The Hindu Business Line : A narrative on derivatives

A SIGNIFICANT announcement was made by the Finance Minister in Para 175 of his Budget speech: "... 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."

Clause 14 of the Finance Bill, 2005 amends Section 43 of the I-T Act so as to exclude from the concept of speculative transactions any eligible transaction in respect of trading and derivatives referred to in clause (aa) of Section 2 of the Securities Contracts (Regulation) Act carried out in a recognised stock exchange. A new sub-clause (b) has been introduced in Section 43(5) for this.

The Notes on Clauses explain as under: "Clause 14 seeks to amend Section 43 of the Income-Tax Act relating to definitions of certain terms relevant to income from profits and gains of business or profession.

"Under the existing provisions contained in the proviso to clause (5) of the said section, certain transactions are not deemed to be speculative transactions.

"The proposed amendment seeks to provide that an eligible transaction in respect of trading in derivatives carried out in a recognised stock exchange shall also not be deemed to be a speculative transaction.

"The proposed amendment also seeks to define certain expressions and prescribed conditions to be fulfilled by the recognised stock exchanges.

This amendment will take effect from April 1, 2006, and will accordingly, apply in relation to the assessment year 2006-07 and subsequent years."

A speculative transaction is a deal which is settled otherwise than by actual delivery. Unabsorbed speculation losses are allowed under the income-tax law to be carried forward for eight years for set-off against speculation profits in subsequent years. The memorandum explains that these restrictions were essentially designed as an anti-evasion measure to prevent claims of artificially generated losses in the absence of an appropriate institutional infrastructure. To quote the memorandum:

"Recent systemic and technological changes included by stock markets have resulted in sufficient transparency to prevent generating fictitious losses through artificial transactions or shifting of incidence of loss from one person to another. The screen-based computerised trading provides for an excellent audit trail. Therefore, the present distinction between speculative and non-speculative transactions, particularly relating to derivatives is no more required... These amendments will take effect from April 1, 2006 and will, accordingly, apply in relation to assessment year 2006-07 and subsequent years."

What is the implication of this amendment? Since it takes effect from 2006-07 onwards, does it imply that up to 2005-06, profits from derivative trading can be considered either as business or speculative profits depending on the facts of the case? As far as FIIs are concerned, we have the celebrated decision of the Authority for Advance Ruling in the Morgan Stanley & Co International Ltd (272 ITR page 416) case, holding that income from derivative trading in the case of a global FII such as Morgan Stanley should be considered only as business income and not as capital gains.

This was also extended to equity trading in the Fidelity Advisor Series VIII (2004 271 ITR page 1) case. These decisions were based on interpretation of the Indo-American DTAA concerning the existence of a permanent establishment (PE) or the taxability of business profits. In respect of traders within India, the law as declared in Section 43 will prevail and there can be controversy on the question whether derivative trading results in speculation gains or business profits.

It is necessary that the amendment now made to Section 43 applies to pending assessments too, either by giving it retrospective effect or making it declarative so that controversies may be avoided. It is not as if the amendment is entirely for the benefit of the taxpayer. In fact, day traders may lose because of the amendment. To put an end to litigation, the amendment should be declared clarificatory.

(The author is a former Chief Commissioner of Income-tax.)

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

Stories in this Section
Short on credibility

Oil: Super spike or crying wolf?

A narrative on derivatives

Superfluity comes sooner with white hairs

Standard, dead and buried

Is FBT a fundamentally blemished tax?

Time to streamline regulatory law-making