DERIVATIVES & SPECULATIVE TRANSACTIONS – TAX ASPECTS BOMBAY CHARTERED ACCOUNTANTS SOCIETY ON 8TH SEPTEMBER 2004 AT WALCHAND HIRACHAND HALL, IMC MUMBAI Pradip Kapasi & Co. Chartered Accountants 1 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 Pradip Kapasi & Co. Chartered Accountants 2 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. Pradip Kapasi & Co. Chartered Accountants 3 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 Pradip Kapasi & Co. Chartered Accountants 4 Instruments & Players • Financial Instruments Index Futures & Options Stock Futures & Options • Market Players Speculators-Day and Position Players Hedgers Arbitrageurs Pradip Kapasi & Co. Chartered Accountants 5 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. Chartered Accountants 6 F&O • Futures-An improvement over Forwards • Options Option & advance Call & Put American & European Pradip Kapasi & Co. Chartered Accountants 7 Futures • • • • • • v. Options Dimensions Rate of Interest as a consideration Pricing Process Exposure Initial Cost Degree of Risk of the parties Pradip Kapasi & Co. Chartered Accountants 8 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 Pradip Kapasi & Co. Chartered Accountants 9 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 CostsPradip Kapasi & Co. Chartered Accountants 10 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 Pradip Kapasi & Co. Chartered Accountants 11 TAXATION Pradip Kapasi & Co. Chartered Accountants 12 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 Pradip Kapasi & Co. Chartered Accountants 13 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 Pradip Kapasi & Co. Chartered Accountants 14 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 Pradip Kapasi & Co. Chartered Accountants 15 Speculation Business • Speculative Transaction – S.43(5) • S.2(h) of SCRA • Shares & Stocks S. 2(46) of Companies Act • Commodity Nirmal Trading Co. 82 ITR 382 (Cal) Compound Financials, 67 ITD 304 (Bang.) ANZ Grindlays Bank, 88 ITD 53 (Del) • Actual Delivery- Lex non cogit ad impossibilia • Difficulties in applying Exceptions • Explanation to S.73 Apollo Tyres, 255 ITR 273 (SC) Pradip Kapasi & Co. Chartered Accountants 16 Business Income • Allowance of Provision • Book Profit & Provision for Losses • Mark to Market and accrual • Method of Accounting • Transaction Cost • Valuation of StockPradip and Fair value accounting Kapasi & Co. Chartered Accountants 17 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 Pradip Kapasi & Co. Chartered Accountants 18 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 Pradip Kapasi & Co. Chartered Accountants 19 Audit • No Special provisions • Regulatory Requirements • Income Tax Act Value or Difference Gross or Net Pradip Kapasi & Co. Chartered Accountants 20 SPECULATIVE TRANSACTIONS Pradip Kapasi & Co. Chartered Accountants 21 Speculation Business • Speculative transaction – S.43(5) • Explanation 2 to S.48 • Speculation Loss – S.73 • Explanation to S.73 Pradip Kapasi & Co. Chartered Accountants 22 Speculative Transaction –s 43(5) • • • • • Contract for sale or purchase Any commodity including stock & shares Periodical settlement Without actual delivery or transfer Exceptions Hedging – to guard loss on price fluctuations Dealer or Investor Jobbing or arbitrage Member of a Forward market or Exchange Pradip Kapasi & Co. Chartered Accountants 23 Explanation 2 to S.28 • ‘Speculation transactions’ - ‘business’ • Distinct and separate business • Separate computation for I T Act R. Chinnaswamy Chettiar, 96 ITR 353 (Mad.) Pradip Kapasi & Co. Chartered Accountants 24 Speculation Business Loss • Restriction on set-off • • • • Jaggannath Mahadeo Prasad, 71 ITR 296 (SC) Profit of Speculation Business only Any such business Priority of set-off–Cir. No. 23 dt. 12.9.1960 - 72(2) Application to loss as also profit Samba Trading & Invts. 58 TTJ 360(Mum) • Carry forward • Period of 8 succeeding years • By – legal heirs Pradip Kapasi & Co. Chartered Accountants 25 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 Pradip Kapasi & Co. Chartered Accountants 26 Hedging - I • Requirements Two contracts Commodities and scrips Holdings & Contract of delivery Guard against price fluctuations • Purchase- Also sale • Different quality-quantity and value Cir. No. 23D dt. 12.9.1960 • Different scrips Circular 23D Index F & O Pradip Kapasi & Co. Chartered Accountants 27 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) • Pradip Kapasi & Co. Chartered Accountants 28 Delivery • • Relevance of intention, payment and delivery Abdul Gani Haji, Habib, 72 ITR 6 (Cal.) Actual delivery Blank transfer forms Mangal Chand Bhanwarlal, 255 ITR 329 (Raj) Delivery Notes Davenport & Co., 100 ITR 715 (SC) Recalled delivery Clayton Commercial, 67 ITD 118 (Del) Intended delivery Gandhi Bhandari & Co., 83 ITD 680 (Pune) Pending delivey Sampath & Iyengar –Ninth Edn. Judicial controversy Pradip Kapasi & Co. No delivery Chartered Accountants 29 Settlement • Settlement without delivery S.63 of Indian Contract Act Shantilal (P) Ltd., 144 ITR 57(SC) Kamani Tubes Ltd., 207 ITR 298 (Bom) • F/E Forward contracts Guard against fluctuation Badridas Gauridu, 261 ITR 251 (Bom) • Loss in illegal contract S.C. Kothari, 82 ITR 794 (SC) • Nature of deemed profit u/s. 41(1) Rajputana Trading Co. Ltd. 72 ITR 286 (SC) Pradip Kapasi & Co. Chartered Accountants 30 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) Pradip Kapasi & Co. Chartered Accountants 31 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) Pradip Kapasi & Co. Chartered Accountants 32 Arbitrage • Nature of Operations • Whether business • Whether speculation business Pradip Kapasi & Co. Chartered Accountants 33 Tax Audit • Applicability Growmore Exports Ltd., 78 ITD 95 (Mum) • Gross or Net Pradip Kapasi & Co. Chartered Accountants 34 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 Kethankumar A.Shah 242ITR 83 (Ker.) • Relevance of books of account Merfin (India) Ltd., 80 ITD 399 (Hyd) Pradip Kapasi & Co. Chartered Accountants 35 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.) Pradip Kapasi & Co. Chartered Accountants 36 Lending /Banking company EE-III • Exception to general rule • Parameters • Overriding . 43(5) C.N.M.P. Inv. (P) Ltd., 78 ITD 297 (Del) Pradip Kapasi & Co. Chartered Accountants 37 GTI ‘mainly’ from EE-IV • Criteria for determination • Relevance of other years Amrutlal & Co., 212 ITR 540 (Bom) Pradip Kapasi & Co. Chartered Accountants 38 Composition of GTI EE-V • Mfg (+) Shares(-) O/I (+) 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 (-) Pradip Kapasi & Co. Chartered Accountants 39 Share business - only business EE -VI • Part to include whole Arvind Investments Ltd., 192 ITR 365 (Cal) Pradip Kapasi & Co. Chartered Accountants 40 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 Pradip Kapasi & Co. Chartered Accountants 41 Losses of a stock broker EE -VIII • Business of purchase and sale of shares • Representative capacity • Application of exception (c) Shri Shrawankumar Agarwal, 249 ITR233(All.). • Same business test Pangal Vittal Nayak,74ITR754(SC) K.L.Jhunjhunwala, 139ITR371(Cal.) Nirmallkumar&Co. 161ITR413(Cal.) • Losses of clients unpaid Shah Prataprai Nowpaji 139 ITR 149(AP) Pradip Kapasi & Co. Chartered Accountants 42 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 Pradip Kapasi & Co. Chartered Accountants 43 Expl. and Derivatives EE - X • Not a ‘share’ Apollo Tyres, 255 ITR 273 (SC) • S. 43(5) does not apply Pradip Kapasi & Co. Chartered Accountants 44 Loss on valuation of stock EE - XI • Purchase and sale of share Associated Capital Market’s 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.) Pradip Kapasi & Co. Chartered Accountants 45 Units and Other Sec. EE - XII • Application to shares only Apollo Tyres, 255 ITR 273 (SC) Pradip Kapasi & Co. Chartered Accountants 46 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) Pradip Kapasi & Co. Chartered Accountants 47 THANK YOU AND GOOD LUCK Pradip Kapasi & Co. Chartered Accountants 48