WHETHER THE LOSS ON ACCOUNT OF DERIVATIVE BUSINESS CAN BE CARRIED FORWARD AND SET OFF AGAINST THE NORMAL BUSINESS INCOME?

[Mr. M. GOVINDARAJAN]

Sec. 43(5) of the Income Tax Act, 1961 defines the term ‘speculative transaction’. According to this section ‘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 scrip.

For the purpose of this section the following shall not be deemed to be a speculative transaction-

(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;

(d)  an eligible transaction in respect of trading in derivatives referred to in clause(ac) of section 2 of the Securities Contracts (Regulation) Act, 1956 carried out in a recognized stock exchange;

(e)   an eligible transaction in respect of trading in commodity derivatives carried out in a recognized association.

For the purpose of sub clause (d) "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 in accordance with the provisions of the Securities Contracts (Regulation) Act, 1956 or the Securities and Exchange Board of India Act, 1992 or the Depositories Act, 1996 and the rules, regulations or bye-laws made or directions issued under those Acts or by banks or mutual funds on a recognized 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;

For the purpose of sub clause (e) “eligible transaction” means any transaction,—

(A) carried out electronically on screen-based systems through member or an intermediary, registered under the bye-laws, rules and regulations of the recognized association for trading in commodity derivative in accordance with the provisions of the Forward Contracts (Regulation) Act, 1952 and the rules, regulations or bye-laws made or directions issued under that Act on a recognized association; and

(B) which is supported by a time stamped contract note issued by such member or intermediary to every client indicating in the contract note, the unique client identity number allotted under the Act, rules, regulations or bye-laws referred to in sub-clause (A), unique trade number and permanent account number allotted under this Act;

Section 73 of the Act deals with the speculation loss. The section provides that-

• Any loss, computed in respect of a speculation business carried on by the assessee, shall not be set off except against profits and gains, if any, of another speculation busi­ness;
• Where for any assessment year any loss computed in respect of a speculation business has not been wholly set off so much of the loss as is not so set off or the whole loss where the assessee had no income from any other specula­tion business, shall, subject to the other provisions of this Chapter, be carried forward to the following assessment year, and—
  •  it shall be set off against the profits and gains, if any, of any speculation business carried on by him assessable for that assessment year ; and
  • if the loss cannot be wholly so set off, the amount of loss not so set off shall be carried forward to the following assessment year and so on.
• In respect of allowance on account of depreciation or capi­tal expenditure on scientific research, the provisions of sub-section (2) of section 72 shall apply in relation to speculation business as they apply in relation to any other business.
• No loss shall be carried forward under this section for more than four assessment years immediately succeeding the assessment year for which the loss was first computed.
  

The explanation to this section provides that 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.

In ‘Commissioner of Income Tax, Delhi-IV V. DLF Commercial Developers Limited’ (2013 (7) TMI 334 - DELHI HIGH COURT)the assessee claimed loss of Rs.492.71 lakhs on account of derivative transactions. As per the assessee the loss in trading of derivates was not a speculative loss in terms of Section 43(5) of the Income Tax Act, 1961 and hence could not be disallowed as speculative loss under any provisions of the Act. The Assessing Officer rejected the contention of the assessee. According to him explanation to Section 73 of the Act can be applied even if there is delivery based on sale and purchase of shares and also in situations of trading of derivatives. The Assessing Officer treated such loss as speculative loss and held that it could not be allowed to be adjusted against business income.   The assessee filed appeal before the Tribunal which held that the loss on account of derivative was not speculative loss and the assessee was entitled to the benefit of section 73 of the Act. Against this order the Revenue filed appeal before the High Court.

The Revenue contended that the Explanation to the Section 73 categorically provides that where any part of the business of the company includes purchase and sale of shares of other company, it shall be deemed to be carrying on speculation business to the extent to which the business consists of that activity. Section 43(5)(d) of the Act has restricted application since it defines speculative transaction and excludes transactions and derivatives only for a limited purpose.   Section 73, on the other hand has wider application and deals with circumstances under which carry forward of such losses can be permitted.

The Revenue further contended that derivatives of the kind and nature traded by the assessee were relatable to stocks and shares which were also the subject matter of transactions under the National Stock Exchange.   The Revenue was of the firm view that the assessee was not entitled to the benefit of Section 73 of the Act.

The assessee contended that the trade and transactions in derivatives as defined under Section 2 of the Securities Contract (Regulations) Act, 1956, were specifically excluded from the definition of speculative transactions.   Even though the definition of derivatives was in Section 43(5) of the Act yet there was no other definition of derivatives in the Act.   The derivatives need not be only in respect of stocks and shares but could pertain to commodities.   The assessee could enjoy the benefit of Section 73 and did not fall within the mischief of its explanation.

The High Court held that the term ‘speculative transaction’ has been defined only in Section 43(5) of the Act.  In terms of the Explanation to Section 73 in case of a company, business of purchase and sale of shares is deemed to be speculation business.   The Court further held that the assessee’s contention that the Parliament intended that such transactions are also excluded from the mischief of Explanation to Section 73 of the Act, is not substantiated.   The 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 has been enacted to clarify that share business of certain types or classes of companies are deemed to be speculative.

Since the underlying asset itself does not qualify for the benefit, as derivatives are entirely dependent on stocks and shares for determination of their value.   Therefore explanation to Section 73 is applicable to the derivative business and hence the loss on account of derivative transactions was not allowed to be set off against normal business income and carried forward as normal business loss.   Hence stock derivate trading loss incurred by a company is speculative loss which can be set off only against speculative gain and it can be carried forward for four years only.