Business of Derivatives Trading & Explanation to Section 73

Section 43(5) 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. Proviso to section 43(5) lists certain exceptions
to the ‘speculative transactions’, vide clasues (a) to (e). Clause (d)
of the proviso provides that an ‘eligible transaction’ in respect of
trading in derivatives referred to in section 2(ac) of the Securities
Contracts (Regulation) Act, 1956 carried out on a recognised stock
exchange shall be deemed not to be a speculative transaction.

Therefore,
derivatives transactions satisfying the needs of being treated as
‘eligible transactions’ are not regarded as speculative transactions for
the purposes of computing business profits u/s. 28.

The
explanation to section 73 provides for a deeming fiction where under
certain business carried on by a company is deemed to be a speculation
business. This fiction of explanation to section 73 applies only to a
company. If any part of the business of the company consists in the
purchase and sale of shares of other companies, such company is deemed
to be carrying on a speculation business to the extent to which the
business consists of the purchase and sale of such shares. Certain
exceptions to this fiction are provided in this regard.

An
interesting issue which has come up for consideration before the courts
is as to whether the business of derivatives transactions, which are not
regarded as speculative transactions by virtue of the proviso to
section 43(5), can be deemed to be a speculation business by virtue of
the explanation to section 73. While the Delhi High Court has taken the
view that the provisions of the explanation to section 73 do apply to
such derivatives trading business, and it is therefore deemed to be a
speculation business, the Calcutta High Court has taken a contrary view
and held that the explanation to section 73 applies only to transactions
in shares, and not to transactions in derivatives, and that therefore
derivatives trading business cannot be deemed to be a speculation
business.

DLF Commercial Developers’ Case
The issue first came up before the Delhi High Court in the case of CIT vs. DLF Commercial Developers Ltd 218 Taxmann 45.

In
this case, the assessee claimed a loss of Rs 492.71 lakh on account of
purchase and sale of derivatives. It claimed that the loss in trading of
derivatives was not a speculation loss in terms of section 43(5), and
could not be disallowed as a speculation loss under any provisions of
the Income Tax Act. The assessing officer rejected that submission, and
held that the explanation to section 73 applied, since it was
independent of section 43(5). He therefore treated the loss as a
speculation loss, and did not permit the adjustment of the loss against
business income.

The Commissioner(Appeals) rejected the
assessee’s contention. In further appeal to the tribunal, the tribunal
held that the explanation to section 73 was not applicable, and granted
relief to the assessee.

Before the Delhi High Court, on behalf
of the revenue, it was argued that the explanation to section 73
categorically provided that where any part of the business of the
company included purchase and sale of shares of another company, it
should l be deemed that the company was carrying on speculation business
to the extent to which the business consisted of that activity. It was
further argued that the intention of section 43 was to define certain
terms for the purposes of sections 28 to 41. It was argued that clause
(d) of the proviso to section 43(5) had restricted application, in that
it excluded transactions in derivatives only for a limited purpose. It
was claimed that section 73 had wider application and related to all
manner of losses concerning shares.

Reliance was placed on
behalf of the revenue on the decisions in the cases of CIT vs.
Intermetal Trade Ltd 285 ITR 536 (MP), CIT vs. Arvind Investments Ltd
192 ITR 365 (Cal) and Eastern Aviation and Industries Ltd vs. CIT 208
ITR 1023 (Cal). It was argued that the specific inclusion of the
activity of sale and purchase of shares of other companies from the
otherwise general application of principles underlying section 73 meant
that those transactions could not claim the benefit of the provision of
s.43(5). It was pointed out that derivatives of the kind and nature
traded by the assessee in the case before the court related to stocks
and shares, and were the subject matter of transactions on a stock
exchange. It was therefore claimed that the tribunal ought not to have
permitted the assessee the benefit of set of such loss.

On
behalf of the assessee, it was argued that the transactions in
derivatives were specifically excluded from the definition of
speculative transactions. Even though that definition was in section
43(5), it could not be ignored, since there was no other definition of
derivatives in the Income Tax Act. It was highlighted that derivatives
need not be only in respect of stocks and shares, but could also be in
respect of commodities. Reliance was placed on the decision of the
Madras High Court in Rajshree Sugars and Chemicals Ltd vs. Axis Bank Ltd
AIR 2011 Mad 144, for this proposition. The attention of the court was
also drawn to the decision of the Bombay High Court in the case of CIT
vs. Bharat R Ruia (HUF) 337 ITR 452, where the court had considered the
pre-amended section 43(5) before insertion of clause (d) in the proviso,
and held that derivatives in the light of the then existing law were
speculative transactions, but that the position had changed after
1.4.2006, when clause (d) was inserted in the proviso to section 43(5).
It was therefore argued that the tribunal had correctly held that the
assessee was entitled to the benefit of set off of the losses.

The
Delhi High Court analysing the provisions of section 73 and section
43(5) held that ; the term “speculative transaction” was defined only in
section 43(5) and the scope of the definition was restricted in its
application to working out the mandate of sections 28 to 41 in as much
as those provisions dealt with the computation of business income and
that it was not possible for the court to ignore or overlook that the
definition was confined in its application, to the extent it excluded
such transactions from the mischief of the expression “speculative
transactions”.

The Delhi High Court observed that while it was
tempting to hold that since the expression “derivatives” was defined
only in section 43(5), and since it excluded such transaction from the
odium of speculative transactions, and further, since it had not been
excluded from section 73, the explanation to section 73 did not apply,
however by doing so, the court would be doing violence to the
parliamentary intendment. This was because a definition enacted for only
a restricted purpose or objective should not be applied to achieve
other ends or purposes. Doing so would be contrary to the statute.

The
High Court stressed the contextual application of a definition or term.
The High Court observed that the stated objective of section 73, as was
apparent from the tenor of its language, was to deny speculative
businesses the benefit of set off of losses against other business
income.

The explanation to section 73 had been enacted to
clarify beyond any shadow of doubt that share business of of companies,
subject to certin exceptions, was deemed to be speculative. The fact
that in another part of the statute, which dealt with the competition of
business income, derivatives were excluded from the definition of
speculative transaction only underlined that such exclusion was limited
for the purposes of those provisions or sections. In the case before it,
the High Court noted that the derivatives were based on stocks and
shares, which fell squarely within the explanation to section 73.

According
to the Delhi High Court, it was therefore ideal to contend that
derivatives did not fall within the provision, when the underlying asset
itself did not qualify for the benefit, as derivatives were entirely
dependent on stocks and shares for the determination of their value. The
Delhi High Court therefore held that the explanation to section 73
applied to the case before it, and that the loss on trading in
derivatives could not be set off against other income.

Asian Financial Services’ Case
The
issue again came up recently before the Calcutta High Court In the case
of Asian Financial Services Ltd vs. CIT 70 taxmann.com 9.

In
this case, the assessee, a company, incurred a loss of Rs. 3,24,76,185
in futures and options transactions in shares being loss in derivatives
transactions. It claimed that this loss should be set off against other
business income, including profit from transactions in shares. The
assessing officer, for the purposes of s. 73, treated such loss as a
deemed speculation loss and did not allow set off of the loss against
the business income, by applying the explanation to section 73. While
the Commissioner (Appeals) allowed the assessee’s appeal, the tribunal
held against the assessee, holding that the explanation to section 73
applied, and the loss was a speculation loss, which could not be set off
against any other income.

Before the Calcutta High Court, on
behalf of the assessee, it was argued that the loss was on account of
derivatives being the futures and options which was excepted from the
definition of the speculative transaction and as a consequence the loss
was to be treated as a business loss under the proviso to section 43(5).
It was argued that once it was deemed to be a business loss under the
proviso to section 43(5), the question of applying section 73 or the
explanation to that section for the purpose of refusing the loss to be
set off against business income was palpably wrong. It was claimed that
the decision of the Delhi High Court relied upon by the tribunal did not
lay down good law, and that the Delhi High Court erred in holding that
dealing in derivatives was also a speculation loss within the meaning of
section 73.

On behalf of the revenue, it was argued that
section 43(5) was a general provision, while section 73 was a specific
provision. Attention was drawn to the explanation to section 73 to
submit that a company dealing in purchase and sale of shares amongst
others, which did not come within the exceptions carved out in the
explanation itself, was hit by the mischief of the explanation. A
question was raised that whether it could be said that when a business
consisting of purchase and sale of shares of other companies amounted to
a speculation business, business in derivatives, which depended on the
value of the underlying shares, was anything other than a speculation
business. It was argued that the view taken by the Delhi High Court in
DLF Commercial Developers’ case ( supra) was the correct view.

The
Calcutta High Court rejected the arguments of the revenue, observing
that, it could not be said that section 43(5) was a general provision
and section 73 was a specific provision. The Calcutta High Court in
fact, expressed the contrary view that the object of section 43(5) was
to define “speculative business”. The High Court observed that chapter
IV-D of the Income Tax Act, consisting of sections 28 to 44DB, dealt
with profits and losses of business or profession. It observed that when
the statute talked of profit, it also referred to losses, because loss
had been construed as a negative profit.

The Calcutta High Court
noted the language of the explanation to section 28 and observed that
from a plain reading of the explanation, the following deductions could
be made:

1. speculative transactions carried on by an assessee might be of such a nature as to constitute a business;

2. such speculation business carried on by an assessee should be deemed to be distinct and separate from any other business.

The
Calcutta High Court therefore concluded that speculation transactions
might partake the character of deemed business where the statute so
provided. The court then noted the definition of speculative transaction
contained in section 43(5), and the five exceptions contained in the
proviso thereto, and observed that such excepted transactions came
within the category of deemed business, which was distinct and separate
from any other business.

Addressing the question as to whether
loss arising out of such deemed business could be set off against the
profit arising out of other business or businesses, the High Court noted
that the provisions of section 70 permitted an assessee to set off loss
against his income from any other source under the same head, unless
otherwise provided. Therefore, the losses from the deemed business could
be set off against other business profits, unless otherwise provided.
The question was whether the explanation to section 73 provided
otherwise. According to the Calcutta High Court, a plain reading of the
explanation showed that it did not provide otherwise. Therefore,
according to the Calcutta High Court, the irresistible conclusion was
that the assessee was entitled to set of such loss arising out of deemed
business against other business income.

While the Calcutta High
Court agreed with the view of the Delhi High Court that shares fell
squarely within the explanation to section 73, it expressed its
disagreement with the treatment of derivatives at par with shares by the
Delhi High Court, since the Legislature had treated them differently.

The
Calcutta High Court therefore allowed the appeal of the assessee,
holding that the loss in derivatives transactions was not covered by the
explanation to section 73, and could be set off against other business
profits.

Observations
The definition of “securities”
u/s. 2(h) of the Securities Contracts (Regulation Act), 1956 makes it
clear that shares and derivatives are distinct from each other, though
both are securities, and even though derivatives derive their value from
the underlying shares or commodities.

The Companies Act, 2013
eliminates any possibility of treating the derivatives and shares to be
one. Section 2(84) defines ‘shares’ while section 2(33) defines the term
’derivatives’ and section 2(81) defines ‘securities’ and a combined
reading of all of them clearly confirm that the shares are not
derivatives for the purposes of the Companies Act, 2013 and if they are
not so there is no reason to treat as one and the same unless they are
defined to mean so for the purposes of the Income tax Act. In fact,
clause(d) of section 43(5) in turn refers to clause (ac) of section 2 of
the SCRA for providing the meaning to the term ‘derivatives’ for the
purposes of the Income tax Act.

It is well settled that a
deeming fiction is to be strictly construed. The explanation to section
73 deems certain business to be a speculation business, and is therefore
a deeming fiction. This deeming fiction merely refers to purchase and
sale of shares, and does not refer to purchase and sale of any other
securities. Therefore, given the fact that derivatives are not referred
to in the explanation, the deeming fiction of the explanation cannot be
extended to cover derivatives.

This view is supported by the
decision of the Supreme Court in the case of CIT vs. Apollo Tyres Ltd
255 ITR 273, where the Supreme Court held that units of mutual funds
were not shares, and therefore that the business loss in dealing in such
units was not covered by the explanation to section 73. In the case of
units of mutual fund also, as in the case of derivatives, the value of
the mutual fund units is derived from the underlying assets, which are
shares. If transactions of trading in mutual fund units do not fall
within the ambit of the explanation to section 73, logically,
transactions of trading in derivatives should also not fall within the
ambit of the explanation.

We have no doubt that the decision of
the Delhi high court could have been different had the court’s attention
been drawn to the decision of the apex court delivered in the context
of explanation to section 73 i.e on the same subject as is the subject
of discussion here.

Further, the provisions of section 43(5),
explanation 2 to section 28, and section 73 should be regarded as one
integrated scheme, for the limited purpose of set off of business loss
against any other income.

The term “speculation” is not used in
any other section of the Income Tax Act, and therefore this is a logical
interpretation. In the absence of section 73, there was no necessity of
the definition of speculative transaction in section 43(5), nor of
explanation 2 to section 28. When an item is specifically excluded from
the provisions of section 43(5), the intention clearly is to exclude it
also from the provisions of section 73, unless section 73 expressly
provides to the contrary. In any case, the explanation to section 73
while referring only to shares, clearly indicates that loss of trading
in derivatives does not fall within the deeming fiction of the
explanation.

The better view, therefore, seems to be that of the
Calcutta High Court, that loss on trading in derivatives is not
governed by the explanation to section 73, and that such loss incurred
by companies can be set off against other income.