PANKAJ AGARWAL,KANPUR vs. JT.CIT CIRCLE-1(1)(1), KANPUR

Because prejudice to the above grounds of appeal

The facts of the case are that on perusal of the Audit report of the assessee, the ld. AO observed that the net profit of the assessee had gone down and the assessee explained the low net profit on account of a derivative loss of Rs.1,86,89,600/-. When asked to provide the details of the loss and why such loss should be allowed, the assessee submitted that the same was a non-speculative business loss, that was covered by the provisions of section 43(5) of the Income Tax Act and the set off was allowable, as per the provisions of section 72 of the Income Tax Act, 1961. On perusing the documents of the assessee, the ld. AO found that the assessee had a total loss from derivatives of Rs.2,47,02,865/-. The loss to the extent of Rs.60,13,263.98/-, had been set off from the profit of commodity transactions and a net loss of Rs.1,86,89,600/- had been claimed. The ld. AO observed that the same was not a business loss of the assessee, for the reason that it had been certified as investment by the Auditor in the audit report dated 24.09.2012 (in Annexure-III).

The ld. AO rejected the replies so filed by the assessee on the grounds that the definition of short term capital asset was defined as per section 2(42A) of the I.T. Act, 1961 and Explanation 2 of the same section defined, ‘securities’ for the purposes of short term capital gain. She further observed that the meaning of securities was taken as per Clause (h) of section 2 of the Securities Contracts (Regulation) Act, 1956 which included derivatives. Relying upon such definition, the ld. AO concluded that short term capital gain can arise in derivative transactions when the same are held as investments by the assessee. She held that the amendment that was brought into section 2(14) in the definition of capital asset, was with regard to Foreign Institutional Investors, for whom securities have to invariably be treated as capital asset contrary to their Indian counterparts, whereas resident Indians have the option to treat derivatives as investments or trade, based on the fulfillment of certain conditions. Thus, the ld. AO held that the contention of the assessee that the securities were not capital assets prior to 1.04.2015 was misguided and had no basis. The ld. AO further pointed out that there was a close nexus between derivative transactions and other investments pursued by the assessee. She observed that the assessee had pledged his shares in investment portfolio for the margin required for derivative transaction. She further referred to the guidance notes on accounting of futures and contracts from the point of view of buyers and sellers and observed that accounting of futures and options, required the assessee to pay to the trading member / clearing member, the initial margin determined by the clearing corporation as per the byelaws / regulations of the exchange, for entering into equity index futures contracts. He pointed out, that the assessee had the option that instead of paying the initial margin in cash, he could pledge his shares/securities in the de- mat account with the member as a non-cash margin. Those pledged securities had 5 earned dividend and capital gain for the assessee and could be adjusted if the assessee incurs loss, for which cash was not readily available. Thus, on this basis he held that the assessee’s investments and derivative portfolios were closely inter- linked and therefore, treatment of both of them should be the same i.e. as capital assets. The ld. AO also observed that for any trade, there were general accounting policies and standards that were required for maintenance of accounts to arrive at the correct profit / loss of that trade. She pointed out that the ICAI had issued a guidance note for traders on how to maintain the books and prepare accounts for trading in derivatives which refuted the assessee’s contention that there were no opening or closing balances and no physical delivery of derivatives. Quoting from the various accounting guidelines laid down by the ICAI, the ld. AO pointed out that as per the requirement of section 145 of the Income Tax Act, 1961, accounting standards prescribed by the CBDT are to be followed in computing the business income. She further pointed out that AS-1 prescribed by CBDT vide Notification No. SO (69)(E) dated 25.01.1996 provided that accounting policies adopted by an assessee should be such as to represent a true and fair view of the state of affairs of the business in the financial statements prepared and presented on the basis of such accounting policies. She held that the turnover of the trade and other regular features of running business have to be taken into account for treating the portfolio as a trading / business portfolio. She pointed out that the assessee had not maintained or produced details with regard to the same at the time of the assessment proceedings. No turnover was calculated by the assessee and the transactions which were left open on the last day of the financial year were not brought on record script wise. Despite having open position on the balance sheet date, the assessee had not provided script wise details. She further observed that audit under section 44AB had not been done and separate profit and loss account and balance-sheet as proposed by guidelines of ICAI had not been prepared. Thus, the entries passed for derivative transaction as business, had failed the test of treating it as a separate business of the assessee. She also pointed out that the assessee had not disclosed open contracts properly in the audit report to carry forward running accounts as in a trading concern. She, therefore, held that the transactions were in the nature of investment only and were liable to be treated as short term capital asset for income tax purposes. She held that the assessee could not take shelter under the provisions of section 43(5) which was for traders in the business of derivatives and not for investors. On going through the investment portfolio of the assessee, She observed that the assessee had diversified the portfolio in such a way so as to bear the risks attached with the debt and volatile market. Merely because he had to square up his derivative position every three months and take up fresh position or pay mark to market on daily basis, would not detract from the fact that the prime purpose of such transactions was to preserve the value of the investment portfolio. The ld. AO held that the derivative being a security and a right under a contract, was capable of being assigned. It was, therefore, a property and thereby a capital asset. There was transfer of capital asset when the transaction was squared by an opposite corresponding transaction and similarly when squaring up was on expiry of the contract, it should be treated as extinguishment of rights in capital asset as per section 2(47) of the Income Tax Act, 1961. She pointed out that the Hon’ble Supreme Court in the case of CIT vs. Grace Collis 248 ITR 323, had held that the definition of transfer in section 2(47) contemplates the extinguishment of the rights in a capital asset as distinct and independent of such extinguishment consequent upon the transfer. Thus, he held that on expiry of derivatives there was a transfer of a capital asset. He further observed that securities transaction tax have been paid. Furthermore, She held that as derivative did not come under equity shares in a company or unit of equity oriented mutual fund, section 111A of the Income Tax Act, 1961 was not applicable on derivative securities and they should be charged at 30% and not the concessional rate of 15% under section 111A. Finally, she observed that in the audit report filed by the assessee on 24.09.2012 Part B of Column 8 (A) says the nature of business and profession had been written as, ‘Coaching to Students’. Thus, She held that the assessee had himself confessed of not having any other business. Lastly, She pointed out that the assessee had earned dividend under section 10(34) on shares and mutual funds that were held as investment and pledged with the exchanged as margins. He had also claimed exempt long term capital gain on listed securities under section 10(38) of the Income Tax Act, 1961. Further, the assessee had debited all the expenditure related to the investments, including derivatives in the capital account, and not the P & L account. All these went to show that the assessee was actually investing in derivatives and seeking it to camouflage it as a business transaction to set it off against business income. She therefore, made an addition of Rs.2,47,02,865/-, by disallowing the set off against commodity transactions.

Furthermore, the ld. AO observed that the assessee had reported huge exempt income in the form of exempt long term capital gain under section 10(38), dividend from mutual fund under section 10(34) and exempt interest under section 10(15) and 10(11), amounting in total to Rs.1,55,94,309/-.She held that there were certain hidden charges in the form of processing fees, surrender charges, brokerage and handling charges which had not been reported by the assessee while earning the income. She, therefore, made reference to the provisions of Rule 8D of the Income Tax Rules, 1962 and applying the same determined the disallowance as per section 14A r.w.r. 8D(ii) at Rs. 12,35,930/-. Accordingly, the ld. AO also made this addition to the income of the assessee under section 14A.

With regard to the addition of Rs. 12,35,000/- under section 14A, the assessee submitted that the assessee had not claimed any expenditure with respect to exempt income in the income and expenditure account. There were no borrowed funds and there was no finding by the ld. AO that any expenditure had been incurred 9 by the assessee for the purposes of earning tax free income. The ld. CIT(A) held that the purpose and intention of bringing section 14A on the statute was to curb the claiming of expenditure relating to exempt income against taxable income. Placing reliance on the decision of the Hon’ble Supreme Court in the case of Maxopp Investments Limited 402 ITR 640 (SC), he pointed out that the principle behind enacting Section 14A, was to disallow any expenditure incurred in relation to the income which does not form part of the total income under the Act. He, therefore, held that as per the principle of apportionment of expenses ingrained in section 14A of the Act, the expenditure which was attributable to the exempt income needed to be disallowed. Even if there were no direct identifiable expenses, a certain amount of time, effort and infrastructure of the company were used for making decisions on investments. Therefore, out of the expenditure debited to the P & L account, a portion of expenditure attributable to such investment operations capable of yielding exempt income, is liable to be disallowed under Rule 8D(2) r.w.s. 14A of the Act. The ld. CIT(A) held that it was an undisputed fact that the assessee had made investment in earlier years. He pointed to sub section (2) of section 14A which laid down that the ld. AO shall determine the disallowance and sub section (3) laid down that the provisions of sub section (2) would apply, where the assessee claims that no expenditure was incurred by him. He held that as the ld. AO was not satisfied with the submissions of the assessee, he had worked out the amount of disallowance under section 14A r.w.r. 8D. He pointed out that the show cause letter issued to the assessee which discussed the facts, along-with computation of disallowance, could be regarded as the satisfaction of the ld. AO for invoking the provisions of section 14A of the Act. Therefore, he held that the ld. AO had rightly invoked the provisions of section 14A of the Act and he dismissed the appeal of the assessee in this regard. On other issues involved in the assessments, the ld. CIT(A) allowed the appeal.

The assessee is aggrieved at this summary disposal and has accordingly come in appeal before us. Shri. Rakesh Garg, Advocate representing the assessee pointed out, that besides maintaining an investment portfolio of shares and mutual funds, on which the assessee was earning dividend and in appropriate cases, profits on sale, the assessee had over a number of years been trading in derivatives. These derivatives included commodities, which had been treated as business income and derivatives in securities, on which the assessee had made a loss. Since the assessee was having a huge volume of transactions in the trading derivatives, the trading in derivatives which was periodically settled was treated as business income by the assessee. In the present assessment year, the assessee had made a profit of Rs.60,13,263.98/- on commodity derivatives while losses of derivatives in securities of Rs.2,47,02,865/- had been incurred. Thus, there was a net loss of Rs.1,86,89,600/-, which had been claimed for set off. The ld. AR drew our attention to section 43(5) of the Income Tax Act, 1961 which was the definition of, ‘speculative transaction’ and further pointed out that for the purposes of this Section, Clause (d) stated that an eligible transaction in respect of trading in derivatives referred to in Clause (ac) of section 2 of the Securities Contracts (Regulation) Act, 1956 (42 of 1956) carried out in a recognized stock exchange and Clause (e), an eligible transaction in respect of trading in commodity derivatives, carried out in a recognized stock exchange, which is chargeable to commodities transaction tax under Chapter VII of the Finance Act, 2013, shall not be deemed to be a speculative transaction. The ld. AR pointed out that as these provisions were contained in Chapter IV of the Income Tax Act, which related to the computation of business income, therefore, the income earned from such transactions would be business income and the losses incurred from such transactions would be business losses. He further pointed out that the ld. AO had no objection to considering the income from commodity derivatives as business income but strangely had refused to consider the loss from trading in derivatives of securities as business loss. It was pointed out that during the course of assessment proceedings, copies of the contract notes and bills of the transactions of derivatives entered into with the brokers had been produced and the copies of accounts of brokers have also been filed. The transactions so disclosed, reflected daily purchase and sale of derivatives and the total volume of such transactions ran into crores of rupees. It was submitted that the magnitude of purchase and sale and the ratio between purchase and sale and the holding period, defined the nature of the transaction and showed that the assessee was trading in derivatives. In earlier years, also the assessee had shown income and loss from trading in derivatives as business income and business loss and there had never been any objection to the same. It was, therefore, inexplicable as to why the ld. AO had held that the loss incurred by the assessee and trading in derivatives insecurities was not a business loss, but a capital loss. It was submitted that the ld. AO was wrong in stating that the assessee had always treated the trading in derivatives as an investment. In reply to the accusation that he had maintained a consolidated books of accounts, the ld. AR submitted that a separate ledger had been maintained for derivatives and furthermore it was submitted that the assessee was an individual, whose books of accounts had been audited under section 44AB. Thus, the requirement of an audit had also been fulfilled. The ld. AR pointed that derivatives were not shares and therefore, they could not be considered as stock or investment. The ld. AR also drew our attention to page nos.22, 82, 176 and page 39 of his paper book which contained the accounts of Angel Capital and Debt Marking Market Ltd.; India Infoline Ltd.; ICICI Securities Ltd., and Master Capital & Services Ltd, respectively through whom the assessee had traded in that derivatives. The ld. AR also questioned the assumption by the ld. AO that the assessee being in the profession of coaching was not qualified to be a trader. It was submitted that an assessee was a B.tech from IIT, Kanpur and had been dealing in shares and derivatives for a long time. It was further submitted that there were no reason for the assessee to show derivative income as business income rather than as capital gains, if that were not so, because derivatives were taxed at the rate of 30% whereas capital gains were only taxed at the rate of 20%. This very fact showed that the assessee had always regarded the trading in derivatives as an adventure in the nature of trade and therefore, it was rightly assessed under the head business income. It was further pointed out that the assessee had always been offering this income under the head business and the Department had accepted it as such previous to this assessment year. While the ld. AR conceded that in the first six years, the assessment had taken place under section 143(1), he pointed out that in the assessment year 2010-11, the case of the assessee had been scrutinized under section 143(3) and in the assessment year 2015-16, section 148 initiated on similar grounds had been dropped. The ld. AR placed reliance on two Tribunal decisions in the case of Ramesh Verma vs. ACIT, Gonda and in the case of Kippy Engineering Pvt. Ltd. vs. DCIT, Central Circle, Kolkata. He also filed a copy of the CBDT Circular dated 15.06.2007 in support of the facts that it was possible for any taxpayer to have both an investment portfolio and a trading portfolio and the mere fact that some securities were held as investments, was not a ground to hold the other securities were not being traded. With reference to the disallowance under section 14A, it was submitted that the ld. AO had made an estimated disallowance presuming hidden expenses, but in this case, there was no interest because there was no borrowed funds. Furthermore, it was submitted that all the expenses on capital gains had been debited to a personal account i.e. they had been debited to capital account and they had not been set off against normal income. That being the case, there was no question of any further disallowance under section 14A.

On the other hand, Shri. Sanjeev Krishna Sharma, ld. Sr. DR appearing on behalf of the Revenue submitted that the assessee was primarily running a coaching institute and even in his audit report, the only business disclosed was that of running 13 a coaching institute. Therefore, his business could not be share trading but he could only be an investor. It was submitted that the case of the assessee had not been examined in detail in the past, because most of the cases had been done in a summary manner. He then drew our attention to para 5.6 of the AO’s order, where he pointed out that the ld. AO had observed that the assessee had not maintained separate books of accounts and got them audited; the accounts so prepared were not in accordance with ICAI guidelines and he further pointed out that on page 11 of the assessment order in para (V), the ld. AO had explained the accounting that was to take place at the time of squaring off of an options contract and pointed out that the accounting treatment in case of delivery settled indexed options and stock options were transfer of shares and equities. He, therefore, submitted that there was no difference in the investment portfolio of the assessee and the so called trading portfolio. He pointed out that since the assessee was not following the accounting standards that were laid down in the matter and had not got his accounts of derivative transactions audited and also failed to explain whether the imbalances on the last day are margins that were left with the brokers or the profits not booked by the assessee, in the circumstances, the assessee must be held to only have an investment portfolio and was not covered by CBDT Circular No.4/2007 dated 15.06.2007 which has dealt mainly with share trading transactions. It was also submitted that the assessee could not take shelter under section 43(5) of the Income Tax Act, 1961, which is for the traders in business of derivatives and not for investors. In the circumstances, he further pointed to para 4.3 of the order of the ld. CIT(A) wherein the ld. CIT(A) had pointed to the same. In view of these arguments, he relied upon the orders of the ld. AO and the ld. CIT(A) and prayed that the additions made by the ld. AO may be sustained.

We have duly considered the facts and circumstances of the case and the arguments advanced by both parties. We observe that the presumption of the AO, 14 that because the assessee was running a coaching institute, he could not be a trader but must necessarily be an investor, is not based on any sound reasoning. It is entirely possible that an assessee may have a main business and also do a side business. We note that the assessee has been dealing in shares and derivatives for many years. It is therefore unreasonable to hold that he had no understanding of how to do trades in derivatives, only because he ran a coaching institute, without any empirical evidence to back up this assumption. We also note that the assessee has taken the help of at least four broking houses and clearing agents to perform these trades. It is not unreasonable to hold that he could do trades with professional assistance, even if he himself was not accomplished in all the nuances of derivative trading and therefore this is no reason to hold that his foray into derivative trading was in the nature of investment .We note that the CBDT in the circular no 4/2007 dated 15.06.2007 has pointed out that it is possible for a taxpayer to have two separate portfolios, one for investment and the other for trading and quoted from judgments to show that the test for determining which security falls into the category of investment and which security falls into the category of stock in trade , depends on various factors such as the magnitude of purchase and sale, the ratio between purchase and sale and also the holding period. The assessee has consistently submitted that the transactions into derivatives ran into crores of rupees, they are marked by frequent sale and purchase without taking delivery and that the holding periods of these derivatives is extremely short and therefore these are demonstrative of the fact that the trading in derivatives were not for investment purposes but rather for making of profit. The Assessing Officer has not refuted these assertions with any empirical evidence that the derivatives traded by the assessee were in the nature of LEAPS(Long Term Equity Anticipation Securities) or even that the average holding period of the derivatives were sufficient to justify their reclassification as capital assets rather than business assets. She has also not highlighted any instance showing that the derivatives were used strategically as hedging tools against investments in listed securities, allowing the assessee to mitigate risk without abandoning his investment positions. In the circumstances there is simply no evidence brought on record by the Ld. AO, to justify reclassification of derivatives as capital assets liable to be assessed under the head of capital gains. The Assessee has also submitted that the “Investments” referred to in his balance sheet and audit report are shares and mutual funds of which delivery had been taken, that were purchased either with a view of earning dividend or selling them on appreciation and that these had been offered for tax under the head Capital gains. The AO has not been able to refute, with any empirical evidence that the premium paid for derivatives or the expected gains in open positioned trades on balance sheet date have also been included under the head, “investments” in the balance sheet. In the circumstances, her observation that the derivatives had been certified as investments in the audited accounts of the assessee remain unsubstantiated. In fact, we note, that even while the AO has held that the assessee did not maintain a separate trading portfolio, by accepting the profits on commodity (derivative) transactions as business income, the Ld. AO has contradicted her own findings that all the trades done by the assessee were in the nature of investment or that the assessee was not capable of trading in derivatives as a business. This contradictory stand of treating income from commodity transactions as business income and losses from derivatives in security as short-term capital loss, without any investigation into the volume of trades, the ratio between sale and purchase or the holding period or even whether the derivative trading had been done with a view to hedging against risk to the investment portfolio, cannot therefore be justified. We further note that the assessee has submitted that he had always been showing derivative trading as a separate business income in his returns filed over the previous and subsequent years. We further note the submission that the assessment in AY 2010-11 was done under section 143(3) and no adverse inference was taken on this point and that in the assessment year 2015-16, where notice under section 148 was issued, the notice was dropped without making any such addition. Therefore, the stand of the Ld AO in this assessment year would also appear to be at variance with the principle of consistency.

We would now turn our attention to some of the alleged lacunae pointed out by the Ld. AO and the replies submitted by the assessee with regard to them. The AO has pointed out that the assessee has not maintained separate books of accounts or got them audited, therefore the trading in derivatives cannot be recognized as a separate business. We note the submission of the assessee that a separate ledger accounts have been maintained for trading activities of both securities and commodities and that the assessee is an individual whose books of accounts have been audited under section 44AB. To our mind that satisfies the condition that separate books should be maintained and audited. The second alleged lacuna that has pointed out by the Ld. AO is that the Assessee has pledged shares on which he earns dividends, with trading members instead of depositing cash as initial margin in derivative contracts and this shows an intimate link between the securities held as capital assets and the derivatives. We note that pledging of shares as security to safeguard against default in a derivative contract is nothing more than pledging of an asset as security and does not confer the derivative with the identity of a capital asset. That is something that has to be established by an analysis of the concerned derivative, which the Ld. AO has not done. We also note that the AO has quoted from certain ICAI guidelines regarding accounting of derivatives, but there is no discussion in the order, with reference to the assessee’s accounts, as to how these guidelines have been violated by the assessee. It is not clear from the assessment order as to whether any study was undertaken of the assessee’s accounts with reference to these guidelines, or whether the assessee was asked to show how compliance had been made. Rather the guidelines appear to have been reproduced, in an effort to show 17 that derivatives can be considered to be a capital asset attracting short term capital gains or losses. To our mind, the issue in the present case is not whether derivatives could be regarded to be a short-term capital asset but whether, in the present case, they are so and as we have already observed, this has not been demonstrated with reference to any of the tests which have been laid down for determining whether an asset was a capital asset or a stock in trade. In fact, we observe that the AO has conceded in her order that the assessee had to square up his derivative position every three months and take up fresh position and also pay mark to market on a daily basis. These would indicate the derivative trading carried on by the assessee were in the nature of business transactions rather than investments. We also observe that any shortcoming in the accounting of the assessee with reference to the ICAI guidelines may have their own tax implications but would not justify re-classification of derivatives as “investments” without the evidence to demonstrate that they were so.

In parting with this issue, we note that prior to Fy 2005-06, transactions in derivatives were considered as speculative transactions for the purposes of determination of tax liability under the Income Tax Act. Finance Act 2005 amended section 43(5) so as to exclude transactions in derivatives on “recognized stock exchanges” from the purview of speculative income or loss. Thus, losses on derivative transactions that meet the exception criteria in clauses (d) and (e) of section 43(5) can now be set off against any other income of the year and also carried forward for set off against any other income of the subsequent year. The two case laws relied upon by the Ld AR essentially reaffirm this principle. Thus, we note that in the given facts and circumstances of the case, the decision of the Ld AO to reclassify the business loss on derivatives as short-term capital loss was unjustified. We also note that the Ld CIT(A) has chosen to merely rely upon the findings of the AO and not independently applied his mind to the arguments made and evidences placed before 18 him. Thus, we are not in agreement with his decision to sustain the disallowance. Accordingly, we quash the disallowance of business loss from derivative trading in securities of Rs 2,47,02,865/- and direct that the assessee be permitted to set it off against commodity transactions of Rs 60,13,263.98, which in turn have already been accepted as business income by the Ld AO. Ground nos 1 to 4 are accordingly allowed. Ground no 5, being rendered infructuous on account of our decision with regard to Ground nos. 1 to 4, is dismissed as such.

The next issue relates to the issue of disallowance of Rs 12,35,930/- under section 14A. The Ld. AO has invoked the provisions of Rule 8D on the grounds that the Assessee had not shown any expenditure against the exempt income earned from dividends, exempt capital gains, interest on PPF and interest on securities and her belief that there was always some hidden expenditure involved in the form of processing fees, surrender charges, brokerage and handling charges which had not been reported by the assessee while earning the income. Since it was a case of no expenditure the AO has invoked rule 8D(2). However , the assessee has submitted that expenditure against exempt income has not been claimed from profit and loss account, firstly because there was no expenditure made on interest etc as there were no borrowed funds and secondly because expenditure on investments had been claimed from the personal capital account itself. While discussing the issue of derivatives, the AO has also recorded that the assessee had debited all expenditure relating to investments (which she has presumed to include derivatives) in the capital account and not the profit and loss account. If that be the case, then it is neither a claim of expenditure made to earn exempt income being claimed against taxable income, nor a case where the assessee says that no such expenditure has been incurred on tax free investments. In the circumstances, we hold that Rule 8D (2) would not apply to the facts of the present case and therefore there is no justification for invoking the provisions of section 14A, in the given facts and circumstances of the 19