ACCOUNTING OF INDEX FUTURES TRANSACTIONS This Section deals with Accounting of Derivatives and attempts to cover the Indian

scenario in some depth. The areas covered are Accounting for Foreign Exchange Derivatives and Stock Index Futures. Stock Index Futures are provided more coverage as these have been introduced recently and would be of immediate benefit to practitioners. International perspective is also provided with a short discussion on fair value accounting. The implications of Accounting practices in the US (FASB-133) are also discussed. The Institute of Chartered Accountants of India has come out with a Guidance Note for Accounting of Index Futures in December 2000. The guidelines provided here in this Section below are in accordance with the contents of this Guidance Note. INDIAN ACCOUNTING PRACTICES Accounting for foreign exchange derivatives is guided by Accounting Standard 11. Accounting for Stock Index futures is expected to be governed by a Guidance Note shortly expected to be issued by the Institute of Chartered Accountants of India. Foreign Exchange Forwards An enterprise may enter into a forward exchange contract, or another financial instrument that is in substance a forward exchange contract to establish the amount of the reporting currency required or available at the settlement date of transaction. Accounting Standard 11 provides that the difference between the forward rate and the exchange rate at the date of the transaction should be recognised as income or expense over the life of the contract. Further the profit or loss arising on cancellation or renewal of a forward exchange contract should be recognised as income or as expense for the period. Example Suppose XYZ Ltd needs US $ 3,00,000 on 1st May 2000 for repayment of loan installment and interest. As on 1st December 1999, it appears to the company that the US $ may be dearer as compared to the exchange rate prevailing on that date, say US $ 1 = Rs. 43.50. Accordingly, XYZ Ltd may enter into a forward contract with a banker for US $ 3,00,000. The forward rate may be higher or lower than the spot rate prevailing on the date of the forward contract. Let us assume forward rate as on 1st December 1999 was US$ 1 = Rs. 44 as against the spot rate of Rs. 43.50. As on the future date, i.e., 1st May 2000, the banker will pay XYZ Ltd $ 3,00,000 at Rs. 44 irrespective of the spot rate as on that date. Let us assume that the Spot rate as on that date be US $ 1 = Rs. 44.80 In the given example XYZ Ltd gained Rs. 2,40,000 by entering into the forward contract.

Payment to be made as per forward contract (US $ 3,00,000 * Rs. 44) Amount payable had the forward contract not been in place (US $ 3,00,000 * Rs. 44.80) Gain arising out of the forward exchange contract

Rs 1,32,00,000 Rs 1,34,40,000 Rs 2,40,000

Recognition of expense/income of forward contract at the inception

AS-11 suggests that difference between the forward rate and Exchange rate of the transaction should be recognised as income or expense over the life of the contract. In the above example, the

difference between the spot rate and forward rate as on 1st December is Rs.0.50 per US $. In other words the total loss was Rs. 1,50,000 as on the date of forward contract. Since the financial year of the company ends on 31st March every year, the loss arising out of the forward contract should be apportioned on time basis. In the given example, the time ratio would be 4 : 1; so a loss of Rs. 1,20,000 should be apportioned to the accounting year 1999-2000 and the balance Rs. 30,000 should be apportioned to 2000-2001. The Standard requires that the exchange difference between forward rate and spot rate on the date of forward contract be accounted. As a result, the benefits or losses accruing due to the forward cover are not accounted.

Profit/loss on cancellation of forward contract

AS-11 suggests that profit/loss arising on cancellation of renewal of a forward exchange should recognised as income or as expense for the period. In the given example, if the forward contract were to be cancelled on 1st March 2000 @ US $ 1 Rs. 44.90, XYZ Ltd would have sustained a loss @ Re. 0.10 per US $. The total loss on cancellation of forward contract would be Rs. 30,000. The Standard requires recognition of this loss in the financial year 1999-2000.

Stock Index Futures

Stock index futures are instruments where the underlying variable is a stock index future. Both the Bombay Stock Exchange and the National Stock Exchange have introduced index futures in June 2000 and permit trading on the Sensex Futures and the Nifty Futures respectively. For example, if an investor buys one contract on the Bombay Stock Exchange, this will represent 50 units of the underlying Sensex Futures. Currently, both exchanges have listed Futures upto 3 months expiry. For example, in the month of September 2000, an investor can buy September Series, October Series and November Series. The September Series will expire on the last Thursday of September. From the next day (i.e. Friday), the December Series will be quoted on the exchange.

Accounting of Index Futures

Internationally, fair value accounting plays an important role in accounting for investments and stock index futures. Fair value is the amount for which an asset could be exchanged between a knowledgeable, willing buyer and a knowledgeable, willing seller in an arms length transaction. Simply stated, fair value accounting requires that underlying securities and associated derivative instruments be valued at market values at the financial year end. This practice is currently not recognised in India. Accounting Standard 13 provides that the current investments should be carried in the financial statements as lower of cost and fair value determined either on an individual investment basis or by category of investment. Current investment is an investment that is by its nature readily realisable and is intended to be held for not more than one year from the date of investment. Any reduction in the carrying amount and any reversals of such reductions should be charged or credited to the profit and loss account. On the disposal of an investment, the difference between the carrying amount and net disposal proceeds should be charged or credited to the profit and loss statement. In countries where local accounting practices require valuation of underlying at fair value, size=2 index futures (and other derivative instruments) are also valued at fair value. In countries where local accounting practices for the underlying are largely dependent on cost (or lower of cost or fair value), accounting for derivatives follows a similar principle. In view of Indian accounting practices currently

not recognising fair value, it is widely expected that stock index futures will also be accounted based on prudent accounting conventions. The Institute is finalising a Guidance Note on this area, which is expected to be shortly released. The accounting suggestions provided in the Indian context in the following paragraphs should be read in this perspective. The suggestions contained are based on the authors personal views on the subject.

Regulatory Framework
The index futures market in India is regulated by the Reports of the Dr L C Gupta Committee and the Prof J R Verma Committee. Both the Bombay Stock Exchange and the National Stock Exchange have set up independent derivatives segments, where select broker-members have been permitted to operate. These broker-members are required to satisfy net worth and other criteria as specified by the SEBI Committees. Each client who buys or sells stock index futures is first required to deposit an Initial Margin. This margin is generally a percentage of the amount of exposure that the client takes up and varies from time to time based on the volatility levels in the market. At the point of buying or selling index futures, the payment made by the client towards Initial Margin would be reflected as an Asset in the Balance Sheet.

Daily Mark to Market

Stock index futures transactions are settled on a daily basis. Each evening, the closing price would be compared with the closing price of the previous evening and profit or loss computed by the exchange. The exchange would collect or pay the difference to the member-brokers on a daily basis. The broker could further pay the difference to his clients on a daily basis. Alternatively, the broker could settle with the client on a weekly basis (as daily fund movements could be difficult especially at the retail level).

Example
Mr. X purchases following two lots of Sensex Futures Contracts on 4th Sept. 2000 :

October 2000 Series November 2000 Series

1 Contract @ 1 Contract @

Rs. 4,500 Rs. 4,850

Mr X will be required to pay an Initial Margin before entering into these transactions. Suppose the Initial Margin is 6%, the amount of Margin will come to Rs 28,050 (50 Units per Contract on the Bombay Stock Exchange). The accounting entry will be :

Initial Margin Account Dr To Bank

28,050 28,050

If the daily settlement prices of the above Sensex Futures were as follows:

Date 04/09/00 05/09/00 06/09/00

Oct. Series 4520 4510 4480

Nov. Series 4850 4800 --

07/09/00 08/09/00

4500 4490

---

Let us assume that Mr X he sold the November Series contract at Rs 4,810. The amount of Mark-to-Market Margin Money Sensex receivable/payable due to increase/decrease in daily settlement prices is as below. Please note that one Contract on the Bombay Stock Exchange implies 50 underlying Units of the Sensex.

Date 4th September 2000 5th September 2000 6th September 2000 7th September 2000 8th September 2000

October Series October Series November Series November Series Receive(RS) Pay(RS) Receive(RS) Pay(RS) 1,000 500 2,500 1,500 1,000 500 -

The amount of Mark-to-Market Margin Money received/paid will be credited/debited to Mark-toMarket Margin Account on a day to day basis. For example, on the 4th of September the following entry will be passed:

Bank A/c To Mark-to-market Margin A/c

th

Dr. 1,000 1,000

TOn the 6 of Sept 2000, Mr X will account for the profit or loss on the November Series Contract. He purchased the Contract at Rs 4,850 and sold at Rs 4,810. He therefore suffered a loss of Rs 40 per Sensex Unit or Rs 2,000 on the Contract. This loss will be accounted on 6th Sept. Further, the Initial Margin paid on the November Series will be refunded back on squaring up of the transaction. This receipt will be accounted by crediting the Initial Margin Account so that this Account is reduced to zero. The Mark to Margin Account will contain transactions pertaining to this Futures Series. This component will also be reversed on 6th Sept 2000.

Bank Account Dr Loss on November Series Initial Margin Mark to Market Margin

15,050 Dr 2,000 14,550 2,500

Margins maintained with Brokers

Brokers are expected to ensure that clients pay adequate margins on time. Brokers are not permitted to pay up shortfalls from their pocket. Brokers may therefore insist that the clients should pay them slightly higher margins than that demanded by the exchange and use this extra collection to pay up daily margins as and when required. If a client is called upon to pay further daily margins or receives a refund of daily margins from his broker, the client would again account for this payment or refund in the Balance Sheet. The margins paid would get reflected as Assets in the Balance Sheet and refunds would reduce these Assets. The client could square up any of his transactions any time. If transactions are not squared up, the exchange would automatically square up all transactions on the day of expiry of the futures series. For example, an October 2000 future would expire on the last Thursday, i.e. 26th October 2000. On this day, all futures transactions remaining outstanding on the system would be compulsorily squared up.

Recognition of Profit or Loss

A basic issue which arises in the context of daily settlement is whether profits and losses accrue from day to day or do they accrue only at the point of squaring up. It is widely believed that daily settlement does not mean daily squaring up. The daily settlement system is an administrative mechanism whereby the stock exchanges maintain a healthy system of controls. From an accounting perspective, profits or losses do not arise on a day to day basis. Thus, a profit or loss would arise at the point of squaring up. This profit or loss would be recognised in the Profit & Loss Account of the period in which the squaring up takes place. If a series of transactions were to take place and the client is unable to identify which particular transaction was squared up, the client could follow the First In First Out method of accounting. For example, if the October series of SENSEX futures was purchased on 11th October and again on 12th October and sold on 16th October, it will be understood that the 11th October purchases are sold first. The FIFO would be applied independently for each series for each stock index future. For example, if November series of NIFTY are also purchased and sold, these would be tracked separately and not mixed up with the October series of SENSEX.

Accounting at Financial Year End

In view of the underlying securities being valued at lower of cost or market value, a similar principle would be applied to index futures also. Thus, losses if any would be recognised at the year end, while unrealised profits would not be recognised. A global system could be adopted whereby the client lists down all his stock index futures contracts and compares the cost with the market values as at the financial year end. A total of such profits and losses is struck. If the total is a profit, it is taken as a Current Liability. If the total is a loss, a relevant provision would be created in the Profit & Loss Account. The actual profit or loss would occur in the next year at the point of squaring up of the transaction. This would be accounted net of the provision towards losses (if any) already effected in the previous year at the time of closing of the accounts.

Example
A client has bought Sensex futures for Rs 2,00,000 on 1st March and Nifty futures for Rs 2,50,000 on 7th March. On the 31st of March, the market values of these futures are Rs 2,20,000 and Rs 2,35,000 respectively. He has not squared up these transactions as on 31st March. The client has an unrealised profit of Rs 20,000 on the Sensex futures and an unrealised loss of Rs 15,000 on the Nifty futures. As the net result is a profit, he will not account for any profit or loss in this accounting period.

Alternative Example
A client has bought Sensex futures for Rs 2,00,000 on 1st March and Nifty futures for Rs 2,50,000 on 7th March. On the 31st of March, the market values of these futures are Rs 2,20,000 and Rs 2,15,000 respectively. He has not squared up these transactions as on 31st March. The client has an unrealised profit of Rs 20,000 on the Sensex futures and an unrealised loss of Rs 35,000 on the Nifty futures. As the net result is a loss of Rs 15,000, he will record a provision towards losses in his Profit or Loss Account in this accounting period. In the next year, the Nifty future is actually sold for Rs 2,10,000.

At this point, the total loss on that future is Rs 40,000. However, Rs 15,000 has already been accounted in the earlier financial year. The balance of Rs 25,000 will be accounted in the next financial year.

INTERNATIONAL PRACTICES
Statement of Financial Accounting Standard No. 133 issued by the Financial Accounting Standard Board, US defines the criteria /attributes which an instrument should have to be called as derivative and also provides guidance for accounting of derivatives. The Standard is facing tough opposition and controversies from the US business and industry. What is a Derivative? The standard defines a derivative as an instrument having following characteristics: y y A derivatives cash flows or fair value must fluctuate or vary based on the changes in an underlying variable. The contract must be based on a notional amount of quantity. The notional amount is the fixed amount or quantity that determines the size of change caused by the movement of the underlying. The contract can be readily settled by net cash payment

Accounting for Derivatives as per FAS 133

The standard requires that every derivative instrument should be recorded in the Balance Sheet as assets or liability at fair value and changes in fair value should be recognised in the year in which it takes place. The standard also calls for accounting the gains and losses arising from derivatives contracts. It is important to understand the purpose of the enterprise while entering into the transaction relating to the derivative instrument. The derivative instrument could be used as a tool for hedging or could be a trading transaction unrelated to hedging. If it is not used as an hedging instrument, the gain or loss on the derivative instrument is required to be recognised as profit or loss in current earnings.

Derivatives used as hedging instruments

Derivative instruments used for hedging the fair value of a recognised asset or liability, are calledFair Value Hedges. The gain or loss on such derivative instruments as well as the off setting loss or gain on the hedged item shall be recognised currently in income.

Example
An individual having a portfolio consisting of shares of Infosys and BSES, may decide to hedge this portfolio using the Sensex Futures Contract. The gain or loss on the index futures contract would compensate the loss or gain on the portfolio. Both the gains and losses will be recognised in the Profit and Loss Statement. If the hedge is perfect, gains and losses will offset each other and hence will not have any impact on the current earnings. However, if the hedge is not a perfect hedge, there would be a difference between the gain and the compensating loss. This would affect the current reported earnings of the individual. If the derivative instrument hedges risk of variations in cash flow on a recognised asset and liability, it is called Cash Flow hedge. The gain or loss on such derivative instruments will be transferred to current earnings of the same period or the periods during which the forecasted transaction affects the earnings. The remaining gain or loss on the derivative instrument if any shall be recognised currently in earnings.

Similarly if the derivative instrument hedges risk of exposures arising out of foreign currency transactions or investments overseas or in subsidiaries, it is called Foreign Currency Hedge.

Hedge Recognition
Accounting treatment for trading and hedging is completely different. In order to qualify as a hedge transaction, the company should at the inception of the transaction: y y y y y Designate the hedge relationship Document such relationship Identifying hedge item, hedge instrument and risks being hedged Expect hedge to be highly effective Lay down reasonable basis for assessment effectiveness. Ineffectiveness may be reported in the current financial statements earnings.

Earlier there was no concept of partial effectiveness of hedge. However FASB recognised that not all hedging transactions can be perfect. There can be a degree of ineffectiveness which should be recognized. The Statement requires that the assessment of effectiveness must be consistent with risk management strategies documented for that particular hedge relationship. Further the assessment of effectiveness is required whenever financial statements or earnings are reported.

Conclusion
The Indian accounting guidelines in this area need to be carefully reviewed. The international trend is moving towards marking the underlying securities as well as associated derivative instruments to market. Such a practice would bring into the accounts a clear picture of the impact of derivatives related operations. Indian accounting is based on traditional prudence where profits are not recognised till realisation. This practice, though sound in general, appears to be inconsistent with reality in a highly liquid and vibrant area like derivatives. TAXATION OF DERIVATIVE TRANSACTIONS IN INDEX FUTURES This Note seeks to provide information on the taxation aspects of index futures transactions. The contents of this Note should not be treated as advice or guidance or authoritative pronouncements. Readers are advised to consult their tax advisors before taking any action relating to their tax computations or planning. This Note is not intended for any such purpose. In the absence of special provisions, the current provisions, which are inadequate to handle the complexities involved are reviewed in this Note. It is expected that the Central Board of Direct Taxes (CBDT) will shortly provide guidelines for taxation aspects of Derivative transactions.

Speculation Losses Cannot be set off

Losses from Speculation business can be set off only against profits of another speculation business. If speculation profits are insufficient, such losses can be carried forward for eight years, and will be set off against speculation profits in these future years. (Section 73)

Definition of Speculative Transactions

Section 43(5) defines speculative transactions as those which are periodically or ultimately settled otherwise than by actual delivery or transfer. By this definition all index futures transactions will qualify prima facie as speculative transactions, as delivery of such futures is not possible. Exceptions are provided to this definition to cover cases where contracts are entered into in respect of stocks and shares by a dealer or investor to guard against loss in holdings of stocks and shares

through price fluctuations. Another exception is provide for contracts entered into by a member of a forward market or a stock exchange in the course of any transaction in the nature of jobbing or arbitrage to guard against loss which may arise in the ordinary course of his business as such member. The CBDT has issued a Circular No 23 dated 12th September 1960 on this area. The important provisions of this Circular are summarised below: y Hedging sales can be taken to be genuine only to the extent the total of such transactions does not exceed the ready stock, the loss arising from excess transactions should be treated as total stocks of raw material or merchandise in hand. If forward sales exceed speculative losses. Hedging transactions in connected, though not the same, commodities should not be treated as speculative transactions. It cannot be accepted that a dealer or investor in stocks or shares can enter into hedging transactions outside his holdings. By this interpretation, transactions in index futures will not be covered under the definition of hedging. Speculation loss, if any carried forward from earlier years, could first be adjusted against speculation profits of the particular year before allowing any other loss to be adjusted against those profits.

y y

Deemed Speculation
As per Explanation to Section 73, where any part of the business of a company 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 purchase and sale of such shares. The CBDT has issued a Circular No 23 dated 12th September 1960 on this area. The important provisions of this Circular are summarised below: y Company whose Gross Total Income consists mainly of Income chargeable under the heads Interest on Securities, Income from House Property, Capital Gains and Income from Other Sources Company whose principal business is Banking Company whose principal business is granting of loans and advances

y y

Most brokers and dealers are currently caught within the mischief of this Explanation, especially after the wave of corporatisation of brokers businesses. The Explanation however does not cover index futures.

Possibility of Speculation treatment

In view of the above provisions, it appears that the possibility of the Income Tax department treating index futures transactions to be speculative and taxed accordingly, is high as far as assessees carrying on business are concerned, unless a clarification is issued by the Central Board of Direct Taxes. Another possible view (as far as non-business assessees are concerned) could be that gains and losses from index futures be treated as short term capital gains. This view can gain support from the fact that such assessees are not covered within the ambit of Sections 43 and 73 referred to above.

Possible Arguments :

It is possible to argue that index futures transactions are not speculative transactions. Some lines of argument are explored below. 1. Section 43(5) speaks of purchase and sale of any commodity, including shares and stocks. Index futures are not commodities. Further, index futures are also not stocks and shares. Hence, section 43(5) does not apply to futures transactions. The question of examining the provisos (exceptions) does not arise. 2. Exceptions to speculative transactions as provided in Section 43(5) also include hedging transactions undertaken in respect of stocks and shares. Proviso (b) to Section 43(5) sates 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. It however remains to be seen whether index futures can be covered under stocks and shares. To our mind, it appears that if index futures are considered to be part of stocks and shares as per the wording of Section 43(5), then the proviso will also become applicable and hence hedging contracts through the mechanism of index futures will not be considered speculative. On the other hand, if index futures are not part of stocks and shares, then neither Section 43(5) nor the proviso apply and hence the entire gamut of index futures transactions will remain out of the purview of speculative transactions. 3. Explanation to Section 73 speaks of purchase and sale of shares of other companies. Index futures are not shares. Hence, this Explanation does not apply to futures transactions. It is believed and understood that foreign exchange forward transactions are currently not being caught within the mischief of Sections 43 and 73. This lends more comfort to the possibility of index futures also being left out of this net, though only experience will indicate the stand the Income tax department will take. Other Possible Controversies: 1. The Income tax department may take a stand that profits and losses accrue on a day to day basis, in view of the daily settlement procedure. This could be contrary to the accounting guidelines, which (as it currently appears) may advocate profit (loss) recognition at the expiry of the contract. 2. It appears currently that accounting guidelines will require recognition of unrealised losses at financial year end, but not unrealised profits. The Income tax department may not agree with this conservative treatment APPENDICES 1. 2. 3. 4. Section 43(5) Section 73 Section 28 - Explanation Circular No 23 dated 12th September 1960

APPENDIX 1 INCOME TAX ACT, 1961 Section 43 (5)1 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: Provided that for the purpose of this clause: a. a contract in respect of raw materials or merchandise entered into by a person in the course of his manufacturing or merchanting business to guard loss against loss through future price

fluctuations in respect of his contracts for actual delivery of goods manufactured by him or merchandise sold by him; or

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

c.

a contract entered into by a member of a forward market or a stock exchange in the course of any transaction in the nature of jobbing or arbitrage to guard against loss which may arise in the ordinary course of his business as such member

APPENDIX 2 INCOME TAX ACT, 1961 SECTION 73 Losses in speculation business 1. Any loss, computed in respect of a speculation business carried on by the assessee, shall not be set off except against profits and gains, if any, of another speculation business. 2. Where for any assessment year any loss computed in respect of a speculation business has not been wholly set off under sub-section (1), so much of the loss as is not so set off or the whole loss where the assessee had no income from any other speculation business, shall, subject to the other provisions of this chapter, be carried forward to the following assessment year,and:

i. ii.

it shall be set off against the profit and gains, if any, of any speculation business carried forward to the following assessment year; and if the loss cannot be wholly set off, the amount of the loss not so set off shall be carried forward to the following assessment year and so on.

3. In respect of allowance on account of depreciation or capital expenditure on scientific research, the provisions of sub-section (2) of section 72 shall apply in relation to speculation business as they apply in relation to any other business. 4. No loss shall be carried forward under this section for more than eight assessment years immediately succeeding the assessment year for which the loss was first computed. Explanation. Where any part 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. APPENDIX 3 Section 28

Explanation 2 Where speculative transactions carried on by an assessee are of such a nature as to constitute a business, the business (hereinafter referred to as speculation business) shall be deemed to be distinct and separate from any other business. APPENDIX 4 Central Board of Revenue Circular No. 23(XXXIX) of 1960 Dated 12th September 1960 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 sub-section (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. Boards 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 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 Boards decision The Board accepted this point. Attention is invited to Boards 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 no intention to speculate, the transaction should be excluded from the purview of speculative transactions Boards 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 a 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 treated as a loss arising in a speculative transaction. Point (iv) Bonafide hedging transactions by a dealer or investors on shares 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. Boards 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 dealers or the investors 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. Boards decision The suggestion is accepted. For the purpose of set-off under section 10 and section 24(1) (of the 1922 Act) the speculation loss of any year should be first set-off 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. ii. (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 years losses from other sources against the remaining part, if any, of the current years speculation profits, or to first set off the current years losses from non-specculation business and other sources against the current years 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 years speculation profit, whichever is advantageous to the assessee.