CALL OPTIONS OR PUT OPTIONS ARE TRANSACTIONS OF DERIVATIVE MARKETS AND CANNOT BE TERMED AS SPECULATIVE IN NATURE

[Mr. M. GOVINDARAJAN]

Section 43(5) of the Income Tax Act, 1961 (‘Act’ for short) defines the term ‘speculative transaction’ as 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 scrips.  For this purpose-

1. 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
2. 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
3. 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; or
4. 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; or
5. an eligible transaction in respect of trading in commodity derivatives carried out in a recognized association, which is chargeable to commodities transaction tax under Chapter VII of the Finance Act, 2013”

shall not be deemed to be a speculative transaction.

The explanation to Section 43(5) defines the term ‘eligible transaction’ for the purpose clause (d)  as any transaction-

• 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 recognized stock exchange; and
• 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.

The explanation (2) to Section 43(5) defines the term ‘eligible transaction’ for the purpose of clause (e), as any transaction-

• carried out electronically on screen-based systems through member or an intermediary, registered under the bye-laws, rules and regulations of the recognised association for trading in commodity derivative in accordance with the provisions of the Forward Contracts (Regulation) Act, 1952 (74 of 1952) and the rules, regulations or bye-laws made or directions issued under that Act on a recognised association; and
• 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 2(ac) of the Securities Contract (Regulations) Act, 1956 defines the term ‘derivate’ as including-

• a security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences of any other form of security;
• a contract which derives its value from the prices, or index of prices of underlying securities.

In ‘Rajshree Sugar and Chemicals Limited V. Axis Bank Limited’ – 2008 (10) TMI 594 - MADRAS HIGH COURT it was held that the term derivate has to include foreign currency as an underlying security of the derivative.

In simple terms derivatives are financial instruments where values depend on the value of other underlying financial instruments.   The International Accounting Standard defines the term ‘derivative’ as a financial instrument-

• whose value changes in response to the change in a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, a credit rating or credit index, or similar variable (sometimes called underlying);
• that requires no initial net investment or little initial net investment relative to other types of contracts that have a similar response to changes in market conditions; and
• that is settled at a future date.

Actually derivatives are assets, whose values are derived from values of underlying assets.   These underlying assets can be commodities, metals, energy resources and financial assets such as shares, bonds and foreign currencies.

In ‘IVF Advisors Private Limited V. Assistant Commissioner of Income Tax’ –2015 (5) TMI 706 - ITAT MUMBAI the appellant is an investment management consultant.  The assessee filed return for the year 2009-10 declaring total income as NIL.  The return was selected for scrutiny by the Department.  The Department analyzed the profit and loss account of the assessee.  The Department found that the assessee has claimed a loss of ₹ 91,63,235/-  and was of the view that the loss cannot be allowed in the light of the provisions of Section 43(5) read with Section 2(ac) of Securities Contracts (Regulation) Act, 1956.  The assessee filed appeal against the order of adjudicating authority before the Commissioner (Appeals).  Before the Commissioner (Appeals) the assessee contended that the contracts in foreign currency futures were not speculative transactions and the foreign currency contract does not satisfy the condition of being a speculative transaction.   Therefore the loss on account of foreign currency futures was not speculative loss.  The Commissioner (Appeals) confirmed the assessment order holding that the Assessing Officer has correctly held that such loss was a speculation loss within the meaning of Section 43(5) of the Act.

Aggrieved against the order of Commissioner (Appeals), the appellant filed the present appeal before the Tribunal.   The assessee reiterated the contentions raised before the authorities below. The Revenue has failed to interpret the proviso to Section 43(5).   The contracts entered into by the assessee cannot be said to be speculative in nature because the contracts have ultimately been settled by the delivery of forex.

The Tribunal observed that proviso (d) excludes the transaction from the definition of speculative transaction in respect of trading of derivatives referred to in Section 2(ac) of the Securities Contract (Regulation) Act, 1956.  The derivatives also include securities.  The definition of ‘eligible transaction’ shows that the transaction must have been carried out electronically in accordance with the provisions of Securities Contracts (Regulation) Act and the rules and regulations or bye laws made or directions issued under this Act or by banks or mutual funds on a recognized stock exchange and which is supported by time stamped contract note issued by such stock broker or sub-broker or intermediary to every client indicating in the contract not the unique client identity number and permanent account number.

The tribunal relied on FAQ of SEBI in its web site for the definition  of ‘derivate’  According to SEBI the derivative  indicates that it has no independent value i.e., the value is entirely derived from the value of the underlying asset.   The underlying asset can be securities, commodities, bullion, currency, live stock of anything else.   In other words, derivate means a forward, future, option or any other hybrid contract of pre-determined fixed duration, linked for the purpose of contract fulfillments to the value of a specified real or financial asset or to an index of securities.

The Tribunal held that the transaction of the appellate cannot be treated as speculative transaction.  The contract note shows that the assessee has either entered into a call option or put option and on the settlement day the transaction has been settled by delivery, either the asseseee has paid US dollar on the settlement or has taken delivery of US dollars.   The derivatives include foreign current and call option/put option, are transactions of derivative markets and cannot be termed as speculative in nature.  The Tribunal allowed the appeal and set aside the order of Commissioner (Appeals).