In June this year, the Central Board of Direct Taxes (CBDT) came out with Circular No. 4/2007 on differentiation between gains from shares as capital gains and business profits for the purpose of taxation. Some of its issues remain open-ended and unclear. The issues concern how to distinguish between shares held as stock-in-trade and those held as investment.
Clause 10 of the said circular emphasises that “Where an assessee has two portfolios, the assessee may have income under both heads i.e., capital gains as well as business income.” It important to distinguish the two categories because it is common for a tax-payer to simultaneously indulge in “investment” as well as “trading.”
In clause 11, the Circular advises the Assessing Officers to keep clause 10 in mind but gives discretionary powers to officers.
The circular uses the principle that where the investment is to derive dividends, profit derived from sale of shares will yield capital gains and not revenue receipts.
However, this concept seems to have a basic flaw. It is common practice to aim capital gains, while dividends are incidental. In my opinion, unless covered otherwise, in line with the definition of short term capital asset, all the transactions in the case of a share or any other security listed in a recognised stock exchange in India or a unit of UTI or of a Mutual Fund should result into Capital Gain (either short term or long term, depending upon the holding period). Accordingly, all such transactions should get taxed under the head “Capital Gains” unless covered otherwise.
The classical definition of a share/ security to be treated as a capital asset is where it is bought for delivery. Accordingly, the shares that have been bought for delivery (including those kept with a broker as agent) should be treated as capital asset and any gains from sale of such shares should be treated as capital gains.
Current regulations do not allow delivery in the Futures & Options segment. If delivery is the criterion then gains from derivatives should not quality for capital gains. In that case, it would mean that gains arising out of dealing in derivative instruments would be either ‘Speculative Profits’ or ‘Profits from Business or Profession’.
For academic purposes and by the test of delivery, any derivative transaction where the tax-payer does not hold underlying shares, either by self or through an agent like broker, should be treated as speculative. On the other hand, if the objective of a derivative transaction is hedging the risk/volatility and the tax-payer holds the underlying shares on the date, he takes a counter-position in derivatives of the said share, gains from such a transaction should be treated as business profits. Accordingly, all ‘naked’ derivative transactions without holding the underlying share or without the purpose of hedging could be treated as speculative gains. The basis of making distinction between speculative gains and business profits should be based on the books of accounts of the tax payer, as correctly identified and reflected in CBDT circular.
Now, the question is: which transactions do we treat as one resulting in business profit?
To an extent, the answer is within the circular itself i.e. just like any other business, if shares are treated in the books of the tax-payer as stock-in-trade, he is in the business of shares and not an investor. I believer it should be left to the tax-payer to classify certain shares as stock-in-trade in an accounting year, within which he should not be allowed to change the treatment. However, in a different accounting here, a conversion of stock-in-trade and investment into each other should be allowed.
I believe that following this methodology could remove room for doubt and misuse or misinterpretation of facts.
(The writer is president & head, corporate finance, with the Aditya Birla Group, and these are his personal views).