DEEMED SPECULATION BUSINESS IN PURCHASE AND SALE OF SHARES- fall in stock valuations shall also be deemed speculative loss- so held by Bombay High Court- the decision needs a review and appeal before the Supreme Court because artificial meaning must be interpreted in a purpose seeking manner and not as per plain language.

[C.A. DEV KUMAR KOTHARI]

The fiction to deem normal loss as speculative business loss:

Herein the author attempts to discuss some aspects relating to deemed speculative business in purchase and sale of shares by certain companies. Relevant provision is section 73 of the Income Tax Act, 1961 in which a fiction is created by way of an explanation to deem real share business loss as speculative business loss. This provision is a fiction created under law to achieve certain objective. Therefore, in view of the author the deeming provisions must be applied only when it really serve its purpose and not in each and every circumstances.

Explanations to section 73- deemed speculation:

 According to explanation to section 73 of the Act, in case of certain type of companies business activity of purchase and sale of shares of other companies is deemed to be speculative business. Thus, loss arising from purchase and sale of shares (held as stock-in-trade) is deemed to be speculative loss for the purpose of set off in the previous year itself as well as for carry forward and set off in future. Thus, in specified circumstances in case of certain companies such loss is eligible for set-off against only speculation business income.

Definitions of certain terms relevant to income from profits and gains of business or profession.

Section 43. In sections 28 to 41 and in this section, unless the context otherwise requires⁷—

(5) ³²"speculative transaction"³³ means a transaction in which a contract³³ for the purchase or sale of any commodity, including stocks and shares, is periodically or ultimately settled otherwise than by the actual delivery³³ 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 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; ³⁴[or]

³⁴[(d) an eligible transaction in respect of trading in derivatives referred to in clause ³⁵[(ac)] of section 2³⁶ of the Securities Contracts (Regulation) Act, 1956 (42 of 1956) carried out in a recognised stock exchange;]

shall not be deemed to be a speculative transaction.

³⁷[Explanation.—For the purposes of this clause, the expressions-

(i) "eligible transaction" means any transaction,-

(A) carried out electronically on screen-based systems through a stock broker or sub-broker or such other intermediary registered under section 12 of the Securities and Exchange Board of India Act, 1992 (15 of 1992) in accordance with the provisions of the Securities Contracts (Regulation) Act, 1956 (42 of 1956) or the Securities and Exchange Board of India Act, 1992 (15 of 1992) or the Depositories Act, 1996 (22 of 1996) and the rules, regulations or bye-laws made or directions issued under those Acts or by banks or mutual funds on a recognised stock exchange; and

(B) which is supported by a time stamped contract note issued by such stock broker or sub-broker or such other intermediary to every client indicating in the contract note the unique client identity number allotted under any Act referred to in sub-clause (A) and permanent account number allotted under this Act;

(ii) "recognised stock exchange" means a recognised stock exchange as referred to in clause (f) of section 2³⁸ of the Securities Contracts (Regulation) Act, 1956 (42 of 1956) and which fulfils such conditions as may be prescribed and notified³⁹ by the Central Government for this purpose;]"

The above definition provides scope of speculative transactions and exceptions from the same. Transactions which are settled otherwise then actual delivery are generally speculative transactions, however, there are some exceptions provided to this general rule. Therefore, some transactions which are really of speculative nature but the same are not regarded as such. Such transactions are popularly called hedging transactions. Transactions in future and options at stock exchanges is a new feature and one of such exceptions.

Actually not speculative but deemed as speculative loss:

On other hand we also find that in some cases transactions which are really not speculative but loss arising there from is deemed as speculative loss in some circumstances, vide explanation to Section 73 of the Income Tax Act, 1961 which reads as follows:

Losses in speculation business.

Section 73.  xxx

" [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.] "

Summary of some relevant circulars:

Losses - Speculation business

Transactions not treated as speculative - The following transactions are taken out of the category of speculative transactions:

1. Contracts 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.

As regards hedging in raw materials, the ITO should not be too particular about the quantities and timing so long as the transactions constitute genuine hedging.

2. Contracts in respect of stocks and shares entered into by a dealer or investor in stocks and shares to guard against loss in his holdings through price fluctuations.

3. Contracts entered into by members of forward markets and stock exchanges in the course of any transactions in the nature of jobbing or arbitrate to guard against losses which may arise in the ordinary course of their businesses—Circular : No. 13(102)-IT/53, dated 8-9-1954.

SECTION 43(5)  Speculative transaction

Scope of 'speculative transaction' - Where bona fide 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.

Hedging transactions in connected, though not the same, commodities should not be treated as speculative transactions.

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.

Hedging transactions having reasonable relation to the value and volume of dealer's or the investor's holdings are excepted from the ambit of speculative transactions; but transactions in scrips outside his holdings are not.

For the purpose of set off under sections 10 and 24(1) of the 1922 Act, the speculation loss of any year should first be set off against the speculation profits of that year and the remaining amount of speculation profit, if any, should then be utilised for setting off any loss of that year from other sources.—Circular : No. 23D(XXXIX-4) [F. No. 412(4) 60/TPL], dated 12-9-1960.

Notified Stock Exchanges under clause (ii) in Explanation to clause (d) of proviso to clause (5) of section 43 - In exercise of the powers conferred by clause (ii) in the Explanation to clause (d) of the proviso to clause (5) of section 43 of the Income-tax Act, 1961 (43 of 1961) read with sub-rule (4) of rule 6DDB of the Income-tax Rules, 1962, the Central Government hereby notifies the following stock exchanges as recognised stock exchanges for the purposes of the said clause with effect from the date of publication of this notification in the Official Gazette, namely :—

(1) National Stock Exchange of India Limited, Mumbai

(2) Bombay Stock Exchange Limited, Mumbai

2. The Central Government may withdraw the recognition granted to the stock exchange if any of the conditions prescribed in rule 6DDA of the Income-tax Rules, 1962, subject to which the recognition is granted, is violated.

3. This notification shall remain in force until the approval granted by the Securities and Exchange Board of India is withdrawn or expires, or this notification is rescinded by the Central Government as provided in sub-rule (5) of rule 6DDB of the Income-tax Rules, 1962 - Notification No. - SO 89(E), dated 25-1-2006.

Fiction and deeming provisions:

The above provisions and relevant circulars explains that certain  fictions are  created by law to achieve certain purpose. Some speculative business is not considered as speculative business and some real business is considered as speculative business. Therefore, such fiction should be applied only when the relevant circumstances are such that require application of the fiction.

Case of companies where Explanation to s. 73 is applicable:

This Explanation apply to companies only who are engaged either fully or partly in business of 'purchase and sale' of shares of other companies.

Here it is worth to note that the expression business of trading in shares of other companies or loss from trading in shares of other companies, is not used. The words used are 'in purchase and sale of shares of other companies', therefore, there should be purchase and sale both. As this is a fictional provision, there should be strict but purposive interpretation. Therefore, it can be said that business activity of 'purchase and sale of shares' of other companies is only hit by the explanation.

The term 'Share' has not been defined in the Act. Therefore, the term has to be understood as per common understanding vis- a-vis provisions of the Companies Act, 1956. `Share' has been defined in the Companies Act, 1956 in section 2(46) as follows:

(46)  "share" means share in the share capital of a company, and includes stock except where a distinction between stock and share is expressed or implied."

As per the above meaning share may be a share in capital of a company and there can be different types of shares for example:

A. equity shares of different face value and types,

B. preference shares of different types,

C. stock in capital of company.

 The requirement is that it must represent a share in the capital of any company, which means that it must represent share already allotted and in force (not having been forfeited) which confers rights to dividend, voting rights and right to participate in surplus of company in the event of liquidation of the company. Share may be of any type of company like a private company, a public company, a listed company or a company whose shares are not listed on any stock exchange.

Rights to allotment of shares is not share:

 A right for allotment of shares is only a right to get shares allotted. This may be by way of 'right entitlement' or 'entitlement for preferential allotment' under any contract or understanding. Thus, if some one purchase and sell right entitlements or sells his rights to allotment of shares in private placement/preferential allotment etc. it will not amount to purchase and sale of shares and therefore deeming provision of explanation shall not be applicable.

 Debentures and bonds are not shares:

 Debentures and bonds are instruments used to raise loan/borrowed capital and not share capital. Even in case of debenture that are convertible in to shares, deeming provision shall not be applicable. Purchase and sale of debentures and bonds will not be covered by the explanation to section 73.

However if debentures were held as stock-in-trade and shares received on conversion are also held as stock-in-trade and then sold the revenue is likely to apply deeming provision in case there is loss. However, it can be argued with force that allotment of share cannot be called as purchase of share.

Shares of co-operative societies is not covered:

 The deeming provisions do not cover shares of co-operative societies. Because co-operative society is not a company within the meaning of the companies Act as well as within the scope of section 73. Therefore, purchase and sale of shares of co-operative societies shall not attract deeming provision.

Units of mutual funds and UTI are not shares of companies:

Mutual funds issue units to its investors. A mutual fund is not a company. Mutual fund is usually is a trust and its funds are managed by professional managers through Asset Management Company. There are no voting rights attached to units of mutual fund, as is the case of share of a company or a co-operative society.

UTI is deemed to be a company under section 32 of the UTI Act and distribution of income to unit holders is deemed to be dividend. However, the deeming provision being a fiction has to be applied for limited purposes.

Merely because UTI is deemed as company and distribution of income is considered as dividend, it will not make unit of UTI, as a 'share' as there has not been any specific provision to that effect. Thus the supreme court has held, in case of Apollo Tyres Ltd V CIT [2008 -TMI - 6081 - SUPREME Court] that purchase and sale of units of UTI shall not amount to purchase and sale of shares. Therefore, deeming provision of section 73 shall not apply.

Similarly units of other mutual funds cannot be called share of a company and purchase and sale of units will not be equated as purchase and sale of shares of other companies.

In this regard it is also worth noting that units and shares are qualitatively different. In case of shares there is right to attend general meeting and exercise voting rights which are in proportion of shares held/amount paid up on shares in case of a poll. However, in case of units of mutual fund generally such rights are not available. 

Detachable warrants/warrants are not covered:

Similarly instruments like detachable warrants giving right to subscribe shares/debentures in company is not share and therefore purchase and sale of detachable warrants/warrants shall not be hit by the explanation.  

Shares in "joint stock Company" (before registration) is not covered:

 Shares held in a 'joint stock company' within the meaning of section 566 of companies Act are not shares of a company. However, on registration of such joint stock company under section 574 of the Companies Act, joint stock company gets  duly incorporated as a company. Therefore, shares of such incorporated company shall be covered by the explanation to section 73 if they are purchased and sold. 

 Shares allotted cannot be called share purchased:

 If some one make an application or subscribe to the memorandum and articles of association and shares are allotted/issued, it cannot be said that shares have been purchased thought they have been acquired. Therefore, in case shares are acquired by way of application and allotment process and also held as stock-in-trade, it will not be hit by deeming provision.

Shares allotted on conversion of debentures cannot also be called, as 'shares purchased' therefore on sale of such shares explanation to S. 73 will not be applicable.

Shares allotted on merger, demerger etc. cannot be called as shares purchased:

Similarly in case of shares received in the events like merger and demerger of companies, cannot be called as shares purchased. Therefore, even if original shares were purchased and held as stock-in-trade, new shares received on merger, demerger etc. shall not be hit by deeming provision.

Forfeiture or redemption of share is not sale:

 Shares may be redeemed. Redemption generally apply in case of preference shares. Preference shares may be redeemed by way of conversion into new securities or payment in cash. In some circumstances, the company may forfeit shares. Some times in special circumstances like low market price of shares or inability to pay money due one may not pay amount due on allotment/call and shares may be forfeited by the company. In such circumstances it cannot be said that the shareholder has sold the shares to the company. Therefore, loss arising on redemption or forfeiture of shares held, as stock-in-trade shall not be hit by deeming provision.

Purchase and sale of own shares is not covered:

 A company may purchase its own shares for cancellation. However, in some circumstances if a company purchase its own shares and then sell the same, it will not be hit by explanation to section 73 because this explanation is applicable to only purchase and sale of shares of other companies.

Non-applicability to capital gains

This will not be applicable in case of computation under the head ' Capital gains', when the shares are held as investment and capital asset. In that case loss on transfer of shares of companies will be considered as loss under the head capital gains and not as business loss. However, in case of frequent purchase and sale of shares even if they are held as investment as per books of account of assesses some times Revenue Authorities may try to bring them in the category of business of purchase and sale of shares or adventure in nature of trade as trading activity falling under the head 'Business' and then to apply explanation to section 73.

Loss due to stock valuation should not be covered:

As discussed above the fiction apply to 'business of purchase and sale of shares of other companies', and not to trading in shares of other companies. Therefore, in case shares are purchased, and held as stock-in-trade and valued at market rate which is lower than cost then the loss due to fall in stock valuation should not be considered as speculative loss, because in this case there is no purchase and sale of shares. It cannot be said that the assessee company indulged in activity of purchasing and selling shares to claim loss to be set off against other normal business income or income under other heads of income.

Bombay High Court held stock valuation loss is to be deemed as speculative loss:

However, we find that in a recent judgment Bombay high Court has held that even loss due to stock valuation is to be deemed as speculative loss. An analysis of decision in case of M/s. Prasad Agents Private Ltd. Versus Income Tax Officer 2009 -TMI - 32754 - (Bom.) is made herein below:

a. The assessee is a non-banking financial company the appeal is for the assessment year 2001-2002.

b. The A.O. held that loss of Rs.6,00,877/- in share trading, was a speculation loss by virtue of Explanation to Section 73 of the Income Tax Act, 1961.

c. In an appeal preferred  before C.I.T. (A) the learned  C.I.T. (A)  in his order  observed that the business of the appellant consists of trading and investment in shares, debentures, bonds, mutual funds and other securities pursuant to its Memorandum of Association.

d. The CIT(A)  (not Tribunal  as mentioned in report) on consideration of  the arguments  and  placing  reliance on the order of the Delhi Bench in Aman Portofolio Pvt. Ltd., 92 ITD 324 (Delhi) as also the clarification issued by C.B.D.T.'s Circular No.204 dated 24th July, 1976 held that the A.O. was not justified to treat the loss in shares as speculative loss and accordingly the disallowance on that count was deleted.

e. On appeal of revenue the I.T.A.T. considered and noted that the Tribunal had taken the decision in the case of High Power Motors Pvt. Ltd. in ITA No.2094/Mum/2004 vide order dated 8th May, 2008. and has also placed reliance on the judgment of the Supreme Court in Chainrup Sampathram 24 ITR 481 where the Supreme Court had taken a view that loss or profit on account of valuation of closing stock has to be treated as speculative loss and allowable as revenue loss or revenue receipt as the nature of these profits are similar to the nature of business in trading of shares and for that reason allowed the appeal filed by the Revenue and set aside the order of C.I.T. (A).

f. The assessee preferred an appeal on four questions.  However in opinion of the High Court following two questions would arise for consideration:-

 " (i)Whether, on the facts and in the circumstances of the case and in law, the Tribunal was justified in treating Rs.6,00,877/- as speculation loss by dint of the Explanation to Section 73 of the Act?

(ii) Whether on the facts and in the circumstances of the case and in law, the Tribunal was correct in treating the loss Rs.6,00,877/- originating from and traceable simply and barely to the valuation of stock of shares as covered by the ken of the Explanation to Section 73 of the Act? "

g. Learned Counsel of assessee  submitted that in so far as Question (i) is concerned, the Explanation has to be read with Circular No.204 and if so read it would be clear that the object of the provisions is to curb the device sometimes resorted to, by business houses controlling groups of companies to manipulate and reduce the taxable income of companies under their control. It is submitted that it is not the contention of the Revenue that the Assessee controls the group companies and the transactions were done to manipulate and reduce the taxable income of the companies under their control.

h. Learned Counsel of revenue submitted that the language of the Explanation to Section 73 is clear. It is further submitted that no doubt the Circular has been issued. However, it is for the Court to decide the true effect of the Explanation to Section 73 and the effect of the Circular.

i. The Statement of Objects and reasons for the Explanation  provide as under:-

 " The main objectives of the amendments proposed to be made are to unearth black-money and prevent its proliferation; to fight and curb tax evasion; to check avoidance of tax through various legal devices, including the formation of trusts and diversion of income or wealth to members of family; to reduce tax arrears and to ensure that in future, tax arrears do not accumulate; to rationalise the exemptions and deductions available under the relevant enactments, and to streamline the administrative set-up and make it functionally efficient."

j. Counsel of revenue submitted that a perusal of the explanation would, therefore, make it clear that where any part of the business of the company consists in the purchase and sale of shares of other companies, for the purpose of Section 73 such company shall be deemed to be carrying on speculation business. On consideration of the said provision considering the language of the Explanation there is atleast no scope for ambiguity. The language of the Explanation is clear, in as much as a company carrying on business of purchase and sale of shares shall be deemed to be carrying on speculation business.

k. Courts  attention was invited to Circular No.204. The Circular contains the explanatory notes to Taxation Laws (Amendment) Act, 1975. Para.19.1 deals with the treatment of losses in speculation business. In so far as this paragraph is concerned there is no dispute in respect of its language wherein it uses the following expression:-

"The amending Act has added an Explanation to Section 73 to provide that the business of purchase and sale or shares by companies which are not investment or banking companies or companies carrying on business of granting loans or advances will be treated on the same footing as a speculation business."

L. The assesses Counsel, relies on paragraph 19.2. which reads as under:-

 "The object of this provision is to curb the device sometimes resorted to by business houses controlling groups of companies to manipulate and reduce the taxable income of companies under their control."

Courts view: the court considered that from this paragraph in the explanatory note in respect of the amending Act that the argument advanced on behalf of the assessee by their Counsel may merit some consideration. In our opinion, however, a gainful reading of paragraphs 19.1 and 19.2 read with language of the Explanation would not bear out the submission as made on behalf of the Assessee.

Para.19.1 does not refer to group companies, but refers to companies dealing with shares. It is in that context para.19.2 may be considered to mean that it also includes cases of such group companies. That does not mean that the explanation to Section 73 must be restricted only to group companies and not to other companies who carry on business of sale and purchase of shares either having no controlling interest in other companies or purchasing shares to control other companies. Once the language is clear the Court must give effect to the language for its true interpretation. If the language is in conflict with the Circular then to that extent to ignore the circular. The Circular cannot be read in the manner sought to be argued on behalf of the assessee as that would defeat the very object as set out in the statement of object and reasons to the Taxation Laws (Amendment) Act, 1973. In the light of the above, the Tribunal was right in taking the view it has taken. The first question is accordingly answered against the assessee.

Assessees counsel about stock valuation

 The learned Counsel of assessee then sets out that even if the question (i) is answered in favour of the assessee nevertheless the explanation specifically refers to purchase and sale of shares of any other companies and does not refer to losses suffered on account of book valuation. Our attention is invited to Section 43(5) which reads as under;-

"speculative transaction" means 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."

Court also considered Section 28 . Explanation 2 which reads as under:-

"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."

Explanation 2, to Section 28, therefore, treats the business in respect of speculative transactions to be distinct and separate from any other business. Section 43(5) holds those transactions to be speculation respect of which a settlement is otherwise periodically or settled other than by delivery or transfer of the commodity or scrips. Reading these provisions learned Counsel submits that the 'speculative value' would not fall within the explanation.

Court also considered Commissioner of Income Tax, West Bengal vs. Hind Construction Ltd., [2008 -TMI - 6313 - SUPREME Court] that if a person revalues his goods and shows higher value for them in his books he cannot be considered having sold his goods and made profits therein. The issue before the Supreme Court was in respect of sale of machinery. The Court there held that there was no sale.

That High Court thus found that judgment, therefore, would really of no much assistance.

Then the court consider ed the judgment of the Supreme Court in Chainrup Sampatram vs. Commissioner of Income-tax, West Bengal, 24 ITR 481, where the Supreme Court observed that the valuation of unsold stock at the close of an accounting period is a necessary part of the process of determining the trading results of that period and can in no sense be regarded as the source of such profits. The Supreme Court in Sanjeev Woollen Mills vs. Commissioner of Income Tax, [2008 -TMI - 6166 - SUPREME Court] considered the judgment in Chainrup Sampatram (supra) for the purpose of considering the rational behind valuation of the stock at  cost or market  value whichever is lower.

On the other hand on behalf of the Revenue the learned Counsel has contended that the  finding recorded by the Tribunal as also to the observations in Sanjeev Woolen Mills [2008 -TMI - 6166 - SUPREME Court] that there is nothing inconsistent in the said judgment of the view taken by the Tribunal.

Conclusion of Bombay High Court:

There can be no difference between the losses suffered in the course of trading by delivery and losses in terms of the book value.

 As long as the assessee is carrying on business of trading by way of purchase and sale of shares even if in respect of any financial year, there are no transaction and yet the company has stock in trade of shares, the book value will have to be considered for the purpose of considering the profit and loss in case of speculative business.

 There can be no doubt that the explanation to Section 73 cannot be read to mean only when there is a purchase and sale of shares in the course of the financial year.

 The explanation will cover both shares which are stock in trade and shares which are traded in the course of the financial year for the purpose of considering the loss and profit for that year.

AS per the High Court the Tribunal, has correctly answered the issue by holding that the loss of profit on account of valuation amounts to revenue losses or revenue receipt. The second question, therefore, also will have to be answered against the assessee and in favor of the Revenue.

Therefore, the court dismissed the appeal of assessee.

The weaknesses in arguments on behalf of assessee:

It appears that the counsels of the assessee could not forcefully point out various fictions and deeming provisions in relation of speculative business, as discussed in this write-up. Particularly various situations in which real thing is not considered as real but some thing else. When really speculation transactions are not considered speculative and when real transactions are considered as speculative. Thus, in law in both type of transactions artificial meaning have been given.

That the expression' business of purchase and sale of shares', is different from 'business of trading in shares' or share business. The expression 'purchase and sale of shares' has restricted meaning then the 'expression trading in shares' or business in shares.

That fiction can be applied when purchase and sale of shares result into loss and such loss is intended to be set off against other taxable income.

That when totally artificial meanings have been assigned, then the purpose of such artificial meaning ahs to be considered. In case of normal meaning, a circular may be disregarded, if language of law is clear, but this rule is not applicable when artificial meanings have been assigned only with a set purpose in mind. In case of such artificial meaning, the fiction should apply only when situation so warrant for application of the fiction and not in each and every circumstance.

That the Tribunal (now High Court also) has not considered the circular of the board in its totality. Undue importance has been given to one part pertaining to generality of issues and another part which is specific to the Explanation to Section 73 has been not given due importance.

That specific words 'purchase and sale of shares of other companies', has not been given proper importance.

Therefore, this decision of Bombay High Court is a fit case to be carried in appeal before the Supreme Court.