Equity oriented Derivatives are not shares of companies , trading loss cannot be deemed speculative loss by invoking Explanation to S.73- a study

[CA DEV KUMAR KOTHARI]

Important links and references:

Section 2 (84) of the  Companies Act 2013 – meaning of share

Section 2 (ac) and (h) of  The SECURITIES CONTRACTS (REGULATION) ACT, 1956

Apollo Tyres Ltd. Vs Commissioner of Income-tax 2002 (5) TMI 5 - SUPREME Court- units of UTI are not share in company.

CIT  Vs  DLF Commercial Developers Limited ITA 94/2013 Dated: - 11 July 2013  2013 (7) TMI 334 - DELHI HIGH COURT

DLF Commercial Developers Limited, Versus Additional Commissioner of Income-tax, Range10, 2011 (11) TMI 646 - ITAT DELHI

Share:

As per Companies Act 2013 vide  section 2 (84) “share” means a share in the share capital of a company and includes stock.

Shares can be of different nature and tenure. In this write-up we are concerned with equity shares of companies which are listed on stock Exchanges and many of such shares also form part of various indices at Stock Exchange and also covered in different series of equity oriented derivatives on stock exchanges. 

Derivative:

From SECURITIES CONTRACTS (REGULATION) ACT, 1956

Definitions.

2. In this Act, unless the context otherwise requires,

    ac)   “derivative” includes:

(A)  a security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security;

(B) a contract which derives its value from the prices, or index of prices, of underlying securities;]

(h) “securities” include:

shares, scrips, stocks, bonds, debentures, debenture stock or other marketable securities of a like nature in or of any incorporated company or other body corporate;

(ia) derivative

From http://www.sebi.gov.in/faq/derivativesfaq.html

       The term "Derivative" indicates that it has no independent value, i.e. its value is entirely "derived" from the value of the underlying asset. The underlying asset can be securities, commodities, bullion, currency, live stock or anything else. In other words, Derivative means a forward, future, option or any other hybrid contract of pre-determined fixed duration, linked for the purpose of contract fulfilment to the value of a specified real or financial asset or to an index of securities.

With Securities Laws (Second Amendment) Act,1999, Derivatives has been included in the definition of Securities. The term Derivative has been defined in Securities Contracts (Regulations) Act, as:-

A Derivative includes: -

a.      a security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security;

b.      a contract which derives its value from the prices, or index of prices, of underlying securities;

Thus derivative can be for many type of assets including securities of different type and tenure like bonds, deposit certificates, debenture, equity commodities and even indexes of prices of different kind.

Difference in equity shares of companies and  equity oriented derivatives:

Equity share of a company	Derivative in equity shares of companies
Shares are issued by companies and a share represent proportionate share in capital of company	Derivatives are not issued by companies and unit of derivatives does not represent proportionate share in any of company whose shares may be composed in the derivative.
Shareholder has voting rights in company.	Derivative held does not confer any voting rights in any company.
Shareholder has rights for corporate benefits and privileges announced by company.	Derivative does not carry any benefit in corporate benefits and privileges announced by  any of company represented by the particular derivative.
By holding shares a person or group of persons can control companies.	Holding of derivatives does not provide any control over any of company.
Shares can be held for short, medium or long term and indefinitely also.	Derivatives have limited life and expiry on the predetermined expiry date. For example, presently derivatives in Nifty equities a series for any month expires on the last Thursday of that month.
Shares held in a company continue to be share in particular company, except changes due to schemes of arrangement of companies like amalgamation, merger, demerger etc.	In case of derivatives composition of equities are changed from time to time depending on policies of stock exchange / SEBI, market conditions, volume of trading in shares of any company, changes in composition of indices at stock exchange and also perception of big investment houses and advisory houses.
Price of shares in any company changes depending on working and other news of company and industry in which it engaged. It fluctuates based on present and expectation about company and particular industry and markets in general and particularly with equity market, and commodity markets related with raw material, process and packing material and finished goods relevant to company.	In case of derivatives held, the price is not dependent on any particular share but on price of many shares which are covered in particular derivative. The price does not move with market at present, but expectation of market in future and before expiry. Therefore, what is applicable in case of shares is not at all applicable in case of derivatives. Furthermore stock exchanges also changes composition of derivatives from time to time, this also causes fluctuation in price of derivatives.
Price of shares can possibly be influenced to a little extent, by some factors and actions of people in control of companies, but there is little scope in view of stringent legal frame work for such activities by related persons, prohibition on insider trading, disclosure requirements etc.	Price of derivatives cannot be influenced by people in management of companies covered by particular derivative. Only price of different shares can impact value of derivatives.
Shares can be considered as an asset having life in perpetuity, as the company issuing a particular share has. The life of shares goes along with life of company unless capital is reduced and / or shares are redeemed.	As can be noted from definition of derivative a Derivative means a forward, future, option or any other hybrid contract of pre-determined fixed duration, Thus, the life of derivative is of fixed duration and has nothing to do with life of any company.
Shares of a company, even a company having several companies as subsidiary and associates cannot be equated with a unit of mutual fund.	Derivatives can be compared with units of a mutual fund. For example, derivative of Nifty bank can be compared with a banking sector mutual fund, but this is only to the extent of composition of investment by such mutual fund and composition of derivative. But other differences apply to derivative and unit of mutual fund.

Units of mutual fund vis a vis derivatives:

Units of a mutual fund are also backed by shares held by mutual fund. But by holding units of a mutual fund, the unit holder does not become a shareholder of company in which mutual fund holds shares. Therefore, a unit holder does not become entitled to any right, benefit or privilege in respect to shares of companies held by mutual fund.

For example, when a mutual fund hold shares in any company, the mutual fund receives corporate benefits announced by company in respect of shares held by mutual fund. Thus dividend declared by company, in respect of shares held by mutual fund, will be received by mutual fund and not by unit holders. The mutual fund may declare dividend, such dividend shall be payable by mutual fund to its unit holders.

It is well recognize and settled that a unit in mutual fund is not a share of any company. A unit is not even share in the Asset Management Company (AMC) of the Mutual Fund. For example, holder of master share or master gain of UTI is not a shareholder in any company whose shares are held by the mutual fund. The unit holder is also not a shareholder of UTI Assets Management Company which manages funds of UTI.

Explanation to S.73- deemed speculation vis a vis derivatives:

Explanation to S. 73 is to discourage dealing in shares of other companies with a view to reduce tax liability. That cannot be applied in any manner to derivatives. Any of companies which form basis of any derivative cannot control price of derivatives, a general investor cannot control price of derivatives.

For this reason also derivative cannot be considered as shares for invoking the Explanation to s. 73.

In judgment of the Supreme Court in case of Apollo Tyres Ltd , loss on sale of Units of UTI ( a mutual fund) was  held not to be loss on purchase and sale of shares in companies, therefore, deeming provision of Explanation to S. 73 was held not to be applicable.

Units of any other mutual funds are also backed by shares held by such fund. In that case also a unit holder does not become a shareholder of  companies in which mutual fund hold shares.

Similarly derivatives in equity may be backed by a set of shares of companies, or indices of stock exchanges,  but the mechanism of derivatives is entirely different. Derivative cannot, by any stretch of imagination be said to be share in company. Therefore loss on sale of derivatives cannot be considered as speculative loss under any provisions of the IT Act.

The business in derivatives is considered as normal business, it is not considered as speculative business in general sense as well it is excluded from meaning of speculative business also. The Explanation to S.73 cannot be invoked either for units of a mutual fund, derivatives, or even in case of other securities which are convertible in equity in future or on exercise of option by holders of such securities.

Purchase and sale of equity oriented derivatives are therefore, not purchase and sale of shares. Therefore, Explanation to S. 73 is not applicable.

Provisions:

From meaning of  equity shares of a company and equity oriented derivative, and difference as noted in the tabular manner,   it is clear that derivatives in equities cannot be called shares of any company or companies, though such derivatives may be backed by shares of such companies.

Explanation to section 73 of the IT Act states that where a company carries on the business of purchase and sale of ‘shares’ of other companies, such company shall for the purpose 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.

On a plain reading of the section, and explanation, it would be clear that the section applies to trading in shares of other companies only and not to other instruments. Had the intention of the parliament been to include other securities/instruments, it would have been specifically included it in the section.

It is settled factual and legal position that shares do not include derivatives, although the underlying asset of a derivative may be a set of shares of different companies.

Tax treatment of derivatives is dealt by section 43(5)(d) of the IT Act. On a plain reading of section 43(5)(d) of the Income Tax Act, it is clear that the section is applicable to derivatives only. The section specifically goes on to say that trading in derivatives shall not be deemed to be a speculative transaction. If the intention of the legislator was to treat this as a speculative transaction in the case of companies trading in shares and securities, then it would be stated so in no uncertain terms, besides, since section 73 was already existing, the legislator could have simply amended section 73 to include derivatives. This new clause was inserted by the  Finance Act 2005 w.e.f. 01.04.2006  for the benefit of traders of derivatives and to promote this new financial instrument. If this new section was intended to be subject to the provisions of section 73 of the IT Act, then there would not have been any need for this section.

EXTRACT OF BUDGET SPEECH FOR BUDGET OF 2005-06

“175.     As Hon’ble Members are aware, there have been significant developments in the past decade in the capital market including the introduction of trading in financial derivatives. We have also established a transparent system of trading with adequate safeguards for audit trail. Hence, I propose to amend the Income Tax Act to provide that trading in derivatives in specified stock exchanges will not be treated as “speculative transactions” for the purposes of the Income Tax Act.

The Finance Minister has stressed upon transparency and audit trail in his budget speech while introducing section 43(5)(d) of the IT Act.

Purpose of deemed speculation:

Circular no 204, dated 24-7-1976 after the introduction of explanation to section 73 is relevant. The circular states that the object of this explanation is to curb manipulation sometimes resorted to by business houses controlling groups of companies to reduce the taxable income of companies under their control. This circular as well as the budget speech of the Finance Minister stress in no uncertain terms that intention of section 73 was to curb manipulation.

“Circular No. 204, dated 24-7-1976

Taxation Laws (Amendment) Act, 1975-III

Treatment of losses in speculation business - Section 73

19.1 Section 73 provides that any loss computed in respect of speculation business carried on by an assessee will not be set off except against the profits and gains, if any, of another speculation business. Further, where any loss, computed in respect of a speculation business for an assessment year is not wholly set off in the above manner in the said year, the excess shall be allowed to be carried forward to the following assessment year and set off against the speculation profits, if any, in that year, and so on. The Amending Act has added an Explanation to section 73 to provide that the business of purchase and sale of 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. Thus, in the case of aforesaid companies, the losses from share dealings will now be set off only against profits or gains of a speculation business. Where any such loss for an assessment year is not wholly set off against profits from a speculation business, the excess will be carried forward to the following assessment year and set off against profits, if any, from any speculation business.

Taxation Laws (Amendment) Act, 1975-III

19.2 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. “

Some related judgements in which derivatives were  equate with shares:

1. 2013 (9) TMI 733 - DELHI HIGH COURT, HIGH COURT OF DELHI in the matter of Commissioner of Income-tax –V vs. Nasa Finelease (P.) Ltd passed on 6^th September 2013 wherein it was held that derivative transactions are not Speculative transactions.
2. 2007 (9) TMI 291 - ITAT BOMBAY-J, IN THE ITAT, MUMBAI 'J' BENCH in the matter of Deputy Commissioner of Income tax vs. SSKI Investors Services (P) Ltd wherein it was held that derivative transactions are not Speculative transactions.
3. 2012 (6) TMI 82 - ITAT KOLKATA IN THE ITAT KOLKATA BENCH 'A' in the matter of Deputy Commissioner of Income-tax, Circle-4, Kolkata v. Madanlal Ltd wherein it was held that derivative transactions are not Speculative transactions and are not covered under explanation to Section 73.

Equity derivative is share in company for purpose of S.73.:

Contrarily, the honourable Delhi High Court in case of DLF (supra.) held that equity derivatives is share for the purpose of S.73.

On reading of judgment it appears that nature of derivatives and difference between share and derivative was not considered by the Tribunal and the High Court.

In CIT  Vs  DLF Commercial Developers Limited ITA 94/2013 Dated: - 11 July 2013 2013 (7) TMI 334 - DELHI HIGH COURT  the court was influenced by mere fact that  equity derivatives, in that case were  supported or backed by shares of companies. Therefore, Court considered such derivatives as shares.

In case of DLF Commercial Developers Limited even comparison and some similarity of units of a mutual fund and derivative were not considered. In case of a mutual fund some shares may be held for longer duration, still a unit of mutual fund is not considered a share of any company. The judgment in case of Apollo Tyre (supra)  was also seems not considered in case of   DLF Commercial Developers Limited.

Therefore, the judgment in case of DLF Commercial Developers Limited has not taken all related aspects about derivative and has been rendered ignoring the factual aspects and differences between share and derivative. The judgment is based more on technical aspects of interpretation without consideration of factual aspects.

DLF Commercial Developers Limited has filed an appeal before the Hon’ble Supreme Court which has been admitted.

In the light of the above discussion summary can be made as follows:

Derivatives in equities are entirely different from shares in companies and cannot be called shares in companies.

Trading of derivatives of equities  are normal business and not speculative business.

Loss in equity – derivatives cannot be treated or deemed as loss on purchase and sale of shares of companies and cannot be deemed to be speculation loss under section 73 of the IT Act.