Unified regulator for equity & commodities market - A Tax Spin to SEBI-FMC Merger!
Sunil Gidwani, Partner, Tax and Regulatory Services, PwC
Background
For a large producer and consumer of several commodities like India, commodity markets play a critical role in India’s future economic growth, and the need to strengthen the commodity derivatives markets cannot be undermined. The Financial Sector Legislative Reforms Commission (FSLRC) had recommended creation of unified financial agency to subsume all non-banking regulators including the SEBI and the Forward Markets Commission (FMC). Subsequent to the announcement made by Finance Minister earlier this year, the historic event of merger of the two large regulators came into effect from September 28, 2015. This watershed development in the Indian derivatives markets is expected to strengthen these markets and enable their further development. The merger however creates certain ambiguity under tax laws.
As per Section 73 of the Income-tax Act, 1961 (‘Act’) losses arising from speculative transactions can only be set off against gains arising from speculative transactions, whereas losses arising from ordinary business transactions can be set off against gains arising from any business transactions. Hence, it becomes important to determine the characterisation of a transaction and accordingly apply the set-off rules.
Speculative transactions, as defined in section 43(5) of the Act are transactions in which a contract for the purchase or sale of any commodity is settled otherwise than by the actual delivery. Certain transactions, as covered by the proviso to section 43(5), are considered as ordinary or non-speculative transactions, even when the said transactions are settled without actual delivery. Two such transactions relate to the following:
(a) Commodity derivatives traded in a recognised association and chargeable to commodities transaction tax (‘CTT’) [clause (e)]
(b) Security derivatives as covered under the Securities Contracts (Regulation) Act, 1956 (‘SCRA’) and traded on a recognised stock exchange [clause (d)]
This article analyses the characterisation of transactions in commodity derivatives and currency derivatives for a financial investor transacting in these instruments on the stock/commodity exchanges.
Commodity derivatives
From 2013 onwards, commodity derivatives transactions entered into in a recognised association attract CTT, and trading in such derivatives is not considered as ‘speculative transaction’. For this purpose, various associations have been recognised as per the Forward Contracts Regulation Act, 1952 (FCRA).
The FCRA was repealed with effect from 28 September 2015. Therefore, a question that arises is whether the derivative transactions effected on commodity exchanges will henceforth be regarded as speculative or not.
An important aspect to be considered is that as per the amendment made by the Finance Act, 2015, all existing recognised associations under FCRA are deemed to be recognised stock exchanges under the SCRA. Accordingly, all the existing recognised associations—National Commodity and Derivatives Exchange Limited (NCDEX), Universal Commodity Exchange Limited (UCX), Multi Commodity Exchange of India Limited (MCX) and Ace Derivatives and Commodity Exchange Limited (ACE) shall become approved stock exchanges under the SCRA.
Therefore, logically, the benefit of transactions carried out on the stock exchanges should be made available to derivative transactions as well. Ideally, the Section 43 should be amended to make a reference to derivative transactions effected on stock exchanges (instead of recognised associations) recognised in accordance with the SCRA (instead of the FCRA). However, since the tax law has not been amended to clarify the position of commodity derivatives transactions, we need to rely on interpret the law as exists.
One needs to bear in mind that several new provisions have been introduced in SCRA to deal with commodity derivatives and cover them under its ambit. One could draw an analogy from Section 8[1] of the General Clauses Act, 1897, which deals with replacement of an old law with a new law. It provides that when an existing piece of legislation is repealed and re-enacted, in other words replaced by a new one and a reference is made to the repealed law, it should be read as a reference to the new law or re-enacted law. Going by the context in which the merger of the two regulators has taken place and the changes that have been made to SCRA, it should be reasonable to take a view that the amendment to SCRA is tantamount to re-enactment of old law (FCRA). Hence, any reference in Section 43 of IT Act to FCRA should be understood as reference to the SCRA.
However, in order to avoid any possibility of unnecessary litigation on this account, Section 43 should be amended to make a reference to SCRA. In the meantime, the Central Board of Direct Taxes (‘CBDT’) should issue a clarification that commodity derivative transactions will still be eligible for exclusion from the definition of speculative transaction.
Currency derivatives
As mentioned earlier, transactions in security derivatives are regarded as ordinary transactions and not speculative transactions. It is therefore necessary to analyse whether ‘currency derivatives’ are ‘security derivatives’ under the income-tax provisions.
As per section 2(ac) of the SCRA, derivatives includes a contract for differences. Currency derivatives can be settled by a payment for difference. Accordingly, it should be possible to take a view that currency derivatives are derivatives as per the SCRA. Currency derivatives are traded in the same manner as security derivatives, i.e. traded on recognised stock exchanges and are settled on the clearing house of recognised stock exchanges, in accordance with the rules and bye-laws of such stock exchanges.
Separately, for the purpose of treating transactions in security derivatives as ordinary and not speculative, amongst other exchanges, United Stock Exchange of India Limited and Metropolitan Stock Exchange of India Limited (earlier known as MCX Stock Exchange Limited) have also been notified. When these stock exchanges were notified, they were dealing solely in currency derivatives. Even today,the United Stock Exchange of India Limited has not applied for trading in the equity segment or equity derivative segment.
Furthermore, instruction no. 3 of 2010 issued by the CBDT state that for determining whether the loss from a transaction in respect of foreign exchange derivatives is a speculation loss or not, the tax officers may refer to exclusion provided under clause (d) to proviso to section 43(5) of the Act which deals with security derivatives.
In the recent rulings of the Income-tax Appellate Tribunal,[2] it has been held that the clause (d) exempting derivatives includes foreign currency derivatives, and the same cannot be termed as speculative in nature.
Based on the above, it should be possible to take a view that currency derivatives are covered within the ambit of derivatives under the SCRA and accordingly, currency derivatives transactions carried out in recognised stock exchanges (hitherto recognised associations) should be regarded as ordinary transactions and not speculative transactions.
In the recently released draft report of the Standing Council on the international competitiveness of the Indian financial sector released by the Ministry of Finance, it has been mentioned in the context of currency derivatives that the exchange transactions on which securities transaction tax (STT) is paid are deemed to be non-speculative and that since currency derivatives do not attract STT, these transactions may be treated as speculative. It appears that reference to STT payment is misplaced because currency derivatives are not subject to STT, and based on the above discussion, such transactions can still be characterised as ordinarybusiness transactions.
Separately, since the FMC and commodity exchanges have no role to play in currency derivatives, there will not be any impact of the merger of the FMC with SEBI on the above analysis.
Conclusion
Based on the above analysis, it should be possible to take a view that currency derivatives and commodity derivatives will qualify as ordinary business transactions and accordingly, any losses arising from such transactions should be eligible for set-off against any other business profits and the merger of SEBI and FMC should not have an adverse tax impact, though a clarification by amendment in law or a CBDT circular is desirable As done in the past on similar occasions, SEBI could proactively take this matter up with the Finance Ministry officials.
(For any comments or questions, author can be reached at sunil.gidwani@in.pwc.com)
[1]Section 8 (of General Clauses Act, 1897)-Construction of references to repealed enactments.
(1) Where this Act, or any Central Act or Regulation made after the commencement of this Act, repeals and re-enacts, with or without modification, any provision of a former enactment, then references in any other enactment or in any instrument to the provision so repealed shall, unless a different intention appears, be construed as references to the provision so re-enacted.
[2]Inventurus Knowledge Services Pvt Limited v ITO, ITA no, 5922/Mum/2013 dated 21 October, 2015 and IVF Advisors Private Limited v. ACIT (ITA No. 4798/Mum/2012 – decided on 13 February 2015). In the latter case, the matter is pending before Bombay High court.