Derivative by itself cannot be termed as an investment or stock in trade

Thus, 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, stocks and shares. Derivative trading in India takes place either on a separate and independent derivative exchange or on a separate segment of an existing stock exchange. Derivative exchange/segment functions as a self regulatory organization (SRO) and SEBI acts as an oversight regulator. The clearing and settlement of all trades on the derivative exchange/segment would have to be through a

clearing corporation/house which is independent in governance and membership from the derivative exchange/segment. The existing derivative contracts which are permitted by SEBI are index future contracts (June 2000), index options (June 2001) and stock options (July 2001), stock futures (November, 2001), sectoral indices (December, 2002), mini derivative (F & O) contract on index (Sensex and Nifty) (December, 2007), longer tenure index options contract and volatility index (January 2008), bond index (April, 2008) and exchange traded currency derivatives (August 2008). The natures of every transaction are different. Therefore, in every transaction of derivatives whereby securities are purchased and sold the nature of transaction has to be looked into as a whole before arriving at a decision whether the purchases or sales were for the purpose of investment or stock in trade. Future contract means a legally binding agreement to buy or sell the underlying security on a future date. The contract express on a pre-specified date which is called expiry date of the contract. On expiry, “futures” can be settled by delivery of the underlying asset or by cash. Option contract is a type of derivative contract which gives the buyer/holder of the contract the right (but not the obligation) to buy/sell the underlying asset at a pre-determined price within or at end of a specified period. The buyer/holder of the “option” purchases the right from the seller/writer for a consideration which is called the premium. The seller/writer of an “option” is obligated to settle the “option” as per the terms of the contract when the buyer/holder exercises his right. Future contract based on an index i.e. the underlying asset is the index, are known as index futures contracts. For example, futures contract on Nifty index and BSE -Thirty index. These contracts derive their value from the underlying assets. Similarly, the options contract which are based on some index, are known as index options contract. However, unlike index futures, the buyer of index option contract has only the right but not the obligation to buy/sell the underlying index on expiry. We can see from the above that derivative itself is merely a contract between two or more parties for purchase/sale of securities by taking delivery or by settlement on certain pre-determined terms. Therefore, derivative by itself cannot be termed as an investment or stock in trade. The entire transactions of purchase/sale of securities/shares through derivatives and later on dealing with those shares/securities will determine whether an investment is made or stock-in-trade is procured. In the preset case before us, the natures of the transactions of derivatives in its entirety on case to case basis are not produced before the Bench and also before the revenue. Therefore, we hereby dismiss this alternate ground raised by the appellant.

IN THE ITAT AHMEDABAD BENCH ‘B’

Mask Investment Ltd.

v.

Assistant Commissioner of Income-tax (OSD) 

IT Appeal No. 2380 (Ahd.) of 2009

[Assessment year 2006-07]

June 22, 2012

ORDER

A. Mohan Alankamony, Accountant Member - This appeal is filed by the assessee aggrieved by the order of learned CIT(A)-I in appeal No.I/213/08-09 dated 14/07/2009 for assessment year 2006-07 passed u/s 143(3) read with section 250 of the IT Act.

2. The assessee has raised three grounds and one additional ground in its appeal wherein ground No.3 is general in nature and does not survive for adjudication. The surviving grounds No.1 and 2 and the additional ground are reproduced herein below for consideration.

“1.  That on the facts and in the circumstances of the case, the Hon’ble C.I.T.(A) has erred in sustaining addition of Rs.7,00,000/- by way of disallowance of “Loss on Forfeiture of Shares” as Business loss and treating same as “Capital Loss.”

 2.  That on the facts and in the circumstances of case, Hon’ble C.I.T.(A) has erred in sustaining addition of Rs. 33,08,337/-by way of disallowance of “Loss on Sale of Shares” as Business loss and treating same as “Capital Loss.”

Additional Ground:

“(4) Without prejudice to other grounds of appeal, the appellant, as an alternate plea, humbly begs to pray that in case if a view is ultimately held that the loss on sale of shares is assessable under the head ‘capital gains’, then the profits and gains from the purchases/sales of the derivatives (future and options of the shares must also be assessed under the head ‘capital gains’ as the transactions in both the types of securities (i.e. shares and derivatives of shares)part of the same activity of the appellant company and consequently loss of one should be allowed to be set off against the profits of other”.”

3. The assessee is a Private Limited Company engaged in the business of shares, stocks and mutual funds. The assessee filed its return of income for assessment year on 27-06-2006 declaring income of Rs. 3,50,579/-. The case was taken up for scrutiny assessment and order u/s 143(3) was passed on 29-12-2008 wherein additions were made for Rs. 7,00,000/- being forfeiture of shares by M/s. Kapees Filament Pvt. Ltd., considering it to be capital loss and not trading loss. Similarly, the assessee had claimed a trading loss of purchase and sale of shares of Mohit Industries, however, the same was held by the learned AO to be investment and on re-working arrived at a long term capital gain of Rs. 6,21,524/- against 501014 shares and short term capital loss of Rs. 6,21,524/- against 556775 shares.

4. The learned AO had considered both (a) forfeiture of shares (b) purchase and sale of shares, to be in the field of investment and held it to be taxable under the head capital gains; short term or long term, because these shares were disclosed in the balance sheet under the head investment.

5. Ground No.1: forfeiture on account of purchase and sale of shares of M/s. Kapees Filament Pvt. Ltd. amounting to Rs. 7,00,000/-. The learned AR submitted before us that the partial payment made for allotment of shares of M/s. Kapees Filament Pvt. Ltd. for Rs. 7,00,000/- was disclosed under the head investment held in stock in trade and, therefore, being part of stock in trade, the same ought to be treated as trading loss and not as capital loss. The learned DR on the other hand, firmly asserted that the disclosure of the assessee of the above said investment was under the head investment and, therefore, the loss on account of the same has to be held as capital loss and cannot be debited in profit & loss account.

6. We have heard the rival submission and perused the material on records carefully. At the outset, we must say that on examining the balance sheet of the assessee at page 8 of the paper book, it is obvious that the assessee has disclosed the investment for allotment of shares of M/s. Kapees Filament Pvt. Ltd. being partly paid up under the head “investment in equity shares”. The Ld. AR or the assessee did not produce any other materials to establish that these partly paid equity shares were held as stock in trade. Therefore from the books of accounts and statement of affairs of the company it is very clear that the intention of the assessee for making such payment was for investment and not for trading purpose. There are no other materials before us to look beyond the statement of affairs of the assessee which were duly audited and signed by the directors of the company to infer that such investments were made for trading purposes. Therefore, we do not have any hesitation to hold that the partly allotted shares of M/s. Kapees Filament Pvt. Ltd. to be in the nature of investment of the assessee and income or loss arising out of purchase and sale of the same has to be taxed under the head capital gains, either short term or long term as per the provisions of the Act. It is ordered accordingly.

7. Ground No.2: loss on account of purchase and sale of shares of Mohit Industries for Rs. 33,08,337/-. During the assessment proceedings the learned AO observed that the assessee had purchased 1066789 shares at an average rate of Rs.18.15 for a total consideration of Rs. 1,93,60,706/-. On sale of the same the assessee had shown average sale consideration at Rs.15.05 aggregating to total sale consideration to Rs. 1,60,52,368/- and thus worked out a trading loss of Rs.33,08,337/-. However, the learned AO observed that the assessee had disclosed 1054289 shares of Mohit Industries as investment in equity shares. Accordingly, the learned AO worked out 510014 to be classified as long term investment as shown in Annexure A of the assessment order. The average purchase consideration per share was worked out at Rs. 13.80 amounting to Rs. 70,47,48,338.76 and the total sales consideration was worked at an average rate of Rs.15.04 amounting to Rs. 76,69,363 and thus arrived at long term capital gain at Rs. 6,21,524/-. Similarly, for the rest of Rs. 5,56,775/- as shown in Chart A of the assessment order, the learned AO worked out the purchase cost of each share at average rate of Rs. 22.11 amounting to Rs. 1,23,12,867.57 and the sale of these shares at an average rate of Rs. 15.06 amounting to Rs. 83,83,005.34 and thus worked out short term capital loss at Rs. 6,21,524/-.

8. The learned AR vehemently argued stating that these shares were held by the assessee as stock in trade and not as investment and, therefore, the loss on account of purchase and sale of the same has to be treated as trading loss while the learned DR argued stating that these purchases and sales of shares fall in the field of investment and therefore has to be dealt under the head income/loss from capital gains.

9. We have heard the rival submissions and carefully perused the materials on record and the case laws relied upon both the parties. On our examining the balance sheet of the assessee we find that the investments of shares in Mohit Apparels Pvt. Ltd., were disclosed by the assessee under the head investment. There were no shares of Mohit Industries Pvt. Ltd. disclosed under the head investments in the balance sheet of the appellant company. Further on perusing the assessment order and the Balance sheet of the appellant company at page 10 of the paper book filed by the appellant it appears that the share in Mohit Industries are held as stock in trade. Thus it is very clear that the objective of the assessee company in purchasing the shares of ‘M’ Mohit Industries Pvt. Ltd., was to trade in these shares and not for holding the same as investments. It is pertinent to note that Section 2(14) of the Act specifically excludes stock-in-trade from the ambit of “Capital asset”. Therefore, we hereby hold that the gain or loss accrued on purchase and sales of shares of Mohit Industries to be treated as trading loss.

10. Additional ground of the assessee: to treat the purchases and sales of derivatives (futures and options) under the head income from capital gain/loss. The learned AR submitted that in case if a view is taken by the Bench to hold loss on sale of shares is assessable under the head capital gains, then profit and gains from the purchase/sales of the derivatives (features and options) of the shares must also be assessed under the head “capital gains” since the transactions in both the types of securities were part of the same activity of the appellant company and consequently loss of one should be allowed to be set off against the profit of the other. The learned AR further submitted that in the instant case the learned AO had assessed the profits from “derivatives” as business income, however, assessed the loss from purchase and sale of shares under the head “capital gains” which is erroneous. The learned AR argued stating that both the shares as well as derivatives are defined as securities under Section 2(h) of the Securities Contracts (Regulations) Act, 1956 and therefore, same treatment has to be given when it comes to assessment of profit derived from purchase and sale of the same. The learned DR firmly relied upon the order of the revenue.

11. We have heard the rival submissions and carefully perused the materials on record and case laws relied upon by both the parties. Whether a transaction is to be taxed under the head “capital gain” or “profits and gain from business” would depend upon the nature of transaction. The intention of the assessee for procuring the asset has to be examined to determine whether the asset is to be treated as investment or stock- in- trade. If the intention of the assessee was for making investments then the profit or loss arising out of the transaction will be taxed under the head “capital gains” and at the same time if the intention of the assessee was to trade by holding the asset as stock in trade, the income or loss arising out of the transactions will be taxed under the head “income from business or profession” (trading profit or loss). At this juncture, it is very essential to understand the nature of transactions in dealing with derivative. The Security Laws (Second Amendment Act, 1999) has included derivatives in the definition of “securities”. Derivative includes:-

(a)  A security derived from a debts instruments, share, loan, whether secured or unsecured, risk instruments 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 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, stocks and shares. Derivative trading in India takes place either on a separate and independent derivative exchange or on a separate segment of an existing stock exchange. Derivative exchange/segment functions as a self regulatory organization (SRO) and SEBI acts as an oversight regulator. The clearing and settlement of all trades on the derivative exchange/segment would have to be through a clearing corporation/house which is independent in governance and membership from the derivative exchange/segment. The existing derivative contracts which are permitted by SEBI are index future contracts (June 2000), index options (June 2001) and stock options (July 2001), stock futures (November, 2001), sectoral indices (December, 2002), mini derivative (F & O) contract on index (Sensex and Nifty) (December, 2007), longer tenure index options contract and volatility index (January 2008), bond index (April, 2008) and exchange traded currency derivatives (August 2008). The natures of every transaction are different. Therefore, in every transaction of derivatives whereby securities are purchased and sold the nature of transaction has to be looked into as a whole before arriving at a decision whether the purchases or sales were for the purpose of investment or stock in trade. Future contract means a legally binding agreement to buy or sell the underlying security on a future date. The contract express on a pre-specified date which is called expiry date of the contract. On expiry, “futures” can be settled by delivery of the underlying asset or by cash. Option contract is a type of derivative contract which gives the buyer/holder of the contract the right (but not the obligation) to buy/sell the underlying asset at a pre-determined price within or at end of a specified period. The buyer/holder of the “option” purchases the right from the seller/writer for a consideration which is called the premium. The seller/writer of an “option” is obligated to settle the “option” as per the terms of the contract when the buyer/holder exercises his right. Future contract based on an index i.e. the underlying asset is the index, are known as index futures contracts. For example, futures contract on Nifty index and BSE -Thirty index. These contracts derive their value from the underlying assets. Similarly, the options contract which are based on some index, are known as index options contract. However, unlike index futures, the buyer of index option contract has only the right but not the obligation to buy/sell the underlying index on expiry. We can see from the above that derivative itself is merely a contract between two or more parties for purchase/sale of securities by taking delivery or by settlement on certain pre-determined terms. Therefore, derivative by itself cannot be termed as an investment or stock in trade. The entire transactions of purchase/sale of securities/shares through derivatives and later on dealing with those shares/securities will determine whether an investment is made or stock-in-trade is procured. In the preset case before us, the natures of the transactions of derivatives in its entirety on case to case basis are not produced before the Bench and also before the revenue. Therefore, we hereby dismiss this alternate ground raised by the appellant.

12. In the result, the appeal of the assessee is partly allowed