent such practice ?

In author’s opinion rather than going after individual case, there should be change in tax law under which it should be provided that if the shares received on transfer under a merger is sold within 5 years from the date of effective date of merger, the 20 % of the value shall be charged to tax . This will deter buyer of such companies , as the game is to convert black money as quickly as one can. If buyer has to wait for five years, he may not be interested in such practice.

Can we catch them?

Yes, follow the method given in Chapter: Unquoted Share & Tax Evasion

ii. Create artificial loss on account of merger.

This method is applied , usually ,by business groups who can ascertain their business profitability in advance.

Let us take an example. A business group consists of a number of private limited companies . The company estimates that out of group companies , there will be huge income in three companies AB Pvt Ltd , XY Pvt ltd and MN Pvt ltd. The group wants to evade paying any tax on the profit , in a legal way. So , this is what they do :

1. The private limited companies will buy/apply for the shares of other private limited companies which are of same group at a very high price , say Rs 200 per share .

2. The money used for buying shares remains within group.

3. The private limited company whose shares were bought will then merge with another public listed companies , the market price of which is , say Rs 1 or Rs 2 .

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4. The whole merger operation is done in a manner as if they fulfill all criteria.

5. The restructuring is arranged in such a manner that the shares ratio to be allotted is fixed keeping in mind the gains or losses.

6. The newly acquired shares of the merged company are valued at market price which are obviously very low as on 31st March on stock exchange (predetermined before doing merger). Thus the diminution in value as on 31st March eats away the profit of usual business .

7. The money , which was paid for acquiring shares of group private limited companies , remains within group and are used in the manner group controller wants to use.

How to Prevent them ?

The fundamental to tax evasion by this mode is the inflated valuation of share of private limited company. Since the money remains within group and on account of such merger with a company whose shares are quoted at a low price , benefits the group in artificially reducing the taxable profit.

The law as it is today is in favour of tax evaders. It is also favourable for tax evaders that once High Court approves a merger plan, income tax department questioning the valuation or that such merger was done for sole purpose of tax evasion is not accepted by tax appellate authorties1. Hence, if such practice is to be stopped , it has to be prevented .

In fact SEBI realized the problem of loss making & over valuation of unlisted companies with listed companies (although in context of erosion of shareholder values). This in order to bring more transparency and efficiency in the governance of a listed company amended listing agreement vide its

1 ACIT vs. TVS Motors Co. Ltd. (2011) 128 ITD 47/36 DTR 89 (Chen-nai)(Trib.)


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Circular nos SEBI/CFD/DIL/LA/ 5/2008/4/09 dt September 4, 2008 under which it provided as under :

In order to safeguard the interest of shareholders, the listed company as well as the unlisted company which are getting merged shall each be required to appoint an independent merchant banker for giving a fairness opinion on the valuation done by valu-ers. Further, the “Fairness opinion” of the merchant bankers shall be made available to the shareholders at the time of approving the resolution under Clause 24.

SEBI needs to examine the valuer report , because after all the merger of “manufactured company” in a listed company creates weaker companies for existing shareholders.

The Role of Regional Director .

The Regional Director , under Ministry of Corporate Affairs who is given a copy of merger petition filed with the High Court under section 394A of the Companies Act has most important role to play as far as prevention of this kind of tax evasion practice is concerned.

It has been provided in proviso to section 394(1) that the High Court shall not sanction the merger scheme unless a satisfactory report has been received from Regional Director . It is of paramount importance that the report should indicate that the affairs of the company have not been conducted in a manner prejudicial to the interest of member or to public interest.

Therefore, examining the merger from tax angle should also be one of the in built responsibilities of regional Director for which ,in authors opinion , law requires a change . Income Tax Department must be given a chance to take a stand on the scheme of amalgamation or demerger because it is judicially held that the merger or restructuring purely for tax purpose is not in public interest and may not be approved as section 391 -394 of Companies Act

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which deals with mergers of companies requires High Court to be satisfied that the proposed merger does not defeat public interest .

Refer Wood Polymers limited [1977] 109 ITR 177 in which Gujarat High Court rejected the petition by assessee stating as under

It must be confessed that it is open to a party to so arrange its affairs so as to reduce its tax liability. The assessee or party can arrange its affairs so that he or it may not incur any tax liability. But it must be within the power of the party to arrange its affairs. If the party seeks assistance of the court only to reduce tax liability, the court should be the last instrument to grant such assistance or judicial process to defeat a tax liability, or even to avoid tax liability. If the party has so arranged its affairs, as to reduce or even avoid tax liability and the taxing authority disputes it, and the matter is brought before the court, the court would adjudicate upon the dispute between the revenue and the assessee on the rival contentions. That is not the situation here. In such a situation, the court would not be concerned as to the modality of avoidance of tax but here the tax cannot be avoided unless the court lends its assistance, namely, by sanctioning the scheme of amalgamation. In other words, the judicial process is used or polluted to defeat the tax by forming an appropriate device or subterfuge. Such a situation can never be said to be in public interest. It is clearly opposed to public interest and on this ground the court would not sanction the scheme of amalgamation. Accordingly, Petitions Nos. 10 of 1975 and 12 of 1975 are rejected. ..”

Therefore, law must be changed so as to provide the Income Tax Department an opportunity to go into the issue of taxation , the report of Regional Director must contain the view of the Commissioner of Income Tax ‘s view regarding the proposed merger .


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What A.O can do ?

There are two , certain ways to deal with such tactics by evader.

1. One is that the diminution in value of closing stock , may be declared speculative loss , provided other conditions of Explanation to section 73 of the I T Act is fulfilled.2

2. If the said shares are shown as investment and assessee tries to adjust with capital gains , the benefit of adjustment may not be given if the shares are sold after 12 months from holding initially.3

iii. Merger after revaluation of shares of Pvt Ltd Company

This method is also adopted to create artificial loss in the target merged company. The modus operandi is simple. The value of assets in a private limited company is arbitrarily enhanced . Then that company after some time is proposed to me merged with another company , where , there is expectation of gains or income. If the High Court approves plan , the company merged with another company . After a year or two , the existence of the company is very much obliterated and the annual accounts (balance sheet) does not show this information regarding revaluation of assets .

The merged company sells the asset which it received on transfer from merging company. In that year the cost of acquisition , which was revalued before merger is taken as cost , thereby , in many case , the loss is claimed , whereas , there should be gain .

This modus operandi works on principle of non continuance of reporting of old data regarding the merger and revaluation of asset in subsequent annual reports. What it means if the income tax department has the knowledge that 2 Paharpur Cooling Tower Ltd., 85 ITD 745 (Kol.)3 CIT vs. Harprasad 99 ITR 118 (SC), Ramjilal Rais 58 ITR 181 (All)

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the asset which is sold was actually revalued before its merger , then only action can be taken. But where is the link of such past record ?

How to prevent such evasion?

There should be law that a separate note in the balance sheet should be given of all assets of merging company which were revalued till the time it is carried forward in annual accounts . The The till the year it is carried forward. This will help authorities in determining true capital gains or income the A.O in the year of sale with information. The fear of being caught , may deter evaders from adopting this evasion practice.

Case Law Reference

1. CIT vs Gautam Sarabahi Trust [1988] 173 ITR 216 (Guj)- Section 47(vii) not applicable if asset other than shares are transferred to shareholder of amalgamating compnay..

2. Miheer H Mafatlal vs Maftlal Industries Ltd (1997)1SCC 579 (SC)

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How To Decide If Share Transaction Is Business Or Investment Activity? In recent time, this issue has caught the attention of all once again, as many share dealers are declaring their business income as short term capital gains for the reasons not hard to guess. These are :

1. Wide gap in tax rates for business profit and capital gains Long term capital gains on Share = NIL tax. Short term capital gains on share= 15% Business Profit = General rate max : 30%. [As the book is going to press, Budget 2008 proposes rate of 15%] 2. Similarity in the nature of transaction in case of short term capital gains and share dealing business is same.

The difference between the two activities-business and short term capital investments-is so thin a line that identifying that line had been a vexed problem before judicial authorities for many years. However, there is a basic consensus among judicial fraternity that the issue can be decided by the facts and circumstances of each case and whole issue is a mixed case of facts and law.

Be that as it may, but the fact remains that the wide gap in tax rate between the capital gains and business profit is so alluring for share dealers that a tax evader take the shelter under short term capital gains rather than considering it as business activity.

How to identify the cases?The first sign of a case where business adventures in shares are declared as short term investment activities, is that an assessee who was always showing more business income from share dealing suddenly shows huge short term capital gains. To reach at a conclusion, you will have to compare the figures of profits under different heads of at least last three years on following parameters

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1. Number of transactions as short term investments vs. number of transactions as business.

2. Value of transactions in short term investment vs. value of transactions as business.

3. The short term gains vs. the business gains.

If you find a sudden increase in short term gains, both number wise and value wise, compared to business gains, the case for that year must be scrutinized to see if the capital gains are not business income.

How to decide whether capital gains is actually business income?

Before proceeding to decide on the issue,following words of Supreme Court of India in case of G. Ventakaswami Naidu & Co vs CIT [1959] 35 ITR 594 are worth noting

“It is impossible to evolve any formula which can be applied in determining the character of isolated transactions which come before the courts in tax proceedings. It would besides be expedient to make any attempt to evolve such a rule or formula. Generally speaking, it would not be difficult to decide whether a given transactions is an adventure in the nature of trade or not. It is the cases on the borderline that cause difficulty.”

Therefore, A.O will find two types of cases related to this issue.

1. Transactions clearly falling under business head, have been claimed by the assessee as “capital gains”.

2. Transactions which are on borderline of the two cases.

How To Decide If Share Transaction Is Business Or Investment Activity?

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In both the cases the facts and evidences related to transactions can be collected in form of answers to following questions :

1. What is the general profile of the assessee? Whether the purchase and sale of share is the main business of the assessee?

2. What is the general nature of transactions of assessee in last three years? Specially find out the general nature of transactions of assessee during Asst Years 2003-04 & 2004-05 when short term gains were taxed at normal rate of tax.

3. What is the manner of showing purchase of shares in the books of account?It is advised that the answer to this question should be found out discreetly while examining books of account i.e ledger and cash book or bank book, share ledger, etc.

4. What is the magnitude of purchase and sale of shares under short term vis a vis under business head?

5. Find out the period of holding of each share in case of short term gains and business transaction.1

6. How much dividend earned on the shares sold as investment (short Term) ?

For this, investigation can be done in following manner

i. Visit the internet site of the company whose shares have been sold on short term basis.

ii. Find out the record dates of dividend.

If assessee sells majority of shares on short term basis before the record dates for dividend, it only means that the intention of the assessee was not the dividend receipt. Therefore, the purchase and sale of those shares were more of an adventure rather than investment.

7. What was the intention and motive of assessee at the time of purchase of shares? Was the motive of assessee to earn quick profit?

1 Wall Fort Financial Services Ltd vs Addl.CIT [2010]134 TTJ 656 (Mum)

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8. What were the circumstances under which the sale was done? Was there any special circumstance which forced the assessee to affect the sale?

9. What is the general profile of the assessee? Whether the purchase and sale of share is the main business of the assessee?

10. What was the source of funds utilized for purchase of shares? Was the purchase of share made by borrowing of funds or by way of sale of another investment? Generally, a person does not invest by borrowing the funds but generally business is run on borrowed funds.

11. Has the assessee set up a complete system in place for purchase and sale of the share?

12. Whether separate demat accounts are maintained by assessee for investment & stock-in-trade?

Different facts ,Different Courts & Different Parameters !

The case laws on the subject are many and all decisions are based on the facts and circumstances of the case before the court.

1. Authority on Advance Ruling in case of Fidelity Advisor Series VIII (A.A.R. No. 566 OF 2002) after considering various decision of Supreme Court and High Court on this issue, held as under :

where a company purchases and sells shares,

1. it must be shown that they were held as stock in trade

2. that existence of the power to purchase as sell shares in the memorandum of association is not decisive of the nature of transaction;

3. substantial nature of transactions,

4. manner of maintaining books of accounts,

5. magnitude of purchases and sales

6. the ratio between purchases and sales and the holding


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would furnish a good guide to determine the nature of transactions; Ordinarily purchase and sale of shares with the motive of earning a profit, would result in the transaction being in the nature of trade/an 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.

2. Treatment of share dealings in earlier years and in subsequent years

Magnitude, frequency and facts associated with share dealings are important factors. Supreme Court in Raja Bahadur Visheshwara Singh & Others vs. Commissioner of Income Tax, Bihar & Orissa, (41 ITR 685)

the assessee purchased shares during a period of 10 years from his own funds. He then borrowed substantial amounts for making further purchases of shares and securities. He made profits on selling some shares in the subsequent years. The Income Tax Appellate Tribunal, taking note of the magnitude and frequency of the transactions and the ratio of sales to purchases and total holdings, held that the appellant must be regarded as a dealer in shares and securities and that the profits of those years were as-sessable to income tax. On reference, the Patna High Court held that there was sufficient material to support the findings of the Appellate Tribunal. On further appeal to the Hon’ble Supreme Court it was, inter alia, held :

that if on the evidence which was before the Tribunal, i.e. the substantial nature of the transactions, the manner in which the books had been maintained, the magnitude of the shares pur-chased and sold and the ratio between the purchases and sales and the holdings, the Tribunal came to the conclusion that there was material to support the finding that the appellant was dealing in shares as a business, it could not be interfered with by the High

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Court;that the High Court was right in holding that there was sufficient material to support the finding of the Appellate Tribunal.”

3. Initial intention and subsequent conduct matters

i) In Dalhousie Investment Trust Co. Ltd. Vs Commissioner of Income Tax (Central), Calcutta (68 ITR 486), Apex Court held

It appears to us that the facts and circumstances in this case can lead to no other conclusion except that these shares were purchased and sold by the assessee with the motive of earning a profit by such purchases and sales and not with the object of investing its capital in these shares in order to derive income from that investment. It is true that the principal business of the assessee was to invest capital and to derive income from dividends on shares and interest on other investments ; but, at the same time, the object contained in the memorandum of association of the assessee company clearly showed that one of the objects was also to deal in shares, stocks, debentures, etc., by acquiring, holding, selling and transferring them.

ii) In Commissioner of Income Tax, Nagpur vs. Sutlej Cotton Mills Supply Agency Ltd. (100 ITR 706), the Apex Court was seized of an issue to decide whether purchase of shares in sister company and sale of those shares amounts to adventure in the nature of trade ? Overruling the High Court’s decision, the Apex Court concurred with the Tribunal order stating:

If the dominant intention was to carry on an adventure in the nature of business, the profit can be taxed ; otherwise not. In other words, the question is whether the assessee purchased the shares in a commercial spirit with a view to make profit by trading in


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them. The Tribunal found, after taking into account all the relevant circumstance that the dominant intention of the assessee was to make profit by resale of the shares and not to make an investment.

The finding that loss or profit is a trading loss or profit is primarily a finding of fact, though in reaching that finding the Tribunal has to apply the correct test laid down by law. When we see that the Tribunal has considered the evidence on record and applied the correct test, there is no scope for interference with the finding of the Tribunal

4. Systematic Activity Amounts To Trade

The Authority on Advance Ruling in XYZ/ABC Equity Fund (250 ITR at page 194).

Whether the company’s activities will amount to trading is basically a question of fact. In this case, we find a very intricate and complete system of investment has been devised by the petitioner-company in collaboration with other companies including an Indian company. Elaborate provisions have been made as to how the investment will be done; how the advisers will decide upon the investments to be made, the sale proceeds of the shares if and when shares are sold will be kept in the custody of the Custodian who will have to receive and maintain an account on behalf of the Mauritius company. There are various other facets of this elaborate system which cannot be simply regarded as investment. The scheme devised appears to be an elaborate business scheme to invest money from Mauritius in India. Such activity cannot be treated as investment activity. These activities reveal an elaborate business set up for trading in shares in India. Having regard

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to these facts and also the stated objects in the memorandum of association of the company, we are of the view that the company has purchased very large quantities of shares with the sole object of making profits by selling these shares at an appropriate time. The gains from the sale of shares will have to be treated as trading profits as and when the shares are sold.

5. Object in memorandum of association not final1

i) Supreme Court in A.V.Thomas & Co. Ltd. vs Commissioner of Income-tax [48 ITR 67], held that

a memorandum of Association is not conclusive as to the real nature of transaction which has to be deduced from the circumstances in which the transaction took place and not from the memorandum.

ii) In CIT vs P.K.N.Co.Ltd. [60 ITR 65,] the Apex Court held

The purpose or the object for which it is incorporated where the taxpayer is a company may have some bearing, but is not decisive, nor is the circumstance that a single plot of land was acquired and was thereafter sold as a whole or in plots decisive. Profit motive in entering into a transaction is also not decisive. Here, as already pointed out, the primary object of the company was to take over the assets of the P. K. N. firm to carry on the business of planters and to earn profits by sale of rubber. The incidental sale of uneconomic or inconvenient plots of land or houses could not convert what was essentially an investment into a business transaction in real estate.

iii) In Kishan Prasad and Company Ltd. vs. CIT [1955]; 27 ITR 49, 52 the issue before the Supreme Court in this case was

1 Oriental Insurance Company vs CIT, 1957 32 ITR 164 (SC)


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“Whether on a proper construction of the relevant clauses of the appellant company’s memorandum of association and articles of association and on a consideration of the circumstances in which the shares of the Sarswati Sugar Syndicate were purchased and sold, it could be held that the purchase and sale of such shares was a part of the appellant company’s business activities and was a business deal ?

“The only question for consideration therefore is whether it is a receipt from business and not a mere appreciation in capital. An argument was put forward at one stage on behalf of the revenue that the assessee-company, by virtue of its memorandum of association, was allowed to deal in money, notes, bills, hundies and other securities and that the shares which were purchased and sold fell within the category of securities. The High Court negatived this contention and Mr. Joshi on behalf of the respondent has also conceded this point. The High Court held, however, that the intention and purpose of the adventure was to obtain the managing agency of the sugar mill and the directorship in the sugar company and this fell within the object”

6. Burden of proof that the assets sold were part of investment account or activity lies on assessee

In CIT vs. Associated Industrial Development Co.(P) Ltd (82 ITR 586), the Supreme Court decided the case in favour of Revenue. This was a case of the assessee company being managing agents of various companies. It sold shares held by it in three of its companies and derived substantial profits. The assessee claimed profits as capital gain and not income. The Apex Court held

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Whether a particular holding of shares is by way of investment or forms part of the stock-in-trade is a matter which is within the knowledge of the assessee who holds the shares and it should, in normal circumstances, be in a position to produce evidence from its records as to whether it has maintained any distinction between those shares which are its stock-in-trade and those which are held by way of investment. The assessee, in the present case, made no

attempt whatsoever to make out a case that the shares which had been sold were a part of its capital investment. Nor did it place any material from which it could be established that those shares had been treated in its books differently from other shares held by it. The mere fact that the sale proceeds were paid into the overdraft account in which admittedly proceeds of sale of all the shares held by the assessee were being credited as and when the sales were made and that these shares had not been sold with any amount of frequency could not be regarded as sufficient to establish that these shares had been held by way of investment

Consistency regarding treatment of assets in preceding /succeeding years mattersDelhi High Court in Gulmohar Finance Ltd 170 taxman 483 dt 28 February 2008

It was noted by the Tribunal that in earlier assessment years, the assessee had shown the shares held in BT Tech Net Ltd. as an investment right from the date of purchase and this was shown as such in the balance-sheet of the assessee, which was filed along with the return of income. No objection was taken to this posi-tion in the earlier years. However, the CIT has now decided that it was not an investment without there being any change in facts and therefore, the Tribunal held that there was no occasion for the CIT to take a contrary view than what was disclosed and accepted


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on earlier occasions.

Punjab & Haryana High Court in CIT vs Girish Mohan Ganeriwala 135 TAXMAN 233

It is not in dispute that the Department in the previous as-sessment years had treated such transactions in the hands of the assessee as his income from capital gains and did not dispute that the income derived from the sale of shares was business income. The findings in the previous years, no doubt, do not operate as res-judicata but that does not mean that in every subsequent year it is open to the Assessing Officer to take a different view in the matter. Of course, he can take a different view if some fresh mate-rial is placed before him. TheCIT(A) and also the Tribunal have found that no fresh material was placed before the Assessing Officer

ITAT Mumbai while allowing appeal by assessee held in Janak S. Rangwalla vs ACIT 2007 11 SOT 627 as under

7. In the facts of the present case, the assessee is holding the shares as investment from year to year. It is the intention of the assessee which is to be seen to determine the nature of transac-tion conducted by the assessee. Though the investment in shares is on a large magnitude but the same shall not decide the nature of transaction. Similar transactions of sale and purchase of share in the preceding years have been held to be income from Capital Gains both on Long Term and Short Term basis. The transaction in the year under consideration on account of sale and purchase of shares is same as in the preceding years and the same merits to be accepted as Short Term Capital Gains. There is no basis for treating the assesses as a Trader in shares, when his intention was to hold the shares in Indian companies as an investment and not as stock in Trade. The mere magnitude of the transaction does not change the nature of transaction, which are being assessed as Income from Capital Gains in the past several years. The Assessing Officer is directed to set off the Long Term Capital Loss against the Short Term Capital gain of the year under consideration. The grounds of appeal raised by the assessee are allowed.

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Mumbai High Court while affirming decision by Tribunal in case of CIT vs Gopal Purohit 228 CTR 5822 held as under

the Tribunal has observed in paragraph 8.1 of its judgment that the assessee has followed a consistent practice in regard to the nature of the activities, the manner of keeping records and the presentation of shares as investment at the end of the year, in all the years. The revenue submitted that a different view should be taken for the year under consideration, since the principle of res judicata is not applicable to assessment proceedings. The Tribunal correctly accepted the position, that the principle of res judicata is not attracted since each assessment year is separate in itself. The Tribunal held that there ought to be uniformity in treatment and consistency when the facts and circumstances are identical, particularly in the case of the assessee. This approach of the Tribunal cannot be faulted. The revenue did not furnish any justification for adopting a divergent approach for the Assessment Year in question. Question (b), therefore, does not also raise any substantial question.

Shantilal M. Jain vs ACIT No. ITA No. 2690/Mum/2010 dt 27 April 2011

we find from Assessment Years 2003-04 to 2008-09, the As-sessing Officer has consistently accepted the STCG shown by the assessee except for Assessment Year 2006-07 i.e. the impugned assessment year. Under these circumstances, we are of the con-sidered opinion that Rule of consistency as propounded by the jurisdictional High Court in the case of Gopal Purohit (supra) will squarely be applicable to the facts of the present case.

9. In view of the above discussion, we are of the considered opinion that the income derived from the sale/purchase of share in the instant case has rightly been treated by the assessee as STCG. Therefore, we set aside the order of the CIT(A) and direct the As-sessing Officer to accept the STCG as declared by the assessee. We

2 SLP filed by Income Tax Dpt dismissed by Supreme Court vide its order dt 15.11.2010


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hold and direct accordingly. The grounds raised by the assessee are accordingly allowed.

What is the view of CBDT on this issue?This issue is not a new one and as such the Central Board of Direct Tax is also not oblivious of the varied interpretation of the issue by different assessing authorities. Accordingly, it issued instruction number 1827 dt 31/8/1989 wherein the A.Os were asked to take the guidance from a number of decisions of Supreme Court which were referred in the said instruction. The said instruction concluded with following words

“Although the tests laid down by the courts may help determine the issue in particular cases the decision will ultimately turn on the facts of each case.”

Draft Instruction dt 16/05/2006

CBDT issued draft instruction on 16th May 2006 to help to decide whether a particular transaction is investment or business. These are : “

1. Whether the purchase and sale of securities was allied to his usual trade or business / was incidental to it or was an occasional independent activity

2. Whether the purchase is made solely with the intention of resale at a profit or for long term appreciation and/or for earning dividends and interest.

3. Whether scale of activity is substantial.

4. Whether transactions were entered into continuously and regularly during the assessment year.

5. Whether purchases are made out of own funds or borrowings

6. The stated objects in the Memorandum and Articles of Association in the case of a corporate assessee

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7. Typical holding period for securities bought and sold

8. Ratio of sales to purchases and holding

9. The time devoted to the activity and the extent to which it is the means of livelihood.

10. The characterization of securities in the books of account and in balance sheet as stock in trade or investments.

11. Whether the securities purchased or sold are listed or unlisted.

12. Whether investment is in sister/related concerns or independent companies

13. Whether transaction is by promoters of the company.

14. Total number of stocks dealt in.

15. Whether money has been paid or received or whether these are only book entries.”

Further Case Law Reference

1. Supreme Court-Raja Bahadur Kamakhya Narain Singh v. CIT [1970] 77 ITR 253, - treatment given to a transaction in the books of account is of importance 2. Delhi High Court -CIT vs Ess Jay Enterprises (P) Ltd. 165 Taxman 465 -3. CIT vs N.S.S. Investments (P) Ltd. 277 ITR 149 [Madras] The tribunal had rightly held that the profits earned on the sale of shares were capital gains, not business income. 4. Dy.CIT vs A.T.N. International Ltd. [2005] 4 SOT 239 (Kol.)5. CIT vs H. Holck larsen [1986] 160 ITR 67 (SC) , 6. Jaggilal Kamalpat vs CIT 75 ITR 186 (SC) - Shares bought on borrowed funds and sold within short period , are held business activity.7. New Era Agencies P. Ltd. Vs. CIT [1968];68 ITR 585 (SC)8. Ramnarain Sons P Ltd vs CIT 41 ITR 534 (SC)

–End–


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Why Should You Scrutinize Transactions Of Last Seven Days ?

Let us start with an example: the P & L account of a share dealer for FY 2008-09 (Asst Yr 2009-10) was as under :

Opening 52,00,000 Sale 2,10,00,000Purchase 1,48,00,000 Closing Stock 45,00,000Expense 25,00,000Net Profit 30,00,000

The closing stock-in-trade details were as under

Number Value

RIL 5000 Rs. 30,00,000TISCO 1000 Rs. 7,00,000Infosys 600 Rs. 8,00,000 Rs. 45,00,000

During the scrutiny assessment, the assessee submitted copies of demat transaction statement where the balance of share as on 31st March was confirming with the closing stock shown by the assessee. The A.O still charged the assessee that he had concealed income and accordingly made addition to the total income. Why ?

The reason was this!

The A.O asked for the ledger account of the assesee from his broker. A careful scrutiny of the ledger account of the assessee in the books of his broker showed that he had sold 300 shares of RIL on 29/3/2009 at a price of Rs 900. This was the last date in the FY 2008-09 when the stock exchange was open. The A.O further found from the confirmation from the Stock Exchange that it delivered the shares on 3/4/2010. Therefore, the A.O concluded that the sale actually

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took place during FY 2008-09 and accordingly any revenue accruing to the assessee has to be accounted for by the assessee. The date of transaction is to be taken as per contract note in case the share transaction was through broker of recognised stock exchange. [Refer Part III for The CBDT circular in this regard]

This step of shifting the transaction to next year is generally resorted by an assessee when he finds that the gain in last week of the year is very high. Add to this is the fact that, he has not delivered the shares yet.

Lessons learnt !

In case of share dealer, one must give attention to sale & purchase shown in the first 15 days in the beginning of the year and last 15 days of the year. Following steps should be taken in this regard :

1. Ask the broker of the assessee to give the ledger account of the assessee.

2. If the assessee is a broker, ask the stock exchange for the data of trade done in last week of the year. Match the transaction shown by the Stock Exchange with the share ledger of the broker assessee. If any discrepancies like above found, enquire about that

3. The transaction date is the date on contract note and not the date of delivery of share in demat account. Therefore income or loss accrues on the date of transaction itself as per mercantile system of accounting.

Case Law Reference

Suresh K. Jajoo and Vimla S. Jajoo vs ACIT [2010] 39 SOT 514 (ITAT,Mumbai)

–End–

Why Should You Scrutinize Transactions Of Last Seven Days ?

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How To Handle Cases Of Evasion Through Penny Stocks?

The term “penny stock” has in recent time become very (in) famous. In Indian context, the penny stocks are those shares which are purchased or sold in abysmally low quantity in stock exchange. The obvious reason for such low demand of share of these companies among investors are their pathetic performance business wise. Since there is no demand for those shares, market prices of such “penny stocks” are also quoted extremely low. Thus, a Rs 10 face value penny shares may be quoted in a stock exchange at, say Rs. 1.

But time changes, so are the laws under Income Tax Act. In recent times, amendments in section 112, introduction of section 111A and insertion of section 10(38) of the I T Act made “penny stocks” capable of some “performance by manipulation”. These amendments were

1. The tax rate in case of short term gains on shares were reduced to 10 % from Asst Yr 2005-06 [insertion of section 111A] which is now kept at 15 % .

2. Section 10(36) introduced from 1/3/2003 by which long term capital gains was made exempt. But this was available to a very limited numbers of shares i.e BSE 500 listed companies.

3. Then came section 10(38) which totally exempted the long term capital gains on shares without any kind of condition other than that the shares should be transacted through recognized stock exchange and that securities transaction tax should be chargeable on such sale.

Therefore, a few unscrupulous brokers in connivance with other brokers used the penny stocks listed in regional stock exchange to take the maximum benefit of these three amendments brought in by the government to give fillip to the stock market. The result was that these shares which were untouchable till

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recent times and quoting at Rs 1, now quotes at some point of time even at Rs. 100 or more. Lots of people are making “huge long term capital gains” without liability of any tax as long term gains are tax exempt. At the same time, the price of those shares are hammered down, to a very low value, usually at the end of year. This facilitates the artificial loss creation. These losses are purchased by many persons for lowering their other high business income. In other words, a class of brokers with dubious character have started two new businesses through penny stocks manipulations :

1. Selling long term gains to persons having black money. Thus a person who wants to convert black money of Rs. 10 lakh into white shall give cash of Rs. 10 lakhs and shall get a long term gains of Rs. 10 lakhs through elaborate process devised by these brokers.

2. Selling losses to the business man who needs it to reduce the profit of their real business.

Sign of manipulated penny stock investments

The obvious characteristics of manipulated penny stock investments and resultant gains or losses are :

1. Most of these shares (penny stocks) may be listed on some regional stock exchanges only, like Calcutta, Kanpur, Magadh, Banglore etc.

2. Most of the deals in these shares are done by only a group of select brokers of that stock exchange.

3. Even those people are investing in these shares who might have never made any investment in shares.

4. Investors in these stocks get huge long term gains only. 5. The long term period is generally not more than one year and

one month i.e. 13 months.


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6. Most of the time the investors who are getting losses are getting only either short term loss or business loss. You won’t find long term loss.

7. These “penny stock” companies do not perform to the extent that they become news for their business performance. Therefore, in newspaper or TV or other media, they are never mentioned. Still, people from remote places make huge investments in these shares and get either huge LTCG or short term or business loss. For example, A.O may find that a businessman from Assam invests and claim tax free LTCG on a share of an unknown company listed on Calcutta Stock Exchange.

Modus operandi of brokers’ cartel

The modus operandi of the brokers cartel involved in “penny stock” manipulation can be easily understood.

1. Unknown companies’ shares which are having hardly any volume on these regional stock exchanges are taken up by the rogue brokers.

Let’s say, share of a company named Xlobe Securities Ltd is quoting at Rs 5 a share. The brokers’ cartel will select this stock and show purchase in name of Mr X who wants to convert, say Rs 10 lakhs.

2. The price of this share will be jacked up by process of circular trading. The circular trading is done among the closely related brokers by crisscross purchase and sale. This way brokers’ cartel will jack up the price of the unknown share to Rs 150 in one year

3. At that time Mr X will sell the share to someone of the same cartel. The person who purchases the share at very high price will sell within a few days only to someone else and claim huge short term/business loss for adjusting the gain of real business.

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This way the unscrupulous brokers facilitate not only routing back Rs. 10 lakhs of Mr X as white money in form of tax free long term gains, but also provides scheme for others to evade tax by adjusting artificially created loss. This scheme of tax evasion is planned to project that

i. The share of such unknown share was purchased legally through stock exchange.

ii. The share was held for twelve months in the demat account.

iii. The shares were sold after one year through stock exchange and the transfer of share took place from demat account. This is also legally done.

Criss Cross deals among brokers A,B,C,D,E

In next pages, the basic steps to catch evasion through penny stocks are discussed which are categorized under following two heads:

I. Steps to follow : when LTCG on penny stocks is created legally.

II. Steps to follow : when LTCG is created with the help of some false documents.


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Part I: Steps to follow when

LTCG On Penny Stocks Is Created Legally

Investigating a legally created long term capital gain is quite an uphill task

for an assessing officer. The difficulty arises because the tax evaders make it

appear authentic by following all legal steps. The truth however is that the

long term capital gains were not earned but were bought from a broker.

There is a stark similarity between legally created LTCG and legally created

gift. Persons who wanted to route black money used the virtues of a gift.

So, only rich businessmen were getting gifts from poor unknown employees

or persons. Even in those cases, all efforts to make the transaction perfectly

legal were made by the tax evaders. In case of such bogus gift receipt, the

tax evaders tries to show that

1. Gift is received by cheque

2. A gift deed signed by the donor is produced.

3. Gifts are shown to be given out of capitals with the donors

Still the strongest reason responsible for a gift-that there was love and affection-

remains missing. Additions u/s 68 by A.O proving that such gifts are nothing

but mere purchase of cheques were confirmed, by the higher judicial authority.

Therefore, the A.O has to proceed, in case of penny stock investigation on

similar line that despite the tax evaders’ effort to colour the share transaction

as legal and authentic, the facts and circumstances of the case prove that what

is made apparent by the assessee is in fact not real but a managed show.

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How Sumati Dayal case helps in assessing illegal LTCG?

The inspiration for investigating cases which are made legally correct, but comes from landmark judgment of Supreme Court in Sumati Dayal vs Commissioner of Income Tax [214 ITR 801]. A brief discussion of the facts of the case is necessary for proper understanding that A.O has the power to go deeper and see if the apparent is actually real.

The facts of the case was that during the assessment year 1971-72, Smt Sumati Dayal received a total amount of Rs. 3,11,831 by way of race winnings in jackpots and treble events in races at Turf Clubs in Bangalore, Madras and Hyderabad. The A.O held that the sum of Rs. 3,11,831 is not winnings in races and he treated the said receipts as income from undisclosed sources and assessed the same as income from other sources. The Appellate Assistant Commissioner confirmed it. Smt Dayal went to Settlement Commission, where majority decision went against her. Then she approached Supreme Court. The apex court also dismissed her petition. The relevant portion of this decision is given as under

“There is no dispute that the amounts were received by the appellant from various race clubs on the basis of winning tickets presented by her. What is disputed is that were they really the winnings of the appellant from the races. This raises the question whether the apparent can be considered as the real. As laid down by this court the apparent must be considered the real until it is shown that there are reasons to believe that the apparent is not the real and that the taxing authorities are entitled to look into the surrounding circumstances to find out the reality and the matter has to be considered by applying the test of human probabilities. (See : CIT v. Durga Prasad More [1971] 82 ITR 540 (SC), at pages 545, 547).”


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The ratio of this case squarely applies to the cases of penny stock frauds perpetrated by certain assessees in connivance with some brokers. The evaders make it apparent that

1. The said shares were purchased and sold through stock exchange,

2. The payments were routed through banks.

3. The shares were delivered in demat accounts.

Still, the A.O, taking inspiration and authority from the judgment in case of Sumati Dayal can enquire and investigate to prove that in reality it is a case of purchasing capital gains by giving cash against cheques in the guise of sale value of shares.

Line of investigations

The basic lines of investigation in case of legally created LTCG on penny stock case are :

i) Examination of assessee

ii) Examination of broker.

iii) Enquiry about company and its activities.

iv) Enquiry with stock exchange

Examination of the assessee

Call the assessee u/s 131 of the I T Act and record his statement on following questions under oath

(let us say we are investigating LTCG on company XYZ, share)

1. In last three to four years, what was the volume of share transactions done by him?

2. What types of shares have been purchased by him?

3. Is he a trader or an investor?

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4. What is his way of choosing the shares for investment purpose?

5. What is his qualification?

6. Who are the brokers through whom he invests money?

7. How does he convey the orders to broker i.e. whether he visits the brokers office or he orders by phone?

8. When did he open the demat account and what is the name and address of the DP?

9. Does he know the broker from whom he purchased shares of XYZ Ltd?

10. How did he come in contact with the broker? Identify the person through whom he got this broker’s address?

11. How did he give order to the broker?

12. Whom did he talk generally in broker’s office?

13. Can he tell the broker’s office address?

14. How did he come to know about the company, XYZ?

15. Has he read any thing in any newspaper or magazine or seen on any T.V channel about XYZ ltd?

16. What does the company XYZ Ltd do?

17. When was the first time he heard about the company, XYZ Ltd?

18. Can he tell the net profit and dividend given by the company XYZ Ltd in last three years?

19. Who is the managing director or CEO of the company?

20. Where is the head office of the company?

21. What made him to invest in the company XYZ?

22. Whether other members of his family also invested in the same company and made profit out of it?


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23. How many transactions have been done with this broker in past?

24. How many shares listed on NSE or BSE were purchased or sold by him in last three years.

25. How does he monitor the price of share?

26. Has any friend of his also purchased shares in M/s XYZ Ltd?

After this, call the broker and ask him following questions under an oath?

1. Does he know the assessee’s name? Ask him details like-the height, built and colour of the assessee?

2. How many shares of the company XYZ Ltd have been purchased and sold by him in the last two-three years?

3. Does he also give tips to his client?

4. When did the assessee become his client? Give a copy of the client application form.

5. Did he suggest the assessee to invest in the company XYZ’s shares? If not, which employee has given suggestion?

6. When was the time he suggested assessee to purchase XYZ’s shares?

7. How did he suggest–by phone or in person?

8. Why did he suggest company’s XYZ,s share ? Give reasons-like fundamentals of the company, or future business proposed or past performance on basis of which XYZ Ltd’s share was suggested as an investment.

9. Has he sold the share of company XYZ Ltd on behalf of other clients in the month when the share was purchased for the assessee?

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10. Does he make investments in his own account? If yes, what was the total value of investments in past three years and name of shares?

11. Did he also invest in shares for which he gave tip to his client ? If no, why?

12. What is the client ID of the assessee ?

13. Has he done Off Market deals during the year and if yes, has he informed the Stock Exchange for such off market deals?

14. Has he done off market deals in case of impugned shares i.e M/s XYZ ltd ?

15. Why did he make off market deal? Clarify why online deal was not made.

16. Who are the brokers with whom purchase transactions in impugned share were made?

17. Who are the brokers whom sales transactions in impugned share were made?

18. Has he made any transaction in shares of M/s XYZ Ltd on credit? Give complete details regarding payment given and receipt.

Important documents you must get

Procure following documentary evidence from the brokers account opening form filed by the assessee.

1. The share ledger page related to the company M/s XYZ Ltd.

2. Demat account Transaction statement of brokers POOL account and SELF account page related to XYZ Ltd.

(This, you can also fetch from DP where broker is maintaining the account.)


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Enquire about the activities of company?

The A.O must fetch the balance sheet of the company for at least three years to assess

1. The net profit of the company for last 3 years.

2. Amount of dividend given in last 3 years.

3. The total invested capital, quality of investment and future prospect of the company.

4. Was the P & L account published in any newspaper? If yes, in which newspaper?

5. Whether any kind of press release made during the year by the company? If yes, in which newspaper.

Enquiry with the Stock Exchange

Write a letter to stock exchange for giving information regarding the company in question

i) What was the total volume of the shares traded in last three years in delivery segments?

ii) Whether the company was suspended for trade within last three years? If yes, on what ground.

iii) Whether the brokers involved in the purchase and sale were suspended from trading? If yes, on what ground?

iv) List of top five brokers who purchased and sold the impugned shares during the year under consideration?

v) Details of the off market deals made by the broker in the impugned shares?

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Online enquiry

You can also enquire the figures of volume, share price news and other details related to companies by visiting the website of stock exchanges. You can also view all the orders of stock exchange and SEBI regarding any suspension of trade in case of the company and any order passed against the broker involved. Refer the Part 3 of the book for knowng more on online investigation.

Marshalling of facts

After all these enquiries and examinations, the facts to be brought on the record are :

1. That the assessee does not know the broker.

2. The assessee does not know any thing about the company.

3. The assessee has not invested in shares in past -especially in these kind of companies.

4. The volume of trades in shares of the company XYZ was very low in last few years.

5. The broker is a habitual trader in such company’s shares.

6. The broker does not know his client.

7. The company’s shares are traded only in this exchange and as per the report from the stock exchange, it shows that trade is restricted to certain brokers only.

8. If the A.O comes to know about any suspension of broker or company trade, that should also be highlighted.

9. The assessee could not state why he invested in impugned shares.


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10. Assessee could not give evidence how and through whom he

placed the order.

11. The performance of the company is not at all commensurate with

the escalation in price of shares.

12. There can not be the possibility of knowing a company by an

ordinary investor if he does not read or hear on traditional

media like Newspaper, magazines or T.V. In the instant case ,the

assesee could not convince either how he came to know about

the company or what information he received on which he decide

to invest in impugned share.

13. If the information from the stock exchange or SEBI shows that

the brokers involved in the purchase or sale of shares was ever

suspended for misconduct, that should also be highlighted in the

assessment order.

Therefore, amount of sales claimed as capital gains, has to be added u/s

section 68 of the I T Act on the ground that the credit, is mere a procurement

of money without proper explanation how and why it has come to him/her.

In case loss was created out of manipulated transaction in penny stock, such

loss should be disallowed to be adjusted with any income as the loss is

artificially created, just to evade tax.

Case Law Reference

Baijnath Agarwal vs ACIT(2010) 43 DTR 149 (Agra)-Assessee favour

~End~

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Part II : Steps To Follow When

Bogus LTCG On Penny Stocks Created By Using False Documents.

If you refer the chapter “Evasion Through Bogus Purchase”, most of the

methods described there applies in the instant case also. But in this chapter,

I would like to introduce you a bit of different case of tax evasion. Let me

start with an example.

An assessee claims tax free LTCG of Rs 10 lakhs during FY 2008-09 (Asst

Year 2009-10 ). The computation of the long term capital gain was as under

Shares of ABC Ltd

Sale on 24/1/2009 @ 113 × 10000 11,30,000

Purchase on 12/12/2007 @ Rs13 × 10000 1,30,000

10,00,000

During scrutiny, he submitted following papers in support of claim of long

term capital gains.

i) The contract note for purchase on 12/12/2007

ii) The contract note for sale on 24/1/2009

iii) The balance sheet of earlier year (FY 2007-08) where the purchase

of such share was duly reflected.

iv) Proof that he enclosed the purchase contract note with Return

for Asst Yr 2008-09 (FY 2007-08).



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However, during scrutiny proceedings, A.O found additional facts :

1. Demat transaction statement for FY 2008-09, showed that in case of the share on which assesse claimed long term capital gains, there was no opening balance as on 1/4/2008. There should have been, if he had purchased the shares in FY 2007-08.

2. Further, it was noted from same transaction statement that shares were credited in his accounts on 21/1/2009, three days before the date of sale i.e 24/1/2009 and not on 12/12/2007 as claimed vide contract note.

3. The stock exchange confirmed u/s 133(6) that the broker did not transact in the impugned shares on the date of transaction as reflected in the contract note for purchase submitted by the assessee.

4. When assessee was confronted with these evidences, he stated that shares were not delivered to him by the broker as he had asked the broker to retain the shares with the broker only.

5. The A.O contacted DP of the broker and sought the demat transaction statement of the broker–both pool account and personal account-for the relevant period. It was noted that the impugned shares were not with the broker, not only on the date of transaction but even after one month.

What do you infer from the facts of the case narrated above? Since the share had come to assessee’s account just three days before, one can not say that it was never purchased. Shares were sold and cheques were received for sale consideration. So, there was certainly purchase and sale of shares, but the claim of the assessee of purchasing shares one year before is not correct. As such, claim of long term gain on sale of those shares was patently false.

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Additional issues to deal with!

The A.O is required to decide on two additional issues which arise in such cases :

i. Unexplained investment

First issue is that if the purchase was done three days before the sale i.e 21/1/2009 but claimed to purchase on 12/12/2007, it is clear that the purchase cost on 21/1/2009 was not passed through the books of account for FY 2008-09. It also means that out of books cash was utilized for purchasing that share. Therefore, there should be examination by the A.O on issue of addition u/s 69 of the I T Act in FY 2008-09 as the unexplained investment u/s 69 of the I T Act.

ii. Short termgainorbusinessprofit

Second issue involved in the aforesaid case is that the assessee may claim that even in case one does not accept his claim of long term capital gains, the gain should be assessed as short term capital gains.

Accepting such contentions, when the whole scheme of the assessee was of defrauding the revenue, itself shows that intention of the assessee was not of investment, but merely to evade tax. Therefore, the fact that the shares were held for a few days only, the gain or loss can be assessed under “business head” only and the purchase amount not recorded in books of account should be added as unexplained investment..

Case Law Reference

1. Shiva Gas vs CIT 302 ITR 318 [Delhi] , 2. DCIT vs Anita Bansal ITA No. 2025/

Del/2009, (Delhi ITAT) Both Revnue favour. 3. CIT vs Anupam Kapoor 299 ITR 180

(P & H) 4. Manoj Aggarwal, Bemco Jewellers (P) Ltd. and Bishan Chand

Mukesh Kumar vs DCIT 310 ITR 99 [ITAT,Delhi]



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Tax Evasion through Futures & Option Trades !

This is a kind of tax evasion where the broker facilitate either himself or by conniving with another broker to generate profit and loss for clients as per their requirement which may arise for varied reasons, some of which are given below:1. A person has loss in current year or carried forward loss , he wants to bring

unaccounted cash as legitimate gains.2. One has business gains, and he wants to have loss to adjust it.3. One has taken huge loan from bank , but the business is running in loss .

He fears that on account of loss, bank may withdraw loan or reduce teh exposure. So , he needs fake profits. While the tax outgo will not be huge despite showing gains because he already has business loss from main business.

How they do it?The fact that the derivative (F & O ) transactions can be done online makes it easier for any broker to manufacture profits & loss on Futures & Option trading as and when required by clients. The broker can do the fictitious trade himself, or he connive with another broker to complete the trade .

Lets understand with examples:

Type 1 : One broker performing buy and sale for both clientsLet us say, a Broker who is member of NSE is approached by two of its cli-ents Mr X & Mr Y. Mr X wants profit and Mr Y wants loss. The broker will choose Option trade in a particular which is almost illiquid counter. Then , broker himself performs buy and sell for the aforesaid clients and then per-form reverse buy and sale to square off the deals. Following chart will clarify the methodology :

Transactions in UTI Bank American Type PUT Option Trade Time(hh:mm:ss)

Option rate

Cash Seg Price

Contract (Qnt)

Trade (Value)

Sell Client Name

Buy Cli-ent Name

10:15:32 15 489.2 4500 67,500 Mr X Mr Y10:15:55 3 489.2 4500 13,500 Mr Y Mr X

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As can be seen that same broker has bought and sold the PUT option for two of his clients and in process has created gains and losses for Mr X and Mr Y.

Mr X who is losing money has to pay Rs 54,000 (Rs 67,500 - Rs 13,500 ) by cheque to the broker whereas Mr Y will get the gain Rs 54,000 by cheque . Mr X will receive back Rs 54000 in cash minus brokers commission . The cash is paid by Mr Y who gets cheque from Broker.

Thus once the process of fake derivative trade is completed , it helps Mr X le-gally in lowering his profit whereas Y succeeds in routing black money to him-self without paying any tax as he has loss (either current year or carry forward )

Type 2 : Two brokers unite to create fake derivative trades

In the above situation, one broker has done both buy and sale transaction. The same fictitious derivative trade solely for the purpose of generating gains and losses on behalf tax evaders Mr X & Mr Y , can also be done by two conniving brokers . The situation arises when either broker has not found both clients or he is trying to help another broker by finding one of his clients for the trade.Simple Modus Operandi !One broker is buying say 4500 number of contracts at a price 15 at time 10:15:32 through the selling broker. Thereafter, the transactions are reversed and the sell-



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ing broker now becomes the buying broker for his client (who had sold in the first leg of the transaction) by buying again 4500 number of contracts at price Rs 3 at time 10:15:35.

The operation of the brokers for manufacturing gains and losses can be repre-sented graphically as under :

Problem for A.O to detect them ?

Fact of the matter is that for an assessing officer , it is almost impossible to catch such malpractice. The reasons are as under :

• There is involvement of two persons. Since both the persons , in most of the cases are , being assessed with different A.Os , it is not even suspected that such things have happened.

• Every legal documents are as perfect as anyone’s else which mean that even if an A.O questions them, the appellate authority will find it hard to digest when stock exchange will also authenticate the derivative transactions , actually happening through them.

• The money transactions are routed through bank , thus colous of genuine-ness is given .

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So, How to catch them ?

As stated earlier, there are some pointers for A.O to start investigation in the de-rivative transactions. When income tax return of an assessee is being scrutiniz-ing and one finds that there are huge losses from derivative trading , one should do following exercise1. Ask for contract notes for both buy and sell.2. Give attention to the date and time of buying and selling orders printed in the contract notes. If the difference in timing is found to be a minute or 10 minutes , that derivative transaction is good case for investigation.3. Write a letter to stock exchange and verify regarding those trades on following points : 1.Name,PAN and address of brokers involved in those trades 2. Name and PAN of the clients who bought and sold

4. If one finds that the brokers for both the persons who bought and sold are same , your case can be stronger.

Problem for Income Tax Department

One has to understand that the derivative trades like share trades are done under SCRA and SEBI rules which gives those transaction legal meaning. Income Tax Department has no jurisdiction to declare a transaction illegal despite the fact that evidences- both actual and circumstantial- shows so . Appellate authorities will find hard to digest the conclusion of the Income Tax Department , if the same transaction is considered legal under different Central law (Like SCRA)

Therefore , it is of utmost importance that if SEBI , after going through income tax department’s gathered facts and starting investigation , declares those trans-action as illegal and fictitious , the case for income tax department becomes much easier .

Has SEBI ever caught such mal-practice in past ?Oh , yes. Here is the press release PR No. 191/2007 dated June 19, 2007 issued by SEBI .



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Order in the matter of dealing in Futures and Options Contracts on the National Stock ExchangeShri G.Anantharaman, Whole Time Member, SEBI, has passed an order dated June 18, 2007 in the matter of dealing in Future and Option (F&O) segment on the National Stock Exchange (NSE) directing that:

........Preliminary examination of the transactions in the F & O segment in the NSE for the period January to March 2007 brought out that the bro-kers and clients at NSE were buying and selling almost equal quantities of contracts within the day and such buy/sell was synchronized in nature. In most of the cases, the same quantity and in few cases substantially the same quantity of the original trade was closed out /reversed during the day at a price which was significantly above or below the price at which the first/original transaction was executed, without significant variations in the traded price of the underlying. The entities /brokers have indulged in non genuine trade transactions to create false and misleading appear-anceoftradingandforbookingprofit/lossesonsuchtransactions.The findings of the preliminary examination brought out prima facie violation of SEBI (Prohibition of Fraudulent and Unfair Trade practices relating to securities market) Regulations by the client entities and of the SEBI (Stock Brokers and Sub brokers) Rules and Regulations, 1992 by brokers. The find-ings brought out the need for immediate and appropriate action at this juncture to check such abuses in future and accordingly an ad-interim order has been passed to ensure orderly development of the options market and the directions therein are accordingly based.”

The order of SEBI is regarding many brokers including many top ranking bro-kerage house. The order can be found at SEBI website or on following address http://www.watchoutinvestors.com/Press_Release/sebi/2007191.asp .All the orders passed by Executive Director are available there at the time of writing this book.Thus key to stop such mal-practice is to declare such gains and loss illegal under another SCRA and other Central law passed in this regard. This is possible only with the help of SEBI. If SEBI analysese derivative segment data time to time , and its findings are immediately passed on to Income Tax department , tax evasion by “such manufacturing of gains and loss” can be checked .

~End~

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Tax Evasion by Changing Client Codes

A facility provided by stock exchange for rectification of genuine error while trading for clients has become a tool for buying , selling and distributing the gains or loss as it suits. Let us take an example.

Mr X is promoter of many private limited companies. Let us say, his 3 compa-nies have opened trading account with a broker who is member of NSE. Mr X wants a ceratin amount of loss in one company and another amount of gain in aonther company.

On a particular day, the broker finds one of his client ,say Mr Y has earned profit on derivative trades, which he is ready to transfer to others for equivalent cash. So, broker will change the client code of original trade with the client code of the company of Mr X in whuch such trade was to be transferred. This is done after the trade hour upto the time allotted by NSE for rectification of order. Thus , the trade now appears legally as if done by company of Mr X and all the gains , which was actually of Mr Y , transferred to companies of Mr X . Mr X will pay cash equivalent of gains and the broker gets extra commission .

Similarly, if Mr X wants to reduce profit in one of his companies , he will simply buy loss from that broker who will substitute someone else loss to the company of Mr X .

Thus every step would seem as if the real trade was done by the substituted party.This kind of substitution of client code, which was allowed by stock exchange ,for genuine purpose has been abused by the unscrupulous brokers and their clients so much that all the authorities have now become alert and are bringing mechanism to check such malpractice.

NSE’ recent circular on penalty imposistionThe practice of changing the code is so massive among brokers that NSE has recently issued Circular No. NSE/INVG/2011/596 February 17, 2011 by which heavy penalty proportionate to reporting of error is proposed to be im-posed. The penalty proposed to be imposed as per NSE circular is as under:


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Sub: Modifications to client code

Trading members are aware that Securities and Exchange Board of India (SEBI) vide ref. no. CIR/DNPD/01/2011 dated January 3, 2011 has issued a circular regarding the modification to client codes post trade execution (copy enclosed).

Pursuant to the said circular, the following monthly penalty structureforclientcodemodificationsin the Capital Market Segment (CM), Equity Derivatives Segment (F&O) and Currency Derivatives Segment (CDS) is being made applicable w.e.f. Feb-ruary 2011.

Modified client codes for non-institutional or-ders as a percentage of total orders(matched) in CM and modified client codes for non-insti-tutional trades as a percentage of total trades (F&O and CDS)

Amount (in Rs)

Less than or equal to 1% NILGreater than 1% but less than or equal to 2% 5000/- per segmentGreater than 2% but less than or equal to 4% 25000/- per segmentGreater than 4% but less than or equal to 5% 50000/- per segmentGreater than 5% 100000/- per seg-

ment

The aforesaid circular of NSE which is issued after SEBI circular dt 03 janu-ary 2011[Read in Back to Basic part ] is showing the gravity of the problem .

CBDT’s measureCentral Board of Direct Taxes vide NotificationNo.14dated9March2011made three important changes 1. the stock exchange can not erase the transactions (in respect of cash and

derivative market) once registered in the system .2. Stock exchange will ensure that the modification of client code is for genu-

ine purpose.3. Every stock exchange which has got recognistion under Rule 6DDB shall

submit a monthly statement in Form 3BB .

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The Form 3BB has been devised so as to get clear picture of who did the initial trade and which client code was substituted.

No doubt the measures like this , shall prevent many a malpractice , but only after the said notification i.e 09/03.2011 which was issued at fag end of FY 2010-11. So , till FY 2010-11 , catching the malpractice of changing client code for tax evasion remains a challenge for tax authorities.

How to catch them?The fundamental reason for changing the client code is to either get a gain or loss. The gains are required by persons who are having losses in other busi-ness or are individuals or HUF who want to use the exemption limits to raise some capital or someone who simply wants to convert black money .Similarly ,the losses are bought by persons who have business gains . Based on these premises, following rule to detect such cases for further enquiry can be devised

If A.O finds there is gains on usual business carried by the assessee, but sud-den loss from F & O segments , specially at the fag end of Financial year , has adjusted the business gains to either reduce it considerably or actually turn into loss , in those cases , the big losses should be noted and a letter to related stock exchange should be sent to verify for :

1. Whether the assessee (Give PAN) has actually traded as per contract note?

2. Whether there was any change in the client code by the broker ?

It must be noted that the notice to Stock Exchange should be drafted in a man-ner that contains following details

• Name of Broker• Name of client (assessee)• Date of trade• Trade no• Traded segment : Futures or option• Traded Quantity :

The aforesaid basic minimum details will help stock exchange authorities to search for relevant data and furnish same to you.

Tax Evasion by Changing Client Codes


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How to prove that client code is fake or not for genuine pur-pose.

The A.O can the enquiry and certain pointers of investigations are (you need luck for success on this front) are :

1. Whether any telephone or email is there as an evidence that the order was placed by assessee ?2. Whether the assessee had ever placed any order on the Futures & Option earlier or this is the single transaction ?3. Whether the original client has placed similar orders on the same day? 4. Whether broker has changed the client code in case of part orders only?4. Whether the percentage of client code change by the said broker is more in case of trades which resulted in loss ? 5. Whether the change in case of other cases , where the loss was generated , has business gains ? For this A.O should contact A.Os of those cases for knowing whether they have also business gains in the usual business they carry .6. What is the month in which all losses in derivative occurred ?

SEBI help a must !The law for all practical purpose is on side of perpetrators of fake trades in derivative segments by client code modifications . Even if one gets the informa-tion from stock exchange that the loss pertains to a client code changed order, will that be suffice for A.O to say that the loss is fictitious or not genuine. In author’s opinion, such conclusion on part of A.O will not sustain judicial scrutiny .

Since , SEBI is the authority for judging regarding the genuineness of the trade transaction, under SEBI and SCRA and other securities’ law , a delegation of enquiry by issuing commission u/s 131 of the I T Act to SEBI or even stock exchange authorities is much better step. Stock exchange has also teh responsi-bility to investigate the matter as per SEBI direction, so their investigation wing can also be taken help of.

~End~

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Don’t Forget These Points!

The topics covered in part II are not evasion practices, but are

pointers to special provisions of Income Tax Act & Other laws

which affect total income of an assessee.


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Part II

Don’t Forget These Points

1. Why Should You Keep An Eye On Warrant? 113

2. How Preference Share Creates Capital Gains? 118

3. Can Scrutiny Of Security Deposit Bring Tax? 123

4. Why Knowledge Of SCRA Is Important For Share Cases? 125

5. How To Easily Apply Explanation To Section 73? 134

6. ESOP, Phantom Stock Option & A rewind on FBT ! 142

113

Why Should You Keep An Eye On Warrant?

What is a warrant ?

The warrant is an instrument issued by a company which endows a subscriber a right to get share of the issuer company during specified period for a prefixed price. In other words; a warrant is a bearer document of title to shares stated therein. The warrant is issued against fully paid shares and generally issued along with debenture. The warrant is considered negotiable instrument and is actually traded on the stock exchange similar to shares trade.

Is warrant a capital asset?

The warrant is not a simple instrument, but an instrument which is both-a capital asset as well as a right to subscribe the share at a predetermined price. Therefore the question of capital gains may arise the moment one gets share in exchange of warrant or simply transfer the warrants by selling it.

Capital asset as defined u/s 2(14) of the I T Act includes all types of property except certain exempted categories given in the proviso there under. “Warrant” is not listed in the exempted categories. Therefore, warrant falls under the definition of capital asset on following ground :

n It is tradable commodity.

n It is allowed to be listed and traded through stock exchange.

n Transfer of warrants take place in the same manner how one transfers the shares.

n It falls under the definition of Security. The word ‘security’ is not defined in the I T Act. But at numerous places the meaning of the word security has been borrowed from the definition in clause (h) of section 2 of the Securities Contracts (Regulation) Act, 1956. Which is as follows


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(h) “securities” include—

(i) shares, scrips, stocks, bonds, debentures, debenture stock or other

marketable securities of a like nature in or of any incorporated

company or other body corporate;

(ia) derivative;

(ib) units or any other instrument issued by any collective investment

scheme to the investors in such schemes;

(ic) security receipt as defined in clause (zg) of section 2 of the

Securitisation and Reconstruction of Financial Assets and

Enforcement of Security Interest Act, 2002;

(id) units or any other such instrument issued to the investors under

any mutual fund scheme;

(ii) Government securities;

(iia) such other instruments as may be declared by the Central Government

to be securities; and

(iii) rights or interest in securities;

One can see that the meaning of ‘security’ includes “other marketable security

of like manner” which certainly covers warrants.

Another proof that warrant falls under the definition of security is the

Explanation given under section 2(42A) which defines short term capital asset.

The Explanation given under it provides the basis for determining the period

from which the capital asset shall be taken as held. Clause (d) and (e) under

the Explanation state how to determine the date of acquisition of afinancial

asset received on the basis of his right in other share or security. The warrant

is a financial asset against which shares are allotted.

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How capital gains arise?

Capital gains in case of warrants may arise in following two ways.

1. Purchase and sale of warrants from market.

2. Getting shares on surrender of warrants.

While the first one is very straight forward to understand, the second issue

needs to be discussed. That is what has been done in this chapter.

Section 2 (47) defines transfer in relation to capital asset .It defines under clause

(i) & (ii) “meaning of transfer” to include

i) The sale, exchange or relinquishment of the asset; or

ii) The extinguishment of any rights therein

Shares are issued on surrender of warrants to registered holder of warrants.

The shares may be allotted with or without price. Therefore, one kind of asset

is exchanged with another class of asset between company and the registered

holder. The presence of word “exchange” in the definition of transfer of capital

asset clearly brings such exchange of shares in lieu of warrants within the

fold of capital gains.

Computation of capital gains

This is somewhat a difficult area because warrants are issued along with some

other assets, normally along with debenture where one pays for subscribing

such debenture which includes warrants. Therefore, it appears that warrants are

given free of cost. But that may not be the actual case. Costs of acquisition

Why Should You Keep An Eye On Warrant ?


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of warrants are computed in following manner :

1. When warrants are issuedon rightsbasis against specificpayments.

In that case cost of warrant is whatever is actually paid for acquiring the

warrant as provided in sub-clause of (iii) of clause (aa) of section 55(2) of

the I.T. Act which provides

“in relation to the financial asset, to which the assessee has

subscribed on the basis of the said entitlement, means the

amount actually paid by him for acquiring such asset;”

2. When warrants are issued on rights basis without any payment.

In that case the warrants cost is to be taken as Nil as provided in sub-clause

(iiia) of clause (aa) of section 55(2) of the I.T. Act which provides

“(iiia) in relation to the financial asset allotted to the assessee

without any payment and on the basis of holding of any

other financial asset, shall be taken to be nil in the case of

such assessee;”

3. When warrants are purchased from open market.

In this case, the cost of the warrant will be the price for acquiring the right

as well as the price paid to company for acquiring the warrant as is provided

in sub-clause (iv) of clause (aa) of section 55(2) of the I.T. Act

“ (iv) in relation to any financial asset purchased by any

person in whose favour the right to subscribe to such asset

has been renounced, means the aggregate of the amount of

the purchase price paid by him to the person renouncing

such right and the amount paid by him to the company or

institution, as the case may be, for acquiring such financial

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asset;”

4. What will be the cost if the warrants are issued along with debenture

against lump sum payments :

In that case, the cost should be apportioned in the following manner

i) Fair market value of debenture on the basis of actual rate of

interest offered by issuing company

Minus

ii) Price offered by financial institution for buyback of such

debenture.

Cost of warrants = I - II

Lessons learnt!

If you find that an assessee was holding warrants in past and those

warrantsarenotreflected in theyear inwhichyouarescrutinizing,you

must enquire regarding the existence of that warrant. As stated above,

if shares are exchanged for warrants, capital gains have to be shown in

the year in which such exchange took place.

–End–

Why Should You Keep An Eye On Warrant ?


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How Preference Share Creates Capital Gains?

The share capital of a company limited by shares may be of two kinds

(a) Equity share capital, and

(b) Preference share capital.

Section 85 of the Companies Act defines “preference share capital” to mean:

thatpartofthesharecapitalofthecompanywhichfulfils

both the following requirements :

(a) as respects dividends, it carries or will carry a

preferential right to be paid a fixed amount or an amount

calculated at a fixed rate, which may be either free of or

subject to income-tax ; and

(b) with regard to capital, it carries or will carry, on a

winding up or repayment of capital, a preferential right to be

repaid the amount of the capital paid up or deemed to have

been paid up, whether or not there is a preferential right

to the payment of either or both of the following amounts,

namely :—

(i) any money remaining unpaid, in respect of the amounts

specified in clause (a), up to the date of the winding up or

repayment of capital ; and

(ii) any fixed premium or premium on any fixed scale, specified in the memorandum or articles of the company.

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The preference shares, as far as, Income Tax Act is concerned are at par with equity shares. The points worth giving attention are:

1. The preference share is a capital asset.

2. The purchase & sale of preference share gives rise to capital gains.

3. Redemption of preference shares gives rise to capital gains.

4. Conversion of preference share to equity shares gives rise to capital gains.

The last two topics- redemption and conversion of preference shares are being discussed in this chapter.

A. Redemption of preference share

The redemption of preference share gives rise to capital gains. There is very clear decision of Supreme Court on this. The Apex court in Anarkali Sarabnhai vs CIT 224 ITR 422 held that when preference shares were redeemed by the company, the shareholder had to abandon or surrender the share in order to get the amount of money in lieu. Therefore, there is a relinquishment. Sec. 2(47) of the Income-tax Act defines transfer for the purpose of capital asset .The definition of transfer includes the word “relinquishment”. As such, tax on the capital gains on such transfer is attracted.

The Apex Court in the same case also considered the decision of the Bomaby High Court in case of Sath Gwaldas Mathuradas Mohata Trust v. CIT [1987] 165 ITR 620, which dealt with the question which was raised before the Apex Court. There the question was whether the amount received by the assessee on redemption of preference shares was liable to tax under the head “Capital gains”. After referring to the meaning given to “transfer” by section 2(47) of the Income-tax Act, the Bomaby High Court held :



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“ Here, a regular ‘sale’ itself has taken place. That is the ordinary concept of transfer. The company paid the price for the redemption of the shares out of its fund to the assessee and the transaction was clearly a purchase. As rightly observed by the Tribunal, if the company had purchased a valuable right, the assessee had sold a valuable right. ‘Relinquishment’ and ‘extinguishment’ which are not in the normal concept of transfer but are included in the definition by the extended meaning attached to the word are also attracted in the transaction. The shares were assets and they were relinquished by the assessee and thus relinquishment of assets did take place. The assessee by virtue of his being a holder of redeemable cumulative preference shares had a right in the profits of the company, if and when made, at a fixed rate of percentage. Quite obviously, this was a valuable right and this right had come to an end by the company’s redemption of shares. Thus, the transaction also amounted to ‘extinguishment’ of right. Under the circumstances, viewed from any angle, there is no escape from the conclusion that section 2(47) was attracted and that the amount of Rs. 50,000 received by the assessee was liable to be taxed under the head ‘Capital gains’.

B. Conversion of preference share into equity shares

It has been judicially held that conversion of preference share into equity or any other asset is transfer as defined u/s 2(47) of the I T Act. Two important decisions in this regard are:

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Add.CIT vs Trustees of HEH Nizam’s Second Supplementary Family

Trust [1976] 102 ITR 248 A.P

CIT vs G Narshimhan (Deceased) 236 ITR 327

In case of Trustee of HEH Nizam’s case, the Apex Court held as under

The view expressed by the Supreme Court in that case leaves

no room for any doubt that the conversion of 6,000 preference

shares into 60,000 ordinary shares in nothing but a barter.

Option was given to the persons holding preference shares to

convert into ordinary shares on or after 1st July, 1961, but

not later than 30th June, 1966, and they were redeemable at

par at any time after 30th June, 1966, at the option of the

company by giving notice of three calendar months. This is a

case where there were unsubscribed ordinary shares and the

company allowed exchange of such shares with the preference

shares in accordance with the terms and conditions attached

to the issue of preference shares. In view of the authoritative

pronouncement of the Supreme Court, we hold that the

conversion of preference shares into ordinary shares is a

transfer by way of “exchange” within the meaning of section

45 of the Income tax Act, 1961. Therefore, the first question

is answered in the affirmative and in favour of the assessee.

Supreme Court in case of G Narshiman held as under

“the amount distributed by a company on reduction of its

share capital has two components—distribution attributable

to accumulated profits and distribution attributable to

capital (except capitalised profits). Therefore, in the present



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case, to the extent of the accumulated profits in the hands

of Kasthuri Estates (Pvt.) Ltd., whether such accumulated

profits are capitalised or not, the return to the shareholder

on the reduction of his share capital, is a return of such

accumulated profits. This part would be taxable as dividend.

The balance may be subject to tax as capital gains, if they

accrue.”

Lessons learnt!

Therefore, while scrutinizing the cases of any assessee, it is very important

to know the origin of share held by him. The moment you find that a person

had preference share in the balance sheet in the past, and in later years it is

not reflected, you must enquire what happened to those preference shares. If

you find that there was redemption or conversion of preference share, charge

tax on the resultant capital gains in the year in which such conversion or

redemption took place.

–End–

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Can Scrutiny Of Security Deposit Bring Tax?

Let us start with an example.

While scrutinizing the case of a share dealer for assessment year 2009-10, the A.O found that assessee had shown security deposits with the bank in his balance sheet. The A.O asked for details of security deposit from the bank. The reply of the bank was as under

Loan sanctioned = 2 Crore

The security deposits made

1. Shares in RIL valued at Rs 5, 00,00. 2. NHAI Bond valued Rs 25,00,000

The A.O perused the balance sheet and found that both these assets are reflected under assets in the balance sheet. The A.O was satisfied that there was nothing more to enquire on this point.

Was he correct to conclude the enquiry?What he forgot to see was the origin of the NHAI Bonds. The A.O should have asked “When and why did you buy the NHAI bonds?” The answer to this question is the key to confirm if there is nothing more to enquire about and could have given a new twist to the enquiry.

Let us say, the A.O asked that question and the answer from the assessee was that he purchased the NHAI bond in F Y 2007-08 for saving long term capital gains tax.

Secondly when the Return for Asst Year 2008-09 (FY 2007-08) was perused, it was found that the assessee had indeed purchased the NHAI Bond in that year and exemption under section 54EC was claimed. It was further noted that the long term gain that year was of Rs 25,00,000 on sale of share of a private limited company.

If the A.O is alert, it is not hard to find that by virtue of Explanation given

under section 54EC(2), Rs 25,00,000 should have been taken as long term capital gain in the assessment year in which such loan or advance was taken. The Explanation given under section 54EC (2), is reproduced below

Explanation. —In a case where the original asset is transferred and the assessee invests the whole or any part of the capital gain received or accrued as a result of transfer of the original asset in any long-term specified asset and such assessee takes any loan or advance on the security of such specified asset, he shall be deemed to have converted (otherwise than by transfer) such specified asset into money on the date on which such loan or advance is taken.

Bonds of NHAI were one of the specified assets on the basis of which assess claimed exemption. As such, the A.O missed to assess capital gain of Rs. 25,00,000 !

Lessons learnt 1. If you find that the assessee has placed security deposit with any

bank or any other person for advance or loans, you must issue a notice u/s 133(6) and acquire the details of such security deposits.

2. Closely scrutinize the list of assets kept as security deposits to know if there is any asset out of following asset

a. National Bank for Agriculture and Rural Development

b. National Highways Authority of India

c. Rural Electrification Corporation Limited

d. National Housing Bank

e. Small Industries Development Bank of India

3. If you find any of the specified asset in the list of assets kept as security, confirm the date of purchase and find if three years have elapsed or not. If not invoke the provision as sated above.

Can Scrutiny Of Security Deposit Bring Tax ?

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Why Knowledge Of SCRA Is Important For Share Cases?

Securities Contract (Regulation) Act or SCRA regulates stock market in India. Apart from the SCRA, there are other Rules and Laws by which SEBI regulates the stock market in India. As far as Income Tax Act assessment is concerned , relevance of SCRA is very high because tax evasion is almost impossible without contravening laws -specially SCRA - which governs shares and securities transactions.

It is legally settled now that illegal losses are not allowed to be adjusted with the legal income of a person. The basic premise on which this chapter is written is that one of the use of stock market is to generate losses through share transaction to adjust the real business income. If that loss can be proved illegal , the game of adjustment of income , which is legal , is over.

Therefore, in this chapter a few of the important provisions of SCRA which is generally bye passed by the tax evaders are being discussed. Let us start with two examples.

Example 1: In one case, the A.O found that the assessee company had shown purchase of shares of company X during the year. Those shares were just kept as closing stock-in-trade. Since the market value of the share as on 31st March was substantially lower than purchase cost the diminutions in the value of closing stock shares were adjusted in P & L account. The A.O on enquiry found that :

1. The shares of X ltd were claimed to be purchased from a firm in which the directors of the assessee company were partners.

2. The firm, on being enquired about their purchase, told that the shares which were sold by them to the company were purchased from the partners.

3. It was also revealed that the shares were transacted manually i.e those shares were not dematerialized and purchase and sale

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took place manually only. 4. Neither any broker nor any stock exchange was involved.

5. X ltd confirmed that the shares were never transferred to anybody. It is registered, still, in the name of the partners.

The A.O not only disallowed the loss for reasons revealed in enquiry, but also took alternative argument that even if the transactions were considered to have happened, would have been illegal transactions. As such, the losses could not be allowed to be adjusted with legal income.

Example 2: A private limited company , having registered office in Nariman Point , Mumbai earned , say Rs 50 lakhs as income from shares dealings. It , however , showed net profit of Rs 2 lakhs only. The A.O , on scrutiny found that there was loss in diminution of value of two listed companies shares which the assessee had bought during the year under consideration. The diminution in value of these shares Rs 48 lakhs adjusted the profit earned on other shares.

Further enquiry by A.O, following facts came-

1. the shares were sold by a group company and no broker was involved in share transaction.

2. As on 31st March of the year concerned, neither the shares were transferred to assessee’s demat account nor the assessee made payments

3. The payment was done in first week of May and shares were also transferred to assessee’s account in May only.

The A.O declared the loss on impugned shares as illegal and therefore, he , did not let it be adjusted with the legal income.

How the A.O proved purchase as illegal?In view of the A.O, the share purchase in both the aforesaid cases were in violation of sections 2(i)(a) ,13, 17 & 18 of Securities Contract (Regulation) Act and as such the losses as a result of those purchases are also illegal , therefore, not suitable to be adjusted with legal income.

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So, let us see , what section 2(i) ,13, 17 & 18 of SCRA says

Section 13

This provision under SCRA says that if an area is notified in official gazzette for the purpose of section 13 , the transaction in shares can not take place without involvement of members of recognized stock exchange in the notified area.

Section 16

Section 16 of SCRA empowers govt to notify any area in which transaction in shares shall be illegal without its prior permission

The Central Government vide NotificationdatedJune27,1969and the SEBI vide Notification datedMarch 01, 2000 in the Official Gazette, made the section 16 of the SCRA applicable to the whole of India . Thus , it prescribed that no person in the territory of India to which SCRA extends, shall

without the permission of the Central Government, enter in to any contract for the sale or purchase of securities other than such spot delivery contract or contract for cash or hand delivery or special delivery in any securities as is permissible under the said Act, and the rules, bye laws and regulations of the recognized stock exchange

Section 17 of SCRA

17. (1) Subject to the provisions of sub-section (3) and to the other provisions contained in this Act, no person shall carry on or purport to carry on, whether on his own behalf or on behalf of any other person, the business of dealing in securities in any State or area to which section 13 has not been declared to apply and to which the Central Government may, by notification in the Official Gazette, declare this section to apply, except under the authority of a licence granted by the Securities and Exchange Board of India] in this behalf.



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In simple terms , section 17 of SCRA prohibits a person to transact in shares without involvement of brokers of recognized stock exchange.

Section 18

However exception to this rule of prohibition is provided in section 18 (1) of SCRA which states that section 17 shall not apply to spot delivery contracts.

18. Exclusion of spot delivery contracts from section 13,14,15, and 17

(1) Nothing contained in sections 13, 14, 15 and 17 shall apply to spot delivery contracts.

Therefore, one needs to know what is “Spot Delivery. The term “spot delivery” is defined under clause (i) of section 2 of SCRA as :

(i) “spot delivery contract” means a contract which provides for,—

(a) actual delivery of securities and the payment of a price therefore either on the same day as the date of the contract or on the next day, the actual period taken for the despatch of the securities or the remittance of money therefore through the post being excluded from the computation of the period aforesaid if the parties to the contract do not reside in the same town or locality;

(b) transfer of the securities by the depository from the account of a beneficial owner to the account of another beneficial owner when such securities are dealt with by a depository;

Hence , combined reading of section, 13, 16, 17, definition of “spot delivery” and section 18 of SCRA show that

• The transaction in share can not be done unless one involves members of recognised stock exchange.

• Only exception is that two persons can transact without involvement of share broker only when the delivery of share is given and the payments were also made at most, within 24 hours of transaction.

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Judicial view on the matterSecurities Appellate Tribunal in case of Alok Khetan versus SEBI, Appeal No. 55 of 2007, Date of decision : 17.07.2007 held as follows

The learned counsel for the parties are agreed that the central government had issued a notification in the year 1969, and thereafter the Board issued a similar notification in March, 2000 in exercise of its delegated authority under section 16 of SCRA prohibiting any person in the territory of India to enter into any contract for sale or purchase of securities other than spot delivery or contract for cash or hand delivery or special delivery or contract in derivatives as is permissible under SCRA or the Act and the Rules and Regulations made there under and Rules, Regulations and Bye laws of a recognized stock exchange. In other words, the prohibition contained in the notification means that no security could be traded in an off market transaction except by way of spot delivery contract as defined in section 2(i) of SCRA. ‘Spot delivery contract’ referred to in this section means a contract which provides for actual delivery of securities and payment of a price therefore either on the same day as the date of the contract or on the next day.

In view of the aforesaid admitted fact it is clear that the appellant sold his unlisted shares on 25.08.1999 in an off market transaction and received the sale consideration of Rs.22,50,000/- only in January, 2000 which is much beyond the time permitted by section 2(i) of the SCRA. Since the transaction was off market the contract for the sale of shares could only be by way of spot delivery in view of the restriction imposed by the Board under section 16 of SCRA which mandates that the sale consideration ought to have been received either on the same day of the transaction or



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on the following day. It is, thus, clear that the sale of shares by the appellant on 25.08.1999 in the off market transaction is violative of the restriction imposed under section 16 read with section 2(i) of SCRA.

Sebi in Case of D.S.Pendse and others in order dated 5/1/2007 held as follows on the issue of spot delivery

The object of Section 13 is to make a transaction in securities in an area other than between the members of a recognized stock exchange or through or with such member, illegal after Section 13 has been made applicable in the said area. The effect of this provision is that if a transaction in securities has to be validly entered into, such a transaction has to be either between the members of a recognised stock exchange or through a member of a stock exchange or with a member of a recognised stock exchange. This view has been upheld by the Page 6 of 14 Hon’ble Bombay High Court in the case of Dahiben Umedbhai Patel and Others v Norman James Hamilton and Others.

15. A contract for sale of shares, in order to qualify as a “spot delivery contract” must provide for actual delivery of shares and the payment of price either on the same day as the date of the contract or on the next day, etc. This view was reiterated by the Hon’ble Bomaby High Court in a similar

situation in the case of Norman J. Hamilton v Umedbhai S. Patel and Others. It is, therefore, clear that as the said transactions did not result in delivery of shares or in payment of price consideration, they cannot be termed as spot delivery contracts. These transactions were, therefore, not exempted under Section 18 of the Act from being governed by Section 13 of the SCRA and thus were illegal contracts by virtue of the provisions of the SCRA.

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Summing UpThe evaders try to do transactions without involvement of stock exchange, so that the price can be manipulated according to their choice. If you find such transaction which generally result in loss, following steps need to be taken:

1. Find out the date of transactions shown. 2. Ask assessee to submit evidence of delivery of share. 3. Find out evidence of payment made. 4. Take the statement why the transactions were not done through a

broker.

If there is no payment or payment has been shown quite later than actual date of delivery, invoke section 2(i) , 17 & 18 of the SCRA and declare the loss as illegal loss.

Is public limited company share transaction comes within SCRA ?Yes, as held in Bhagwati Developers (P) Ltd. Vs. Peerless General Finance & Investment Co. Ltd. the High Court of Calcutta, [2004] 51 SCL 204 (CAL.) , Hon’ble Calcutta High Court upheld the decision of the Company law Board that

The Company Law Board found, as findings of fact, that the provi-sions of the Securities Contracts (Regulation) Act, 1956 would be ap-plicable to public limited company even though it’s shares might not be listed on any recognised stock exchange..

2.Nishkalp Investment & Trading Co Ltd vs Hinduja TMT ltd [2007 ] 79 SCl 368 (Mumbai ) , Mumbai High Court held the same view.

Can illegal loss be adjusted with legal income?Supreme Court’s in Maddi Venkataraman and Company P. Ltd. vs. CIT [1998]; 229 ITR 504 (SC) has held that illegal loss can not be adjusted with the legal income. The relevant portion of the decision is given as under :

“In the instant case, the assessee had indulged in transactions in violation of the provisions of the Foreign Exchange



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(Regulation) Act. The assessee’s plea is that unless it entered into such a transaction, it would have been unable to dispose of the unsold stock of inferior quality of tobacco. In other words, the assessee would have incurred a loss. Spur of loss cannot be a justification for contravention of law. The assessee was engaged in tobacco business. The assessee was expected to carry on the business in accordance with law. If the assessee contravenes the provisions of the FERA to cut down its losses or to make larger profits while carrying on the business, it was only to be expected that proceedings will be taken against the assessee for violation of the Act. The expenditure incurred for evading the provisions of the Act and also the penalty levied for such evasion cannot be allowed as deduction. As was laid down by Lord Sterndale in the case of Alexander von Glehn and Co. Ltd. [1920] 12 TC 232 (CA), it was not enough that the disbursement was made in the course of trade. It must be for the purpose of the trade. The purpose must be a lawful purpose.

Moreover, it will be against public policy to allow the benefit of deduction under one statute, of any expenditure incurred in violation of the provisions of another statute or any penalty imposed under another statute. In the instant case, if the deductions claimed are allowed, the penal provisions of the FERA will become meaningless. It has also to be borne in mind that evasion of law cannot be a trade pursuit. The expenditure in this case cannot, in any way, be allowed as wholly and exclusively laid out for the purpose of the assessee’s business.”

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Explanation to sec.731 & SCRA violation by a company assessee.

If the aforesaid illegal purchase & sale were done by a company and you find that share transaction by the company otherwise it falls under Explanation to section 73 of the I T Act following three steps should follow:

1. In the assessment order, describe clearly the reason why the

transaction is speculative as per Explanation to section 73.

2. Describe how the transaction is “illegal” for reasons stated in this

chapter.

3. Do not allow illegal speculation loss to be carried forward by

following decision of Supreme Court in case of CIT vs Kurji

Jinabhai Kotecha (1977) 107 ITR 101 in which it was held that

where a loss arises from illegal speculative business, it could not

be carried forward to the subsequent years for set off against the

profits of another speculative business.

[ More case laws on illegal losses/expense are given in Part III of the book]

–End–

1 Aman Portfolio (P) Ltd. vs. DCIT (2005) 92 TTJ (Del) 351].



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How to Easily Apply Explanation To Section 73?

Speculation loss plays a very important role in determining the taxable profits of a person. Share transactions by companies are treated a little harsher under the I T Act, because earlier certain business houses started a practice of creating loss out of share transactions within their group companies and thereby minimizing the taxable profits. The government, to check such malpractice brought1 Explanation to section 73 which is applicable only in case of companies. The said Explanation states

“Where any part2 of the business of a company (other than a company whose gross total income consists 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 in the purchase and sale of shares of other companies, such company shall, for the purposes of this section, be deemed to be carrying on a speculation business to the extent to which the business consists of the purchase and sale of such shares”

How to detect a case where this Explanation applies?

Step 1 : See if the assessee is a company.

If the answer is YES, proceed to step 2.

Step 2 : Are there loss on account of share for any of the reason given below ?

1 Introduced from 1/04/1977 . Read CBDT Circular 204 24/07/19762 CIT vs Arvind Investments 192 ITR 365-(Cal) High Court held that Explanation applicable even if entire business is of share dealing.

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1. Is there any loss on account of purchase & sale

2. Is there loss in value of closing stock of shares?

If answer to any of the question above is YES, proceed to step 3, otherwise not.

Step 3 : Find out if the principal business of company is banking?

Or

Find out if the company’s business is mainly of granting of loans or advances?

i) Remember a NBFC, only on the basis of recognition as NBFC , can not be regarded as carrying business of mainly granting of loans and advances.

ii) It often happens that while analyzing whether a company has utilised its capital for granting loans and advance ,, the figures from balance sheet is taken. It must be remembered that the amounts shown in balance sheet is the amount as on 31st March and based on that the analysis can be woefully wrong . For example , a company may use its money for shares and purchase and only in the last month of financial year , advances loans . The balance sheet figure as on 31st march , in that case , does not show whet it did through out year. Therefore, in author opinion, the analysis must be done on the fund movements for last two years , not be taking the net amounts shown as on 31st March , but going into the movement of fund during the year.

If answer to any of these questions is YES, the case falls under exception to Explanation to section 73 of the I T Act. As such there is no need to go to Step 4. Share transactions by such companies are not speculative transactions. However if the answer is NO, then proceed to Step 4 & 5.

Step 4 : Compute the Business income. But before you do that, please note following points which are very important

1. In case of loss, do not put negative sign. Treat all amounts, income or loss as positive for computing total business for the purpose of computing business income for the purpose of application of

How To Easily Apply Explanation To Section 73?


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section 73 of the I T Act. This is as per the decision of Calcutta High3 court in case of Eastern Aviation and Industries Limited vs CIT 208 ITR 1023. (Refer Part III of the book)

2. Dividend income attributable to shares which are closing stock-in-trade or which were in opening stock, has to be taken as income from business and not as income from other source. This is based on judgment of Mumbai Tribunal in case of DCIT vs Akrosh Investment & leasing P Ltd (20040 90ITD 287 which quoted Supreme Court’s judgment in Western States Trading Co. (P.) Ltd v. CIT [1971] 80 ITR 21 (SC) wherein their Lordships held thus:-

“If shares are held by an assessee as part of his trading assets, dividends on those shares would form part of the income from business of the assessee. The assessee will therefore be entitled to claim set off of loss from its business carried forward from earlier years against dividends of the current year from the shares held as stock-in-trade of his business under section 24(2) of the Income-tax Act, 1922.”

Fillup theblanks tofindoutbusiness income Rs. i. Business income or loss from non share business _________

ii. Share trading income or loss __________

iii. Share speculation income/loss __________

iv. Dividend Income attributable __________

Total business income = (i +ii+iii +iv)

Step 5 : Compute Income other than business

i. House property income __________

3 Aryasthan Corporation Ltd. VS. CIT (2002) 253 ITR 401 (Cal)

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ii. Capital gains ___________

iii. Income from other sources ___________ Income other than business income = ( i +ii +iii)

Step 6 : Compare step 4 & step 5.

If Business income (Step 4) is greater than other income (step 5), all conditions are satisfied. In that case, you can conclude that the loss on account of share transaction or devaluation in stock in trade is to be treated as speculation loss as per Explanation to section 73 of the I T Act.

Arguments of assessee and how to counter it?Assesse may raise certain other issues and arguments. Fortunately, solution and counter argument come from judicial rulings. Read below

Argument 1. Explanation does not apply in case both purchase and sale do not take place in the same year.Both purchase and sale in the same year is not a criteria for application of the Explanation as per following case laws :

i. CIT v. Sun Distributors & Mining Co. Ltd. [1993] 68 Taxman 223 (kol)

ii. DCIT vs Akrosh Investment & leasing P Ltd (20040 90ITD 287 (Mum)

iii. Western Metal Caps Ltd vs ACIT(2000) 110Taxmann 237(Ahd)

In CIT v. Sun Distributors & Mining Co. Ltd. [1993] 68 Taxman 223, their Lordships of Hon’ble Calcutta High Court held that it was not a requirement of section 73 that both purchase and sale of shares should take place in the same year. What is required to attract section 73 is that the business of the assessee should consist of purchase and sale of shares. Their Lordships observed as under:-

“Section 73 will apply where any part of the business of the company consists in the purchase and sale of shares of other


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companies. Therefore, it has to be seen whether the assessee has such a business. It might be that in a particular year shares were only sold or in a particular year the shares were only purchased. The second does not require that both sale and purchase should take place in the same year. What is to be seen is whether the business of the assessee consists in purchase and sale of shares. In the instant case, the assessee had a business of buying and selling the shares. The shares were treated as stock-in-trade. The closing stock of the shares had been valued just as any other stock-in-trade was valued by an assessee. There were small lots of sale of shares in this year. But that would not make any difference to the main question, which was whether the assessee was engaged in the business of all sale and purchase of shares. If it was found that any part of the business of the assessee consisted in the purchase and sale of shares, then for the purpose of section 73 such a company shall be deemed to be carrying on a speculation business to the extent the business consisted of purchase and sale of such shares. It is not the requirement of the section that both purchase and sale of shares should take place in the same year. But what the section requires is that there need be a business of sale and purchase of shares and the assessee-company carries on that business in the relevant year of account. The very fact that shares were valued as stock-in-trade and the loss was disclosed as a purchase and sale of shares was carried on by the assessee. To the extent such business was carried on, the business of the assessee must be treated as speculation business.”

Argument 2 : Assessee argues that Explanation to section 73 does not apply to a case of loss out of valuation of stock in trade?

This argument is incorrect in view of ruling given in case of Paharpur Cooling Towers Ltd vs DCIT (2003) 85ITD 745 (Kol)(Confirmed by Kolkata High Court vide order dt 5/10/2010 239 CTR 394 ) which is discussed in brief as


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under :

“During the course of assessment proceedings, Assessing Officer noticed that in the relevant previous year’ the assessee has sold some shares which were held by it as stock in trade’ and that the assessee incurred loss of Rs. 1,41,60,772 on such transactions. It is also an admitted position that main source of income for the assessee was under the head ‘income from business’ and, accordingly, the assessee’s case was not covered by exclusion clause in Explanation to section 73….

the loss on share transaction was treated as speculation loss since assessee company’s main income was not from interest on securities, income from house property, capital gains or income from other sources. Aggrieved inter alia by the loss on share transactions being treated as ‘speculation loss’, assessee carried the matter in appeal before the CIT(A) but without any success.

The Tribunal held

“It is not in dispute that the loss was incurred in a business which can be described as ‘speculation business’ if provisions of Explanation to section 73 is applied. There is also no doubt about the fact that conditions laid down under Explanation to section 73 were clearly and unambiguously satisfied ..”

In Prudential Constructions Co Ltd vs Asst CIT (200) 75ITD 338 (Hyd), on the same issue the Tribunal held as under :

“One of the arguments advanced by the learned counsel is that the loss relating to purchase and sale of shares can, at the most, be treated as speculation loss and not the loss resulting in on account of valuation of closing stock. We do not agree with such proposition. As mentioned earlier, the appellant is carrying on business of trading in shares. Where the appellant is carrying on business of purchase and sale


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of shares, the value of opening stock and the closing stock form integral part of the computation of profit or loss from share trading. The correct profit or loss cannot be determined without taking into account the value of opening stock and the value of closing stock. In fact, in the Profit & Loss Account, the entire loss of Rs. 1,60,33,083 arising on account of share transactions including valuation of closing stock has been adjusted against the profit and gains from business. The appellant has not adjusted only loss of Rs. 6,26,225 to the Profit & Loss A/c and it had adjusted the entire loss of Rs. 1,60,33,083 to the business profit. Therefore, while making the adjustment under section 143(1)(a), the Assessing Officer was duty bound to examine this aspect as to whether loss arising from share transactions was correctly adjusted against business profit or not. Since the appellant had adjusted the entire loss of Rs. 1,60,33,083 and not of Rs. 6,26,225, the Assessing Officer was justified in treating the entire loss as speculation loss. It may also be mentioned that there cannot be any controversy as made out by the appellant that the loss on share transactions has to be determined by excluding the value of closing stock of the shares. it is only made out by the appellant to wriggle out the rigours of Explanation

to section 73 of Income-tax Act.”

Case law ReferenceThe controversy about explanation to section 73 is similar to controversies on the subject of capital or revenue receipts or about business or investment activities. Some of the case laws given here are for better understanding of the

subjects :

Is allotment of shares covered under explanation?Laxmi Feeds & Exports Ltd. VS. ACIT, 62 ITD 315. If there is only acquisition of shares and not purchase of shares, in as much as, the 100,000

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shares in question were obtained only by way of subscription to a public is-sue.AMP Spinning & Weaving Mills ltd vs ITO 100 ITD 142 (, Ahmedabad)- purchase include shares allotted.

What is principal business ?

1. Fund Criteria- Kanoria Investments P Ltf 232 ITR 7 , Offshore India Ltd 15 ITD 549 (Kolkata ITAT)

2. Income criteria: Melville Finvest Ltd vs JCIT 89 ITD 528 (Hyderabad ,ITAT) , JCIT vs Haldia Investment ltd 85 ITD 212 (Kolkata ITAT)

Loss vs income for comparisonCIT vs Park View Properties Pvt Ltd (2003) Pvt ltd 261 ITR 473 -loss in share dealing is negative profit.

Units of mututal Funds covered?

Units not covered . Apollo Tyres Ltd vs CIT 255 ITR 273 (SC)

Miscelleaneous

Rajen Enterprise Limted 41 ITD 469 (Mumbai ITAT), DCIt vs Frontline Capi-tal Securities Ltd 96 TTJ 201(Delhi,ITAT) , Rohini Capital Services Ltd vs CIT 92 ITD 317 (Delh)

–End–



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ESOP, Phantom Stock Option & A rewind on FBT !

What Is Employees Stock Option ?

In simple terms, stock option is a right given by an employer company to an employee to apply for allotment of company’s shares at a prefixed price within a specified period. In general pre-fixed price of the shares is much less than the market price. Thus, for an employee ESOP is a kind of incentive or bonus or perquisite.

For example Reliance Industries Ltd, may grant share options under which an employee of RIL may be eligible after 31/12/2007 to apply for 100 shares. If he does apply, he will be allotted 100 shares at a price of Rs 100 on 31/10/2008. Let us say, the market price of RIL shares on 31/10/2008 (allotment date) is Rs 200. So, the benefit of Rs 100 is attached to the shares offered under ESOP. If an employee applies for shares under the ESOP scheme, he will get share for Rs 100 only which mean that on allotment date itself, he is getting lottery of Rs 100 per share. However, if the market price of RIL is below Rs 100, the employee has the option not to apply for allotment of shares because it is not beneficial for him.

Recent history of taxation on ESOP

Taxation policies regarding Employees Stock Options have changed over years.

• Upto 31/03/2000- There was no specific law about ESOP. The department was assessing it as perquisite and employee was fighting out on different grounds.

• From 01/04/2000 to 31/03/2007 , grant of stock option was not treated as perquisite in hand of employees if the stock option was granted in terms of ESOP scheme notified by the Government.

• From 01/04/2007, Fringe Benefit Tax on ESOP was imposed . However , on that condition, the grant of option in hand of employee remained

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Why Shares Issued Under ESOP Need Special Attention?

tax free.

• From 01/04/2009 , the grant of stock option has been made fully taxable as perquisite in a hand of employees.

Types of Stock Related Benefits to Employees

1. Employee Stock Purchase Plan (ESOP) or Employees Stock

Option Scheme—Under this scheme a certain amount are withheld

from participating employees salary and the accumulated amount

is utilized to acquire the share on a future date.

2. Employee Stock Ownership Plan (ESOP)–Under this scheme

employee is given an option to acquire shares of the company at

a predetermined price after a certain period, directly or indirectly

through trust.

3. Employees Stock Purchase Scheme(ESPS)–under this, a company

offers shares to an employee, as part of a public issue or otherwise

at a predetermined price.

4. Employees Stock Option Scheme (ESOS)- Under this a company

provides option to employees to buy a specified number of shares

at a specified price during a specified price.

5. Stock Appreciation Rights or Plans under which the employees

are awarded stock equivalents at a certain pre-determined value,

and after a certain minimum stipulated period, the employees are

allowed to encash such rights.


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Four important terms related to ESOP!

• Grant date : The date on which option to acquire shares are given to em-

ployee. It means from that date employee gets right but no obligation to

acquire shares. This is , in a way , an announcement by the employer that the

employee is entitled to share from that date.

• Vesting Date : The date on which an employee becomes entitled to exercise

option and acquire shares.

• Exercise Date : The date , employee actually exercise his right and actually

acquires by paying the exercise price .

• Exercise Price: The price paid by employee for acquiring shares as per com-

pany ESOP policy.

What is taxation rule regarding the ESOP ?

As on today , the grant of shares by employer company to employee at no cost or less cost in any form is taxed as perquisite u/s 17(2) of the I T Act. The provision can be summarized as under :

1. Any of the following if allotted to an employee either without any cost or less cost comes within perquisites

(i) shares, scrips, stocks, bonds, debentures, debenture stock or other marketable securities of a like nature in or of any incorporated com-pany or other body corporate; (ii) Government securities; (iia) such other instruments as may be declared by the Central Gov-ernment to be securities; (iii) rights or interests in securities;(iv) Equity shares issued by company to employees or directors for providing know-how or making available rights in nature of intel-

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lectual property rights or value addition , by whatever name2. Securities or shares must be allotted or transferred either directly or indirectly by the employer or former employer.3. Perquisite vale is determined by reducing the exercise price from Fair Market Value . 4. Rule 3(8) of I.T. Rule 1957 provides method of determination of Fair Market Value . Following table shows the different methods for detrmination of Fair Market Value (FMV ) of shares :

Nature of share allotted FMV determination methodShares are listed in recognised stock exchange

Average of opening & closing price of the shares on listed stock exchange as on exer-cise date. If share is listed on more than one stock exchange, then stock exchange which shows highest volume on the exercise date shall be taken for determination of FMV

If listed , but no trading on the exercise date

Closest date to exercise date on which sale took place. Highest volume exchange will be taken into consideration.

Unlisted shares Merchant banker has to determine value ei-ther on Exercise Date or any date earlier thereof but not more than 180 days old.

If security given is not shares Merchant banker has to determine value ei-ther on Exercise Date or any date earlier thereof but not more than 180 days old.

What is Phantom Stock Option?\

Phantom Stock Option is nothing but another name for Stock Appreciation

Rights or Plans under which the employees are awarded stock equivalents at a

certain pre-determined value, and after a certain minimum stipulated period, the

employees are allowed to encash such rights.

The fact that there is no actual allotment of shares , it does not fall within the am


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bit of section 17(2)(vi) , because one of the condition for ESOP being treated as perquisite is that the securities must be allotted or transferred to employee.

In case of Stock Appreciation Rights , there is no allotment of shares , but only appreciation in the price of shares on the date of exercise date with respect to the price on the date of notional grant of those shares. Thus an employee never pays a penny and gets the reward in form of appreciation in share price.Special Bench of Mumbai Tribunal in case of Sumit Bhattacharya 300 ITR (AT) 347 (Mum SB) held that

we have come to the conclusion that redemption of stock ap-preciation right is an employment related benefit, in the nature of deferred wages contingent upon financial performance of the ultimate employer, i.e., parent company of the company with which the assessee has entered into employment contract, which is a purely monetary benefit. The same is directly of the income nature. As for the reliance placed by the learned counsel for the assessee on the judgments in the cases of the NA Mody (supra) and TP Sidhwa (supra), in support of the proposition that an employment related benefit cannot be taxed under a head other than ‘income from salaries’, wefind thatHon’bleSupremeCourt has duly considered these judgments and yet come to theconclusionthatwhenanemploymentrelatedbenefit isreceived from a person other than the employer, the same is taxable under the head ‘income from other sources’.

Thus the SAR should be assessed as differed wages in case SAR is being re-ceived by employee from his current employer and as “income from other sources” if the same is being received from a peson other than employer , but for the reason of performance as an employee with his actual employer.

Have companies evaded tax due to ESOP during FY 2006-07?

ESOP scheme was brought under Fringe Benefit Tax vide Finance Act 2007 which provided that FBT will be payable on shares vesting after 1/4/2007 under ESOP scheme. The proposal was brought by the Budget in February 2007. So, there was a mad rush of advancing the dates of vesting and exercise

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dates of ESOP shares to March 2007. Employees were asked to exercise the option before 31/3/2007 to save the company from payment of FBT.

Let us see what were the rules of exemption in case of ESOP up to 31/03/2007.

From Asst Year 2001-02, an amendment in section 17(2) made the issue of shares under ESOP or ESOS non taxable in the hands of employees provided the ESOP-ESOS scheme of the company is in accordance with the guidelines issued by the Central Government. The Central Government notified the ESOP Guidelines dated 11/10/2001 vide notification no. 323 of 2001 (F.No. 142/48/2001-TPL) dt 11/10/2001.

What are the conditions?The Guidelines dated 11/10/2001 contains following conditions under Clause 2, 4 and 5 which are important

2. Any such Plan or Scheme shall be incorporated in a written document specifying, the following namely:

i) The total number of shares that may be issued under such Plan or Scheme.

ii) The class of employees who would be entitled to participate in such Plan or Scheme.

iii) The pricing formula on the basis of which shares would be allotted to the employees, including the price at which such shares are offered at the time of grant or exercise of option.

iv) The number of shares or stock equivalent which would be issued to any employee or classes of employees and the basis of such award, if any.

v) The period by and the manner in which the approval of shareholders would be obtained.

vi) The lock in-period of such shares from the date of option or exercise of option or purchase of shares under such Scheme or Plan, a the case may be.


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vii) If the shares are unlisted, the basis of valuation of shares with reference to the company’s account for the last three financial years and a brief explanation as to how the basis was arrived at.

viii) The conditions relating to the restriction on non-transferability of such shares.

Provided that the conditions contained in the written document shall not be changed after the date the Scheme or Plan comes into effect.

Further Clause 6 of the Guideline provided procedure as under:

6. Every company issuing shares directly or through its parent under Employees’ Stock Option Plan or Scheme to its employees shall furnish a copy of the document describing particulars as specified in clause 2 above with the Chief Commissioner of Income-tax having jurisdiction over it within a period of 6 months from the date of issue of these guidelines or within 6 months of the effective date of the Scheme or Plan, whichever is later. If the Plan or Scheme is incorporated in any language other than English, an English translation of the same should also be enclosed.

Point of enquiry As is pointed out earlier, that once Budget proposal was announced , there was mad rush to prepone vesting of ESOP shares. Therefore , it is high time that scrutiny on line of following parameter should be carried out on all large com-panies which has a policy of issuing ESOP and issued shares under ESOP dur-ing the months of Feburary to March 2007.1. Whether the company submitted the copy of scheme within the specified period to the office of jurisdictional Chief Commissioner of Income tax?2. Whether any promoter employee has been issued ESOP share i n contravention of clause 5 of the Guideline?3. Was there any violation of SEBI regulation on ESOP scheme?

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4. Was there any change in the condition given in the document which was submitted before the Chief Commissioner? If yes, whether such a change was done in normal course by the Administrator or for evasion of tax?

Whether such change comes within the legal right of the administrator of the ESOP scheme needs be examined and if the change is not bona fide (prima facie which appears to be the case, the benefit should be treated as perquisite.) All such companies will be liable to TDS and employees who were allotted ESOP shares are liable to tax on salary u/s 17(2) of the I T Act.


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Back To Basics

This part consists of many topics which are basic to any investigation and understanding of shares transactions. Relevant circulars, certain how-tos, important judgments, terminologies associated with share transactions, relevant allied laws and provisions, online investigation tools, important addresses are incorporated all at one place.

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Part III

Back To Basics

1. What Are The Procedure For Share Transactions In Dematerialized Form? 153

2. How Internet Can Bring You Information You Always Wanted For ? 155

3. Important Circulars/Instructions Issued By CBDT 156

1. Period of holding in case of dematerialized shares.

2. Determination of the ‘date of transfer’ and holding period for the purpose of capital gains.

3. Distinction between shares held as stock-in-trade and shares held as investment

4. What is the meaning of ‘hedging’ with respect to Explanation to section 73 ?

4. Important Circulars Issued By SEBI. 169

1. Transfer of shares from pool account to clients account.

2. Time duration for transfer of funds and securities from member to client.

3. What is the definition of ‘negotiated deal’ ?

4. Circular regulating negotiated deal.

5. Circular regulating broker-client relationship.

6. Mapin abolished

7. NSE Circular on Penalty for Client Code Modification

5. Certain Important Judgments You Must Refer To 183 1. What are the views of different courts

on the issue “business or investment income” 2. Are illegal expense or losses allowable?


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3. Is surplus on “sale as going concern” taxable as capital gains?

4. Are bonus shares or rights to shares capital asset? 5. Does exchange of shares fall within the meaning of transfer? 6. Does reduction of share capital give rise to capital gains? 8. Whether trading in units and govt. securities fall within the ambit

of the word “commodity” as given in section 43(5) of the IT Act? 9. Whether the sale of warrants received against debentures held as

stock-in-trade give rise to taxable revenue receipt?

6. What Is A Contract Note? 187 7. Why Is Demat Transaction Statement Important

For Share Investigation? 189 9. What Is A Private Limited Company

And What Are Its Privileges? 19110. What does “Beneficial Owner” mean in context of share ownership ? 192 11. What Are Derivatives? 19312. Books Maintained By The Broker & Stock Exchanges? 196 13. The Addresses of Different Stock Exchanges? 197

14. Address of Six Regional Directors (RD) under Ministry Of Corporate Affairs 202

15. Meaning of Words & phrases One Must Know 203

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What Are The Procedures For Share Transactions In DematerializedForm?

It is important to know procedure through which a purchase and sale of shares are carried out in case of dematerialized form. The procedures are summarized below

Purchase procedure

1. Investor gives purchase orders to his broker.

2. The broker enters the order in his online screen provided by his stock exchange (say NSE, or BSE or CSEA). The broker has to enter the client ID of the person for whom he is transacting. This way even Stock Exchange can identify who is the purchaser of the share.

3. Once purchase order goes to main server of the Stock Exchange, it is matched on first –cum-first serve basis and a notification of execution of the order reaches to the brokers involved.

4. At present T +2 settlement period is in practice. This means that within three days, the broker will arranges payment to the clearing corporation. The broker gets payment from the client and issues a contract note.

5. Broker receives credit of shares in his pool account with his DP on the payout day.

6. Broker gives instruction to his DP to debit his account and transfer the shares to the account of the purchaser. As per SEBI instruction, the broker has to debit his account within two days. [Refer part III for SEBI circular in this regard]

7. Investor gives receipt instruction to his DP for receiving the


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those shares in his account.

8. If the instructions match, the DP of the purchaser credits the investor’s account

9. Investor makes payment to the broker. In many cases, broker, takes payment in advance from customer the moment the order is executed and contract note is issued.

Sale Procedure1. Investor gives sale orders to his broker.

2. The broker enters the order in his online screen provided by his stock exchange (say NSE, or BSE or CSEA). The broker has to enter the client ID of the person for whom he is transacting.

3. Once sale order goes to main server of the Stock Exchange, it is matched on first–cum-first serve basis and a notification of execution of the order reaches to the brokers involved.

4. Investor sells shares in the book entry segment of NSE or other exchange

5. Investor gives receipt instruction to his DP to debit his account and credit the broker’s pool account

6. On the pay-in day the broker instructs his DP to debit that account and credit the clearing corporation of NSE

7. Broker receives payment from clearing corporation.

8. Investor receives payment from the broker.

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How Internet Can Bring You Information You Always Wanted For?

The internet is today a gigantic database of all kinds of information. The investigators can get immense help from internet and related information. For example, in case of share investigation, following information can be obtained from internet

1. List of all brokers and sub-brokers registered with stock exchanges. This list consists of complete address of brokers and with address of all terminals placed at different places.

For example, if you go to NSE site, and click members button there, you can download complete list of brokers and sub-brokers in excel format.

2. Orders of SEBI are posted on their websites www.sebi.gov.in and also the stock exchanges concerned. These orders can be downloaded. Therefore, if you want to see if any member broker of an exchange was suspended for particular period, you can visit SEBI or Stock exchange website and click the button for legal orders. One can also see if any rigging in price of the share was resorted by the brokers.

3. You can visit a company’s web site to know the record dates of dividend, bonus etc.

4. If you are investigating a private limited company, visit the Department of Company Affairs site www.mca.gov.in . You can get lots of information on a company -some free and some after paying RS 50

5. These days you can also verify the orders from stock exchange websites.

6. At the end use , google.com to search whatever you want to know about company. You may get information which even company does not know if it is in public domain. Just check yourself !


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Important Circulars /Instruction Issued By CBDT.

1. Period of holding in case of dematerialized shares- Circular No 768.Transactions in securities-Determination of “date of transfer” and the “periodofholdingofsecurities”heldindematerializedformundersection45(2A) of the Income-tax Act, 1961.

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

2. Under the new system, the movement of the scrips physically from one person to another is totally done away with by introducing certain intermediaries, chief among them being a depository and a participant. In order to implement the system of holding and transferring securities through the electronic media, firstly the Depositories Act, 1996, has been enacted. The object of this Act is to regulate the working of the depositories in securities and matters incidental thereto. A depository is an organisation where the securities of a shareholder are held in the electronic form on the request of the shareholder, through the medium of a depository participant. The depository is comparable to a bank where an investor who decides to utilise its services can open an account with

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it through a depository participant. However, a depository is not merely a custodian but is in fact the registered owner of the security and it is the depository whose name is entered as such in the register of the issuer. The person actually entitled to the security becomes the beneficial owner, whose name is recorded as such in the books of the depository.

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

Important Circulars/Instructions Issued by CBDT


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periodofholdinginrespectofsharesheldinthedematerializedform,the FIFO method would apply. Clarifications have been sought on the manner of application of the FIFO system for the determination of the date of transfer and the period of holding.

4. The primary issue under the Income-tax Act in the case of securities whether held in physical or form or in the dematerialized form remains the determination of the cost of acquisition and the period of holding. The board had earlier issued Circular No. 704, dated 28th April, 1995, which explains the manner in which the “date of transfer” and “period of transfer” and “period of holding” does not change even when the securities are held in dematerialized form is that the distinct trail linking every share to a certificate and its unique distinctive number linking it with its subsequent sale is not available.

5. Section 45(2A) stipulates that in the case of securities held in dematerialized form, for determining “date of transfer” and “period of holding”, the FIFO method would be applicable. The FIFO method is generally used to determine the value of any item moving out of a stock account and those remaining in stock at any point of time. When applied to an account holding dematerialised stock, it implies that, out of the existing holdings, the item that first entered into the account is deemed to be the first to be sold out. However, once the sale is linked with an earlier purchase, for determination of their “date of transfer” and “period of holdings”. Board’s Circular No. 704 would be applicable. That is to say that the relevant contract notes as explained in Circular No. 704 will have to be referred to, for ascertaining the cost of the securities sold and the date of transfer. When actually operating an account of dematerialised stock by applying the FIFO system, certain other issues can arise. For instance, an investor can hold part of his holdings of the security in physical form and the remaining in dematerialized form. Further, he may hold his dematerialised holdings in more than one account with one or more depositories. In such

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Important Circulars / Instruction Issued By CBDT.

a situation there can be doubts whether the FIFO system is to be applied globally on the entire holdings of physical and dematerialized holdings or not. In this connection, it is clarified that :

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

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

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

Date of credit Quantity Particulars

1-6-1997 2,000 Purchased directly in dematerialised form on 25-5-1997

5-6-1997 5,000 Dematerialized share originally purchased in November, 1985

10-6-1997 4,000 Purchased directly in form on 10-6-1997

15-6-1997 3,000 Dematerialized sharesoriginally dematerialized purchased in May,


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1962

If say, 2,500 shares were sold from out of this account, then the period of holding and the cost of acquisition of the first 2,000 shares should be as from 25-5-1997 and the cost thereof, whereas the balance 500 shares will be treated as having been acquired in November, 1985, at the relevant cost. This is the effect of the FIFO method.

(Para 225/296/97-ITC dt. 24-4-98 issued by Deptt. Of Revenue CBDT, New Delhi)

2. Determination of the ‘date of transfer’ and holding period for purposes of Capital Gains

1. Under the provisions of sub-section (42A) of section 2 of the Income-tax Act, 1961, the shares held in a company or any other security listed in a recognised stock exchange in India or units of the Unit Trust of India or units of a mutual fund specified under section 10(23D) shall be regarded as short-term capital assets if they are held by an assessee for not more than 12 months immediately preceding the date of its transfer. Clarifications have been sought as to which date should be regarded as the date of transfer and also abiout the date from which the holding period of the securities should be reckoned. Clarifications have also been sought as to how the holding periods will be computed for the purposes of capital gains when the securities, purchased in several lots at different points of time and which are taken delivery of in one lot, are subsequently sold in parts and no correlation of the dates of purchase and sale is available.

2. When the securities are transacted through stock exchanges, it is the established procedure that the brokers first enter into contracts for purchase/sale of securities and thereafter, follow it up with delivery of shares, accompanied by transfer deeds duly signed by the registered holders. The seller is entitled to receive the consideration agreed to as

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on the date of contract. The Board are of the opinion that it is the date of broker’s note that should be treated as the date of transfer in cases of sale transactions of securities provided such transactions are followed up by delivery of shares and also the transfer deeds. Similarly, in respect of the purchasers of the securities, the holding period shall be reckoned from the date of the broker’s note for purchase on behalf of the investors. In case the transactions take place directly between the parties and not through stock exchanges the date of contract of sale as declared by the parties shall be treated as the date of transfer provided it is followed up by actual delivery of shares and the transfer deeds.

3. As regards the second issue, where securities are acquired in several lots at different points of time, the First-in-first-out (FIFO) method shall be adopted to reckon the period of the holding of the security, in cases where the dates of purchase and sale could not be correlated through specific numbers of the scrips. In other words, the assets acquired last will be taken to be remaining with the assessee while assets acquired first will be treated as sold. Indexation, wherever applicable, for long-term assets will be regulated on the basis of the holding period determined in this manner.

[F. No. 225/86/95-ITA-II, dt. 28-04-1995 from CBDT, New Delhi]

3. Distinction between shares held as stock-in-trade and shares held as investment -Instructions No 1827 dt 31/8/1989The question whether a particular assessee is a trader in shares or the shares are held as capital assets sometimes gives rise to disputes and litigation. Over the years the courts have laid down the various tests or factors to be taken into account in determining this question.

2. Certain general principles in this regard were laid down by the Supreme Court in the case of G.Venkata Swami Naidu & co. Vs. CIT (1959)


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35 ITR 594. In this case the Supreme Court was dealing with a question whether the excess sum realised on the sale of certain plots was assessable as income from an adventure in the nature of business. The Supreme Court held that in deciding the character of such transaction, several factors were relevant. For instance :

i. Whether the purchaser was a trader and the purchase of the commodity and its resale were allied to his usual trade or business or were incidental to it.

ii. The nature and quantity of the commodity purchased and resold - if the commodity purchased is in very large quantity, it could tend to eliminate the possibility of investment for personal use, possession or enjoyment.

iii. The repetition of the transaction.

3. The Supreme court observed that the presence of all these factors may be held in the court to draw an inference that a transaction is in the nature of trade’ but it is not a matter of merely counting the number of facts and circumstances pro and con what is important to consider is their distinctive character. In each case, it is the total effect of all relevant factors and circumstances that determines the character of the transaction.

4. The Supreme Court in this case also discussed the test of intention. It held that in cases where the purchase has been made solely and exclusively with the intention of resale at a profit and the purchaser has no intention of holding the property for himself or otherwise enjoying it or using it, the presence of such intention is a relevant factor and unless it is off-set by the presence of other factors, it would raise a strong presumption that a transaction is an adventure in the nature of trade.

5. In the case of H. Mohammad & Co. Vs. CIT (1977) 107 ITR 637 the Gujarat High Court observed that a stock-in-trade is something in which

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a trader or a business man deals, whereas his capital asset is something with which he deals. According to the High Court one of the indicators for deciding as to what is stock-in-trade is whether a particular assessee is buying or selling the goods or commodity or whether he has merely invested his money with a view to earning further income or with a view to carrying on his other business. It was further held by the High court that the distinction between stock-in-trade and investment is that of selling outright in the course of the business activity and deriving income from exploitation of one’s own assets.

6. These general principles hold good in respect of shares also. However certain specific issues relevant for determining this question with reference to shares have also been decided by the courts. In the case of Sarder Indra Singh & sons Ltd. Vs. CIT (1953) 24 ITR 415, the Supreme Court was dealing with the case of a company which was incorporated with the object, inter alia of carrying on the business of bankers, financiers, managing agents and secretaries and was also empowered to invest and deal with the monies of the company not immediately required for its business upon such securities and in such manner as might from time to time be determined. It was held by the Supreme Court in this case that to constitute business income, it was not necessary that surplus should have resulted from such a course of dealing in securities as by itself would amount to the carrying on of business or if the realisation of securities is a normal step in carrying on the assessee’s business. The Supreme Court observed that the principle applicable in all such cases was well settled and the question always was whether the sales which produced the surplus were so connected with the carrying on of the assessees business that it could fairly be said that the surplus was the profit and gains of such business. On the facts of this case it was held that the surplus resulting from sale of shares and securities constituted business income.

7. The aforesaid principles laid down by the Supreme Court was followed


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by Andhra Pradesh High court in the case of SBH. Vs.CIT (1988) 151 ITR 703. The main business of the SBH was to accept deposits and to advance loans and the money constituted its stock-in-trade. The banking company has to carry on its business in accordance with the provisions of the banking regulation act, 1949. Sec.24 of the said act requires every banking company to maintain in India either in cash or in the shape of gold or in the shape of unincumbered approved securities, 20% of its total time and demand liabilities at any given point of time. It was held by the High Court that what section 24 of the said Act did was to insist on the observance of a normal prudent banking business practice. If the banking company chooses to invest the money in unincumbered approved securities it is only one mode of keeping a portion of its deposits in ready cash or readily-convertible-into-cash securities. Any income arising from the sale of such securities is, therefore closely connected with the banking business and is business income, it was concluded by the High court.

8. In the case of Karam Chand Thapar and brothers (P) Ltd Vs. CIT (1971) 83 ITR 899 it was held by the Supreme Court that the circumstance that the assessee had shown certain shares as investment in its books as well as its balance sheet was by itself not a conclusive circumstances, though it was a relevant circumstance.

9. The decisions in the CIT Vs. Associated Industrial Development co. (1971) 82 ITR 586 (SC) and A.N. Ramaswami Chettiar Vs. CIT (1963) 48 ITR 771 (Madras) may also be referred to for guidance.

10. Although the tests laid down by the courts may help determine the issue in particular cases the decision will ultimately turn on the facts of each case.

11. These instructions may please be brought to the notice of the Assessing officers in your region.

[F.No 181/1/89 - IT(AI) dated 31/08/1989 from Central Board of Direct Taxes]

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4. What is the meaning of word ‘hedging’ used in explanation to section 73 ?A circular No. 23 (XXXIX) of 1960 dated 12th September 1960 of Central Board of Revenue states as under :

“A number of representations and suggestions have been received by the Board from associations and chambers of commerce regarding the manner in which the provisions of Section 24 of the Income Tax Act, particularly those of explanation 2 to subsection (1) thereof, are being interpreted and applied by the Income-tax officers. The Direct Taxes Administration Enquiry Committee have also made a few suggestions on this subject in chapter III of their Report. The board have carefully considered the points involved. Those points and their decisions thereon are given below :

Point (i) Under clause (a) of the proviso to Explanation 2 to Section 24(1) of the Income Tax Act 1922, the Income-tax Officers exclude from the category of speculative transactions only a “hedging purchase” transaction entered into with reference to specific contracts for sale of goods but do not exclude a “hedging sale” transaction made against stocks in hand or against contracts for purchase of ready goods. The latter type of transactions are also genuine hedging transactions and should be excluded from the category of speculative transactions so that any losses sustained therein will be allowed to be set off against other income.

Board’s decision - The intention has always been that where bonafide forward sales are entered into with a view to guarding against the risk of raw materials or merchandise in stock falling in value, the losses arising as a result of such forward sales should not be treated as speculation losses. Accordingly, Income-tax Officers should not treat such transactions as speculative transactions within the meaning of Explanation 2 to Section 24(1). It is to be noted in this connection that hedging sales can be taken to be genuine only to the extent the total of such transactions does not exceed the total stocks of raw materials


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or merchandise in hand. If the forward sales exceed the ready stock, the loss arising from the excess transactions should be treated as loss arising from speculative transactions and not from genuine hedging transactions.

Point (ii) Hedging transactions in connected, though not the same, commodities should not be treated as speculative transactions.

Board’s decision - The Board accepted this point. Attention is invited to Board’s letter No. 13 (102) IT/53 dated September 8, 1954, in which it was stated that as regards hedging in raw materials, the Income-tax Officers should not be particular about the quantities and timing so long as the transactions constitute genuine hedging. Similarly, Income-tax Officers should not treat genuine transactions in connected commodities as speculative transactions though the transactions may not be in identically the same commodity. Thus, hedging transactions in one type of cotton against another type of cotton, one variety of oil seed against another, one type of grain against another, should not be treated as speculative transactions provided the other conditions of Explanation 2 to Section 24 are satisfied. The conditions mentioned in last two sentences of the decision on point (i) above will apply here also.

Point (iii) Where a transaction contemplating actual delivery is ultimately settled (wholly or partially) by paying differences and without actual delivery due to any reasons and where there was not intention to speculate, the transaction should be excluded from the purview of speculative transactions

Board’s decision - The Board are unable to accept this suggestion as a general rule. It is already provided that if on the facts of any case it can be demonstrated that the forward transaction has been entered into only for safeguarding against loss through future price fluctuations, such a transaction should not be treated as speculative transaction but as a case of hedging. However, the case of a bonafide ready delivery contract being settled by delivery to a substantial extent and by payment of difference paid need be

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treated as a loss arising in a speculative transaction.

Point (iv) Bonafide hedging transactions by a dealer or investors on shares should not be allowed provided that the hedging transactions are up to the amount of his holdings even though these transactions may extend to other types of shares not held by him.

Board’s decision - The Board are unable to accept this suggestion. It cannot be accepted that a dealer or investor in stocks or shares can enter into hedging transactions in scrips outside his holding. The materials words in clause (b) of the proviso to Explanation 2 to Section 24(1) are “to guard against loss in his holdings of stocks and shares through price fluctuations”. Therefore, hedging transactions having reasonable relations to the value and volume of the dealer’s or the investor’s holdings are expected from the ambit of speculative transactions; but transactions in scrips outside his holding are not.

Point (v) Speculation loss, if any carried forward from the earlier years or the speculation loss, if any in a year should first be adjusted against speculation profits of the particular year before allowing any other loss to be adjusted against those profits.

Board’s decision - The suggestion is accepted. For the purpose of setoff under Section 10 and Section 24(1) (of the 1922 Act) the speculation loss of any year should be first setoff against the speculation profits of that year and the remaining amount of speculation profits, if any, should then be utilised for setting off of any loss of that year from other sources. For the purpose of Section 24(2) (of the 1922 Act) the Income-tax Officer may allow the assessee :

(i) either to first set off the speculation losses carried forward from an earlier year against the speculation profits of the current year and then set off the current year’s losses from other sources against the remaining part, if any, of the current year’s speculation profits, or to first set off the current year’s losses from non-speculation business and other sources against the current


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year’s speculation profit and then to set off the carried forward speculation losses of the earlier year against the remaining part, if any of the current year’s speculation profit, whichever is advantageous to the assessee.”

–End–

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Important Circulars Issued By SEBI

1. Transfer of shares from pool account to clients account. [SEBI Circular Dated 1/2/2001]

2. Time duration for transfer of funds and securities from member to client [MRD/DoP/SE/Dep/Cir-30/2004 August 24, 2004]

3. What is the definition of ‘negotiated deal’ ?

4. Ciruclar regulating negotiated deal.

5. Circular regulating broker-client relationship.

6. MAPIN Abolished

7. NSE Circular on Penalty for Client Code Modification

1. Transfer of shares from pool account to clients account.

SMDRP/Policy/Cir-05/2001

February 01, 2001

To, The President/Executive Director/Managing Director of all the Stock Exchanges/ NSDL/CDSL

Dear Sir,

Please refer to SEBI circular no. SMDRP/Policy/Cir-11/99 dated May 7, 1999 advising stock brokers/clearing members to transfer the securities from their respective CM Pool account to the respective beneficiary account of their clients within 15 days from the pay-out day of the settlement.

It has now been decided that with effect from February 12, 2001, clearing member shall be required to transfer the securities from their respective CM


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Pool account to the respective beneficiary account of their clients within 6 calendar

1. Days after the pay-out day, instead of the existing time limit of 15 days.

2. The securities lying in the pool account beyond the above period would not be eligible for delivery in the subsequent settlement(s) and would also not be eligible for pledging or stock lending purpose, until the same is credited to the beneficiary accounts.

3. The securities lying in the pool account beyond 6 calendar days would attract a penalty at the rate of 6 basis point per week on the value of securities. The penalty so collected by the depositories shall be credited to a separate account with the depository and earmarked for defraying the expenses in connection with the investors’ education and awareness programs conducted by the depository.

4. The securities, which are lying in these accounts beyond the specified time period, shall initially be identified based on FIFO (First-In First-Out) basis. However, with effect from March 5, 2001 the securities shall be identified based on the settlement number basis. The clearing corporation/houses of the stock exchanges shall provide the settlement-wise details of securities to the depositories and the depositories shall maintain the settlement-wise records for the purpose.

5. Further with effect from April 2, 2001, stock exchanges shall introduce the settlement system for direct delivery of securities to the investors. Clearing corporation/clearing house (CC/CH) shall ascertain from each clearing member, the beneficial account details of their respective clients who are due to receive pay out of securities. Based on this, the CC/CH shall send pay out instructions to the depositories so that the client receives pay out of securities directly to the extent of

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instructions received from the respective clearing members. To the extent of instruction not received, the securities shall be credited to the CM pool account.

6. With effect from April 2, 2001, the time limit of 6 calendar days after the pay-out day for transferring the balances to the beneficiary accounts of clients shall be reduced to 4 calendar days or 2 working days, whichever is later. The penal provisions mentioned above shall be applicable on the balances lying in the pool account after this period.

The above decisions would not be applicable to the securities lying in CM Pool account maintained with clearing corporation/house of the stock exchange for the purpose of vyaj badla and/or ALBM/BLESS transactions.

Stock exchanges/depositories are advised to implement the above decisions, under intimation to us.

Yours faithfully,

P. K. KURIACHENDIVISION CHIEFSECONDARY MARKET, DEPOSITORIES,

2. Time duration for transfer of funds and securities from member to client

MRD/DoP/SE/Dep/Cir-30/2004

August 24, 2004

1. The Executive Directors/Managing Directors/Administrators Of All Stock Exchanges

2. The Managing Director, NSDL


3. The Executive Director, CDSL

Dear Sir / Madam,

Sub: Time duration for transfer of funds and securities from member to client

1. Please refer to our circular No. SEBI/MRD/Policy/Cir-19/2004 dated April 21, 2004 and SMD/Policy/Cir-6/2003 dated February 06, 2003.

2. In partial modification of the aforesaid circulars, it has been decided that the members shall be required to transfer the funds and securities from their respective Pool account to the respective beneficiary account of their clients within 1 working day after the pay-out day.

3. The other provisions of the aforesaid circulars remain unchanged.

4. The Stock Exchanges are advised to

4.1. make necessary amendments to the relevant bye-laws, rules and regulations for the implementation of the above decision immediately.

4.2. bring the provisions of this circular to the notice of the member brokers/clearing members of the Exchange and also to disseminate the same on the website.

4.3. communicate to SEBI, the status of the implementation of the provisions of this circular in Section II, item no. 13 of the Monthly Development Report for the month of September 2004.

5. This circular is being issued in exercise of powers conferred under Section 11 (1) of the Securities and Exchange Board of India Act, 1992, to protect the interests of investors in securities and to promote the development of, and to regulate the securities market.

Yours faithfully,V S SUNDARESAN


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3. What is the definition of ‘negotiated deal’ ?SMDRP/POLICY CIR-2/99

January 14, 1999

The President/Executive Director/Managing Director of all Stock Exchanges

Dear Sir,

Sub: Measures to improve market microstructure

With a view to further improve the market microstructure and provide for increased transparency, efficient price discovery and the curb unhealthy market practices so as to enhance the confidence of the investors, SEBI in consultation with members of Inter-Exchange Surveillance Group and some of other Stock Exchanges has decided to implement the following measures :

1. No Exchange shall allow the ‘All or None’ or ‘Minimum Fill’ order facility in their trading system.

2. The Price Band applicable to the Normal Trades will become applicable to the Negotiated Trades (including Cross Deals, Bulk Deals and all trades where the price is not determined on the Exchange’s trading system). As of date, the applicable price band is 8% from the previous days close for the normal market on the Exchange. All the regulations relating to the Price Bands for the securities in normal market will also apply to the Negotiated Trades (including Cross Deals, Bulk Deals and all other trades where the price is not determined on the Exchange’s trading system).

3. Delivery and payment for all “hand delivery” trades (including Trade for Trade, Negotiated Trades, Cross Deals, Bulk Deals, etc.) must be completed within the time or on the date stipulated when entering into the deal which time shall not be more than 7 days following the date of the contract.


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These aforementioned decisions shall be made effective for each stock exchange from the commencement of the first trading period after receipt of this circular. The stock exchanges shall, if necessary, amend their bye-laws for the purpose of implementing these decisions.

Yours faithfully,

P.K. BINDLISHDIVISION CHIEF 4. Circular regulating negotiated deal.

SMDRP/POLICY/CIR-32/99September 14, 1999

The Executive Directors /Managing Directors of all the Stock Exchanges.

Dear Sir,

Please refer to our earlier circulars dated March 31, 1997, August 04 & 12, 1998 and January 14, 1999 relating to negotiated deals. The following decisions have been taken based on the recommendations of the Committee on Negotiated Deals, which met on September 01, 1999:

1. All negotiated deals (including cross deals) shall not be permitted in the manner prescribed in circulars mentioned above and all such deals shall be executed only on the screens of the exchanges in the price and order matching mechanism of the exchanges just like any other normal trade.

Provided, however, that Foreign Institutional Investors (FIIs) can avail of the provisions of the special bargains on the exchanges in accordance with their bye-laws or obtain suitable exemptions from exchanges for purchases or sales between FIIs in such companies where the ceiling of FII investment of 24% or 30 % as the case may be, has been reached.

The above decision was taken as negotiated deals avoid transparency

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requirements, do not contribute to price discovery and some investors do not

have benefit of the best possible price and militate against the basic concept of

stock exchanges, which are meant to bring together a large number of buyers

and sellers in an open manner.

2. Similarly, negotiated deals in listed corporate debt securities shall

not be permitted and all such trades will have to be executed on the

price and order matching mechanism of the stock exchanges as in

the case of equities.

Currently, trading in the debt market takes place largely over the telephone

and through the mechanism of negotiated deals. The world over the trend is

to move away from a telephone based debt market to a screen based trading

system of the exchanges which allows greater transparency, better price

discovery, reduction in transaction cost and benefits the investors.

As government debt securities and money market instruments are under the

regulatory jurisdiction of RBI and do not fall within the purview of SEBI,

the aforesaid decision will not apply to such securities.

The above decisions comes into effect from the settlement subsequent to the

date of the SEBI Press Release issued in this regard on September 01, 1999,

a copy which is enclosed.

Yours faithfully,

P. K. BINDLISH

DIVISION CHIEF

Secondary Market, Depository

Research & Publication

Email: [email protected]


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5. Circular regulating broker-client relationship?November 18, 1993

Ref. : SMD/SED/CIR/93/23321

To,

THE PRESIDENTS/EXECUTIVE DIRECTORS OF ALL THE STOCK EXCHANGES

Dear sir,

Regulation Of Transactions Between Clients And Brokers

This has reference to SEBI’s letter No.SMD/SED/2913/93 dated March 9, 1993. On receiving the comments from various stock exchanges on the norms circulated by us it has been decided that the norms as set out in the annexure shall be made applicable to the stock brokers in all the stock exchanges. You are, therefore, hereby directed to make necessary provisions in your Bye-laws and Regulations for the purpose. The amendments to be made to the Bye-laws and Regulations should be forwarded to us for formal approval.

The norms are required to be made applicable in all the stock exchanges with effect from January 1, 1994 onwards. These may be widely circulated amongst member-brokers so that they are made aware of the proposed measures.

Yoursfaithfully,

Sd/-C.B. BHAVE

REGULATION OF TRANSACTIONS BETWEEN CLIENTS AND BROKERS

1. It shall be compulsory for all Member brokers to keep the money of the clients in a separate account and their own money in a separate account. No payment for transactions in which the Member broker is taking a

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position as a principal will be allowed to be made from the client’s account. The above principles and the circumstances under which transfer from client’s account to Member broker’s account would be allowed are enumerated below.

A] Member Broker to keep Accounts: Every member broker shall keep such books of accounts, as will be necessary, to show and distinguish in connection with his business as a member -

i. Moneys received from or on account of each of his clients and,

ii. The moneys received and the moneys paid on Member’s own account.

B] Obligation to pay money into “clients accounts”. Every member broker who holds or receives money on account of a client shall forthwith pay such money to current or deposit account at bank to be kept in the name of the member in the title of which the word “clients” shall appear (hereinafter referred to as “clients account”). Member broker may keep one consolidated clients account for all the clients or accounts in the name of each client, as he thinks fit: Provided that when a Member broker receives a cheque or draft representing in part money belonging to the client and in part money due to the Member, he shall pay the whole of such cheque or draft into the clients account and effect subsequent transfer as laid down below in para D (ii).

C] What moneys to be paid into “clients account”. No money shall be paid into clients account other than -

i. money held or received on account of clients;

ii. such money belonging to the Member as may be necessary for the purpose of opening or maintaining the account;



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iii. money for replacement of any sum which may by mistake or accident have been drawn from the account in contravention of para D given below;

iv. a cheque or draft received by the Member representing in part money belonging to the client and in part money due to the Member.

D] What moneys to be withdrawn from “clients account”. No money shall be drawn from clients account other than -

i. money properly required for payment to or on behalf of clients or for or towards payment of a debt due to the Member from clients or money drawn on client’s authority, or money in respect of which there is a liability of clients to the Member, provided that money so drawn shall not in any case exceed the total of the money so held for the time being for such each client;

ii. such money belonging to the Member as may have been paid into the client account under para 1 C [ii] or 1 C [iv] given above;

iii. money which may by mistake or accident have been paid into such account in contravention of para C above.

E] Right to lien, set-off etc., not affected. Nothing in this para 1 shall deprive a Member broker of any recourse or right, whether by way of lien, set-off, counter-claim charge or otherwise against moneys standing to the credit of clients account.

2. It shall be compulsory for all Member brokers to keep separate accounts for client’s securities and to keep such books of accounts, as may be necessary, to distinguish such securities from his/their own securities. Such accounts for client’s securities shall, inter-alia provide for the following:-

a. Securities received for sale or kept pending delivery in the market;

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b. Securities fully paid for, pending delivery to clients;

c. Securities received for transfer or sent for transfer by the Member, in the name of client or his nominee(s);

d. Securities that are fully paid for and are held in custody by the Member as security/margin etc. Proper authorization from client for the same shall be obtained by Member;

e. Fully paid for client’s securities registered in the name of Member, if any, towards margin requirements etc.;

f. Securities given on Vyaj-badla. Member shall obtain authorization from clients for the same.

3. Member Brokers shall make payment to their clients or deliver the securities purchased within two working days of pay-out unless the client has requested otherwise. Stock Exchange shall issue a Press Release immediately after the pay-out.

4. Member Brokers shall buy securities on behalf of client only on receipt of margin of minimum 20 percent on the price of the securities proposed to be purchased, unless the client already has an equivalent credit with the broker. Member may not, if they so desire, collect such a margin from Financial Institutions, Mutual Funds and FII’s.

5. Member brokers shall sell securities on behalf of client only on receipt of a minimum margin of 20 percent on the price of securities proposed to be sold, unless the member has received the securities to be sold with valid transfer documents to his satisfaction prior to such sale. Member may not, if they so desire, collect such a margin from Financial Institutions, Mutual Funds and FII’s.

6. Member brokers shall issue the contract note for purchase/sale of securities to a client within 24 hours of the execution of the contract.

7. In case of purchases on behalf of clients, Member brokers shall be a liberty to close out the transactions by selling the securities, in case the client fails to make the full payment to the Member Broker for the



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execution of the contract within two days of contract note having been delivered for cash shares and seven days for specified shares or before pay-in day (as fixed by Stock Exchange for the concerned settlement period), whichever is earlier; unless the client already has an equivalent credit with the Member. The loss incurred in this regard, if any, will be met from the margin money of that client.

8. In case of sales on behalf of clients, Member broker shall be at liberty to close out the contract by effecting purchases if the client fails to deliver the securities sold with valid transfer documents within 48 hours of the contract note having been delivered or before delivery day (as fixed by Stock Exchange authorities for the concerned settlement period), whichever is earlier. Loss on the transaction, if any, will be deductible from the margin money of that client.

6. MAPIN abolished !

CHIEF GENERAL MANAGERMarket Regulation Department-Division of PolicyE-mail: [email protected]: 022-2644 9370

MRD/DoP/Cir- 08/2007June 25, 2007

1. The Executive Directors/Managing Directors/Administrators of All Stock Exchanges

2. Chairman & MD, NSDL3. MD & CEO, CDSL4. All SEBI registered intermediaries Dear Sir / Madam,

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Sub: PANas the sole identificationnumber forall transactions in the securities market

1. As you are aware, SEBI vide circular No. MRD/DoP/Cir- 05/2007 dated April 27, 2007 has made PAN the sole identification number for all participants in the securities market, irrespective of the amount of transaction.

2. In light of the above, it has been decided to discontinue with the requirement of Unique Identification Number (UIN) under the SEBI (Central Database of market Participants Regulations), 2003 (MAPIN regulations)/circulars.

3. The stock exchanges are advised to bring the provisions of this circular to the notice of the member brokers/clearing members and to disseminate the same on their websites.

4. The Depositories are advised to bring the provisions of this circular to the notice of the Depository Participants of the Depository and also to disseminate the same on their websites.

5. This circular is being issued in exercise of powers conferred under Section 11 (1) of the Securities and Exchange Board of India Act, 1992, and Section 19 of the Depositories Act, 1996 to protect the interests of investors in securities and to promote the development of, and to regulate the securities market.

Yours faithfully,S V Murali Dhar Rao

7. SEBICircularon ClientCodeModificationCIR/DNPD/01/2011 January3, 2011

Sub: Modifications to client code post trade execution



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1. Stock Exchanges can permit modifications to client code post trade execution only in case of genuine error or wrong data entry made by trading members. This facility has been provided for the smooth functioning of the system and is expected to be used more as an exception rather than routine. Accordingly, Stock Exchanges are advised to:

• Set objective parameters for identification of client code modifications arising as a result of genuine error or wrong data entry. These objective parameters should be approved by the Governing Board of the Exchange and disclosed to the trading members.

• Impose monetary penalty in addition to disciplinary action against members who do not meet the laid down objective parameters.

• Include verification of client code modification as a reporting item in internal audit report of the trading members.

1. This circular is issued in exercise of the powers conferred under Section 11 (1) of the Securities and Exchange Board of India Act 1992, read with Section 10 of the Securities Contracts (Regulation) Act, 1956 to protect the interests of investors in securities and to promote the development of, and to regulate the securities market.

2. The circular shall come into force from the date of the circular.

3. This circular is available on SEBI website at www.sebi.gov.in, under the category “Derivatives- Circulars”.

Yours faithfully,

Sujit Prasad

General Manager 022-26449460

183

Certain ImportantJudgmentsYouMustReferTo

1. Are illegal expense or losses allowable ? 2. Is surplus on “sale as going concern” taxable as capital gain? 3. Are bonus shares or rights to shares capital asset ? 4. Does exchange of shares fall within meaning of transfer ? 5. Does reduction of share capital give rise to capital gains ? 6. Whether trading in units and govt. securities fall within the ambit

of the word “commodity” as given in section 43(5) of the I T Act ?

7. Whether the sale of warrants received against debentures held as stock-in-trade give rise to taxable revenue receipt ?

1. Are illegal expenses or losses allowable? (i) AziAzizAbdulShakoorBrothersvs.CIT[1961];41ITR350

(SC) :

Expenses incurred in transactions carried out in violation of the provisions of the Foreign Exchange Regulation Act were not allowable. Thus, confiscation of gold by way of fine was not an allowable deduction.

(ii) Maddi Venkataraman and Company P. Ltd. vs. CIT [1998]; 229 ITR 504 (SC) :

Infraction of law is not a normal incidence of business. It would be against the public policy to allow the benefit of deduction under a statute if any expenditure is incurred in violation of the provisions of another statute. No deduction can be allowed for that part of sale proceeds which was remitted back to the customers through illegal channels in violation of the Foreign Exchange Regulation Act.

(iii) Swadeshi Cotton Mills Co. Ltd. vs. CIT [1990]; 233 ITR 199 (SC) :

(a) Damages paid for delayed payment of employees’ contribution to EPF contains both the element of penal levy (not allowable


184

as deduction). The scheme of the relevant statute has to be studied to see whether an impost is compensatory or penal in character. When it is composite, only that part which is compensatory has to be allowed.

(b) Penalty imposed for contravention of Central Sales Tax Act is a penalty for infraction of law and is not allowable.

2. Is surplus on “sale as going concern” taxable as capital gain?

In a case where assessee sold its business as going concern if the amount of surplus exceeds the difference between the WDV of the actual cost, of the assets then the surplus amount to the extent of such surplus will have to be treated as capital gains for the purpose of taxation. CIT vs Artex Mfg. Co. LTD. 227 ITR 260 SC 1997.

3. Are bonus shares or rights to shares capital asset? i. Bonus shares are capital asset. CIT vs Chunilal Khushaldas 93

ITR 369 Guj 1974.

ii. Right to subscribe for rights issue of shares is a capital asset. Miss Dhun Dadabhoy Kapadia vs CIT 63 ITR 651 SC 1967. In case of renunciation of such a right, the capital gains will be sale proceeds minus the depreciation in the value of shares held, i.e. the difference between the closing cum-rights price and the opening ex-rights price.

4. Does exchange of shares fall within meaning of transfer ? Exchange of shares is a Transfer. CIT vs TISCO 206 ITR 196 Bom

1994.

5. Does reduction of share capital give rise to capital gains ?

i. Reduction of share capital by reducing the face value of shares was held not to be extinguishment and as such not liable for capital gains. CIT vs Narisimhan 118 ITR 60 Mad 1979.

185

Certain Important Judgments You Must Refer To

as deduction) as well as compensatory payment (allowable

ii. Reduction of share capital by paying part of capital was held as extinguishment. Kartikeya Sarabhai vs CIT 94 TAXMAN 164 SC 1997.

6. Whether trading in Units and govt. securities fall within the ambit of the word “commodity” as given in section 43(5) of the I T Act?

It has been held by Delhi Bench of ITAT in ANZ Grindlays Bank vs Dy, CIT (2004) 88ITD 53 (Delhi)

it is held that the word ‘commodity’ in section 43(5) would not only include stocks and shares but also securities and units in its plain and natural meaning. Consequently, trading is such items, would fall within the scope of ‘speculative transactions’ subject to other conditions being fulfilled.

7. Whether the sale of warrants received against debentures held as stock-in-trade give rise to taxable revenue receipt?

Yes so held by the ITAT in J. T. Holdings (P.) Ltd. vs Income-Tax Officer. 89 itd 569 (23/1/2003). The excerpt from the order

During the accounting period relevant to assessment year 1992-93, the assessee had been allotted 25,000 debentures of Reliance Industries Ltd. The assessee-company had paid Rs. 9,37,500 for the same. The assessee had shown these debentures as stock-in-trade at the end of the accounting year 1991-92. Along with the debentures, the assessee-company was also given 25,000 detachable warrants. These detachable warrants were sold by the assessee-company on 10-6-1992 to M/s. Jayant Mody & Co. for a consideration of Rs. 10,00,000. The assessee did not offer this amount for taxation for the reasons that according to the assessee it is a capital receipt. The assessee


186

submitted before the Assessing Officer that the cost of detachable war-rant was Nil and the same was a capital asset. The assessee-company also submitted that there was no cost of acquisition, therefore, it did not fall in the computation of capital gains under section 48 as held by the Supreme Court in the case of CIT v. B.C. Srinivasa Setty [1981] 128 ITR 294. According to the assessee-company, the sale considera-tion cannot be brought into computation as no cost is ascertainable as held by the Supreme Court in the case of Sunil Siddharthbhai v. CIT [1985] 156 ITR 509 and if it cannot be taxed as capital gain, the same also cannot be taxed under any other head.

The tribunal held on the facts in the case “in case of CIT v. Kunji Lal Gupta [1971] 81 ITR 474 (SC) the shares were held as stock-in-trade and the bonus shares were allotted in proportion to existing holding. The main issue for consideration was whether sale proceeds of bonus shares in the hands of the assessee were capital in nature or the same were revenue receipts. The Hoh’ble Supreme Court held “on the facts, that the sale proceeds of bonus shares received in respect of ordinary shares held by the assessee as part of the stock-in-trade of his business was a revenue receipt”.

In the present case also the detachable warrants had been received by the assessee in respect of the debentures which are held by the assessee as stock-in-trade of the business, therefore, the sale proceeds of detachable Warrants are revenue receipts. The case of the assessee is, therefore, squarely covered with the aforesaid decision of the Hon’ble Supreme Court. In view of the discussion above, we uphold the order of the learned CIT(A).”

-End-

187

What Is A Contract Note ?

A contract note is a legal document which serves as an evidence of a contract

for purchase or sale of share or securities between the purchaser and a broker. A

broker is obliged to issue a contract note for every trade that a broker executes.

There are two types of contract notes –Type A or AA and Type B.

If the member is dealing as a broker then he issues a contract note in the

Type A. On the contrary, when the member trades on his own account, no

brokerage is charged. In that the contract note are issued in Type B.

Contract notes are made in duplicate, and the trading member and Client

both keep one copy each. The Client/s are expected to sign on the duplicate

copy of the contract note for having received the original. Authentic contract

note contains:

SEBI registration number of the Trading Member

Details of trade such as order no., trade no., trade time, quantity,

price, brokerage, settlement number, details of other levies.


188

189

Why Is Demat Transaction Statement Important For Share Investigation ?

When a person opens a bank account, he is given a pass book which shows

the incoming, the outgoing and the balance amount of money in the passbook.

Similarly when a person opens demat account with a depository participant, he

is given a passbook or say a transaction statement which reflects the incoming,

the outgoing and the balance of shares in his /her /its name. In other words,

the demat transaction statement is a passbook of shares.

Therefore, every share purchased or sold are noted in the demat transaction

statement because now most of the shares are traded compulsorily in demat

form only. Therefore, the demat transaction statement is very vital fact finding

book for any investigation in share.

So, when somebody says, he purchased a specific share, verify from his

demat transaction, if he had really purchased the share. The demat transaction

statement should also be perused for any other receipt of shares or whether

the sale numbers are matching. One can also verify if any purchase or sale of

share is actually a speculative transaction because the delivery is made only

in demat form, one can factually verify if the delivery was made or taken in

case a particular transaction.


190

Anatomy of a Transaction Statement

191

What Is A Private Limited Company And What Are Its Privilege?

A private limited company means a company which has a minimum paid up capital of Rs 1 lakh rupees and by its articles:

i. Restricts the right to transfer its shares, if any;

ii. Having maximum shareholder of 50 without including

1. Persons employed in the company and

2. Former employees who have continued to be members

iii. Prohibit invitation to public to subscribe its share or debentures and also for accepting any kind of deposits from any body other than members, directors or relatives.

The privileges of the private company are many. However, here only relevant to the topics covered in the book are given below [Section referred here pertains to Companies Act]

1. Minimum number of members a private limited company should have is two. Therefore, it is easy for any body, let us say, Husband & Wife, to start a company. The maximum number of members can be 50. [section 12 & 3]

2. Minimum number of Directors, a private limited company should have is two. [section 252]

3. Minimum capital required is only Rs 1 Lakhs. [section 3]

4. Unlike public limited company, right to transfer of shares of private company is restricted. [section 3 & 82]

5. Very few numbers of returns are required to be filed in case of private limited company.

6. Existing shareholders have no first right of issuance of fresh


192

capital unlike public limited companies [section 81]

7. A private limited company can assist financially to anyone for purchasing its own shares. [section 77(2) & 77(3)]

8. Private company can give loans to directors. [sec 295]

9. Private company can also give loans to other companies without any restriction as given us/ 372A of Companies Act

10. Investment in other corporate bodies can be made by private companies without any restriction.

Whatdoes“BeneficialOwner”mean in context ofshare ownership ?

The word beneficial owner is of wide import while examining the case of

capital gains. Section 45(2A) states that the meaning of beneficial owner is

given in Depositaries Act 1996. Section 2 is definition section in Depository

Act 1996, where the word beneficial owner is defined as under:

2. (1) In this Act, unless the context otherwise requires -

(a) “beneficial owner” means a person whose name is

recorded as such with a depository;

-End-

193

What are Derivatives?

The term Derivative has been defined in Securities Contracts (Regulations) Act, as:- A Derivative includes: -

i. a security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security;

ii. a contract which derives its value from the prices, or index of prices, of underlying securities;

In simple terms, “Derivative” in context of shares means a “Contract” for the purchase or sale of share, stock indices(like sensex or nifty) within a specified fixed period for a price based on the share or stock indices at the time of buying a contract. However, at present in Indian stock market, you can not get delivery of shares or give delivery of shares. Only the difference in the price has to be given or taken.

Another point to note is that the last date up to which the contract is valid, is called expiry date. On that day, the contract is settled by giving the difference or taking the difference.

For example, if A bought a contract on 1/9/2007 from B to purchase 100 shares of RIL @ Rs 120 per share on any day between 1/9/2007 to 30/11/2007. Let us say, the price of RIL goes to Rs. 130 on 15/9/2007, on that A goes to B and ask him to fulfill the contract signed between them by which he had a contract to buy shares for Rs 120 on any day till 30/11/2007. B can not refuse to fulfill the contract at the same time he is not supposed to give delivery of shares of RIL. So what he does is that he pays Rs 10 (Rs 130-120) per share to A. The total gain of A is therefore Rs 10 x 100 = Rs 1000.

Types of derivatives in Indian stock marketsDerivatives products being traded on Indian stock exchanges are two types:

1. Futures 2. Option


194

They are popularly known as F & O segment of stock market.

What are Future derivatives?In very simple terms, under future contract, you are buying or selling a contract to purchase or sale of share at any time within a specified period at price fixed at the time of signing the contract. The aforesaid example of RIL was an example of futures trading. Let us take another example.

A buys a contract from B by which A can buy 100 shares of TISCO for Rs 400 per share on any day between 1/9/2007 to 30/11/2007. Let us say, the price of TISCO went down to 355 on 25/10/2007. The notional loss of the buyer of the contract to purchase is RS 45 per shares. So, there are two option with A.

1. He can either settle the contract by paying the difference of Rs 45 per share to B and the square off the contract or

2. He can wait till the expiry date i.e 30/11/2007 and whatever the price will be on that date; the account will be settled on that day.

Let us say on 30/11/2007, the price of TISCO is RS 385. So, on that day, when the contract expires, A will have to pay Rs 15 per share(Rs 400 -385) x 100 i.e Rs 1500.

What is Option ?In Future contract, you can not say that you will not fulfill the contract if it does not go in your favour. However in Option contract, you can do so. That is, in Option contract, you have option not to fulfill the contract if you perceive loss. For this facility, you will have to pay a premium at the time of signing contract. Therefore, under option contract, while the risk of loss is minimized to the extent of premium paid, the gain is infinite.

Option are two types:

Option to buy is called Call option

Option to sell is called Put option.

There are two system of settlement of Option contracts-American and European system. In India, American option is being practiced. Under American system, option is exercisable on or before the expiry date. One that is exercisable

195

only on expiry date, is called European option.

What is European or American style Option ?

Under European style of Option, you can not exercise the option before expiry day. However , under American style of option , one can exercise his option any day before expiry day. At present , derivative trading in NSE are European style.

Is delivery of shares possible in case of futures or option ?

Presently , there is no possibility of taking delivery or giving delivery in case of Futures and Options trade done through National Stock Exchange.

However, BSE has started delivery based derivative trades from Feburary 2011. Thus , on BSE , one can settle delivery trade by delivering or taking delivery of underlying shares. Here is extract from BSE Notice dt Monday, January 31, 2011

• Single Stock Futures Contracts: All open positions at expiry will result in delivery obligations.

• Single Stock Options Contracts: Exercise of all open positions will be solely at the discretion of the buyer on the expiry day. In other words, there will be no automatic exercise of these contracts on expiry day. The exercise procedure will be triggered on receipt of exercise notice from the trading member (TM) of the client during the time window provided on the expiry day, from 9:00am – 4:30pm.

• On expiry / exercise of delivery-based stock derivatives contracts, the risk management framework of the cash segment shall be applicable.

What are derivatives ?


196

The Books Maintained By The Broker And Stock Exchange ?

Prescribed books and records to be maintained by a broker and stock exchange. These should be

In case of Broker : (a) Register of transactions (Sauda book).

(b) Clients’ ledger.

(c) General ledger.

(d) Journals.

(e) Cash book.

(f) Bank pass-book.

(g) Documents register showing full particulars of shares and securities received and delivered.

In case of stock exchange(2) Every member of a recognised stock exchange shall maintain and preserve

the following documents for a period of two years:

(a) Member’s contract books showing details of all contracts entered into by him with other members of the same exchange or counterfoils or duplicates of memos of confirmation issued to such other members.

(b) Counter foils or duplicates of contract notes issued to clients.

(c) Written consent of clients in respect of contracts entered into as principals.

As per Rule 15 (1) of the Securities Control & (Regulation) Rule, 1957, every member of a recognised stock exchange shall maintain and preserve the aforesaid books of account and documents for a period of fiveyears.

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Addresses Of Different Stock Exchanges ?

92, Maker Towers F, Cuffe Parade, Mumbai - 400005

Padam Towers, 14/113, Civil Lines, Kanpur - 208001Stock Exchange Building, JLN Marg, Malviya Nagar, Jaipur - 302017

P O Box no 183, New No: 30, (old no: 11), Second Line Beach, Chennai -600001

MES Dr P K Abdul Gafoor Memorial Cultural Complex, 36/1565, 4th Floor, Judges Avenue, Kaloor, Cochin -

OTC Exchange of India

The Uttar Pradesh Stock Exchange Association Ltd. Jaipur Stock Exchange Ltd.

Madras Stock Exchange Ltd.

Cochin Stock Exchange Ltd.

022

0512

0141

044

0484

22188164

2338115

2729094

25228951

3048521

1

2

3

4

5

22188503

2338175

2729082

25244897

2400330

www.otcei. com

upse@vsnl. in

jsel@datainf osys.net

mseed@vsnl. com

SrNo

Name of the Stock Exchange

Addresses STDCode

Phoneno

FaxNumbers

Email Id


198

Bangalore Stock Exchange Ltd.

National Stock Exchange of India Ltd.

Gauhati Stock Exchange Ltd.

The Ludhiana Stock Exchange Ltd.

The Calcutta Stock Exchange Association Ltd.

Bhubaneshwar Stock Exchange Ltd.

Stock Exchange Towers, 51, 1st Cross, J C Road, Bangalore - 560027

Exchange Plaza, Bandra-Kurla Complex, Bandra(E), Mumbai - 400051

Saraf Building Annexe, A T Road, Gauhati, Assam - 781001

Feroze Gandhi Market, Ludhiana - 141001

7, Lyons Range, Kolkata - 700001

6th Floor, IDCO Towers, Janpathi, Bhubaneshwar

080

022

0361

0161

033

0674

41575234

26598235

2517883

2774716

22206928

2545082

6

7

8

9

10

11

41575242

26598237

2541721

2404748

22202514

2545094

edbgse@gias

bg01.vsnl.net.in

cmlist@nse. co.in

iseght@isc india.com

lse@satyam. net.in

www.csei ndia.com

SrNo


Addresses STDCode

Phoneno

FaxNumbers

Email Id

199

The Delhi Stock Exchange Association Ltd.

Vadodara Stock Exchange Ltd.

Ahmedabad Stock Exchange Ltd.

Madhya Pradesh Stock Exchange Ltd.

Pune Stock Exchange Ltd.

DSE House, 3/1, Asaf Ali Road, New Delhi - 110002

Fortune Tower, Sayajigunj, Vadodara - 390005Kamdhenu Complex, Opp, Sahajanand College, Panjarapole, Ambawadi, Ahmedabad - 380001

Palika Plaza, Phase II, 201, 2nd Floor,MTH Compound, Indore - 452001

Shivleela Chambers, 752, Sadashiv Peth, RB Kumthekar Marg, Pune - 411030

011

0265

079

0731

020

23292417

2361534

26307971-74

2432842-48

24485702

12

13

14

15

16

23292181

2361452

26308877

2432849

24460082

www.dsei ndia.com

vse@d2visp.

com

info@asei ndia.org

mpseind@ sancharnet.

in

pune-stock@

vsnl.com

SrNo


Addresses STDCode

Phoneno

FaxNumbers

Email Id

The Addresses Of Different Stock Exchanges ?


200

Bombay Stock Exchange Ltd.

Inter connected Stock Exchange of India Ltd.

Phiroze Jeejeebhoy Towers, Dalal Street, Mumbai - 400023

International Infotech Park, Tower 7, 5th Floor, Sector 30, Vashi, Navi Mumbai - 400703

022

022

22721234

67941000

17

18

22722082

27812061

www.bseindia.com

isesc@bom 3.vsnl.net.

SrNo


Addresses STDCode

Phoneno

FaxNumbers

Email Id

United Stock Exchange of India Limited (USE)

Hyderabad Stock Exchange

Magadh Stock Exchange

Corporate Office : C-7, 2nd Floor, ‘C’ Wing, Laxmi Towers, Bandra Kurla Complex, Bandra (E), Mumbai - 400 051 Registered Office: 25th Floor, Pheeroze Jeejeebhoy Towers, Dalal Street, Fort Mumbai - 400 001 , Tel : 022-42444999, FAX 022-42444900

De-recognizedStockExchanges.

“The Hyderabad Stock Exchange Ltd. (HSE) failed to dilute at least 51% of its equity share capital to public other than shareholders having trading rights on or before the stipulated date i.e. August 28, 2007. Consequently, in terms of section 5(2) of the Securities Contracts (Regulation) Act, 1956, the recognition granted to HSE stands withdrawn with effect from August 29, 2007”

SEBI vide order dated September 3, 2007 refused to renew the recognition granted to Magadh Stock Exchange Ltd.

20

1

2

MCX Stock Ex-change Ltd19

Exchange Square, 3rd Floor, Suren Road, Chakala, Andheri (East) Mumbai - 400 093, Tel 022 67319000, Fax 022 67269575

201

SrNo


Addresses

Saurashtra Kutch Stock Exchange (SKSE)

Mangalore Stock Exchange

SEBI vide order dated July 06, 2007 has withdrawn the recognition granted to Saurashtra Kutch Stock Exchange Limited.

As per Securities Appellete Tribunal order dated October 4, 2006, the Mangalore Stock Exchange is a de-recognized Stock Exchange under Section 4 (4) of SCRA.

3

4

Important

Readers should note that most of the benefits associated with shares are lost if transactions are not done through recognized stock exchange. The Nil tax rates on long term or 15 % tax on short term can not be availed of if an assessee shows gains from stock exchanges which have been derecognized by SEBI. Section10(38),Section111A,112allarereferringrecognizedstock exchange. In fact any transaction through those stock exchange during the period it is derecognized shall be illegal under SCRA Act and as such will have a bearing on allowance of losses out of such dealing.

-End-

The Addresses Of Different Stock Exchanges ?


202

Address of Six Regional Directors (RD) under Ministry Of Cor-porate Affairs [addresses (as on 13/06/2011)

They are in-charge of the respective regions, each region comprising a number of States and Union Territories. They supervise the working of the offices of the Registrars of Companies and the Official Liquidators . There is also an Inspec-tion unit attached to the office of every Regional Director for carrying out the inspection of the books of accounts of Companies under Section 209A of the Companies Act.

EASTERN REGION

Dr. NAVRANG SAININIZAM PALACEII MSO BUILDING3RD FLOOR, 234/4 A.J.C.BOSE ROADKOLKATA-700020PHONE: 033-22870383FAX: 033-22870958EMAIL: [email protected]

SOUTHERN REGION

Sh. K. PANDIAN 5TH FLOORSHASTRI BHAWAN26 HADDOWS ROADCHENNAI- 600006PHONE: 044-28271737FAX: 044-28280436 EMAIL: [email protected]

NORTHERN REGION

B. K. BANSALA-14, SECTOR-I, PDIL BHAVANNOIDA (UP)PHONE: 0120-2445342FAX: 0120-2445341 EMAIL: [email protected]

WESTERN REGION

Sh. S. M. A. MILLATH EVEREST 5TH FLOOR100 MARINE DRIVEMUMBAI - 400002PHONE: 022-22817259, 22811493FAX: 022-22812389EMAIL: [email protected]

NORTH WESTERN REGION

Sh. U. C. NAHTAROC BHAVAN ,OPP RUPAL PARK SOCIETY,BEHIND ANKUR BUS STOP,NARANPURA, AHMEDABAD-380013 PHONE: 079-27437597 FAX: 079-27438371EMAIL: [email protected]

NORTH EASTERN REGION

Sh. B. L. SINHANIZAM PALACE II MSO BUILDING 3RD FLOOR, 234/4 A.J.C.BOSE ROAD KOLKATA-700020 PHONE: 033-22870383 FAX: 033-22870958

203

Meanings of Words & Phrases One Must Know !

Above Par - Means “at a premium”.When the share price is above the face value it is termed as above par.

Arbitrage - The business of buying or selling securities which are reversed in another exchange and profit is earned from the price differential.

Asking Price - The lowest price at which the owner is willing to dispose of the shares.

Asset Securitisation – means assets are held as collateral against the bond issued by the lender to provide liquidity.

Bear- A stock market player who generally keeps on selling the shares.

Beta Shares - Listed but not so frequently traded shares

Bid - An offer to buy a stock at a particular price.

Brokerage - Commission paid to broker for arranging to buy or sell the securities

Bull - A stock player who believes that the prices of the stock are going to rise. (He intends to profit by selling the stock later at a higher price).

Bull Market - Continuous and sustained rise in the price of the shares.

Buy Out - Buying the controlling share holding of a company to take over its assets and business.

Buying–in - When a seller defaults in delivering the shares to the buyer on the Pay-in date, the buyer can enforce the delivery by buying-in the shares against the seller from the market. The seller is then responsible to pay the buyer the difference between the contract price and the buying-in price.

Call Money - Part of the price of the new issues when called for by the company.

Call Option - A marketable contract for which a buyer pays the option writer an option premium to grant the option buyer the right to call (or buy) a specified security form the option writer at a predetermined price within the stated time period.

Cum-bonus - Shares with bonus entitlement

Circuit Breaker - Suspension of trading in a particular scrip for a day or other specified period by the stock exchange due to abnormal price movement in that scrip.

Clearing Account - It is an account held by the broker or Custodian with the clearing corporation for the purpose of carrying out the clearing and settlement function.

Clearing Corporation - An entity responsible for the clearing and the settlement of funds and securities of the trades executed on the exchange.

Clearing Days - The days fixed by the exchange in advance for the settlement of accounts


204

of broker.

Closed Ended Scheme - A scheme which is open for sale only during a specified period. At the end of period redemption takes place.

Closing Price -The trade price of the security at the end of the trading day.

Closing-out - Where a party to a contract does not fulfill the delivery against the sale or payment against the delivery of shares. The other party can close-out the transaction against the defaulting party through the medium of the exchange. The gain or loss arising from the closing out of the transaction will be borne by the defaulting party. Closing out against the failure of the party to take delivery of the shares is called selling-out.

Commercial Paper – These are promissory note issued by companies to overcome short term fund requirement.

Contract Note - The note issued by the broker to the client for the shares dealt by him. The A type of contract note is issued when the broker is acting as a principal and B Type when the broker is acting as a broker.

Cost of Capital - It represents the minimum required rate of return that the suppliers of funds expects to get from the market.

Cum-rights - Shares with entitlements of right to apply for shares.

Current Ratio - The ratio of current assets to current liabilities. If it is more than 1, then the company affairs are in a healthy state.

Current Yield - Dividend or interest received calculated as a percentage of a share or debenture’s current market price.

Daily Margin - The amount which the member must keep with the stock exchange authorities.

Day Minimum/Maximum Range - The minimum/maximum price range for a security on a trading day.

Delisting - The removal of the company’s shares form a stock exchange

Delivery out - A clearing member issues delivery out to the participant authorising it to initiate the transfer of securities to a clearing corporation to fulfil its delivery obligation.

Delivery - Handing over of the shares either to the broker or the client. In the Demat context it suffices if the ‘Delivery out Instructions’ are given in the duly signed prescribed form.

Dematerialization- It is a process by which the physical share certificates are destroyed and in lieu of the same the company credits the investor’s account with equal number of shares to be held electronically in his demat account.

Depository Participant - A representative of the depository system. Financial Institution, Banks, Custodian, Brokers can become DP’s.

205

Depository - An organisation which acts as banker of shares in electronic form.

Derivatives - Futures or options contracts are also know as derivatives.

Dividend -Payment made to share holders out of the company’s profits after tax.

Face Value - The value as appears on the face of the scrip same as the nominal or par value.

Forward Trading - Contracts to buy or sell at a stated price and time in future.

Freeze - Orders, which are beyond the price, band and with quantity beyond the percentage fixed by the exchange. Such orders are subjected to checks by the exchange.

Fungibility - All certificates of the same share are interchangeable if the shares are held in Demat form.

Futures - Future contracts are standardised tradable contracts in the nature of forward contracts.

Going Long - Buying shares for the purpose of speculation. Opposite of going short where the person is selling. These positions are normally held by speculators who do not intend to actually buy or sell, i.e. for buying they may not have requisite funds and for selling the necessary quantity.

Good Till Cancelled - If an order is left untraded, the same is not cancelled by the system, until the broker cancels it or if any of the parameters lapses.

Good Till Date - An untraded order is not cancelled till the particular date mentioned in the order lapses.

Hammering - Concerted selling of shares by operators to bring down the price.

Hedging - Offsetting of the investment risk.

Insider Trading - Using of confidential private information for playing in the market for the purpose of gains.

Index - A measurement of the trend of the movement of the share prices.

Index Funds - Those funds that passively invest in a basket of securities that exactly imitate the market index.

Initial Public Offer -Company’s first offering of stock to the public.

Interim Dividend - An advance instalment of the dividend.

Intrinsic Value - Valuation of stock based on the inputs of the company.

Jobber - A broker who trades frequently in a particular scrip only and is ready to buy or sell any quantity at any time. This entity provides for the liquidity in the scrip. The jobber normally charges a small difference as his commission, which is termed as spread.

Letter of renunciation - Letter informing the company the lack of interest of the investor to invest in the rights issue of the company. These letters of renunciation can be sold in the



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market.

Leveraging - Company’s long term debt in relation to the equity capital of the company.

Limit Order - An order limiting the price, above which the buy order should not be executed and reverse for the sell order.

Lock in period - The period during which no transfer of shares can take place. These are particular kind of shares like promoter’s quota shares, etc.

Market Capitalisation -The total market value, at the current market value, of the total number of shares issued by the company.

Market lot - A fixed minimum quantity of shares could be bought or sold in the exchange.

Market Maker - An entity who is willing to make market in the sponsored security, by offering two way quotes for buying and selling any quantity of shares any time.

Market Price -The last reported price of a share on the exchange.

Market Trades - The transactions done through the exchange mechanism.

Market order - Order to buy or sell the shares at the best available price at that moment of time.

National Securities Depository Limited- An organisation promoted by IDBI, UTI, NSE and SBI to provide facilities for handling securities in electronic form.

Negotiated Deal -A trade between two members of the exchange through negotiation outside the system of the exchange. This trade has to be reported to the exchange and after the exchange approves the same, the trade can be settled through the exchange mechanism.

Net Asset Value -In the case of Mutual Fund, the market value of the shares held by the fund on particular date less the liabilities divided by the number of units issued by the fund.

Non-cleared Securities - Securities that are listed and traded on the exchange but are not settled through the clearing house.

Odd Lot - Odd lot is that quantity which is not in the market lot. In the context Demat trading it has lost any significance because ‘Demat’ share of any odd quantity can be traded.

Off- market Trade - Similar to negotiated deals, but are in big volumes.

Options - The right to buy or sell share or commodities or currencies at a certain price on a specified future date.

Over The Counter Exchange of India - An electronic market for securities, which are of low cap companies and are not listed with any of the regular exchanges.

Over Bought - A term relating to market technical position, wherein the buyers are unable to sustain a prolonged rally in the prices of certain scrips. This happens if the demand for a

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particular scrip exceeds the supply.

Over Sold - Reverse position to over bought.

Price Earning Ratio - An indicator of how highly a shares is valued in the market. Arrived at by dividing the Price of the share by the Earning per share. The ratio tends to be high for a highly rated share.

Par Value - Face value of the share

Pari Passu - Ranking equally. After conversion of debentures into equity the new shares carry the same right as the old one.

Partly Paid Shares - A share for which the full nominal values is yet to be paid.

Payout Ratio - This is dividend per share divided by the earnings per share and the sum multiplied by 100. If the payout ratio is 40%, it means that 40% of the company’s profits after tax have been distributed as dividend and 60% have been transferred to reserves.

Preference Shares - These shares have preference over the equity shares in the matter of distribution of post-tax profit, as well in the event of liquidation.

Premium - Price above the face value of the share.

Private Company -Company which does not have any public share holding

Private Placement - Sell of securities between an issuer and an investor without resorting to public issue.

Prospectus - Public Offer document of the company going public.

Public Company - Company which has issued its shares to public.

Put and Call - Terms pertaining to option indicating right to buy and sell respectively

Quote - Bids for highest and lowest offer for share.

Quoted Company - Companies whose shares are quoted on the stock exchange

Quoted Price - The last traded price of the stock.

Record Date - Date fixed by the company to identify the shareholders on the register of the company for the purpose of dividend, bonus, rights, etc.

Remisier - Person engaged by a member of the stock exchange to solicit business from clients on behalf of the broker.

Renunciation - Giving up the right to subscribe to the rights shares.

Reserves - Profits set aside by the company for the purpose of expansion, etc.

Rigging - The manipulation of share prices by market players through unlawful means.

Rights Issue - Issue of further shares by a company to its existing shareholders.



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Settlement Date - Date on which the transactions entered into during the course of the settlement period is settled by delivery of shares and payment.

Share Transfer Stamps -Stamps used for transfer of shares. Transfer of demat shares does not require any stamp duty.

Short Covering -Buying of shares by a short seller to cover his outstanding position.

Short Position -Selling of shares without being the owner or in possession of the same.

Split - When the existing share certificate is bifurcated into small marketable lots. For example, a split of 1:10 means a share having face value of Rs 10 bifurcated is 10 shares of Rs one each.

Spot Delivery - Contract for execution on the date of the transaction or within next 24 hours.

Spot Market - Transactions for immediate delivery and settlement.

Squaring up - Entering into a reverse transaction during the settlement or subsequently resulting in the net position being zero, i.e. a buy transaction is squared up by a sell transaction.

Stock Option -Options pertaining to shares and securities.

Stock split - When a company changes the face value of its shares to a lower denomination.

Stop Loss - Order with a certain trigger price to avoid further loss on the existing outstanding position.

SWIFT - Society for Worldwide Interbank Financial Telecommunication.

Transfer Deed - Document recording the instance of transfer of share from one shareholder to other.

Underwriting - Entity guaranteeing the subscription of the public issue. Underwriters have to get registration from SEBI.

Venture Capital - Investment in a new un-started business venture with the prospect of reward.

X-Bonus / rights/ dividend - Without the entitlement of Bonus / rights/ dividend.

Yield - Percentage of return in dividend from a particular share.

Zero Interest Bond - Bonds issued by corporate without interest.

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