Are Derivatives really speculative transactions?

1. Special Bench decision:- A recent tribunal decision of the Kolkata Special Bench in Shree Capital Services Ltd. vs. ACIT [ITA no. 1294 {Kol} of 2008 dated 31-7-2009 for A.Y. 2004-05] has upset the apple carts of many in the share trading community. The issues before the Special Bench were primarily two fold. Firstly, whether loss from transactions in share derivatives was a speculation loss within the meaning of section 43 [5] of the Income Tax Act, 1961, more particularly because there was apparently no delivery observed. Secondly, whether the Finance Act 2005 amendment to section 43 [5], by insertion of new clause [d] in the proviso with effect from 1-4-2006, was clarificatory in nature? By this clause [d], transactions in derivatives carried on approved stock exchanges are treated as non speculative transactions.

Prior to this Special Bench decision, two decisions of Mumbai Tribunal {DCIT vs. SSKI Investors Pvt. Ltd. and RBK Securities Pvt. Ltd. vs. ITO respectively] had held that such derivative transactions, even before the amendment, were non speculative.

In the Special Bench decision, both the above issues have been answered against the assessee. The Special Bench has firstly ruled that the derivative was very much a ‘commodity’ within the meaning of section 43 [5] and that since there is no delivery of this commodity involved, the transaction was essentially speculative in terms of this section. The Special Bench has further held that the amendment in clause [d] was prospective and not clarificatory in nature.

The objective behind this article is neither to criticize the Special Bench decision nor support the previous two Mumbai Tribunal decisions. Utmost respectfully, no such result is intended. The objective is only to put the readers to query as to whether a different approach in thinking is possible on the issues before the Special Bench?

2. Section 43 [5]:- To begin with, let us briefly scan the law in section 43 [5] from its history. Under this provision, ‘speculative transaction’ has been defined as meaning ‘ 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 [emphasis supplied in bold italics underlined ] or transfer of the commodity or scrips.’

A proviso appended below this provision carves out certain exceptions to this sub-section. Clause [d] is one such exception inserted by Finance Act, 2005 w.e.f. 1-4-2006, by which transaction of trading in derivatives carried out on a recognized stock exchange [as approved by the Central Government for purpose of this clause] is not treated as a speculative transaction.

3. Legal History: – The law in section 43 [5] [as prior to its amendment by Finance Act 2005] is age old and can be traced back even in to the erstwhile Income Tax 1922. Section 24 [1] therein contained the same law as in the section 43 [5] of the present Act.

The Supreme Court in the case of Davenport & Co. P. Ltd. vs. CIT [1975] 100 ITR 715 {SC} had the occasion to consider the expression ‘actual delivery’ in terms of section 24 [1] of the 1922 Act. The assessee, in this case, had indulged in transactions in purchase and sale of jute goods. The assessee had no godown to stock these goods and only delivery orders had changed hands in these transactions. The argument of the assessee that the handing over of the delivery orders constituted ‘constructive delivery’ of the goods and that its transactions cannot be considered as ‘speculative’ within the meaning of section 24 [1].

Ruling against the assessee, the Supreme Court held as under:-

“Explanation 2 defines a speculative transaction as a transaction in which a contract for purchase and sale of any commodity is periodically or ultimately settled otherwise than by the actual delivery or transfer of the commodity. The words “actual delivery ” in Explanation 2 mean real as opposed to notional delivery. For income-tax purposes speculative transaction means what the definition of that expression in Explanation 2 says. Whether a transaction is speculative in the general sense or under the Contract Act is not relevant for the purpose of this Explanation. The definition of “delivery ” in section 2(2) of the Sale of Goods Act which has been held to include both actual and constructive or symbolical delivery has no bearing on the definition of speculative transaction in the Explanation. A transaction which is otherwise speculative would not be a speculative transaction within the meaning of Explanation 2 if actual delivery of the commodity or the scrips has taken place; on the other hand, a transaction which is not otherwise speculative in nature may yet be speculative according to Explanation 2 if there is no actual delivery of the commodity or the scrips. The Explanation does not invalidate speculative transactions which are otherwise legal but gives a special meaning to that expression for purposes of income-tax only.”

In short, the Supreme Court held that the expression ‘actual delivery’ meant ‘real delivery’ and a constructive delivery was not good enough. This principle laid down by the Supreme Court holds good even today in context of section 43 [5] of the present 1961 Act.

4. Derivatives:- Let us now try to understand transactions in derivatives carried on stock exchanges more particularly ‘index futures’ and ‘stock futures’ because these are the derivatives which are currently being traded in.

An ‘index future’ is a standardized contract to buy or sell a specified security at an agreed future date at an agreed price. An index future, as the name suggests, is a future on the index i.e. the underlying is the index itself. There is no underlying security or stock, which is to be delivered to fulfill the obligation as index futures are cash settled. As other derivatives, the contract derives its value from the underlying index.

A ‘stock future’ is likewise a standardized contract to buy or sell a specified stock at a future date at an agreed price. A stock future, as the name suggests, is a future on a stock i.e. the underlying is a stock. The contract derives its value from the underlying stock.

5. An example of derivative: – From the above, readers may appreciate that what is being traded as a derivative is not the share, but the ‘contract’. Let us see how this happens with the help of an example. Let us say that X and Y agree to buy and sell a particular stock ‘M’ at a future date at an agreed price. The contract that is created is the derivative product called ‘stock future’ which is traded on the stock exchange. It is this ‘contract’ that is the traded product and not the share ‘M’ which is underlying it. Actually, there is no real share ‘underlying’ here and the word ‘underlying’ is just an expression of art. The share is used only as a reference so as to give the derivative an identity relatable to this share and thereby assign it a consequential tradeable value to it. However figmentally imaginative this may seem conceptually, the commercial reality is that derivatives are ‘real’ and traded in millions.

6. Derivative – whether a ‘commodity’?:- We have seen above in the provisions of section 43 [5] that if a transaction of purchase or sale of a ‘commodity’ is settled otherwise than by delivery, then the transaction is treated as ‘speculative’. A share or stock is not generally looked upon as a commodity [i.e. goods], but section 43 [5] uses the expression ‘commodity’ as ‘including shares and stocks’ thereby expanding on the ordinary meaning of ‘commodity’. From this we can understand that the word ‘commodity’ is used in a wider sense in section 43 [5] as more particularly denoting an item which is being traded and in this context, it can be fairly conceded that it can also include a ‘derivative’, which we have seen is as a product traded on the stock exchange. To this extent, we may all agree with the Special Bench’s finding that a derivative constitutes a ‘commodity’ for purposes of section 43 [5].

7. The true test: – Therefore, whether a transaction in purchase and sale of the derivatives on the stock exchange, is a speculative or not in terms of section 43 [5] should be tested with reference to the derivative [the ‘contract’ traded as a product] and not with reference to the so called share underlying it.

So, the moot question is whether or not there is delivery involved in the purchase and sale of this derivative?

8. Delivery in derivatives?:- We have understood the derivative as standardized contract of stock exchange. Therefore, the trading in the derivative is nothing but assignments of this contract for a value. A contract may now further be understood as an intangible product [i.e. a product which cannot handed over physically].

I would now alert the readers on certain propositions I will making. According to me, the common belief, that the concepts of ‘possession’ and ‘delivery’ are only confined to ‘physicals’ i.e. tangibles and not to intangibles, is not accurate. There can be delivery of possession in intangibles, even though the possession is not of a physical property.

What, after all, is delivery? Delivery is generally understood as a voluntary transfer of possession from one person to another.

Let us now see how there is ‘delivery’ and ‘possession’ in the transaction of trading in derivatives.

9. An example of a trade: – Let us once again re-consider the above example of trading in a derivative. X and Y agree to buy and sell a particular stock ‘M’ at a future date at an agreed price. The contract that is created is the derivative product called ‘stock future’ which will be traded on the stock exchange. It is this ‘contract’ that is the traded product and not the share ‘M’ which is underlying it. At this stage, the derivative is only ‘created’ and is now ready for trading.

Now, by this contract, X has acquired the right to buy ‘M’ and Y has acquired the right to sell ‘M”. Can we not say that both X and Y are ‘possessed’ of their individual rights?. Is this not ‘possession’ of the intangible property viz. the derivative?

Per contra, would it not be quaint if we agree in one breath that X and Y hold derivatives and in the other breath, we deny that they possess the same? Will these statements not be self contradictory?

Therefore, to say that that X and Y are in possession of their individual derivatives would be a fair proposition.

Let us now assume that X sells his right to buy ‘M’ to Z for a price. Will it not be fair to say now that it is Z that is possessed of the derivative and simultaneously, X is now dispossessed of the same? Is this not ‘delivery’ of possession of the derivative from X to Z.?

In short, just as there are deliveries in case of transactions involving transfers of tangibles, deliveries also take place in case of intangibles. In case of intangibles, the deliveries take place in their own indigenous ways compatible with the characteristics of intangibleness therein.

This possibility has respectfully not been considered as an issue in the Special Bench decision even after recognizing a derivative as a ‘commodity’. To say on one hand, that a derivative is a commodity [i.e. an item of trade, which should essentially pass hands as movable property] and also say on other hand, that the same commodity is incapable of delivery, may be dichotomy which is not compatible with the very concept of ‘commodity’ as a movable. In fact, the Special Bench has proceeded on the assumption that in transactions of derivatives, there is no delivery involved.

10. Age of intangibles: – Readers may note that it is pertinent that we are living in an age where awareness of intangibles as ‘goods’ is progressively increasing. The fact that intangibles are being treated at a par with tangibles is also receiving judicial cognisance. For example, in the decision of CIT vs. B. Suresh [313 ITR 149 {SC}], which is incidentally the very judgement referred by the Special Bench in its decision, the Supreme Court noted that the difference between the goods and services is getting blurred in globalization, cross border transactions and technological advancements. It would be fitting if legal perceptions about intangibles also change in keeping with time.

It is essential that interpretations of words used in the Income Tax Act be aligned with the context in which the same are used and thereby, purposeful meanings be assigned to them which are compatible with the needs of time. It is submitted that it is in this sense that the word ‘delivery’ used in the provisions of section 43 [5] should be interpreted. The law, after recognizing ‘derivatives’ as ‘commodities’ for the purposes of this section, should not fall short in interpreting ‘delivery’ in a meaning commensurate with intangible characteristics of the derivatives. The word ‘delivery’ in section 43 [5] should be accommodated with a meaning matching with the type of commodity with which it is proposed to be used.

This is one way I am suggesting that the readers should look forward to in their thinkings.

11. Derivatives and ‘actual’ delivery: – If, the readers are reconciled with me to the proposition that derivatives as intangibles are deliverable, they may join me to examine whether there is ‘actual delivery’ of the same in their trading. This is because section 43 [5] requires ‘actual delivery’ as opposed to ‘notional delivery’ as we have seen from the decision of the Supreme Court in the case of Davenport & Co. P. Ltd. vs. CIT [1975] 100 ITR 715 {SC} discussed above.

It is pertinent that the mode of trading in derivatives on the stock exchanges is different from that in this Supreme Court decision. In the Supreme Court decision, the possession of the jute goods was not ‘exclusive’ with the assessee and what was delivered were only the delivery notes i.e. the document of title of goods. The deliveries of the jute goods were thus ‘notional’ and not ‘actual’ in this sense. In case of trading of derivatives, though the derivatives are ‘contracts to buy or sell shares’, they are the very commodities traded on the stock exchange and they are not document of title of the commodities. Therefore, when the derivatives are transferred, the product is transferred and not documents of title of the products. The deliveries are therefore actual and not constructive.

Further, in the Supreme Court decision, the possession of the jute goods was never with the assessee at any time, which possession was in hands of a third party. But, in the instant case of derivatives, no third person holds its possession to the exclusion of the one actually entitled to it.

This are the marked differences between the nature of trade in the Davenport case before the Supreme Court and in the instant case of derivatives.

It is in the above context that I ask the readers to apply the mind as to whether it is possible to take a view that there is ‘actual delivery’ in the trading of derivatives on the stock exchanges? If, the answer to this query is in affirmative, then it would mean that the transactions in derivatives were not ‘speculative’ in terms of section 43 [5] even before the amendment by insertion of clause [d] w.e.f. 1-4-2006. I also leave it to the readers to examine whether the Special Bench decision in the case of Shree Capital Services Ltd. requires reconsideration or not.

12. Amendment –whether clarificatory: – As to what would be the effect of the amendment to section 43 [5] by insertion of clause [d] thereto with effect from 1-4-2006 will also need to be seen. If, the readers agree with my proposition put above that transactions in derivatives were not ‘speculative’ in terms of section 43 [5] even before this amendment, I would still surprise them by saying that the amendment in clause [d] is not fully clarificatory.

This is because the insertion of clause [d] has made a substantial change in the law as prevailing before the amendment. If, before the amendment, the legal position was that transactions carried out on all stock exchanges were non-speculative, after the amendment, transactions would be non –speculative only if the same are conducted on ‘recognized stock exchanges’. Presently, only two stock exchanges have been approved [i.e. National Stock Exchange & Bombay Stock Exchange] for the purposes of section 43 [5] [see Central Government notification – SO 89 {E} dated 25-1-2006}and that too as per the notification with effect from date of publication of the notification i.e. . 25-1-2006]. This notification itself conditions that the approval will take effect only from the date of its publication. The Supreme Court in P. Nageshwara Rao vs. Govt. of A.P. [1994] Suppl [2] SSC 693, 694 {SC} has held that where a notification expressly mentions that the tax imposed under a particular statute would be effective on and from a particular date, its operation cannot be preponed to an earlier date. Therefore, a view may emerge that the approval is effective only from 25-1-2006 and not earlier.

Therefore, the legal position that develops is two fold. Firstly, transactions in derivatives on unapproved exchanges [i.e. other than National and Bombay Stock Exchanges] would be considered as speculative in terms of section 43 [5] from 1-4-2006 [A.Y. 2006-07], though earlier the same may have not been so possibly considered, if my views in the discussion in the previous paragraphs find agreement with the readers. Secondly, transactions in derivatives on Bombay and National Stock Exchanges would be considered non speculative only from 25-1-2006 and not for the period 1-4-2005 to 24-1-2006 as relating to A.Y. 2006-07.

13. Summary of propositions: – In summary, in this article, two possible propositions will emerge for consideration of the readers:-

[a] Firstly, prior to the insertion of clause [d] by Finance Act, 2005 w.e.f. 1-4-2006, it is a possible view that transaction in derivatives involve ‘deliveries’ of intangibles and may therefore not be considered as speculative in terms of section 43 [5]. {See para nos. 2 to 11 above].

[b] Secondly, after the insertion of clause [d], only transactions in derivatives on stock exchanges approved by the Central Government for the purposes of section 43 [5][d] will be treated as ‘non speculative’ and that too from the date of the publication of the notification. Presently, only two stock exchanges have been approved [i.e. National Stock Exchange & Bombay Stock Exchange] for the purposes of section 43 [5] [see Central Government notification – SO 89 {E} dated 25-1-2006}and that too with effect from date of publication of the notification i.e. . 25-1-2006]. Derivative transactions on other non approved stock exchanges will be considered as speculative from Assessment Year 2006-07.

These are the two propositions I have set before the readers to ponder.