1. Taxation of Shares and Securities, Derivatives, Futures and Options
National Conference on Direct Taxes
Nagpur Branch of WIRC of ICAI
12th November 2010
Dhinal Shah
Chartered Accountant

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

3. CAPITAL GAINS Assurance and Advisory Business Services March 27, 20173

4. CAPITAL GAINS
Sec 45 - Gains arising from transfer of capital asset are chargeable as capital gains
Capital Asset
Definition of capital asset refers to any property held and not owned by the assessee
Asset must be a capital asset at the time of transfer
Includes shares and securities
Securities defined in Expl 2 to Sec 2(42A) to mean security as defined under Section 2(h) of Securities Contracts (Regulations) Act, 1956
Section 2(h) of Securities Contracts (Regulations) Act, 1956 defines security to include:
Shares, bonds, debentures or other marketable securities;
Derivatives;
Units or other instruments issued by any collective investment scheme or mutual fund;
Security receipt as per Section 2(zg) of Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act 2002;
Government securities;
Rights or interest in securities etc.

5. CAPITAL GAINS Transfer
Redemption of preference shares involves transfer – Anarkali Sarabhai (224 ITR 422) (SC)
Reduction of share capital is transfer – Kartikeya Sarabhai (228 ITR 163) (SC)
Date of transfer is date of lodging shares with the company
Family arrangement is not a transfer – Kay Arr Enterprises (299 ITR 348) (Madras)
Sec 45(2A) - Income arising from transfer of shares held in demat form would be taxable in the hands of beneficial owner and not in hands of depository

6. CAPITAL GAINS (cont.) Period of holding
Short term and long term – Sec 2(42A) and 2(29A)
Short term if following capital assets held for a period of less than 12 months:
Share held in a company;
Listed security;
Units in UTI or Mutual Fund
For remaining assets, short term if capital assets held for a period of less than 36 months
Points to be considered while computing period of holding
Period of previous owner to be included for capital assets acquired through modes specified in Section 49(1)
For renouncement of rights – Date when right to acquire rights shares comes into existence - Navin Jindal v ACIT (SC) (2010-TIOL-03-SC-IT)
For bonus shares – Date of allotment of bonus shares
For demat shares – FIFO method to be adopted (Circular No. 704 dt 28 April 1995)

7. CAPITAL GAINS (cont.)
Indexation benefit available for all long term capital asset
No indexation benefit available for bonds and debentures
Indexation benefit available from the first year in which asset was held by the assessee
Assets acquired under modes prescribed under Sec 49(1)
Indexation benefit available from year of acquisition of previous owner - Manjula Shah (Mumbai ITAT SB) (2009-TIOL-698-ITAT-MUM-SB)

8. TAXABILITY OF CAPITAL GAINS
Long term capital gains
Section 10(38)
Transfer of long term capital asset being equity shares of a company or unit of equity mutual fund
Chargeable to securities transaction tax
Exempt from tax
Section 112
Transfer of any other long term capital asset
Indexation benefit available
20%
Proviso to Section 112
Transfer of long term capital asset being listed securities or unit of mutual fund / UTI or zero coupon bond
Without indexation of cost, 10%
Short term capital gains
Section 111A
Transfer of short term capital asset being equity shares of a company or unit of equity mutual fund
15%
Other short term capital gains taxable at normal rates

9. CAPITAL GAINS – Conversion of capital assets into stock –in-trade
Conversion of capital assets into stock in trade – Sec 45(2)
• Shirinbai Kooka’s principle
• Sharkey’s principle
• Effect of conversion
– Sir Kikabhai Premchand, 24 ITR 506(SC)
– Dhanuka & Sons 124 ITR 24(Cal)
– ALA firm, 189 ITR 285 (SC)
• Possibility & proofs
• Cost of acquisition
– Keshavji Kaarsondas, 207 ITR 737(Bom),
– B.K.A.V. Birla (Cal)
– Kalyani Exports & Investments, 78 ITD 95 (Pune)
• Period of holding
– S.2 (42A)
– B.K.A.V. Birla 35 ITR 136 (Cal)
• Indexation
– Kalyani Exports & Investments and other views
– Explanation (iii) to s. 48
– Harmonious Construction
• Part shares and securities as stock in trade and remaining as investment.
– Century Builder – 5694/Mum./2000/dt
– Arjun Kapoor (70 ITD 161)(Del)
– Circular No. 4/2007 dt

10. BUSINESS INCOME VS CAPITAL GAINS
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BUSINESS INCOME VS CAPITAL GAINS 10

11. BUSINESS INCOME vs CAPITAL GAINS
Desired parameters • Intention - Period of holding • Frequency - Fund utilised • Time devoted - Set-up • Listing - PMS • Occupation – Scale • Owned fund v. Borrowed fund • Alternative occupation - Bank account • Sales/ Purchase - Utilisation • Treatment in books - Statutory requirements • MOA/AOA - Avg. holding period • Group companies - Promoters • No. of script - Genuineness Applicability of s. 45(2)

12. Comparative Analysis Basis Business Income Capital Gains Taxability
u/s 45 Computation u/s 48
Types
Speculative or Non-speculative
STCG or LTCG
Deduction allowed
All expenses incurred for carrying on the share trading business.
Only expenses incurred in connection with the transfer.
Indexation
No Indexation in any case
Indexation allowed in case of LTCG
Benefit if STT paid
Deduction as an expense u/s 36(1)(xv)
-LTCG exempt u/s 10(36) or 10(38). -STCG chargeable at concessional rate of 15% u/s 111A.
Set-off
Non-Speculative loss can be set off against any head except salary
-No loss as per S.14A -LTCL cannot be set-off against any head and has to be carried forward.

13. CIRCULAR NO. 4/2007, DATED
Principles to be adopted for distinction between shares held as stock-in-trade and investment
Assessee to produce evidence for distinction between shares held as stock-in-trade and held as investment – CIT Vs Associated Industrial Development Company (P) Ltd (82 ITR 586), (SC)
Relevant principles for determining capital gains vs business income as laid down by AAR in 288 ITR 641
Where a company purchases and sells shares, it must be shown that they were held as stock-in-trade
Substantial nature of transactions, the manner of maintaining books of accounts, the magnitude of purchases and sales and the ratio between purchases and sales and the holding would determine the nature of transactions;
Ordinarily the purchase and sale of shares with the motive of earning a profit, would result in the transaction being in the nature of trade/adventure in the nature of trade;
where the object of the investment in shares of a company is to derive income by way of dividend etc. then the profits accruing by change in such investment (by sale of shares) will yield capital gain and not revenue receipt.
Possible to have two portfolios, i.e., an investment portfolio comprising of securities which are to be treated as capital assets and a trading portfolio comprising of stock-in-trade

14. BUSINESS INCOME (contd.)
Issues
Frequency of transactions
Smt. Neerja Birla v. ACIT 66 ITD 148 (Mum.) and
Arjun Kapoor 70 ITD 161 (Del.)
Circular No.4/2007 dt
Tax Audit
The ICAI has in the Guidance Note on Tax Audit opined that in case of speculative transactions, total profits and losses shall be taken as turnover.

15. Deduction from business income
(1) Interest on borrowed capital (2) Brokerage, service tax, stamp duty (3) Penalties, bad delivery charges, auction charges (4) Demat account charges (5) Loss of shares & securities and non payment by brokers (6) Portfolio Management & advisory fees

16. DERIVATIVE TRANSACTIONS
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DERIVATIVE TRANSACTIONS 16

17. ISSUES IN DERIVATIVE TRANSACTIONS
Transactions in futures and options are for a fixed maturity and as per current stock market regulations are settled by cash either before or at their maturity date
Accounting Treatment
As per Guidance Note on Accounting for Equity Index and Equity Stock Futures and Options, derivative contracts not settled as on balance sheet date should be marked to market.
Any loss arising from mark-to-market should be recognised in Profit & Loss A/c and gains, if any, should be ignored
Tax Treatment
As per provisions of Section 43(5), amended with effect from 1 April 2006, any income arising from derivative transaction on recognised stock exchange would not be a speculative transaction
Tax Audit
ICAI in its Guidance Note on Tax Audit has opined that in case of speculative transactions, total profits and losses shall be taken as turnover. The same view may be taken in respect of derivative transactions.

18. TAXABILITY OF DERIVATIVE TRANSACTIONS
Issues
Whether gains / losses arising in derivative transactions would be taxable as business income or capital gains
Prior to
All the derivative transactions are speculative business transactions as amendment in section 43(5) is not retrospective
[Shree Capital Services Ltd (Kolkata ITAT) (318 ITR 1)]
Post
Business Income
Trading in derivatives is a business
High frequency of transactions
Taxable as business income [Morgan Stanley and Co. 271 ITR 416 (AAR), Royal Bank of Canada (323 ITR 380) (AAR)]
Capital Gains
Derivatives are capital asset
Settling of derivatives is transfer
Income arising from transfer of derivatives is capital gains

19. ALLOWABILITY OF MARK TO MARKET LOSS ON DERIVATIVE TRANSACTIONS
Issues
Whether losses arising in mark to market derivative transactions could be allowable under the Act
Whether it be considered as business loss or capital loss
Prior to
All the derivative transactions are speculative business transactions as amendment in section 43(5) is not retrospective
[Shree Capital Services Ltd (Kolkata ITAT) (318 ITR 1)]
Post
Business Loss
Trading in derivatives is a business
Mark to market loss is only notional loss
There is no transfer of capital asset on balance sheet date
No consideration is received for mark to market loss
Capital Loss
Derivatives are capital asset
Mark to market loss is loss arising on balance sheet date

20. SPECULATIVE TRANSACTIONS
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SPECULATIVE TRANSACTIONS 20

21. Speculation Business Speculative transaction – S.43(5)
Explanation 2 to S.28
Speculation Loss – S.73
Explanation to S.73

22. Speculative Transaction –s 43(5)
Contract for sale or purchase
Any commodity including stock & shares
Periodical settlement
Without actual delivery or transfer
Exceptions
Hedging – to guard loss on price fluctuations
Dealer or Investor
Jobbing or arbitrage
Member of a Forward market or Exchange
An eligible transaction of dealing in derivatives, with effect from A.Y

23. Explanation 2 to S.28 ‘Speculation transactions’ - ‘business’
Distinct and separate business
Separate computation for I T Act
R. Chinnaswamy Chettiar, 96 ITR 353 (Mad.)

24. Speculation Business Loss
Restriction on set-off
Jaggannath Mahadeo Prasad, 71 ITR 296 (SC)
Profit of Speculation Business only
Any such business
Priority of set-off–Cir. No. 23 dt (2)
Application to loss as also profit
Samba Trading & Invts. 58 TTJ 360(Mum)
Carry forward
Period of 8 succeeding years
By – legal heirs

25. Hedging - I Purchase- Also sale Different quality-quantity and value
Requirements
Two contracts
Commodities and scrips
Holdings & Contract of delivery
Guard against price fluctuations
Purchase- Also sale
Different quality-quantity and value
Cir. No. 23D dt
Different scrips
Circular 23D
Index F & O

26. Hedging - II Burden of proof Co-relation necessary
Joseph John, 67 ITR 74 (SC)
Co-relation necessary
Somasundaram Chettiar, 194 ITR 1 (SC)
Independent treatment
Arjan Khimji & Co., 121 ITR 421 (Bom)

27. Delivery Recalled delivery
Relevance of intention, payment and delivery
Abdul Gani Haji, Habib, 72 ITR 6 (Cal.)
Actual delivery
Blank transfer forms
Mangal Chand Bhanwarlal, 255 ITR 329 (Raj)
Delivery Notes
Davenport & Co., 100 ITR 715 (SC)
Recalled delivery
Clayton Commercial, 67 ITD 118 (Del)
Intended delivery
Gandhi Bhandari & Co., 83 ITD 680 (Pune)
Pending delivey
Sampath & Iyengar –Ninth Edn.
Judicial controversy
No delivery
Ramalinga Choodambigal 239 ITR 120 (Mad.)

28. Settlement Settlement without delivery F/E Forward contracts
S.63 of Indian Contract Act
Shantilal (P) Ltd., 144 ITR 57(SC)
Kamani Tubes Ltd., 207 ITR 298 (Bom)
F/E Forward contracts
Guard against fluctuation
Badridas Gauridu, 261 ITR 251 (Bom)
Loss in illegal contract
S.C. Kothari, 82 ITR 794 (SC)
Nature of deemed profit u/s. 41(1)
Rajputana Trading Co. Ltd. 72 ITR 286 (SC)

29. Stray transactions Concerted activity and efforts
Treatment under the law
Casual Income
Other sources
Capital Gains
Plurality of transactions
Indian Commercial Co., 106 ITR 465 (Bom)
G.P. Birla HUF, 199 ITR 173(Cal)

30. Deeming Fiction – Expl. to S.73
Company assessees
All companies
Shares
Purchase and Sale
Deemed Speculation Business
Exceptions
GTI mainly from specified heads
Banking Company
Loans & Advances Company

31. Issues relating to Expln. to S.73
(1) Applicability to shares held as investments
Mysore Rolling Mills Pvt. Ltd. 195 ITR 404(Kar)
Trade Team Pvt. Ltd. 54 ITD 36(Bom)
(2) Share broking-Whether business of purchase & sale of shares?
SRJ Securities Ltd. v ACIT 81 TTJ 484 (Del)
DCIT v Frontline Capital Services Ltd. 96 TTJ 201 (Del)
(3) Applicability to securities other than shares
Apollo Tyres Ltd. 255 ITR 273 (S.C.)
(4) Loss due to stock valuation is also covered by Expln to Sec 73
Prasad Agents (2009-TIOL-164-HC-MUM-IT) (Bombay HC)

32. Issues relating to Expln. to S.73 (Cont.)
(5) Whether the Expln. Applies to arbitrage, hedging,etc. excluded from the meaning of speculation u/s. 43(5)?
Rohini Capital Services Ltd. v DCIT 92 ITD 317 (Del)
(6) Settlement for breach of contract is not a speculative transaction
Bhandari Rajmal Kushalraj v ITO 96 ITR 401
(7) Explanation applies to dealing in shares of more than one company
Laxmi Feeds & Export Ltd (62 ITD 315)
(8) Exceptional cases of section 43(5) are also covered by Expl to Sec 73
(9) Speculative loss incurred in earlier years by a company can be set off against profits deemed to speculative under Expln to Sec 73
Lokmat Newspapers Pvt. Ltd (Bom HC)

33. Issues relating to Expln. to S.73 (cont.)
Lending /Banking company
Exception to general rule
Overriding Sec. 43(5)
C.N.M.P. Inv. (P) Ltd., 78 ITD 297 (Del)
GTI ‘mainly’ from
Criteria for determination
Relevance of other years
Amrutlal & Co., 212 ITR 540 (Bom)
Part to include whole
Arvind Investments Ltd., 192 ITR 365 (Cal)

34. ISSUES RELATING TO SEC. 14A
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ISSUES RELATING TO SEC. 14A 34

35. Background
Expenditure incurred for earning exempt income is not allowable as deduction under section 14A
The Assessing Officer (‘AO’) is empowered to determine the amount of expenditure in accordance with method prescribed under Rule 8D if:
AO is not satisfied with the correctness of the claim made by assessee or
If assessee claims that no expenditure is incurred to earn exempt income

36. Rule 8D Disallowance prescribed under Rule 8D is sum of :
Direct Expenditure incurred
for earning exempt income A
Proportionate Interest Expenditure
= Interest Expense X Average Value of Investments
Average Value of Total Assets B
Administrative Expenditure
@ 0.5% of Average Value of Investments C
Total
A+B+C

37. Ruling of Mumbai Special Bench – Daga Capital
Operation of Section 14A is automatic on earning exempt income
Computational provisions of Section 14A read with Rule 8D are procedural and clarificatory in nature
Rule 8D will apply retrospectively to all pending matters
Rule 8D also applicable for business income

38. Recent ruling of Bombay High Court in case of – Godrej & Boyce
The key principles laid down by the High Court are as under:
Section 14A will apply to dividend income although dividend has suffered dividend distribution tax
The computation method provided by rule 8D is constitutionally valid.
Rule 8D notified on 24 March 2008 will not have retrospective effect.
Rule 8D cannot be applied mechanically.
Only if AO is not satisfied with the claim of tax payer and has recorded reasons he can compute disallowance under section 14A.
Upto AY , in absence of rule 8D, AO can compute disallowance under section 14A by reasonable method.
No observation by High Court on applicability of Section 14A to business income

39. Recent ruling of Bombay High Court in case of – Godrej & Boyce
The facts in Godrej’s case as mentioned by the High Court are as under:
Major dividend from group companies
95% consisted of bonus shares
Most of the shares acquired several years earlier
No stage in the past except in last few years has the Department attributed any interest or expenditure towards dividend
Reserves of Rs.276 Cr and Capital of Rs.6.55 Cr more than the investments
In the relevant year no new investments, but disposal of some old investments

40. Scenario up to AY
Rule 8D notified on 24 March 2008 not to have retrospective effect
However, disallowance to be on reasonable basis
Could be argued that basis for disallowance to remain the same as made in the past assessments

41. Scenario post AY
Rule 8D to be applied only if AO not satisfied with the disallowance made by the tax payer himself and has recorded reasons
Responsibility of tax payer to satisfy the AO
Justify its claim by robust documentation and sound principles of apportionment
Responsibility will shift on the AO, to justify why disallowance computed by the tax payer should not be accepted
Could be argued that the basis for disallowance to remain the same as computed in the past

42. CONCLUSION
Up to AY
Disallowance under section 14A to be computed on a reasonable basis
Provide adequate documentation and submissions to minimize the disallowance to be computed on reasonable basis
Post AY
Could be argued that basis of disallowance to remain same as computed upto AY and not as per Rule 8D
Responsibility will shift on the AO, to justify why disallowance computed by the tax payer should not be accepted
Difficult for AO to disregard his own satisfaction with the basis of computation made upto AY

43. Thank You