In pursuit of knowledge

Direct Taxes

Issues under Income Tax on Shares & Securities Transactions

1. Introduction

1.1 I have been requested to focus in this paper on burning issues on the subject. Whether income from shares and securities transactions is to be taxed as business income or as capital gains has been the hot topic in this subject, ever since the CBDT came out with draft instructions of May 2006, trying to bring out the distinction between investment transactions resulting in capital gains and trading transactions resulting in business income. If that were to be discussed in this paper, there would be not much time left to discuss any other issue. Besides, so much has been written and said about this issue in various professional forums regarding factors to be considered for this purpose, and given the fact that the determination of whether particular transactions are in the nature of trading or are in the nature of investments is a mixed question of fact and law, mainly depending upon the circumstances and facts of each case, no purpose would be served by adding further to the discussion that has taken place on this issue. There have been a few recent Tribunal decisions on this issue and I am sure that there will continue to be many more decisions on this issue alone, which will provide ample scope for discussion in the near future.

1.2 The other burning issue on the subject is the controversy in the Vodafone case, as to whether gains on sale of shares of a foreign company by one non-resident to another non-resident can be subjected to capital gains tax in India, if the foreign company is an investment company merely holding the shares of an Indian company. The matter has been argued at length before the Bombay High Court, and its verdict is long awaited. I am sure the High Court decision can be the subject matter of an entire paper.

1.3 However, there are various other related aspects, for which one often searches for an answer, or which one tends to overlook. I thought it would be of greater benefit to participants to address some of these issues in this paper.

2. Implications of gains being treated as business income

2.1 With the tax authorities out to prove that the existence of a large number of transactions in shares is to be treated as business income, while the focus of assessees generally has been on trying to refute the tax authorities arguments through stressing the various factual aspects related to the transactions, very often one tends to miss out on exploring the possible alternative contentions, which could mitigate the impact or at times even dissuade the Assessing Officer from treating such transactions as business transactions. What are these contentions?

2.2 The first aspect of course is that if at all certain shares which have been held for a substantial period of time are now treated as business assets by the Assessing Officer, can the assessee contend that, till the earlier year, these were held as investments and that in case there are regarded as business assets during the current previous year, then the assessee should be regarded as having converted its investments into stock-in trade at the beginning of the previous year? If so, the provisions of section 45(2) would apply, and the difference between fair market value as at the beginning of the previous year and the original cost would be taxed as long-term capital gains, in the year of sale of the shares as stock-in-trade. Only the difference between the sale price and the fair market value as at the beginning of the previous year can be taxed as business income.

2.3 Of course, the assessee would not be able to claim the benefit of exemption for such long term capital gains under section 10(38), on account of the fact that the transfer giving rise to the long term capital gain is the act of conversion of capital assets into stock-in-trade, which is not subject to securities transaction tax. Therefore such long term capital gains would suffer tax, but at a lower rate of 10% without indexation or 20% with indexation (since the shares are listed), as opposed to a rate of 30% for business income.

2.4 Further, if the transactions are to be treated as a business, the assessee is entitled to claim that:

1. The closing stock of shares should be valued at the lower of cost or market value, in effect obtaining the benefit of any diminution in value of shares continued to be held at the end of the year.

2. Various expenses incurred for the purpose of business are to be allowed as a deduction against the share trading profit.

3. If this results in a business loss, such loss can be set off against the long term capital gains.

4. Against tax on such business income, rebate under section 88E for securities transaction tax (till assessment year 2008-09) or against such business income, a deduction for securities transaction tax (after assessment year 2008-09) should also be allowed.
   
   Such claims can result in a substantial reduction in the tax demand which would otherwise have arisen on treating share transactions as a business.

2.5 Of course, in making such a claim, if the assessee is a company, one needs to keep in mind the provisions of the explanation to section 73, which deem business transactions of purchase and sale of shares by a company as speculation business. This would imply that a company will not be able to set off such business loss against the capital gains, but would only be able to carry forward such loss for set off against future share trading profit.

2.6 Can a company take the stand that since both the capital gains as well as the business loss arise from the same assets, and that since only its real income can be taxed, it should be entitled to the benefit of set off of business loss against the capital gains and that only the net capital gains should be taxed?

2.7 While it is true that the courts have held that it is the real income of an assessee which is to be taxed, when there is a specific provision of a taxing statute providing for prohibition of set off of certain loss against other income, such specific provision would prevail over the general principle. Therefore, such share trading loss which is regarded as speculation loss of the company, cannot be setoff against the capital gains arising on the same assets.

3. Transactions through Portfolio Managers

3.1 It has now become very common for investors to entrust their funds or securities to portfolio managers, who carry out the investment activity on their behalf. In case of large investors, the portfolio managers obtain a power of attorney, open a demat account as well as a bank account in the name of the investor, and carry out the transactions in the name of the investor.

3.2 However, for smaller investors, portfolio managers have been operating on a pooled basis, whereby the portfolio manager deposits the funds received from investors into a common account held in the name of the portfolio manager for a particular scheme, purchases and sells shares for that particular scheme in his own name, with the shares being credited and delivered from a demat account in the name of the portfolio manager for the particular scheme. The portfolio manager, in the books of account of the particular scheme, keeps track of the share of investments and bank balance of each investor, which at any point of time constitute the total investments held in that particular scheme and the bank balance in that particular scheme. The transactions of purchases and sales are allocated on a pro rata basis depending upon the funds available of each investor.

3.3 At regular intervals, the portfolio manager provides each investor with a statement showing that particular investor’s proportionate shares purchased and sold, the proportionate income earned by that particular investor, and the proportionate shareholding and bank balance of the particular investor.

3.4 How should these transactions of the portfolio manager on a pooled basis on behalf of the investor be taxed in the hands of the investor? In particular, other than the aspect of whether such transactions constitute a business or not in the hands of the investor, some of the interesting issues that arise are:

1. Given the provisions of section 45(2A), are the gains on such transactions taxable in the hands of the investor or in the hands of the portfolio manager?

2. Given the fact that the portfolio manager is the registered shareholder, through the depository, can the investor still contend that when the dividends are passed on to him by the portfolio manager, they retain the character of dividends? If not, how would such dividend passed on by the portfolio manager to the investor be treated for tax purposes in the hands of the investor?

3. If the transactions are such that they constitute a business, considering the fact that section 45(2A) applies only to capital gains, can it be said that the investor is carrying on a business through the portfolio manager? Or is it really the portfolio manager who is carrying on the business and agreeing to pay a percentage of profits to the investors for the funds provided? Can the investors and the portfolio manager be treated as constituting an AOP?

4. Considering the fact that the contracts with the share brokers are in the name of the portfolio manager, can the investor claim (either for the purpose of exemption or for the purposes of rebate) that STT has really been paid by him on those transactions?

3.5 The answers to these questions can be found in the nature of the relationship between the investor and the portfolio manager. The SEBI (Portfolio Managers) Regulations, 1993 define a portfolio manager as any person who, pursuant to a contract or arrangement with a client, advises or directs or undertakes on behalf of the client (whether as a discretionary portfolio manager or otherwise) the management or administration of a portfolio of securities or the funds of the client, as the case may be. Clause 15 (2) of the regulations clearly provides that the portfolio manager shall act in a fiduciary capacity with regard to the client's funds. The portfolio manager is an agent of the investor, and though he may carry on certain transactions in his own name, such transactions are in his capacity as an agent of the investor.

3.6 Therefore, under general principles, such transactions are the transactions of the investor carried out through an agent, the income from such transactions is liable to tax as the income of the investor, and would take its colour from the circumstances surrounding the actions of the investor. Similarly dividends received by the portfolio manager is received by him in his capacity as an agent of the investor, and accordingly such dividends are taxable (or exempt) in the hands of the investor as dividends. Similarly, STT paid by the portfolio manager is paid by him in his capacity as an agent of the investor, and therefore should be regarded as payments by the investor himself. Accordingly, the investor is entitled to claim exemption or deduction or rebate on account of such STT.

3.7 A relationship between the portfolio manager and an investor cannot be regarded as constituting an AOP, because the entire transactions are carried out by the portfolio manager to whom the funds have been entrusted by the investor as an agent of the investor. Therefore, all actions are those of an investor through his agent. There is no commonality of purpose between the portfolio manager and the investor, since the portfolio manager is seeking to earn his fees for the work done on behalf of the investor, while the investor is seeking to maximise the return on his investments. It is merely a common interest in ensuring that the value of the investments appreciate so that the investor gets the maximum yield on his investments while the portfolio manager earns the maximum fees. As held by the Andhra Pradesh High Court in the case of Deccan Wine and General Stores vs. CIT 106 ITR 111, there must be a common design to produce income and common interest or production of income are not enough to constitute an AOP.

3.8 Fortunately, SEBI, vide SEBI (Portfolio Managers) (Amendment) Regulations, 2008 dated 11th August, 2008, has amended regulation 16(8) to provide that a portfolio manager cannot hold securities in its own name beyond a period of 6 months from the date of the amendment regulations. Therefore, the practice of pooling of investments by portfolio managers will be discontinued from February 2009, and all future transactions will be in the names of investors.

4. Conversion of stock in trade into capital assets

4.1 Till a few years ago, it was only conversion of capital assets into stock-in-trade which was common, and one rarely had an occasion to consider a situation where an assessee converted stock-in-trade into capital assets. Of late however, given the fact that long term capital gains on sale of listed shares on the stock exchange is exempt under section 10(38) and that short term capital gains on sale of listed shares on the stock exchange is subject to tax at a concessional rate of 15%, one often witnesses assessees claiming that shares held by them earlier as stock-in-trade have now been converted into capital assets, in order to claim the benefit of the exemption or concessional rate of tax.

4.2 In respect of conversion of capital assets into stock-in-trade, there are specific provisions in the form of section 45(2), which provide for how such conversion is to be treated for tax purposes. There are no such specific provisions for conversion of stock-in-trade into capital assets, and therefore there had been some uncertainty in this regard. Fortunately, the position seems now fairly clear, due to a few recent decisions.

4.3 The Pune bench of the Tribunal, in a third member decision in the case of Kalyani Exports and Investment Pvt. Ltd. vs. Dy. CIT 78 ITD 95, considered a situation where shares were acquired by the assessee in 1977 and held by it as stock-in- trade till 30th June 1988. These were converted into capital assets on 1st July 1988, and were subsequently sold. The Tribunal held that the assessee was entitled to take the cost of the shares as on the date of acquisition in 1977, to substitute such cost by the fair market value as on 1st April, 1981, and to indexation of cost from 1981. According to the Tribunal, the acquisition by the assessee was only once, and that was at the time of acquisition as stock-in-trade. There was no deeming fiction to deem the conversion of stock-in-trade into capital assets as a transfer or to deem the fair market value as on the date of conversion as the cost of acquisition of the capital assets.

4.4 The Tribunal relied upon the decision of the Supreme Court in the case of Sir Kikabhai Premchand vs. CIT 24 ITR 506, for the proposition that no man can make a profit out of himself, and on the decision of the Calcutta High Court in the case of CIT vs. Dhanuka and Sons 124 ITR 24, where the High Court held that there could not be any actual profit or loss on withdrawal of stock from a trading business.

4.5 Further, the Tribunal drew an analogy from the cases of transfer of agricultural land, where agricultural land which was not a capital asset, subsequently became a capital asset due to the amendment to the Income-tax Act. In those cases, the Gujarat High Court in Ranchhodbhai Bhaijibhai Patel vs. CIT 81 ITR 446, followed by the Bombay High Court in Keshavji Karsondas vs. CIT 207 ITR 737, had held that an asset cannot be acquired first as a non-capital asset at one point of time and again as a capital asset at a different point of time. There can be only one acquisition of the asset and that is when the assessee acquires it for the first time, irrespective of its character at that point of time. Therefore what is relevant for the purpose of capital gains is when the asset was acquired, and not when it became a capital asset.

4.6 The Tribunal also noted the fact that there is no specific provision for tax treatment of conversion of stock-in-trade into investment, similar to the provisions of section 45(2) which provide for the manner of taxation of the capital gains arising on conversion of investment into stock-in-trade. This decision of the Tribunal has been upheld by the Bombay High Court in the case of CIT vs. Janhavi Investments (P) Ltd. 215 CTR (Bom) 72. The High Court has confirmed the fact that even after the scheme of cost indexation has been introduced, the principles laid down by the Gujarat and Bombay High Courts in the context of agricultural land still hold good.

4.7 Therefore, the effect of such conversion of stock-in-trade into investments and subsequent sale can be summarised as under:

1. There is no transfer on conversion of stock-in- trade into investments and no income arising on such conversion.

2. Conversion of stock-in-trade into investments has to be at cost/book value.

3. When the investments are sold, the period of holding would include the period for which the shares were held as stock-in-trade.

4. The date of acquisition of the shares would be the date when the shares were purchased as stock-in-trade, both for the purposes of substitution of cost and at 1-4-1981 as well as for indexation of cost.

5. The cost of the shares would be the price paid for the shares when they were acquired as stock-in-trade.

5. Bonus stripping

5.1 The practice of dividend stripping has now been effectively curbed by the insertion of section 94(7), whereby if shares or units of mutual funds are acquired within a period of three months prior to the record date and transferred within a period of nine months (for shares)/three months (for units) after the record date, any loss claimed in respect of such sale is to be reduced by the exempt dividend/income distribution received in respect of that record date. In a case where multiple dividends are received, the position needs to be examined with respect to each dividend, and those dividends which fall within this period of date of acquisition as well as date of transfer would have to be reduced from the loss that is being claimed on sale of the shares or units.

5.2 However, in respect of bonus stripping, the provisions of section 94(8) apply only to units of mutual funds, and not to shares of companies. One often witnesses assessees resorting to bonus stripping in respect of shares, simultaneously resorting to hedging of the open position in respect of shares through derivatives transactions. This facilitates a claim of loss by the assessee in respect of sale of the original shares, the bonus shares being retained by the assessee for a period of one year to obtain the benefit of the exemption u/s. 10(38), with the potential for loss in respect of the bonus shares being commercially protected through hedging derivatives transactions. This is on account of the fact that the provisions of section 55(2)(aa) provide that the cost of the original shares will continue to remain the original amount, and the cost of the bonus shares is to be taken as nil.

5.3 The question that arises for consideration is whether such loss claimed on account of bonus stripping can be denied to the assessee.

5.4 In the context of dividend stripping, the special bench of the Tribunal in the case of Walfort Shares & Stock Brokers Ltd. vs. ITO 96 ITD 1 (Mum) (SB) had taken the view that prior to the insertion of section 94(7), losses occurring on account of dividend stripping were allowable. This view of the Tribunal has been affirmed recently by the Bombay High Court vide its judgment dated 8th August, 2008 (Income Tax Appeal No. 18 of 2006). The Bombay High Court has negatived the argument of the Department that the decision of the Supreme Court in McDowell's case should be applied, and has held that in the absence of any proof of collusion between the investor and the mutual fund, such transactions could not be treated as designed to create a loss. One interesting aspect which the High Court relied upon was the fact that the market value of the units fell substantially subsequent to the sale by the assessee. Given the fact that the provisions of section 94(7) were specifically inserted to curb this practice, and that they were made applicable with prospective effect, the Bombay High Court affirmed the fact that this provision did not apply retrospectively.

5.5 So far as bonus stripping in respect of shares is concerned, the same logic would apply with greater force, since the market value of shares would fluctuate much more over the period of the one year that the bonus shares would typically be held. Therefore, the assessee is really exposed to a commercial risk when he carries out bonus stripping. He may seek to mitigate this commercial risk by hedging it through derivatives, but this may not be a perfect hedge in most cases. Further, he will have to bear the cost of such a hedge. The very fact that there are such commercial implications of these transactions shows that these are transactions with a commercial substance, and not transactions without any substance just for reduction of tax liability.

5.6 Besides, the fact that bonus stripping was being used to reduce tax liability was known to the tax department, as is borne out by the fact that section 94(8) was introduced specifically for this purpose. The very fact that they chose to restrict the provisions of section 94(8) only to units of mutual funds, while having already enacted the provisions of section 94(7), which apply both to units of mutual funds as well as shares, clearly indicates that it was a conscious decision to keep shares outside the purview of section 94(8).

5.7 Therefore, loss arising on account of bonus stripping in shares does seem to be allowable as a deduction. Of course, such short term capital loss can only be setoff against other capital gains.

5.8 A note of caution here. One needs to keep in mind the risk that if such transactions of purchase and sale of shares are treated as business transactions, the treatment of bonus shares is quite different, as the principle of averaging applies to bonus shares, and not the provisions of section 55(2)(aa). Such a bonus stripping transaction may therefore be a risky proposition for a share trader.

6. Rebate u/s. 88E for STT

6.1 Till assessment year 2008-09, an assessee carrying on the business of trading in shares and securities could claim a rebate under section 88E in respect of the securities transaction tax (STT) paid by him, not exceeding the average rate of tax payable by him on the income arising from such transactions. A few interesting issues have arisen while claiming such rebate.

6.2 The first issue that arises, in a situation where an assessee has two types of securities trading income, is whether the tax payable on such incomes as well as the STT for the purpose of rebate are to be considered in the totality of such transactions, or are to be taken separately for each category of business.

6.3 To illustrate, take a case where an assessee company has share trading profit and derivatives trading income as under. The alternative computations of rebate u/s. 88 are computed below.

	Share Trading	Derivatives	Total
Net Profit	10,00,000	5,00,000	15,00,000
STT Paid	50,000	2,00,000	2,50,000
Rebate u/s. 88
- Alternative 1
(Separately)
Tax on profits	3,00,000	1,50,000
STT Paid	50,000	2,00,000
Rebate (lower of the two)	50,000	1,50,000	2,00,000
- Alternative 2
(Combined)
Tax on profits	3,00,000	1,50,000	4,50,000
STT Paid	50,000	2,00,000	2,50,000
Rebate (lower of the two)	50,000	1,50,000	2,50,000

6.4 If one computes the rebate separately in respect of shares transactions and derivatives transactions, on share transactions, the tax payable is Rs.3 lakh on an income of Rs.10 lakh, the rebate being Rs.50,000. In respect of the derivatives transactions, the tax payable on the derivatives income of Rs.5 lakh is Rs.1.5 lakh, against which the STT paid is Rs.2 lakh, the rebate therefore being restricted to Rs.1.5 lakh. If one computes the rebate under section 88E by taking the totality of all the transactions, the tax payable on Rs.15 lakhs is Rs.4.5 lakhs, while STT paid is Rs.2.5 lakhs, and the assessee is therefore entitled to a rebate of Rs.2.5 lakhs. Therefore, the total rebate amounts to Rs.2 lakhs if the rebate is computed separately in respect of each class of business, as against a rebate of Rs.2.5 lakhs is the totality of such transactions liable to STT is considered for the purpose of rebate. The difference is even more acute if there is a profit in respect of one category, while there is a loss in another category, STT having been paid on both types of transactions. Which is the correct method?

6.5 If one looks at the language of section 88E, it refers to the total income including business income arising from taxable securities transactions, and the deduction being available from the amount of income tax on such income arising from such transactions. The deduction is to be computed of an amount equal to the STT paid in respect of taxable securities transactions entered into in the course of his business during that previous year. This seems to indicate that for the purpose of computing the rebate, one has to take the income from the taxable securities transactions as well as the STT paid in the totality of all such transactions carried on which are in the nature of business, and not consider them category wise.

6.6 What happens in a case where there is a profit from certain types of taxable securities transactions, but a speculation loss from other taxable securities transactions? Take an example where a company has derivatives trading profit, and share trading loss. By virtue of the explanation to section 73, the share trading loss is deemed to be the loss of a speculation business, and cannot be setoff against the derivatives trading profit. The question that arises is whether for the purpose of computing the rebate, the STT paid in respect of both derivatives trading as well as share trading is to be considered, and whether the tax on the income arising from such transactions is to be computed on the net income from such transactions or on the gross income from derivatives transactions?

6.7 If one looks at the composition of the total income, speculation loss is also a part of such income, though it is not permitted to be setoff against the derivatives trading profit. Therefore a view is possible that the STT payable on such transactions is also to be taken into account, but that the tax payable on the income from such STT paid transactions is to be taken on the basis of the normal computation provisions; i.e., after prohibiting the setoff. Effectively therefore, it may be possible to claim the entire STT paid against the tax payable on the income from the derivatives transactions alone.

6.8 An interesting issue arises in the case of companies. Is the rebate under section 88E available against the tax payable on the book profits under section 115JB? Or is the rebate to be first considered against the tax payable, and the net amount of tax after rebate to be compared with the tax payable on the book profits?

6.9 Going by the scheme of the Act, it appears that one has to first compute the tax liability under normal provisions of the Act, and thereafter compute the tax payable on the book profits at 10%, the higher of the two being the actual tax liability. If one goes by the order of the provisions, it appears that the rebate has to be granted first against the normal tax on the income computed under various heads, and then the net tax compared against the tax on book profits.

6.10 Looking at the language of section 88E, the total income has to include income chargeable under the head “Profits and Gains of Business or Profession” arising from taxable securities transactions. If one has computed the tax payable on the book profits under section 115 JB, can one say that the book profits includes income chargeable under the head “Profits and Gains of Business or Profession”?

6.11 Recently, the Delhi bench of the Tribunal in the case of Nafab India P. Ltd. vs. Dy. CIT 303 ITR (AT) 403, has held that book profits under section 115JA cannot be classified under different heads of income, since it is a composite amount of profits. On this logic, the Tribunal held that the concessional rate on long term capital gains was not available to the gains included in such profits.
6.12 On the other hand, if one looks at the form of the return of income (ITR-6), this indicates that the tax on the total income before rebate under section 88E is to be compared with the tax on the book profits, and the rebate under section 88E is to be granted against the higher of the two.

6.13 The better view seems to be that, as accepted by the tax authorities in the form of the return, the rebate is to be granted at the later stage against the tax payable, after having computed the tax payable as the higher of the tax on the normal income and 10% of the book profits.

6.14 Of course, these issues would no longer be relevant for future years, since STT is now an allowable deduction while computing the business income, and no longer eligible for a rebate, from assessment year 2009-10.

7. Section 14A disallowance

7.1 A paper on tax issues in respect of shares and securities transactions would not be complete without a reference to the applicability of section 14A to the expenditure incurred by an investor or trader in shares. To the complications of this section, is added the complication of rule 8D, which has been notified on 24th March, 2008.

7.2 Section 14A seeks to limit expenses claimed as a deduction. Since there are only certain specified deductions allowable under the heads of income “Salaries”, “Income from House Property” and “Capital Gains”, section 14A would therefore effectively apply to situations where expenses are claimed as a deduction under the heads “Profits and Gains of Business or Profession” or “Income from Other Sources”, and would apply to situations where expenses have been claimed as a deduction under these heads of income which are attributable to exempt income.

7.3 The income from shares held as investments typically consists of dividends and capital gains. Earlier, when dividends were subject to tax under the head “Income from Other Sources”, the Supreme Court in the case of Rajendra Prasad Moody 115 ITR 519, had held that interest on loans taken for investment in shares was an allowable deduction under the head “Income from Other Sources” even though no dividends was earned during the relevant previous year. Dividends are now exempt under section 10(34), but are subject to dividend distribution tax under section 115-O. Interest on such loans taken for acquisition of shares is now being disallowed by Assessing Officers on the ground that such interest is paid to earn an exempt income.

7.4 The earlier decision of the Mumbai bench of the Tribunal in the case of Mafatlal Holdings 85 TTJ 821, had held that such interest was deductible as the dividends were actually subject to tax, though not in the hands of the assessee but in the hands of the distributing company. This decision was not followed by the Tribunal in subsequent decisions, including those of the Ahmedabad bench in the case of Harish Krishnakant Bhatt vs. ITO 278 ITR (AT) 1, the Delhi bench in the case of Insaallah Investments Ltd. vs. ITO 23 SOT 130 and the Mumbai bench in the case of Mohanlal M. Shah vs. Dy. CIT 303 ITR (AT) 221, on the ground that what had to be seen was whether the income was taxable in the hands of the assessee.

7.5 Does the fact that capital gains on sale of the shares (the other stream of income) may be taxable change the position, particularly if the shares are short-term capital assets or are not listed? Under the head capital gains, only certain expenditure is allowed as a deduction. Such expenditure should either be the cost of acquisition, the cost of improvement or an expense in connection with the transfer. No other expenditure qualifies for deduction. Interest on loans taken for acquisition of shares is certainly not an expense in connection with the transfer, nor can it be said to improve the shares. Therefore, even if the capital gains is taxable, the interest can only be claimed as a deduction if it can be considered as a part of the cost of acquisition of the shares.

7.6 The Karnataka High Court decision in the case of CIT vs. Maithreyi Pai 152 ITR 247, had indicated that if such interest had not been claimed as a deduction under the head “Income from Other Sources”, it could be claimed as a part of the cost of acquisition of the shares. A similar view in the context of land had been taken by the Delhi High Court in CIT vs. Mithilesh Kumari 92 ITR 9 and by the Andhra Pradesh High Court in Addl. CIT vs. K.S. Gupta 119 ITR 372. However, the Tribunal in the cases of Harish Krishnakant Bhatt and Mohanlal M. Shah has taken a view that such interest would not be deductible even as part of the cost of acquisition, and would accordingly not be allowable at all. The Delhi bench of the Tribunal in Insaallah’s case has however held, following the jurisdictional High Court, that proportionate interest has to be added to actual cost while computing income from capital gain. This is an issue which is likely to be settled only by the Supreme Court.

7.7 Therefore, in the context of shares held as investments, the interest would definitely not be allowable as a deduction by virtue of section 14A, but may or may not be allowable as a deduction in the year of sale of the shares as a part of the cost of acquisition.

7.8 In a situation where shares are held as stock-in-trade, the two streams of income that arise from the shares are dividends and business profits. While one stream, i.e. dividend, which would otherwise have fallen for taxation under the head “Income from Other Sources” is exempt on account of the provisions of section 10(34), the other stream, business profits, is fully taxable. Can section 14A be applied at all in this case to the interest paid on loans taken for acquiring shares held as stock-in- trade?

7.9 The Calcutta High Court, in a couple of decisions in the context of section 80M (CIT vs. Anniversary Investment Agencies Ltd. 175 ITR 199, CIT vs. National and Grindlays Bank Ltd. 202 ITR 559), and the Special Bench of the Tribunal in the case of Punjab State Industrial Development Corporation Ltd. vs. Dy. CIT 292 ITR (AT) 268 (Chd), have taken the view that where a loan has been taken for acquisition of shares which are held as stock-in-trade, the interest is deductible under section 36(1)(iii) as it is paid in respect of capital borrowed for the purposes of the business. The courts had held that no part of the interest was deductible from the dividend under the head “Income from Other Sources”, and deduction under section 80M was allowable on the gross dividend. If this view is correct, following this logic of the courts, the mere fact that the shares which are held as stock-in-trade incidentally give rise to dividends, which is exempt, should not attract the provisions of section 14A.

7.10 In the same context of section 80M, it may be noted that the Bombay High Court had given conflicting views in the cases of CIT vs. Maganlal Chaganlal P. Ltd. 284 ITR 663 and CIT vs. Emrald Co. Ltd. 284 ITR 586, both decisions being rendered by the same bench on the same day. In any case, the issue under section 14A is now pending before the Special bench of the Tribunal in the case of Daga Management P. Ltd.

7.11 Rule 8D now provides a formula for disallowance under section 14A, in a case where the Assessing Officer is not satisfied with the computation of the disallowance by the assessee. It provides that besides the direct expenditure attributable to the earning of exempt income, proportionate indirect interest expenditure is also to be disallowed in the ratio of average investments earning exempt income to the total average assets as per the balance sheet. Further, ½ per cent of the value of average investments earning exempt income is also to be disallowed.

7.12 Various questions arise in respect of the formula under rule 8D, besides the issues discussed above. One interesting aspect in the context of shares and securities is whether it at all applies to a situation where the asset gives rise only to capital gains, and does not give rise to any regular income at all. For instance, where an investor has invested in units under the growth option of a particular scheme of a mutual fund, there can be no income arising from such units other than capital gains. In such a situation, can it be said that these are investments, the income from which does not form part of total income? Further, what happens if the capital gains is exempt under section 10(38)?

7.13 The better view here is that rule 8D has to be read in the context of section 14A. The reference to “investments, the income from which does not form part of total income” in rule 8D, therefore has to be read as investments which give rise to exempt income other than capital gains. The provisions of section 14A do not apply at all to such investments which do not yield a regular income, which is exempt but would otherwise have been taxable under the head “Profits and Gains of Business or Profession” or “Income from Other Sources”. Therefore, such investments are not to be included in the formula for the purposes of computing the disallowance under rule 8D.

8. Conclusion

8.1 There are so many issues in respect of shares and securities transactions, that one cannot really do justice to all of them in one paper. I do hope the issues that I have covered within the limited time span available would be found to be of practical utility to the participants.

8.2 In conclusion, I may just point out that the silver lining behind the recent steep fall in the stock markets is the fact that going forward, Assessing Officers may no longer be keen on treating large volume of share transactions as business income, as that would permit setting off of losses against other income, while assessees would now be keen to treat their share transactions as a business, in order to claim the benefit of set off of their losses! A sea change in the thinking on both sides from the thought process so far!

[Source : Paper presented at Two Days National Tax Conference held on 17th & 18th October, 2008 at Mumbai]