Before discussing the judgment, author consider proper to discuss some general aspects of computation of income, set off, carry forward and set off of carried forward losses from business or profession.

Computation of income:

As per section 14 of the Act, income of any assessee is computed under different heads. One of heads of income is ‘profits and gains of business or profession’ vide clause D of section 14.

In section 14, we find a single head for normal business and speculative business both. Any distinction has not been made.

Income from business or profession is computed in accordance with provisions of part D of Chapter IV which consists of sections 28- 44 DB. This chapter includes general provisions and special provisions applicable in some circumstances.

Section 28 is general provision, this also indicates scope of income from business or profession in an inclusive manner. This is also considered as one of residuary provision for including some income under the head as well as for allowing some expense under this head because what is taxable is ‘income’, and for computing ‘income from business or profession’ , any income of nature of income from business or profession is to be included and any expenses for carrying such business or profession are to be deducted. This is subject to exceptions and conditions found in other provisions of the Act relating to computation of income.

The sub-head “specualtive business”:

In section 14 there is no head of income like ‘income from speculative business’. We find this category or sub head through an Explanation found in section 28. The relevant portion of section 28 is reproduced below:

Profits and gains of business or profession.

28. The following income shall be chargeable to income-tax under the head "Profits and gains of business or profession",—

(i) the profits and gains of any business or profession which was carried on by the assessee at any time during the previous year ;

xxx – not relevant for present study

Explanation 2.—Where speculative transactions carried on by an assessee are of such a nature as to constitute a business, the business (hereinafter referred to as "speculation business") shall be deemed to be distinct and separate from any other business.

******

On reading of the Explanation 2, we find that if some transaction(s) is / are of speculative nature and they constitutes business of assessee, then the business in such transactions is deemed to be a distinct business and considered a ‘speculative business’. Therefore, a business which is not considered as speculative business is generally called normal businesses.

In form of return of income also we find separate computation of business of the nature of normal business and speculative business.

Therefore, we find that the Explanation 2 to section 28 crates a separate category of income falling under the head ‘income from business or profession’. Therefore, income from business or profession is to be divided under two classes (a) normal business or professional income and (b) speculative business income.

It appears that the provisions of Explanation 2 to section 28 was not at all considered and in any case not emphasized before the court in case of DLF.

Speculative transactions deemed not to be speculative transactions:

On reading of S.43(5) we find definition of speculative transactions and exceptions from speculative transactions. Thus some transactions which are speculative transactions but are not considered as speculative transactions and the result of such transactions is considered as normal business income or loss.

The computation of normal business income and speculative business is to be made by applying provisions of S.43(5).

If a transaction, though of speculative nature, falls into exempted category and thus not considered as speculative transaction , under S. 43(5), then the computation of income or loss from such transactions is to be made as normal business income or loss u/s 28.

Rules 6DDA and 6DDB of the Income-tax Rules,1962 are also relevant to section 43(5) and prescribed stringent conditions for stock exchanges to follow to be eligible for notification and to confer benefits of non speculative transactions in derivatives.

The transactions which are speculative transactions and are not excluded from scope of speculative transactions results into speculative profit or loss.

Delivery based transactions in shares- but loss deemed to be

Speculative business loss per Explanation to S.73:

We also find that some transactions are real transactions but in case of loss from such transaction, the loss is deemed as speculative loss for the purpose of set off and carry forward of loss under section73. This is vide an explanation provided after sub-section (4) of section73. These normal transactions are not deemed to be speculative transactions but only the result , in case it is a loss , is deemed speculative loss for the purpose of set off and carry forward of loss when the loss is from business of purchase and sale of shares in certain circumstances.

Set off and carry forward:

If a transaction is considered as non speculative transaction than result of such transaction is considered as normal business income or loss. Therefore, such loss is eligible for set off and carry forward as normal business loss under section 72.

If a transaction, though real is deemed to be speculative transactions , then the profit or loss from such transaction is considered as speculative loss and is eligible for set off and carry forward as speculative loss against speculative income only.

If a business is normal business but loss is deemed to be speculative business then the loss is deemed to be speculative loss for limited purposes of set off and carry forward. This situation is found in case of business of purchase and sale of shares, when the affected assessee suffers loss in such business.

Speculations- excluded transactions:

In section 43(5) we find transactions which are in true sense speculative transactions but are considered as normal transactions or are not considered as speculative transactions, for the purpose of computation of income. Such exempted transactions are for example hedging transactions in commodities and securities, and transactions in certain derivatives of commodities and securities entered into in prescribed manner and through notified exchanges etc.

The definition of 'speculative transaction' in section 43(5) excludes hedging transactions, jobbing and arbitrage, in commodities and securities. Derivative trades in commodities, derivatives in shares from the scope of 'speculative transaction'. Therefore, computation of income or loss from such excluded transactions will be in category of normal business income or loss.

Computation of results of all other speculative transactions will be made as a separate business of the nature of speculative business.

Section 72 and 73:

These sections relates to set off, carry forward and set off of normal business loss, and speculative business loss respectively.

Section 72 starts with wordings … “ where for any assessment year, the net result of the computation under the head “Profits and gains of business or profession” is a loss to the assessee not being a loss sustained in a speculative business…..

We find that S.72 refer to computation under the head income from business or profession. It refers to two computations under the head one not being a loss sustained in speculative business that is being ‘normal loss’ from normal business as popularly understood.

The set off, carry forward and set off of loss being speculative loss is not considered in section 72. Such loss is dealt under section 73

As discussed earlier computation of income under the head ‘income from business and profession is to be made under two categories. Popularly called ‘normal businesses’ and speculative business. The set off and carry forward of loss computed as ‘normal business loss’ is to be considered under section 72. The computation of income made as ‘speculative business’ is to be considered under section 73.

Therefore, a loss from transaction which is of speculative nature, but are exempted from speculative nature, is computed as ‘normal business loss’, and are therefore eligible for set off and carry forward in terms of section 72.

Therefore, results of transactions of exempted categories like hedging transactions, jobbing, and derivatives etc. which are excluded from speculation, will form part of normal profit or loss.

Explanation to S.73 – derivatives are not shares in companies:

Explanation to section 73 deems loss from ‘business of purchase and sale of shares of companies’ as speculative business for the limited purpose of set off and carry forward. This is also subject to several exceptions.

Though derivatives in shares have basis of their value according to value of underlying shares or indices relating to market value of shares, but it cannot be said that derivatives in shares are shares in companies.

Any holding in equity derivatives does not confer any right in shares of any company, it does not represent any share holding in any company, it does not confer any right to vote in general meeting of any company, it does not confer any right to receive any dividend, bonus or right issue or for that matter any right or interest which a shareholder has in company is not held by a holder of derivative in shares. Therefore, a derivative in shares cannot be called shares of any company. It seems that this plea was not raised and distinction between share of a company and derivative in shares was not brought before the High Court.

Case of DLF Commercial:

On reading of the judgment it appears that attention of honorable judges was not drawn to the provisions of Explanation 2 to section 28 and section 72 and difference between shares of companies and derivatives of shares.

The judgment is basically based on provisions of Section 43(5) and S. 73. Though reference to section 28 is found, however, there is no discussion leave aside emphasis on computation in two categories as required u/s 28. There is no discussion of S.72 which refers to computation of business loss in two categories and set off and carry forward of loss computed as loss not being speculative loss (popularly called normal loss).

The question was not also framed properly. On reading of question framed and answer of the court, it appears as if there is a complete bar on carry forward of loss of speculative nature. Whereas law specifically provide for set off and carry forward of speculative loss against speculative profit.

The question framed was as follows:

“Did the Income Tax Appellate Tribunal (ITAT) fall into error in not holding that the loss of Rs. 4,92,71,000/- on account of derivative transaction was a speculative loss, and was entitled to the benefit of Section 73, in view of the Explanation to Section 73 of the Income Tax Act;”

The High Court concluded and answered the above question in favour of revenue. The paragraph 11 and 12 from the judgmenta re reproduced below with highlights:

11. The stated objective of Section 73- apparent from the tenor of its language is to deny speculative businesses the benefit of carry forward of losses. Explanation to Section 73 (4) has been enacted to clarify beyond any shadow of doubt that share business of certain types or classes of companies are deemed to be speculative. That in another part of the statute, which deals with computation of business income, derivatives are excluded from the definition of speculative transactions, only underlines that such exclusion is limited for the purpose of those provisions or sections. To borrow the Madras High Court’s expression, ―derivatives are assets, whose values are derived from values of underlying assets; in the present case, by all accounts the derivatives are based on stocks and shares, which fall squarely within the explanation to Section 73 (4). Therefore, it is idle to contend that derivatives do not fall within that provision, when the underlying asset itself does not qualify for the benefit, as they (derivatives – once removed from it and entirely dependent on stocks and shares, for determination of their value).

12. In the light of the above discussion, it is held that the Tribunal erred in law in holding that the assessee was entitled to carry forward its losses; the question framed is answered in favour of the revenue and against the assessee. The appeal is, therefore, allowed; there shall be no order as to costs.

Observations of author:

With due regards it appears that due to lack of proper question of law and lack of proper submissions the High Court has answered the question in favor of revenue by treating derivatives equal to shares in companies and the provisions of Explanation 2 to section 28 and section 72 have not been considered and that resulted into, with due respect, apparently wrong answer.

The scope of the definitions in section 43 is restricted in its application to working out the mandate of Sections 28 to 41 of the Act. Thus categories excluded from speculation are so excluded for computation of income in two categories. For such computation definition in section 43(5) is relevant. Once a computation falls under category of normal business, the section 72 will be applicable and not section 73. It appears that this plea was not raised.

From answer of the High court it appears that the High court has held that loss is speculative loss and is not at all eligible for carry forward. Whereas, even in case of speculative loss it is eligible for carry forward separately to be set off only against speculative profit in future.

The case is fit case for a review and appeal.

By: CA DEV KUMAR KOTHARI - July 20, 2013