The Hindu Business Line : Speculation in retrospect

THREE different Sections of the Income-Tax Act, 1961 — Explanation 2 to Section 28, Section 43(5) and Section 73(1) — attempt to bring some firewalls into the allegedly free-for-all activities of speculators.

The Ahmedabad Bench of the Income Tax Appellate Tribunal (ITAT) considered the case of an occasional entrant into speculation in Kanubhai A. Patel vs Assistant CIT (2004 89 ITD 255 Ahmedabad).

Let's try hedging

The facts were that Mr Patel derived income from partnership firms, house property, dividend, interest, and so on. Being a shareholder of Tisco, Mr Patel, on the advice of his broker, entered into a transaction for the purchase of 2,000 more shares of Tisco at Rs 14,00,000. Probably on the advise of his broker, he decided to enter into hedge transactions over this purchase and owing to gyrations in the share price, entered into several roll-over hedging contracts during the fortnightly settlement.

This fact was evidenced by the settlement akhadas (accounts) maintained by the broker. A majority of the rollovers were made in April, May and June of 1992 while one was made in July. Knowing that he was making a loss, he made a payment of Rs 4,00,000 to the broker in April 1992 to cover his losses. He claimed the loss as a normal loss and set it off against his other income.

The assessing officer (AO) and the CIT (Appeals) did not concur with Mr Patel and ruled that he has entered into a speculative transaction and if he needs to set off this loss, he needs to use his wits to get a profit from some other speculative transaction as postulated by Section 73(1). Aggrieved, Mr Patel approached the Tribunal.

The debate

Mr Patel's counsel argued that this was one single transaction which had to be renewed on every badla date. Invariably, Mr Patel entered into hedging contract for purchase/sale of an equivalent number of Tisco shares to insure the risk of loss in the investments made for the purchase of 2,000 shares of Tisco. The payment of Rs 4,00,000 was made to cover up the risk of the broker against the loss due to fluctuations in the price of Tisco shares. The loss being genuine and real cannot be termed speculative since Mr Patel was not a speculator. He already owned some shares of Tisco along with investments in various other companies. He dismissed the applicability of Explanation 2 to Section 28 and Section 73(1) to the case since he was contesting the basics — Mr Patel was not in the speculative business at all. He was interested in the proviso to Section 45(2) which stated that a contract in respect of stocks and shares entered into by a dealer or investor therein to guard against loss in his holding of stocks and shares through price fluctuation cannot be labelled a speculative transaction.

The counsel for the Department kept it short and sweet. He claimed that the ratio of the CIT vs Ganga Prasad Birla (1993 199 ITR 173) decision fitted the instant case. Ganga Prasad Birla was labelled a speculator. He ridiculed the idea of calling the loss as a short-term capital loss since there was no capital asset at all.

The verdict

At the outset, the Tribunal concluded that since there was no actual delivery of shares, the transaction was a speculative one. The Tribunal then wanted to determine whether the exemption provided by proviso (b) to Section 43(5) would apply here. It decided to reproduce from the decision of the Gujarat High Court in Pankaj Oil Mills vs CIT (1978 115 ITR 824), where the wafer-thin difference between speculation and hedging was explained.

The Gujarat High Court only reiterated what the Tribunal had determined — in hedging transactions delivery is not contemplated, whereas in speculative transactions one is not too sure whether delivery is contemplated or not. The Tribunal was of the opinion that since Mr Patel did not have enough proof to prove the fact that he intended to take actual delivery of shares in the future, the loss suffered is a speculative one.

The other question that troubled the Tribunal was whether Mr Patel carried on speculative business; this was also answered, thanks to the Ganga Prasad Birla precedent.

The unsaid

One gets the impression that this is not the last word on speculative transactions. The Bombay High Court, in CIT v Kamani Tubes Ltd (1994 207 ITR 298), ruled that there is a perceptible difference between speculative transaction and speculative business. An isolated transaction of settlement of contract otherwise than by actual delivery might be speculative but in the absence of something more it cannot be called a speculative business.

The Supreme Court, in CIT vs Shantilal Pvt Ltd (1983 144 ITR 57 SC), opined that a contract can be said to be settled if, instead of effecting delivery, the promisee accepts any satisfaction which he thinks fit. A breach of contract and awarding of compensation on disputes cannot be called a speculative transaction. There were other decisions that supported the stand of the apex court .

Many a time, past decisions made by other courts are used as the basis to decide cases rather than start from the scratch. Ganga Prasad happened in 1993, and much has happened since, such as options and derivatives. The very nature of the hedging industry has changed so much that the investor has the luxury of indulging in a one-night visit to the hedging industry if he is prepared to take the risk.

If the Sensex behaves in the manner it has post-polls and in pre-Government formation, it would make sense to any investor to book a hedging contract on the BSE Sensex at its nadir and sell of at a time when he feels he has made enough. All he would get is the profit. If this is called a speculative transaction, occasional venturers into the field of options and derivatives need to be doubly careful about documentation and delivery of the shares.

In fact, on the other end of the spectrum, if Mr Patel had made a profit from this transaction, he would have had to show it as income from `other sources' and not `profits and gains of business or profession'.

The deductions he would have got if he declared the same as income from `other sources' would be, to say the least, miserly.

In case he had the luxury of declaring it under the latter, he would have probably claimed even the telephone calls he made to his broker as expenses. Why the converse should not be true is a question that has no answer at present.