2010 (9) TMI 1143 - AT - Income Tax

Derivative transactions not speculative under Income Tax Act

The ITAT Mumbai held that derivative transactions are not speculative transactions under section 43(5) of the Income Tax Act, 1961. The CIT(A)'s decision ... - ISSUES PRESENTED AND CONSIDERED 1. Whether losses from derivative transactions executed prior to the date of notification of recognized stock exchanges are 'speculative transactions' within the meaning of section 43(5) and therefore taxable as speculation losses. 2. Whether derivative contracts constitute 'contract for the purchase or sale of any commodity including stocks and shares' within the scope of section 43(5), or fall outside that definition because they do not result in actual delivery/transfer. 3. Whether the proviso (clause (d)) to section 43(5), as inserted by Finance Act, 2005 with effect from 01.04.2006, excludes derivative transactions carried out on a recognized stock exchange from being treated as speculative transactions for the relevant assessment year, including transactions occurring before the date on which the stock exchange was notified by the Central Government. 4. Whether expenditures attributable to derivative trading, when the trading is held to be non-speculative, are deductible as business expenditure rather than being disallowed as expenses of a speculative business. ISSUE-WISE DETAILED ANALYSIS Issue 1 - Characterisation of derivative losses prior to notification date as speculative Legal framework: Section 43(5) defines 'speculative transaction' as a contract for purchase or sale of any commodity including stocks and shares which is settled otherwise than by actual delivery/transfer. A proviso (clause (d)) excludes eligible derivative transactions carried out in a recognized stock exchange from being treated as speculative, subject to the Explanation and notification of recognized exchanges. Precedent Treatment: The Tribunal examined prior tribunal and judicial decisions addressing whether derivative/futures & options transactions are speculative or business transactions. A decision of a coordinate tribunal had held derivative dealings to be non-speculative. Another decision emphasized that the proviso's protection applies when transactions are eligible and carried out on a recognized exchange. Interpretation and reasoning: The Court accepted the view that clause (d) of the proviso, read with the Explanation, treats eligible derivative trading on a recognized stock exchange as non-speculative for the assessment year 2006-07 and onwards. The notification of the exchange is a subordinate act identifying the recognized exchange; once the exchange is notified, the exclusion operates in relation to the financial year relevant to the assessment year, and the exclusion is not to be read as confined only to transactions executed after the date of notification. The legislative scheme and the proviso's language indicate that eligible transactions carried on at a recognized stock exchange are not to be deemed speculative. Ratio vs. Obiter: Ratio - The proviso (d) excludes eligible derivative transactions carried out at a recognized stock exchange from being speculative for the assessment year 2006-07 and onwards, and that exclusion applies to the assessment year even if individual transactions occurred before the notification date so long as they relate to the financial year/assessment year covered by the proviso. Obiter - detailed policy comments on the nature of subordinate legislation and notification mechanics beyond application to the facts. Conclusions: The Court concluded that losses from the derivative transactions in issue are not speculative losses for assessment year 2006-07 and confirmed the appellate authority's deletion of the addition relating to speculation loss. Issue 2 - Whether derivatives fall within the scope of 'contract for purchase or sale' in section 43(5) Legal framework: The statutory definition in section 43(5) refers to contracts for purchase or sale of any commodity including stocks and shares, settled otherwise than by actual delivery. The Explanation and proviso carve out eligible derivative transactions on recognized exchanges. Precedent Treatment: Tribunal precedents have differed; some earlier orders held derivative transactions to be separate in nature and not speculative, while assessing authorities have treated derivatives as falling within the ambit of section 43(5). The appellate view relied on precedent holding that derivatives traded on recognized exchanges are eligible non-speculative transactions under proviso (d). Interpretation and reasoning: The Tribunal recognized that derivative contracts derive value from an underlying asset but are distinct from direct purchase/sale resulting in delivery. The crucial statutory test is whether the transaction is an 'eligible transaction' in the derivative segment carried out at a recognized stock exchange as per the proviso and Explanation. Therefore, even though derivatives are financial contracts linked to underlying securities, they are excluded from being deemed speculative if they meet the proviso's conditions. Ratio vs. Obiter: Ratio - Derivative contracts, when they qualify as eligible transactions executed on a recognized stock exchange as defined under the proviso and Explanation, are not to be treated as speculative transactions under section 43(5). Obiter - semantic distinctions on whether a derivative is or is not literally a 'contract for purchase or sale' irrespective of proviso application. Conclusions: The Court treated the proviso as determinative; it need not resolve abstractive semantic disputes because eligible derivative trading on a recognized exchange falls outside the definition of speculative transactions for the assessment year in question. Issue 3 - Effect of notification date of recognized stock exchange on eligibility of transactions Legal framework: The proviso refers to 'recognized stock exchange' as to be notified by the Central Government and the Explanation defines 'eligible transaction'. The notification is a subordinate legislative act identifying which exchanges are recognized. Precedent Treatment: A tribunal decision considered that the proviso's protection applies to transactions in the relevant assessment year once the exchange is notified, and that the notification does not operate retroactively to override the principal statute but clarifies recognition for purposes of the proviso. Interpretation and reasoning: The Tribunal accepted that the notification dated within the relevant financial year establishes the exchange as recognized for the purposes of the proviso. The proviso does not state that only transactions executed after the notification date qualify; rather, once the exchange is recognized in relation to the financial year/assessment year, eligible transactions in that segment are to be treated as non-speculative for that assessment year. The notification is subordinate legislation which identifies the recognized exchange and does not curtail the statutory exclusion by temporal restriction unless expressly provided. Ratio vs. Obiter: Ratio - The notification of the stock exchange does not limit the proviso's operation to transactions executed only after the notification date; the exclusion applies for the assessment year where the exchange is recognized for that period. Obiter - extended commentary on the legislative intent in explanatory notes. Conclusions: The Tribunal held that transactions in the derivative segment that are eligible and related to the assessment year 2006-07 are not speculative merely because executed before the formal notification date, and therefore losses are to be treated as business losses. Issue 4 - Deductibility of expenses attributable to derivative trading once trading is held non-speculative Legal framework: If derivative trading is income/loss from business and not speculative business, ordinary business expenses attributable to that trading are deductible under the Act subject to general provisions and substantiation. Precedent Treatment: The appellate authority followed earlier tribunal rulings treating derivative trading losses as business losses and allowing corresponding business expenses; the assessing officer had disallowed expenses treating them as speculative business expenditures. Interpretation and reasoning: Having concluded that the derivative transactions are not speculative for the assessment year, the Court treated the associated expenses as allowable business expenditure attributable to non-speculative derivative trading, rather than expenses of a speculative business which would have different treatment. Ratio vs. Obiter: Ratio - If derivative trading is held to be non-speculative under section 43(5) proviso (d), expenditures attributable to that trading are deductible as business expenses. Obiter - none beyond application of principle to the facts. Conclusions: The Tribunal confirmed deletion of the disallowance of the claimed expenses relating to the derivative trading. Overall Disposition The Tribunal dismissed the revenue's appeal, confirming that the derivative losses and related expenses in issue for the assessment year 2006-07 are not speculative in nature under section 43(5) as interpreted with proviso (d) and the Explanation, and are to be treated as business losses and allowable business expenses accordingly.