DERIVATIVES & SPECULATIVE TRANSACTIONS TAX ASPECTS

BOMBAY CHARTERED ACCOUNTANTS SOCIETY ON 8TH SEPTEMBER 2004 AT WALCHAND HIRACHAND HALL, IMC MUMBAI

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Happenings
Indian Derivatives in Hongkong Ex- RBI Governor-Mr. Bimal Jalan Volume on the Bourses Warren Buffet-www.berkshirehathaway.com Barring Bank-Nick Leeson Infosys-9th April, 2003

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Definitions
A Derivative is: an instrument whose value is derived from the value of one or more underlying assets like commodities, currency, securities, index, etc.
a financial product which is derived from another financial product or commodity.

a term having its origin in mathematics, which refers to a variable which has been derived from another variable.
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Features & Functions

Features
Independent Existence Dynamic in nature Zero value at inception Promise for performance Leverage Cash settled

Functions

Transfer of risk Price discovery Market completion

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Instruments & Players

Financial Instruments
Index Futures & Options Stock Futures & Options

Market Players
Speculators-Day and Position Players Hedgers Arbitrageurs

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Legal Framework
History and Need
SCRA

Wagering Contracts
Dr. L. C. Gupta Comm.-Regulatory Framework J. R. Varma Committee-Containment of Risk SEBI, BSE and NSE Pradip Kapasi & Co.
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F&O
Futures-An improvement over Forwards Options
Option & advance Call & Put American & European

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Futures

v.

Options

Dimensions Rate of Interest as a consideration Pricing Process Exposure Initial Cost Degree of Risk of the parties

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Trading Mechanism
Trading commenced in June 2000 SEBI authorized Exchanges Clearing House-Counter party Derivative segment Clearing and Trading Member Financial guarantee Deposit and Margins Index and Stocks-Options & Futures
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Exchange Operations
S & P CNX NIFTY and BSE SENSEX Standardized Contracts Trading Units & Minimum value Screen based trading Three months cycle Settlement Date-Last Thursday Initial margin-Determination-Cash equivalent Mark to Market-Daily Margins Cash settlement only Range of Strike Price determination Transaction Costs Pradip Kapasi & Co.
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Accounting Guidelines
Guidance Notes of ICAI
Accounting for Equity Index Futures-December 2000 Accounting for Equity Index Options-June 2002 Accounting for Equity Stock Options-June 2002 Accounting for Equity Index stock/stock FuturesOptionsSeptember 2003, ICAIJ

IAS 39 & IAS 32 FAS 133 AS 11, AS 13 & AS 16

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TAXATION

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General
Whether an asset-Security under SCRA

Whether ind. asset-Cash settled, Rights, Warrants

Whether a cap. asset-S. 2(14)- Property with value Head of Income-Relevant factors Likely concession for commodities
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Business Income
Whether Speculation Business Applicability of Explanation to S. 73 Treatment of provision for losses Book Profit Effect of daily settlement Method of Accounting Transaction Cost Valuation at the year end Time of accrual of premium for writer
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Speculative Transaction
S. 43(5)- 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 purposes 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 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 stock 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 in the ordinary course of his business as such member; Shall not be deemed to be a speculative transaction

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Speculation Business
Speculative Transaction S.43(5) S.2(h) of SCRA Shares & Stocks Commodity
S. 2(46) of Companies Act

Nirmal Trading Co. 82 ITR 382 (Cal)

Actual Delivery- Lex non cogit ad impossibilia Difficulties in applying Exceptions Explanation to S.73
Apollo Tyres, 255 ITR 273 (SC)
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Compound Financials, 67 ITD 304 (Bang.) ANZ Grindlays Bank, 88 ITD 53 (Del)

Business Income
Allowance of Provision
Book Profit & Provision for Losses

Mark to Market and accrual

Method of Accounting Transaction Cost Valuation of Stock and Fair value accounting Pradip Kapasi & Co.
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Capital Gains-General

Underlying Assumptions
Right an asset Fictional purchase & sale Merges with a larger asset

Situations
Cash settled Hedging Delivery settled

Short-Term Capital Asset Lapse of contract

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Capital Gains-Specific
Future Contracts-Buyer Specific Future Contracts-Seller Specific Call Options-Buyer Specific Call Options-Seller Specific Put Options-Buyer Specific Put Options-Seller Specific
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Audit
No Special provisions
Regulatory Requirements Income Tax Act
Value or Difference

Gross or Net

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SPECULATIVE TRANSACTIONS

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Speculation Business
Speculative transaction S.43(5)
Explanation 2 to S.48 Speculation Loss S.73

Explanation to S.73
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Speculative Transaction s 43(5)

Contract for sale or purchase Any commodity including stock & shares Periodical settlement Without actual delivery or transfer Exceptions
Hedging to guard loss on price fluctuations

Dealer or Investor

Jobbing or arbitrage Member of a Forward market or Exchange

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Explanation 2 to S.28
Speculation transactions - business
Distinct and separate business Separate computation for I T Act
R. Chinnaswamy Chettiar, 96 ITR 353 (Mad.)

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Speculation Business Loss

Restriction on set-off
Profit of Speculation Business only Any such business Priority of set-offCir. No. 23 dt. 12.9.1960 - 72(2) Application to loss as also profit
Samba Trading & Invts. 58 TTJ 360(Mum) Jaggannath Mahadeo Prasad, 71 ITR 296 (SC)

Carry forward Period of 8 succeeding years By legal heirs

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Deeming Fiction Expl. to S.73

Company assessees
All companies Shares Purchase and Sale

Deemed Speculation Business Exceptions

GTI mainly from specified heads Banking Company Loans & Advances Company
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Hedging - I

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

Purchase- Also sale Different quality-quantity and value

Different scrips
Circular 23D Index F & O

Cir. No. 23D dt. 12.9.1960

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

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Delivery

Relevance of intention, payment and delivery

Actual delivery
Abdul Gani Haji, Habib, 72 ITR 6 (Cal.) 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 Pradip Kapasi & Co.

No delivery

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Settlement
Settlement without delivery
S.63 of Indian Contract Act

Shantilal (P) Ltd., 144 ITR 57(SC) Kamani Tubes Ltd., 207 ITR 298 (Bom) Badridas Gauridu, 261 ITR 251 (Bom)

F/E Forward contracts

Guard against fluctuation

Loss in illegal contract Nature of deemed profit u/s. 41(1)

Rajputana Trading Co. Ltd. 72 ITR 286 (SC)
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S.C. Kothari, 82 ITR 794 (SC)

Stray transactions
Concerted activity and efforts Treatment under the law
Casual Income Other sources Capital Gains

Plurality of transactions
Indian Commercial Co., 106 ITR 465 (Bom) G.P. Birla HUF, 199 ITR 173(Cal)
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Cum-dividend purchase and sale

Dividend and Loss Effect of S.94(7) and (8) Effect ind. of statutory provisions
Soma Textiles & Ind., 87 ITD 326 (Ahd)

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Arbitrage
Nature of Operations Whether business Whether speculation business

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Tax Audit
Applicability
Growmore Exports Ltd., 78 ITD 95 (Mum)

Gross or Net

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Escaping the Explanation EE Investment in Shares EE-I

Business of purchase and sale Relevant factors Investment Income
Mysore Rolling Mills, 105 ITR 405 (Karn) Venkateshwara Rice & Oil Mills, 154 ITR 756 (AP) VIP Growth Fund Ltd., 95 Taxmann 13 (Delhi) Kruti Marketing P. Ltd., 118 Taxman 194 (Ahd)

Investment by a dealer in shares/stock broker Relevance of books of account

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Kethankumar A.Shah 242ITR 83 (Ker.)

Merfin (India) Ltd., 80 ITD 399 (Hyd)
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Relevance of S.70 to S.72 EE-II

Overriding effect
RPG Industries Ltd., 85 ITD 105 (Kol)(TM)

Expl. Over S. 43(5)

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

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Lending /Banking company EE-III

Exception to general rule Parameters Overriding . 43(5)
C.N.M.P. Inv. (P) Ltd., 78 ITD 297 (Del)

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GTI mainly from

Criteria for determination Relevance of other years

EE-IV

Amrutlal & Co., 212 ITR 540 (Bom)

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Composition of GTI
Mfg (+) Shares(-) O/I (+)

EE-V

Associated capital markets, ITA No. 1103, 1104, 3051/M/2001 dt.31.03.03 G Bench Rajan Enterprises, 41 ITD 369(Bom.)

Shares (-) O/I (+)

Eastern Aviation Ind. 208 ITR 1023 (Cal) Aryasthan Corp Ltd., 253 ITR 401 (Cal) Park View Properties Ltd. 261 ITR 473 (Cal.)

Shares (-) O/I (-)

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Share business - only business EE -VI

Part to include whole
Arvind Investments Ltd., 192 ITR 365 (Cal)

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In shares of 1 company EE -VII

Purchase & sale - shares of companies Plural to include singular - GCA
Laxmi Feeds & Exports Ltd. 62 ITD 315(Mum) Akrosh Inv. & Lea. (P) Ltd. 90 ITD 287(Mum)

IPO Subscriptions
Sri Gopal Jalan & Co. AIR 1964 SC 250

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Losses of a stock broker EE -VIII

Business of purchase and sale of shares Representative capacity Application of exception (c)
Same business test
Shri Shrawankumar Agarwal, 249 ITR233(All.). Pangal Vittal Nayak,74ITR754(SC) K.L.Jhunjhunwala, 139ITR371(Cal.) Nirmallkumar&Co. 161ITR413(Cal.) Shah Prataprai Nowpaji 139 ITR 149(AP)
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Losses of clients unpaid

Business Expenditure EE - IX
Effect on quantum of loss Common expenditure
Maharashtra Sugar Mils, 82 ITR 452 (SC) Rajasthan Warehousing Co., 242 ITR 450 (SC) Associated Capital Market Tdg & Inv.s case Section 14A

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Expl. and Derivatives

Not a share
Apollo Tyres, 255 ITR 273 (SC)

EE - X

S. 43(5) does not apply

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Loss on valuation of stock EE - XI

Purchase and sale of share
Associated Capital Markets case Nirvan Holding Pvt. Ltd., ITA No. 529/M/2001 Prudential Const Co. P. Ltd., 75 ITD 338 (Hyd)

Purchase and sale in different years

Sun Dist. & Mining, 68 Taxman 223(Cal.)

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Units and Other Sec.

Application to shares only
Apollo Tyres, 255 ITR 273 (SC)

EE - XII

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Objective behind Expl.

EE - XIII

Losses by dealing in shares of group companies

Cir. No. 204 (Para 19.2) dt. 24.07.1976, 110 ITR 32(St)

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THANK YOU AND GOOD LUCK

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