Commodity Markets

Strange as it may sound, the Indian commodity markets are older than the securities markets, however, very little is known about these markets to the common man. The various commodity markets in India clocked a turnover of over Rs.92 trillion for the period ended April to December 2011. Commodity markets have various components, such as bullion, metals, grains, energy, oil and oilseeds, petrochemicals, pulses, spices, plantation products, etc. and span over 100 commodities. In the recent past, gold and silver have given excellent returns and that is why now there is a sustained interest in the commodity markets. Let us take a bird’seye view of the regulatory aspect of this market, the types of contracts which can be executed, the tax treatment of these contracts, etc.

Forward Contracts (Regulation) Act

The FCRA regulates the forward contracts in commodities. As the name suggests, it does not apply to spot delivery contracts. It is somewhat similar in nature to Securities Contracts (Regulation) Act, 1956.

Forward Market Commission

(a) Ready Delivery Contracts — Contracts where delivery and payment must take place immediately or within a maximum period of 11 days. These are similar to the spot delivery contracts which one comes across under the SCRA. If a commodity contract is settled by cash or by an offsetting contract and as a result of that the actual tendering of goods is dispensed with, then it is not an Ready Delivery Contract. These contracts are outside the purview of the Forward Markets’ Commission. The Amendment Bill seeks to increase the duration from 11 to 30 days.

(b) Forward Contracts — These are contracts for the delivery of goods and are not a Ready Delivery Contract. The FMC regulates these Contracts. Commodity derivatives are also a type of Forward Contract. Thus, a contract which is settled by cash or by an offsetting contract and as a result the actual tendering of goods is dispensed with becomes a Forward Contract.

Forward Contracts can be of three types:

(a) Specific Delivery Contract — It is a Forward Contract which provides for the actual delivery of specific qualities of goods. The delivery must take place during a specified future period at a price fixed/to be fixed. Further, the names of the buyer and seller must be mentioned in the contract. The Amendment Bill proposes to add that such contracts must also be actually performed by actual delivery.

Specific Delivery Contracts cannot be settled by paying the difference in cash or by an offsetting contract. They can be executed on an off-market basis also. Specific delivery contracts are contracts entered into for actual transactions in the commodity and the terms of contract may be tailored to suit the needs of the parties as against the standardised terms found in futures contracts.

Specific Delivery Contracts, in turn, can be of two types — Non-Transferable (NTSDC) and Transferable (TSDC). Non-transferable are those contracts which are only between a defined buyer and a seller and cannot be transferred by either party, whereas ‘transferable contracts’ may be transferred from one person to another till the actual maturity of the contract or delivery date.

(b) Forward contracts other than specific delivery contracts are what are generally known as ‘Futures Contracts’, though the Act does not specifically define the term futures contracts. Such contracts can be performed either:

• by delivery of goods and payment thereof or by entering into offsetting contracts and payment; OR

• by cash settlement, i.e., receipt of amount based on the difference between the rate of entering into contract and the rate of offsetting contract.

Thus, the main difference between Specific Delivery Contracts and Futures is that while Specific Delivery Contracts must be performed by delivery, futures can be cash settled also. Futures contracts are usually standardised contracts where the quantity, quality, date of maturity, place of delivery are all standardised and the parties to the contract only decide on the price and the number of units to be traded. Futures contracts must necessarily be entered into through the Commodity Exchanges.

(c) Option Agreements —

The Amendment Act proposes to add a third category — options in commodities. This would mean an agreement for the purchase or sale of a right to buy and/or sell goods in future and includes a put and call in goods. These must be entered into through the Commodity Exchanges.

Commodity exchanges

Currently, permanent recognition has been granted to three national-level multi-commodity exchanges, Multi-commodity Exchange of India Limited (MCX), National Commodity and Derivatives Exchange Limited (NCDEX), and National Multi-commodity Exchange of India Limited (NMCE) Ahmedabad. These national commodity exchanges have permission for conducting forward/futures trading activities in all commodities, to which section 15 of the FCRA is applicable.

Members of commodity exchanges are commodity brokers.

Trading in forward contracts

Nothing contained in section 15 applies to Specific Delivery Contracts, whether transferable or non-transferable. However, the Central Government is empowered u/s.18(3) to notify such classes of Specific Delivery Contracts to which the provisions of section 15 would also apply.

Regulation of commodity brokers

Commodity brokers cannot provide advisory services to clients for investment in commodities futures contract. Portfolio advisory services, portfolio management services and other services are not permissible in the Commodity Derivative Markets. The FMC has not formulated any guidelines for investment advisory services by any entity and hence, these activities are not permitted to the brokers.

Trading in overseas commodities exchanges and setting up joint ventures/wholly-owned subsidiaries abroad for trading in overseas commodity exchanges is reckoned as financial services activity under the FEMA Regulations and requires prior clearance from the FMC. Any investment in a JV/WOS for such a purpose would have to comply with the requirements for overseas direct investment in a financial service as specified under Rule 7 r.w. Rule 6 of the FEMA Notification No. 120/2004.

FDI in commodity brokerages

Neither the Consolidated FDI Policy issued vide Circular 2/2011, nor the Regulations issued under the FEMA, 1999 contain any specific provision for foreign direct investment in a commodity brokerage. Hence, any FDI in a commodity brokerage would require prior FIPB approval. The FIPB has given approvals to several such FDI proposals.

However, it may be noted that the RBI does not permit foreign banks to invest in commodity brokerages, whether directly or indirectly. Hence, any proposal for FDI by a foreign bank in a commodity broker would not be permissible. It is for this reason that the takeovers of IL&FS Investmart by HSBC and Geojit Securities by BNPI were held up by the RBI till such time as the commodity broking arms were hived-off/restructured. FDI in commodity exchanges is allowed up to 49% (FDI & FII). Investment by Registered FIIs under the Portfolio Investment Scheme (PIS) is limited to 23% and investment under the FDI Scheme is limited to 26%.

Taxation of commodity contracts

Taxation of commodity derivative contracts is one of the issues facing investors and traders in commodities. The first question to be considered is whether the assessee is an investor or a trader and hence, whether his gain is taxable as capital gains or as business income. The various tests, judgments, controversies, etc., which one comes across while dealing with this issue in the case of securities would be applicable even to commodities.

Secondly, in the cases where they constitute a business, the question arises whether they constitute a speculative business. Section 43(5) of the Income-tax Act grants a specific exemption to derivatives traded on stock exchanges. However, there is no specific exemption for contracts traded on commodity exchanges. Hence, one would have to ascertain whether a commodity contract falls under any of the other exemptions specified u/s.43(5).

Further, the losses from speculative commodity businesses can only be set off against speculative commodity businesses. They cannot be set off against profits from delivery based commodity transactions or capital gains or profits from security derivatives transactions.

Stamp duty on contract notes

Stamp Duty on commodity transactions is a State subject and the duty incidence would depend upon the location of the broker’s office which issues the contract note. For instance, under the Bombay Stamp Act, 1958, the State of Maharashtra levies a duty @ 0.005% of the value of the contract for the purchase or sale of any commodity, such as cotton, bullion, spices, oil seeds, spices, etc. Similarly, any electronic or physical contract note issued by a commodity broker, whether delivery based or non-delivery based attracts a duty @ 0.005%.

Maharashtra levies one of the highest incidences of stamp duty on commodity broker notes. Earlier, such contracts were charged with minimum duty of Rs.100 per document.

Section 10B of the Bombay Stamp Act, provides that it is the responsibility of the commodity exchange to collect the stamp duty due on brokers’ notes by deducting the same from the brokers account at the time of settlement of such transactions.

Penalties under FCRA

Any violation of the FCRA is a criminal offence inviting imprisonment and/or a fine. The Bill proposes to make the penalties for violating the FCRA more stringent, for example, violation of some of the provisions would carry imprisonment up to one year and/or a fine ranging from Rs.25000 to Rs.25 lakh. The Bill also seeks to introduce penalties for insider trading similar to what is found under the SEBI Act.

Auditor’s responsibility

Just as a compliance audit of stock brokers requires a knowledge of the securities markets, an audit of commodity brokers requires knowledge of the commodity markets on the part of the auditor. This would include a knowledge of the various applicable Regulations, relevant Exchange Circulars, Compliance Forms, etc.

An auditor of a market intermediary should be well-versed with the important laws in this respect which affect the functioning and the existence of the entity. For instance, in case of the intermediaries, non-compliance with the regulations could result in cancellation of the registration certificate and this would affect the very substratum of the entity.

By broadening his peripheral knowledge, the Auditor can make intelligent enquiries and thereby add value to his services. He can caution the auditee of likely unpleasant consequences which might arise as a result of improperly stamped or unregistered mortgage deeds. It needs to be repeated and noted that the audit is basically under the relevant law applicable to an entity and an auditor is not an expert on all laws relevant to business operations of an entity. All that is required of him is exercise of ‘due care’.