Taxation Matters Relating To Securities and Derivatives

Taxation matters relating to
securities and derivatives
Updated on :7th December’2010

Index
1.Transactions relating to securities and derivatives
1.1. Difference between Delivery in cash, Intraday trading in cash
segment and Derivatives (F&O) segments
2.CGs on shares held as investment
3.Investment Vs. Trading
3.1. Investment Vs. Trading (CBDT Circular)
3.2. Investment Vs. Trading (Case laws)
4.Hedging
5.Case Law on:
Part I Difference between hedging and speculative transaction
Part II Difference between trading income and business income
6.Derivatives
Index
7.Futures and Options
7.1. Futures and Options – Difference
7.2. Taxation of Futures and Options
8.Speculative transaction
8.1. Exclusion of Derivatives from definition of Speculative Transaction
8.2. Case Law:
Income from trading of shares will be speculative business within mea
ning of provision of Explanation to section 73
9.CBDT Circular on Notional losses on forex hedge not tax

deductible
Transactions relating to securities and
derivatives
• Transactions relating to securities and
derivatives can be of three types:
– Cash delivery
– Intraday trading
– Derivatives (F&O Segment)
Difference between Delivery in cash,
Intraday trading in cash segment and
Derivatives (F&O) segments
• For Tax purpose the Income tax act distinguishes between
Delivery, Intraday trading in cash segment and F&O segments.
• Consequently the tax treatment for profit/loss in all three are
different.
• CASH DELIVERY
– Delivery based income can be capital gain or business income.
– If, Delivery is deemed as investment in an asset. Then Capital gains rules
apply.
– On short term investment i.e. shares bought in cash segment and sold
before completion of 1 year from date of purchasing, you have to pay
15% of profits as STCG Tax.
– On long term investments i.e. shares sold after 1 year of holding the
long term tax applies which currently is NIL.
Any loss is allowed to be carry forward and set off for 8 years.
Difference between Delivery in cash, Intraday
trading in cash segment and Derivatives (F&O)
segments (Continued…)
• CASH INTRADAY
– Intraday trading in Cash segment is deemed as speculation, same as lottery or
betting on horse racing.
– The tax rate applicable on profits from speculation income is flat 30%.
– Any loss is allowed to be carry forward for 4 years, to be set off against future
speculation profits.
• DERIVATIVES/F&O
– Dealing in FnO is treated as Business. Thus normal business taxation rules apply as
they would to any other business. The rate of Tax is as per Slab applicable in the
respective year.
NOTE: TAX AUDIT IS ONLY REQD FOR BUSINESS INCOME I.E FOR INCOME FROM
DERIVATIVES/FUTURES AND OPTIONS. Not from Income from Capital Assets or
Speculation Income.
CGs on shares held as investment
• Short term Capital Gains: Gains arising from the sale
of shares held for less than 12 months
• Taxability of short term capital gains: Section 111A
of the Income tax Act - equity shares or equity
oriented funds which have been sold in a stock
exchange and securities transaction tax is paid on
such transaction then the short term capital gain
arising from such transaction will be chargeable to
tax @10% upto assessment year 2008-09 and 15%
from assessment year 2009-10 onwards.
(Continued…)
• If an assessee does the business of selling and
purchasing shares he cannot take advantage
of section 111A or section 10(38). In this case
income will be treated as business income.
• The deduction u/s 80C to 80U can be taken
from the income from short term capital gain
apart from the short term capital gain u/s111A
(Continued…)
• Long Term Capital Gains : The gain arising from the sale of shares held for 12
months or more is termed as long term capital gain.
• Taxability of Long term capital gains: Section 112(1) - any capital gain arising
from a long term capital asset being the listed securities which are sold outside
the stock exchange the long term capital gain shall be calculated on such
securities as below:
a) Tax arrived at @ 20% on such long term capital gain after indexation u/s 48 or
b) Tax arrived at @ 10 % on such long term capital gain without indexation
Whichever is less.
• The long term capital gain on equity shares or units of equity oriented mutual
fund which are sold in the stock exchange and on which securities transaction
tax is paid, is exempt u/s 10(38).
• No deduction is allowed from the long term capital gains from section 80C to
80U.
Investment Vs. Trading
• The tax liability depends upon whether the person is
carrying on an activity of investing or is carrying on a
business of share trading.
• To differentiate between the two, there are several
factors to be considered:
1. The motive for the original purchase as perceived at the
time of sale
If at the time of sale, it is seen that the original motive of
purchase was to earn a quick profit, this would support
the presumption that the transactions represent a
business.
Investment Vs. Trading (Continued…)
2. The period of holding of the shares
The shorter the period, the greater the presumption that the
transactions are in the nature of a business. One indicator of
this is the definition of long term capital asset vis-à-vis shares -
any shares held for more than 12 months are regarded as long
term capital assets. Generally, shares bought with the intention
of holding them for more than 12 months would be an
indicator that the transaction was intended as an investment.
3.The frequency of sale of shares
The more frequent the transactions, the greater the presumption
that it amounts to a business.
4. The circumstances responsible for the sale of shares
If the sale is necessitated by the need for funds for other personal
purposes, such as for payment of taxes or family functions, the
presumption would be that it is merely a realisation of investments.
5. The presence of a clearly discernible motive for the purchase of the
shares
Investors invest in business of the company and traders invest in
stock of the company. Investors go by fundamentals of the business
and traders go fluctuations in a stock price. For instance, where the
purchase of shares was with an intention to acquire controlling
interest in the company, such purchase of shares would be in the
nature of an investment. Similarly, the shares acquired by the
promoter of a company are generally in the nature of investments.
6. The relation of the share transactions to the normal business of the assessee
In the case of a sharebroker or an underwriter, acquisition of shares would
generally be regarded as an extension of his sharebroking or underwriting
business. On the other hand, shares acquired by a professional such as a
chartered accountant, lawyer or doctor would generally be considered to be
investments.
7. The treatment of the shares and profit or loss on their sale in the accounts of
the assessee
The treatment of the shares as stock-in-trade by the assessee would be one of the
indicators of his intention to treat it as a business.
8. The source of funds out of which the shares were acquired - borrowed or own
Investment out of borrowed funds would generally support the presumption of
existence of a business activity. On the other hand, acquisition of shares by
liquidation of another investment would support the presumption that the
transaction is one of change of investment from one form to another.
9. In the case of a company, the existence of an objects clause permitting it to trade in
shares
Since a company cannot carry on any business unless permitted by the objects clause
of its Memorandum of Association, its acquisition of shares would normally not be
regarded as a business activity in the absence of an objects clause permitting share
trading. Since a partnership firm can carry on any activity mutually agreed upon by its
partners, the absence of a clause in the partnership deed to carry on the business of
share trading would not make any difference.
10. The manner of acquisition of the shares
Where the shares were not purchased voluntarily but were inherited or received as a
gift, the presumption would generally be that the sale of such shares is a capital gain.
Similarly, shares acquired from the primary market for long term holding would
generally support the presumption of an investment activity, while acquisition of
shares from the secondary market could indicate either investment or business
activity.
11. The infrastructure employed for the share transactions
If the assessee employs people to assist him in his share activities, such as analysts,
dealing assistants, or acquires various assets such as computer hardware and software,
etc. for this purpose, it indicates an organized activity, supporting the presumption of a
business. On the other hand, investing through a discretionary portfolio manager is
indicative of an investment activity, since the investor does not have to be involved with
the activity of investment on a regular basis, but is merely concerned with the rate of
return on his funds employed.
12. Marketability of the shares
If the shares acquired are not readily marketable, generally the presumption would be
that they are held as investments. The very purpose of acquisition of shares held as
stock-in-trade is to make a quick profit, and the acquisition of non-marketable shares is
not consistent with such a purpose.
13. Delivery
If STT is paid and delivery is taken then its investment, and if no delivery and settled on
same day then trading income.
Investment Vs. Trading (CBDT Circular)
• There is no clarification in this regard in Income Tax Act, it all depends on the
intention of the assessee how he wants to treat the same in the books of
accounts.
• However circular has been issued by CBDT in this regard specifying that the
assessee can have two portfolio one is Investment in shares and second one
is of Business Stock. Enclosed herewith circular and Questionnaire given
by ITAT in various case laws.
A. Principles laid down by CBDT in circular 04/2007 dated 15.06.2007
“(i) Where a company purchases and sells shares, it must be shown that they were
held as stock-in-trade and that existence of the power to purchase and sell shares in
the memorandum of association is not decisive of the nature of transaction;
(ii) the substantial nature of transactions, the manner of maintaining books of
accounts, the magnitude of purchases and sales and the ratio between purchases and
sales and the holding would furnish a good guide to determine the nature of
transactions;
continued…
(iii) ordinarily the purchase and sale of shares with the motive of earning a profit, would
result in the transaction being in the nature of trade/ adventure in the nature of trade;
but where the object of the investment in shares of a company is to derive income by
way of dividend etc. then the profits accruing by change in such investment (by sale of
shares) will yield capital gain and not revenue receipt”.
• A. Details as per decision given by ITAT (Mum) in the case of Management

Structure & Systems Pvt. Ltd. (ITA No. 6966/Mum/2007 – AY: 2004-05)
• What is the intention of the assessee at the time of purchase of the shares (or
any other item) ? This can be found out from the treatment it gives to such
purchase in its books of account. Whether it is treated as stock-in-trade or
investment ? Whether shown in opening/closing stock or shown separately as
investment or non-trading asset ?
• Whether assessee has borrowed money to purchase and paid interest
thereon ? Normally, money is borrowed to purchase goods for the purposes of
trade and not for investing in an asset for retaining.
continued…
• What is the frequency of such purchases and disposal in that particular item ? If purchase and sale are
frequent, or there are substantial transactions in that item, it would indicate trade. Habitual dealing in
that particular item is indicative of intention of trade. Similarly, ratio between the purchases and sales
and the holdings may show whether the assessee is trading or investing (high transactions and low
holdings indicate trade whereas low transactions and high holdings indicate investment).
• Whether purchase and sale is for realizing profit or purchases are made for retention and appreciation
in its value ? Former will indicate intention of trade and later, an investment. In the case of shares
whether intention was to enjoy dividend and not merely earn profit on sale and purchase of shares ? A
commercial motive is an essential ingredient of trade.
• How the value of items has been taken in the balance sheet ? If the item in question are valued at cost,
it would indicate that they are investments or where they are valued at cost or market value or net
realizable value (whichever is less), it will indicate that items in question are treated as stock-in-trade.
• How the company (assessee) is authorized in memorandum of association/articles of association ?

Whether for trade or for investment? If authorized only for trade, then whether there are separate
resolutions of the board of directors to carry out investments in that commodity ? And vice versa”.
continued…
• These principles of law have to be applied to the following facts
(or answer to the below 8 question):
– Treatment given in the Books of Accounts by the assessee, whether treated
entire Investment in shares as an “investment” and not as “stock-in-trade”
– Whether aseessee is share broker or registered with any stock exchange
– Proportion of Long Term Capital Gain in Total Gain
– Whether any derivative transaction carried out by the assessee
– Whether any transaction without delivery carried out by the assessee
– Whether assessee has borrowed money for making investment or used
own surplus fund
– Whether the disclosure made by assessee in past in filing the return has
been accepted by the Income tax Dept
– Has assessee received substantial amount of dividend on the investment
Investment Vs. Trading (Case laws)
CASE LAWS
• Mere possibility of realisation of enhanced value will not render the transaction a business venture
– The question whether transactions of sale and purchase of shares were trading transactions or whether these
were in the nature of investment is a fixed question of law and fact. That depends on the question whether the
excess is an enhancement of the value by realising a security or a gain in an operation of profit-making. The
assessee might invest his capital in shares with the intention to resell these if in future their sale brings in a
higher price. Such an investment, though motivated by a possibility of enhanced value, will not necessarily
render the investment a transaction in the nature of trade. The totality of all the facts will have to be borne in
mind and the correct legal principles applied to these - Raja Bahadur Visheshwara Singh v. CIT [1961] 41 ITR
685 (SC).
– The surplus realised on the sale of shares would be capital if the assessee is an ordinary investor realising his
holding; but it would be revenue, if he deals with them as an adventure in the nature of trade. The fact that the
original purchase was made with the intention to resell if an enhanced price could be obtained by itself is not
enough, but in conjunction with the conduct of the assessee and other circumstances it may point to the
trading character of the transaction. For instance, an assessee may invest his capital in shares with the intention
to resell them if in future their sale may bring in higher price. Such an investment, though motivated by a
possibility of enhanced value, does not render the investment a transaction in the nature of trade. The test
often applied is, whether the assessee has made his shares and securities the stock-in-trade of a business - Raja
Bahadur Kamakhya Narain Singh v. CIT [1970] 77 ITR 253 (SC).
continued…
• Element of carrying on of business must be present
– When an owner of an ordinary investment chooses to realise it and obtains a higher
price for it than when he originally acquired it, the enhanced price is not a profit
assessable to income-tax, but where what is done is not merely a realisation or a
change of investment but an act done in what is truly the carrying on of a business,
the amount recovered as appreciation will be assessable - Raja Bahadur
Visheshwara Singh v. CIT [1961] 41 ITR 685 (SC).
• Where purpose is acquisition of managing agency, transaction is not a
business venture
– If the shares were acquired for obtaining control over the managing agency, the fact
that the acquisition of the shares was integrated with the acquisition of the
managing agency would not affect the character of the acquisition of the shares.
Subsequent disposal of some of the shares could also not convert what was a capital
acquisition into an acquisition in the nature of trade - Ramnarain Sons (P.) Ltd. v. CIT
[1961] 41 ITR 534 (SC)/Rameshwar Prasad Bagla v. CIT [1973] 87 ITR 421 (SC).
continued…
• Where initial intention itself is to make profit by resale, transaction is a
business venture
– It is no doubt correct to say that the principal consideration in determining whether
income from sale of shares is revenue income or capital gain is to find out what was the
purpose of purchase of those shares and, if the purpose was investment, the fact that in
varying the investment, the sale of those shares resulted in a profit will not make that
profit revenue income. However, this principle is not applicable to cases where it is found
that even the initial purchase of shares by the assessee was not for the purpose of
investment; for earning income from dividends, but was with a view to earn profit by
resale of those shares - Dalhousie Investment Trust Co. Ltd. v. CIT [1968] 68 ITR 486 (SC).
• Mere fact that assessee is a big land-holder is not relevant
– The fact that the assessee was, at the material time, a land-holder of a large estate, would
not mean that his transactions in shares, securities and bullion could not be transactions
in the nature of trade. They had, therefore, to be examined in the light of all the facts and
circumstances to ascertain whether they had been entered into in pursuit of a trading
activity - Raja Bahadur Kamakhya Narain Singh v. CIT [1970] 77 ITR 253 (SC).
continued…
• Acquisition out of borrowed capital, and source of acquisition, are
relevant factors
– In the case of purchase and sale of shares the relevant consideration would
be whether the shares have been purchased with borrowed capital and they
are speculative in nature, and whether they have been purchased in the
open market or from the company at the time of its incorporation or
expansion of its capital - CIT v. Sugar Dealers [1975] 100 ITR 424 (All.)
• Later stages of operations must also be looked into
– In order to determine whether an assessee is a dealer in shares or an
investor, the real question is not whether the transaction of buying and
selling the shares lacks the element of trading, but whether the later stages
of the whole operation show that the first step the purchase of the shares is
not taken as, or in the course of, a trading transaction - CIT v. H. Holck Larsen
[1986] 160 ITR 67 (SC).
Hedging
• Hedging is defined as ‘to enter in to transactions that will protect against
loss through a compensatory price movement’. A hedging transaction is
one which protects an asset or liability against a fluctuation in the
foreign exchange rate.
• Hedging contracts can be undertaken to protect investments as well as
stock in trades. Thus income from it can be either of the nature of
capital gains or income from business. Whatever it is, the cost of it will
form part of the cost of the product, to hedge which it is undertaken.
• Hedging contracts entered into by merchants to guard against future
losses through price fluctuation and derivatives transactions, and trading
in the F&O market are exceptions to this section 43(5) of the Income Tax
(IT) Act, 1961, and are not considered as speculative transactions from
assessment year (AY) 2006-07.
Case Law on:
Assessee in garb of entering hedging transaction cannot seek to enter

into speculative transaction in any stocks or shares other than one held
by him as inventory
CASE DETAILS
ITAT, MUMBAI BENCH ‘D’ ACIT v. Dinesh K. Mehta (HUF)
ITA No. 976/Mum/2009
RELEVANT PARAGRAPH
If all speculative transactions will be claimed as hedging transactions,
very purpose behind the provisions of section 73 not permitting set off of
speculative loss against business income will become redundant.
• The first part of Case law describes the difference between hedging
transaction and speculative transaction, whereas, the second part of it
describes the difference between trading income and business income
Case Law on:
(Continued…)
• ORDER
PER N.V. VASUDEVAN, JM :-
This is an appeal by the revenue against the order dated
28.11.2008 of learned CIT(A)-XII, Mumbai for A.Y. 2005-06.
• Conclusion of the case law:
– Hedging transactions, to fall under exception under section 43(5)(b) of
the Act, should be equal to the inventory of the shares held by the
assessee in its business of dealing in shares and securities and only to
this extent, transactions can be said to be hedging transaction which fall
within exception.
– An assessee who is a dealer in shares can also hold shares in investment
portfolio by demarcating the same in his books of accounts. The ruling of
consistency should apply when the facts are identical.
Case Law on:
(Continued…)
• The case law is detailed as below:
• Part I Ground No.1 raised by the revenue reads as follows :-
1. On the facts and circumstances of the case law, learned CIT(A) was justified in
treating the transactions in derivatives and futures as business (hedging)
transactions and not speculative transactions and thereby allowing the loss on
account of the transaction in derivatives as business loss instead of speculation loss.
2. The assessee is a HUF. It is engaged in the business of dealing in shares and

securities. In the profit and loss account, the assessee had debited loss on account
of Nifty hedging transactions of Rs. 1,30,41,270/-. Generally, in transaction of
purchases in Nifty Futures, which is a derivative instrument, there is no actual
delivery of shares. The transaction of purchase at a particular price on a future date
is entered into.
Case Law on:
(Continued…)
• On the specified date, the difference between the agreed price and price prevailing
on the specified date is settled and there is no Shri Dinesh K. Mehta HUF actual
transaction of purchase of the security. On such settlement there could be a loss or
profit.
• The assessee explained that the loss had occurred on account of
purchase of Nifty Futures and these transactions were purely hedging
transactions meant to minimize the loss due to fluctuation of price of
shares which the assessee does on delivery basis in the usual course of
business and held by him as stock-in-trade of his business.
• They are primarily to be regarded as speculative transactions. Loss arising
on account of speculative transactions cannot be set off against income
from regular business.
Case Law on:
(Continued…)
• Speculative transactions have been defined in section 43(5) of the Act to
mean transactions in which, contract for purchase and sale of any
commodity, including stocks and shares, is periodically or ultimately settled
otherwise than by actual delivery or transfer of commodity or script.
• There are certain exceptions to the above definition. Under clause (b) of
section 43(5) of the Act, a contract in respect of stocks and shares entered
into by a dealer or investor therein to guard against loss in his holdings of
stocks and shares through price fluctuations shall not be deemed to be
speculative transactions.
3. According to the Assessing Officer, transaction of derivatives trading in the form of purchase
of Nifty futures was in the nature of speculative transaction. In this regard the Assessing
Officer called for the details of transactions of purchase of Nifty futures, which resulted in the
loss debited to the profit and loss account.
Case Law on:
(Continued…)
• According to the Assessing Officer, to fall under exception under section 43(5)(b) of the Act,
hedging transactions should be equal to the inventory of the shares held by the assessee in
its business of dealing in shares and securities and only to this extent, transactions can be
said to be hedging transaction which fall within exception.
• The Assessing Officer noticed that on the date on which the assessee entered into
transactions of purchase of Nifty futures, position of inventory of shares held by the
assessee on that particular day was less than the value of purchase of Nifty futures.
• In this regard, Assessing Officer has analyzed 38 transactions given by the assessee. Shri
Dinesh K. Mehta HUF
The Assessing Officer thereafter referred to Circular No. 23 dated 12.9.1960; wherein CBDT
had clarified as follows:-
“Hedging sales can be taken to be genuine only to the extent the total of such transactions
does not exceed the ready stock.
Case Law on:
(Continued…)
• Hedging contract is a contract where the person dealing with the actual commodity ensures
himself against the adverse price fluctuations in that commodity in future. The transaction in the
future market corresponds to an earlier transaction in the ready market. The future transaction is
basically to off-set any loss that may arise on the earlier transaction.”
The Assessing Officer thereafter referred to certain judicial pronouncements in the
case of M.G. Brothers Vs. CIT, 154 ITR 695 (AP);
Pankaj Oil Mills Vs. CIT, 115 ITR 824 (Guj). The Assessing Officer thereafter pulled
out following principles :-
• “Thus the basic principles which emerge from the above case laws are follows :-
(i) the test of whether a Futures transaction is for hedging or for speculation hinges
on whether there already exists a related commercial position which is exposed
to risk of loss due to price fluctuation. Hedging can be taken to be genuine only
to the extent the total of such transactions does not exceed the ready stock.
Case Law on:
(Continued…)
(ii) In the case of pure speculator, as distinguished from a
hedger, futures transaction is a business by itself, as he has
no off-setting commercial position. The assessee would bear
the onus to prove that the forward contract of purchase
entered into by it was to safeguard it against the loss
through future price fluctuations in respect of any specific
contracts of sale for actual delivery of shares.
(iii) The basic material required to identify hedge would be as
under:-
(a) Details of original position and details of delivery
and payment for original position.
(b) Details of the hedging transaction
(c) Details of the final settlement of the transaction.
Case Law on:
(Continued…)
Analysis of assessee’s arguments and conclusion:
• In view of the principles which emerge from discussion of the above judicial precedents, it is clear that the onus is
on the assessee to prove that the transaction is not speculative, and it is Shri Dinesh K. Mehta HUF a hedging
transaction.
• In discharge of this onus, the assessee has also to prove that he has in his stock in trade shares which required to
be hedged by taking position in the futures market. To do this, the assessee has to prove at least that the total
value of his stock exceeds the money invested in purchase of Nifty Futures.
4. The Assessing Officer thereafter examined the inventory position of the assessee on various dates on which the
assessee entered into transaction of purchase of Nifty Futures. Wherever the value of purchases of Nifty Futures
were more than the value of inventory, they were treated as speculative transactions.
• For example on 17.6.2004, the value of inventory was Rs. 38.18 lakhs. The value of Nifty purchases were Rs.
1.49 crores. The loss on this transaction of purchase of Nifty Futures on settlement was treated as speculation
loss by the Assessing Officer and disallowed. On the above basis and analysis of transactions, the Assessing
Officer arrived at a sum of Rs. 98,66,738/- as the loss on account of speculative transactions and this loss was
not allowed as a deduction. In respect of the remaining loss the Assessing Officer found that the value of stock
was more than the value of purchase of Nifty Futures and these transactions were accepted by the Assessing
Officer as Hedging transactions and loss to that extent was allowed as deduction.
Case Law on:
(Continued…)
• Circular of CBDT dated 12.9.1960 gives a general guideline with regard to different kind of
speculative transactions. the value and volume of a dealer or investor holding hedging
transactions should be in equal proportion and hedging transactions can never be in excess.
• It is further a condition that hedging transaction should be in respect of very same script
held by an assessee as inventory in the business of stocks and shares. In the present case,
the Assessing Officer has not gone by script-wise tally but has gone by value of overall
inventory. To this extent, the Assessing Officer has been very reasonable.
• There is no doubt truth in the plea of the assessee that Nifty futures and index futures
are the only available form of derivatives trading through which the assessee could hedge
the value of inventory held by him. In such trading there cannot be any identification of
shares and tally the same with the inventory of shares held.
• This aspect has been taken care by the Introduction of clause (d) of section 43(5) of the
Act; therefore, from A.Y. 2006-07, the assessee may not face this difficulty. But in A.Y.
2005-06 as per the law as it stands, the claim of the assessee cannot be accepted. We
therefore reverse the order of CIT(A) and restore the order of the Assessing Officer on
this issue.
Case Law on:
(Continued…)
• Learned counsel for the assessee, however, submitted that the Board Circular itself
says that only excess of the assessee’s position in forward market over actual stock
held in ready market should be considered as speculative. For e.g. on 17.6.2004,
the inventory of stock held by the assessee was Rs. 36.18 lakhs and purchases in
Nifty Futures was Rs. 1.49 crores.
• In Nifty Futures purchase if the assessee incurs loss on the settlement day, the loss
proportionate to the value of inventory i.e. Rs. 36.18 lakhs should not be
considered as speculative loss. To that extent, the loss should be considered as
hedging transaction.
• We have already observed that the shares held as inventory and the shares in
which hedging transactions are entered into should be the same. The Assessing
Officer has however gone by overall value of inventory without individual script
wise tally.
• The plea of the assessee that to the extent of the value of inventory held by the
Assessee on a particular day, the loss in purchase of Nifty Futures should not be
considered as speculative while working out the loss is an acceptable plea
Case Law on:
(Continued…)
• To this extent, plea of the assessee is accepted and the Assessing
Officer is directed to work out speculation loss by taking excess of the
assessee’s position in forward market over actual stock in ready market
and work out the speculative loss proportionately.
• Thus, Ground No. 1 of the revenue is partly allowed.
• Part II Ground No. 2 raised by the revenue reads as follows :-
• On the facts and circumstances of the case and in law, learned CIT(A)
was justified in reversing the action of the Assessing Officer of
treatment of the short term capital gains of Rs. 16,02,739/- as income
under the head ‘profits and gains from business and profession’.
Case Law on:
(Continued…)
5.The assessee declared short term capital gains of Rs. 16,02,739/. The Assessing Officer
was of the view that since, the assessee was dealer in shares and was having huge volume
of share transactions in such business, it was hard to believe that the assessee held shares
as investment also, the Assessing Officer therefore treated the short term capital gain
declared by the assessee also as income from business.
6.On appeal by the assessee, learned CIT(A) held that gain in question was capital gain
and not business income for the following reasons :-
• “I have carefully considered the submissions made for the appellant and the assessment
order. It is true that when a dealer in shares holds shares, the first presumption would be
that the shares held by him constitute stock in trade.
• But, at the same time, it is not impossible that there cannot be a situation in which the
assessee, who is dealer in shares also hold some shares as investment.
• This proposition is supported by the decision of Mumbai Tribunal in the case of J.M.
Share and Stock Brokers Ltd., relied by the appellant. As such, I am not inclined to accept
the Assessing Officer’s line of reasoning that a dealer in shares cannot hold shares as
investments.
Case Law on:
(Continued…)
• In fact, the very decision relied by the Assessing Officer in Motilal Oswal has been reversed
by the same Tribunal on rehearing. The fresh decision on rehearing supports the appellant’s
case. An assessee who is a dealer in shares can also hold shares in investment portfolio by
demarcating the same in his books of accounts has also been upheld by the Delhi Tribunal
in the case of Arjun Kapur Vs. DCIT, 70 ITD 161 (Del) and the Chandigarh Tribunal in Vesta
Investments & Trading Co. P. Ltd. Vs. CIT, 70 ITD 200 (Chd).
• The onus will be of course on the assessee to show that the shares have been correctly so held as
investments notwithstanding the fact that he is a trader in shares.
• In my view, the manner in which the assessee holds the shares will determine whether the shares are
investment or stock in trade. Generally, if the volume and frequency in dealing in shares is large, the
period of holding is low, the conduct of the assessee should point towards that of a trader.
• If this also coupled with the use of borrowed capital the Shri Dinesh K. Mehta HUF presumption in
favour of trading would be strengthened. The manner in which the transactions are accounted
whether a trading transaction or as investment would also be a relevant indicator as this would
manifest the intention of the assessee in dealing with the shares.
Case Law on:
(Continued…)
• The role of the assessee as an investor should be more passive in comparison to that of
a dealer, whose role would be aggressive. The words ‘passive’ means that the role of the
investor would be less in frequency and volume, more use of own capital and larger
period of holding.
• In short, it is the conduct of the assessee that should be the determining factor. In the
assessee’s case, its allocation of shares as stock in trade and investment appears to be
justified by its manner in dealing with the shares.
• Whereas the shares involved in high frequency in dealing large volumes etc. have been
treated as stock in trade, the ones in which the period of holding is larger and volume of
holding is small has been demarcated as investments.
• This method of accounting has been followed consistently by the assessee and this
lends credibility to the assessee’s allocation of shares as investments and stock in
trade.
Case Law on:
(Continued…)
• The Supreme Court in its decision in the case of Karam Chand Thapar Bros. P. Ltd.
Vs. CIT, 82 ITR 899 (sc) has observed that the circumstances that the assessee has
shown particular shares in its books as well as balance sheet as investments is a
relevant factor in deciding whether the shares are investment or stock in trade.
The assessee has reasonably discharged its onus of showing that it is in dual role
of both investor and dealers of shares by cogent evidence and reasoning.
• The Assessing Officer is therefore directed to treat the income of Rs. 16,02,739/-
as income from short term capital gains and not as business income. This ground
of appeal is allowed.
7. We are of the view that the order of learned CIT(A) does not call for
any interference. Admittedly, the assessee had treated the shares in
question as investment in his books of accounts.
Case Law on:
(Continued…)
• In fact, in A.Y. 2004- 05, the assessee had declared short term capital
gain on sale of investments (shares held as investment) the same was
accepted by the Assessing Officer in assessment u/s. 143(3) of the Act.
• The Hon'ble Bombay High Court in the case of CIT Vs. Gopal Purohit,
ITA No. 1121 of 2009 dated 6.1.2010 has held that ruling of
consistency should apply when the facts are identical.
• In view of the acceptance of the assessee’s stand by the revenue in
the past and other circumstances considered by the learned CIT(A), we
see no reason why a different treatment should be Shri Dinesh K.
Mehta HUF given in the present assessment year. For the reasons
given above, we uphold the order of learned CIT(A) and dismiss
Ground No. 2 raised by the revenue.
• In the result, appeal by the revenue is partly allowed.
Derivatives
• Definition:
International Accounting Standard 39 defines a derivative in paragraph 9 as under:
“A derivative is a financial instrument or other contract with all three of the following
characteristics:
(a) its value changes in response to change in a specified interest rate, financial instrument
price, commodity price, foreign exchange rate, index of prices of rates, credit rating or
credit index, or other variable, provided in the case of a non-financial variable that the
variable is not specific to a party to the contract (sometimes called the “underlying”);
(b) It requires no initial net investment or an initial net investment that is smaller than
would be required for other types of contracts that would be expected to have a similar
response to changes in market factors; and
(c) it is settled at a future date.”
The Exposure Draft issued by the Institute of Chartered Accountants of India (ICAI) on the
proposed Accounting Standard on “Financial Instruments – Presentation” also uses the
same definition as used in IAS 39.
Futures and Options
Today, futures and options based on individual stocks or based on stock
indices are the major derivatives traded on the exchanges.
• OPTIONS
Definition:
The ICAI Guidance Note on Accounting for Equity Index and Equity Stock
Futures and Options describes options as under:
“An Option is a type of derivative instrument whereby a person gets the
right to buy or sell at an agreed amount an underlying asset on or before
the specified future date. He is not under any obligation to do so.”
The specified price at which the option can be exercised is called the “strike
price”.

Futures and Options (Continued…)
• FUTURES
Definition
The ICAI Guidance Note on Accounting for Equity Index and
Equity Stock Futures and Options describes “futures” as:
“A futures contract, like a forward contract, is an agreement
between two parties to buy or sell an asset at a certain time in
future for an agreed price. Futures contracts are normally traded
on an exchange. To make trading possible, the exchange specifies
certain standardised features of the contract. The exchange may
also provide for guarantee mechanism to ensure that each party
to the contract meets its obligations and, consequently, risk from
default by parties is minimised.”
Futures and Options - Difference
The difference between futures and options is also highlighted by the Guidance
Note. “Futures and options are both standardised derivative instruments
traded on a stock exchange.
• The difference between these two types of derivative instruments is in respect of
the rights and obligations of the parties involved in such contracts.
• In case of a futures contract, both the parties are under obligation to complete
the contract on the specified date. However, in case of options contract, the
buyer/holder has a right, but no obligation to exercise the Option, whereas the
seller/writer has an obligation but no right to complete the contract.”
• Like options, futures are also for a maximum maturity of 3 months, expire on
the last Thursday of the month and have to be cash settled on maturity.
• Unlike options, where the premium fluctuates for a particular strike price, the
price of the futures itself fluctuates for a particular maturity. On maturity, the
purchaser of a futures contracts receives (or pays) the difference between the
market price of the underlying share/index on the maturity date and the
purchase price of the futures, while the seller of a futures contract receives (or
pays) the difference between the sale price of the futures and the market price
of the underlying share/index on the maturity date.
Taxation of Futures and Options
• Till Assessment Year 2005-06, the Income Tax Act, 1961 did not have
any special provisions dealing with taxation of derivatives transactions
in general, and dealing with futures and options in particular, though
derivatives contracts have been traded on Indian stock exchanges
since 2000.
• The Finance Act 2005 has amended the proviso to section 43(5), with
effect from Assessment Year 2006-07, to provide that derivatives
trading transactions would not be regarded as speculative
transactions, subject to the fulfilment of certain conditions.
• To understand the taxation, one also needs to understand the
accounting treatment. The ICAI Guidance Note on Accounting for
Equity Index and Equity Stock Futures and Options provides guidance
as to how such transactions are to be accounted for.
Taxation of Futures and Options (Continued…)
• In substance, the Guidance Note provides that the profit or loss on the
transactions is to be recognised only on expiry of the future or option or on
squaring up of the position.
• Till such time of expiry or squaring up, the initial margin, premium paid and
mark-to-market margin is to be accumulated and shown as a current asset.
Taxable as business income
In most cases, derivatives transactions are regarded as business transactions
on account of the following factors:
1. The purpose behind entering into most derivatives transactions is to earn
profit from short-term fluctuations in market prices.
2. The period of any derivatives transaction cannot exceed 3 months, and
such transactions are invariably short-term transactions.
3. Often, the sheer volume of trades in derivatives transactions entered into
by a person on an ongoing basis indicates that it amounts to a business.
There can be situations where derivatives transactions may not amount to a
business.
Taxation of Futures and Options (Continued…)
Taxable as capital gains:
• Derivatives transactions can even be carried on by an investor to hedge his investment
portfolio.
• A derivative, the transaction in the nature of hedging of investments, being a security and a
right under a contract, is certainly a valuable right, and can be regarded as property and
therefore as a capital asset.
• When the transaction is squared up by an opposite corresponding transaction, there is
certainly a transfer.
Where the squaring up is on expiry of the contract, whether a transfer is said to be taken
place, is ruled by section 2(47) and Supreme Court case of CIT vs. Grace Collis 248 ITR 323.
Definition of “transfer” as per section 2(47) is, “the expiry of such a contract can possibly be
regarded as an extinguishment of the rights in the asset”.
As held by the Supreme Court in the case of CIT vs. Grace Collis 248 ITR 323, the definition
of “transfer” in section 2(47) clearly contemplates the extinguishment of the rights in a
capital asset distinct and independent of such extinguishment consequent upon the
transfer itself.
(Continued…)
• A view is therefore possible that on expiry of the derivatives, there is a transfer
of the capital asset. The gains or losses arising from such derivatives would
accordingly be taxable under the head “Capital Gains”.
• Though such income would be taxable under the head “Capital Gains”, and the
derivatives transactions would be subject to Securities Transaction tax, such
gains would not be entitled to the concessional tax treatment for short-term
capital gains under section 111A, since the benefit of that section is available
only to equity shares in a company or a unit of an equity oriented mutual fund.
Taxable as Interest
• Another common practice in the stock markets is arbitrage between the cash
market and the futures market. It is a well known fact that the difference in
prices between the futures market and the cash market is primarily dictated by
the short-term interest rates, and such difference is normally equivalent to the
interest that one would earn on short term lending.
(Continued…)
• Therefore, a person having surplus funds may buy shares in the cash market,
while simultaneously selling an equal amount of futures of the same share in the
futures market. He would take delivery of the shares bought in the cash market.
• On maturity of the futures, the shares bought in the cash market would be sold
in the cash market.
• Since the futures would be squared off at the cash market price, the profit on the
transaction would normally consist mainly of the difference between the initial
purchase price in the cash market and the initial sale price in the futures market,
with small adjustments for expenses such as brokerage, securities transaction
tax, service tax and the market spread between the buying and selling quotes in
the cash market.
• If one looks at the substance of these transactions, they are not motivated by a
desire to earn profits, but just to avail of the benefit of the short term interest
rates.
(Continued…)
• The income element in the transactions is determined right at
the outset, and does not fluctuate to any material extent, even if
there is substantial volatility in the market.
• Going by the principle of the substance of the transaction, a
view is possible, as was being taken in the past in the case of
vyaj badla transactions, that such transactions are in the nature
of earning of interest, though they take the form of arbitrage
transactions.
• It may be however noted that other factors, such as frequency
of transactions, nature of other business carried on, etc.,
would also determine whether such transactions are business
transactions or investment or interest.
Speculative transaction
• Section 43(5) of the Income Tax Act defines Speculative Transaction as a
transaction in which a contract for the purchase or sale of any commodity,
including stocks and shares, is periodically or ultimately settled otherwise
than by the actual delivery or transfer of commodity or scrips”.
• Hence, two important criterions are necessary for any transaction to be
categorized as speculative transaction viz.;
– Purchase or sale of any commodity including stocks and shares, and
– It is periodically or ultimately settled otherwise than by the actual delivery or transfer

of commodities or scrips.
• Both the conditions are cumulative and must be fulfilled for the transaction
to be qualified as a "Speculative Transaction".
Speculative transaction (Continued…)
• Taxability of speculative transaction: Losses

will not be eligible for set off against any other
income of the assessee and will be carried
forward and set off against speculative income
only up to maximum of four years.
Exclusion of Derivatives from definition of Speculative Transaction
• A new clause (d) had been added to the proviso to section 43(5),
excluding certain derivatives trading transactions from the definition
of “speculative transaction”. Such exclusion of derivatives
transactions is however subject to certain conditions.
• These conditions are:
a. The transaction should have been carried out electronically on a
screen-based system.
b. The transaction should have been carried out through a stock
broker or sub-broker or other intermediary registered under section
12 of the SEBI Act, 1992 in accordance with the Securities Contracts
(Regulation) Act, 1956, the SEBI Act, 1992 or the Depositories Act,
1996 and the rules, regulations or bye-laws made or directions issued
under those Acts, or by banks or mutual funds.
Exclusion of Derivatives from definition of Speculative Transaction (Continued…)
c. The transaction has to be carried out on a recognised stock exchange.

d. The transaction has to be supported by a time-stamped contract note
issued by such stock broker, sub-broker or other intermediary.
e. The contract note has to indicate the unique client identity number
allotted under SCRA, SEBI Act or Depositories Act and the permanent
account number of the client. SEBI had made such unique identity number
mandatory for all investors for transactions exceeding Rs.5 lakhs.
‘According to Circular No 3/2006, dated 27-2-2006, trading in derivatives of
securities carried out on a recognised stock exchange shall not be deemed
as speculative transaction.’
Case Law:
Income from trading of shares will be speculative business within meaning of provision of Explanation to section 73
• Where assessee is engaged in trading in share of other companies, the business carried
on by the assessee will be in nature of speculative business and profit or loss arising
therefrom will be the speculative profit/loss.
CASE LAW DETAILS

• Decided by: ITAT, DELHI BENCH `B’, DELHI, In The case of: ITO v. Ethno Financial Research
Pvt. Ltd., Appeal No.: ITA No. 2743(Del) of 2008, Decided on: October 30, 2009
RELEVANT PARAGRAPH
• We have heard both the parties and perused the material on record. In this case there no
dispute that trading in shares is not the business of the assessee as authorised by
memorandum of association.
• It is also a fact that the assessee had dealt in futures and as well as traded in shares of
other companies. Therefore, we have to see the applicability of the Explanation to section
73 of the Act to the share trading activities carried on by the assessee.
Case Law:
Income from trading of shares will be speculative business within meaning of provisi
on of Explanation to section 73
(Continued…)
• As per Explanation to Section 73. where any part of business of the company an
assessee whose gross total income is not consisted mainly of income which is
chargeable under the heads “Interest on securities”, “Income from house
property’”, “Capital gains” and “Income from other sources”, or a company, the
principal business of which is the “business of banking or the granting of loans
and advances”; consists of the purchase and sale of shares of other companies,
such company shall, for the purposes of section 73, be deemed to be carrying on
a speculation business to the extent to winch the business consists of the
purchase and sale of such shares.
• The provisions of Explanation to section 73 do not distinguish between the
transaction of trading in shares on actual delivery or without delivery basis.
• Admittedly the assessee does not fall under any of the exceptions provided in the
Explanation and hence, the purchase and sale of shares traded during the year
under consideration is in nature of speculation business within the meaning of
proviso to section 73 of IT Act, 1961.
CBDT issued Instruction No. 03/2010, dated
23-3-2010 to assessing officers
Notional losses on forex hedge not tax deductible
• A company that makes a notional loss on a forex derivative

because of a fall in its value cannot deduct the loss from its
taxable income since it still owns the derivative. This has been
clarified by Central Board of Direct Taxes (CBDT), the apex body
that administers direct taxes in the country.
• The tax body has made it clear that if no sale or settlement has
actually taken place and the loss on mark-to-market basis has
resulted in reduction of book profits, such a loss would not
allowed to be offset against income.
23-3-2010 to assessing officers (Continued…)
• Going one step further, the tax body has said that if a loss arises on actual
settlement of such contracts and is not a notional or marked to market book entry,
the assessing officer would have to determine whether such a loss is on account of
a “speculative” u/s 43(5) or an “eligible” transaction.
• A speculative loss can only be offset against a speculative profit and can be carried
forward for only four years.
• However, an eligible transaction is one that is carried out electronically on a
screen-based system through a stock broker or a sub-broker on a recognised stock
exchange. This means that if companies buy or sell dollars or pounds on NSE and
MCX-SX, the losses or profits arising out of such transactions can be offset against
business gain or losses and can be carried forward for eight years.
• The CBDT has said that after due diligence by the assessing officer, such losses or
gains may be offset against taxable income.
23-3-2010 to assessing officers (Continued…)
• Thus, MTM losses provided for in the books in

compliance with AS-30 may be disallowed
pursuant to specific instruction from the CBDT.
However, the Special Bench of ITAT in the case
of DCIT v. Bank of Bahrain and Kuwait, has
held that these losses are allowable.

Taxation Matters Relating To Securities and Derivatives

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Taxation Matters Relating To Securities and Derivatives

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Taxation matters relating to

securities and derivatives

Updated on :7th December’2010

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

• How the company (assessee) is authorized in memorandum of association/articles of association ?

Assessee in garb of entering hedging transaction cannot seek to enter

2. The assessee is a HUF. It is engaged in the business of dealing in shares and

• Part II Ground No. 2 raised by the revenue reads as follows :-

– Purchase or sale of any commodity including stocks and shares, and

– It is periodically or ultimately settled otherwise than by the actual delivery or transfer

• Taxability of speculative transaction: Losses

c. The transaction has to be carried out on a recognised stock exchange.

CASE LAW DETAILS

• A company that makes a notional loss on a forex derivative

• Thus, MTM losses provided for in the books in

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