|QUERY:||I am holding some shares for investment purposes and other shares for trading. I have made gains from the investment shares. Is the AO correct in treating the gains as business income?|
|ANSWER:||Provisions of the Income-tax Act:
Long-term capital gains on shares are exempt from tax u/s 10 (38). To constitute a 'long-term capital asset' and a 'long-term capital gain', the shares must be held for a period of more than 12 months u/s 2 (29A) & 2 (42A). The term "capital asset" is defined in s. 2 (14) as property of any kind but not including stock-in-trade.
If the shares are held as stock-in-trade, the profits will be assessable as business profits u/s 28.
Circular of the CBDT:
INCOME TAX CIRCULAR NO. 4/2007, DATED 15-6-2007
The Income Tax Act, 1961 makes a distinction between a capital asset and a trading asset.
2. Capital asset is defined in Section 2(14) of the Act. Long-term capital assets and gains are dealt with under Section 2(29A) and Section 2(29B). Short-term capital assets and gains are dealt with under Section 2(42A) and Section 2(42B).
3. Trading asset is dealt with under Section 28 of the Act.
4. The Central Board of Direct Taxes (CBDT) through Instruction No.1827 dated August 31, 1989 had brought to the notice of the assessing officers that there is a distinction between shares held as investment (capital asset) and shares held as stock-in-trade (trading asset). In the light of a number of judicial decisions pronounced after the issue of the above instructions, it is proposed to update the above instructions for the information of assessees as well as for guidance of the assessing officers.
5. In the case of Commissioner of Income Tax (Central), Calcutta Vs Associated Industrial Development Company (P) Ltd (82 ITR 586), the Supreme Court observed that:
Whether a particular holding of shares is by way of investment or forms part of the stock-in-trade is a matter which is within the knowledge of the assessee who holds the shares and it should, in normal circumstances, be in a position to produce evidence from its records as to whether it has maintained any distinction between those shares which are its stock-in-trade and those which are held by way of investment.
6. In the case of Commissioner of Income Tax, Bombay Vs H. Holck Larsen (160 ITR 67), the Supreme Court observed :
The High Court, in our opinion, made a mistake in observing whether transactions of sale and purchase of shares were trading transactions or whether these were in the nature of investment was a question of law. This was a mixed question of law and fact.
7. The principles laid down by the Supreme Court in the above two cases afford adequate guidance to the assessing officers.
8. The Authority for Advance Rulings (AAR) (288 ITR 641), referring to the decisions of the Supreme Court in several cases, has culled out the following principles :-
(i) Where a company purchases and sells shares, it must be shown that they were held as stock-in-trade and that existence of the power to purchase and sell shares in the memorandum of association is not decisive of the nature of transaction;
(ii) the substantial nature of transactions, the manner of maintaining books of accounts, the magnitude of purchases and sales and the ratio between purchases and sales and the holding would furnish a good guide to determine the nature of transactions;
(iii) ordinarily the purchase and sale of shares with the motive of earning a profit, would result in the transaction being in the nature of trade/adventure in the nature of trade; but where the object of the investment in shares of a company is to derive income by way of dividend etc. then the profits accruing by change in such investment (by sale of shares) will yield capital gain and not revenue receipt.
9. Dealing with the above three principles, the AAR has observed in the case of Fidelity group as under:-
We shall revert to the aforementioned principles. The first principle requires us to ascertain whether the purchase of shares by a FII in exercise of the power in the memorandum of association/trust deed was as stockin-trade as the mere existence of the power to purchase and sell shares will not by itself be decisive of the nature of transaction. We have to verify as to how the shares were valued/held in the books of account i.e. whether they were valued as stock-in-trade at the end of the financial year for the purpose of arriving at business income or held as investment in capital assets. The second principle furnishes a guide for determining the nature of transaction by verifying whether there are substantial transactions, their magnitude, etc., maintenance of books of account and finding the ratio between purchases and sales. It will not be out of place to mention that regulation 18 of the SEBI Regulations enjoins upon every FII to keep and maintain books of account containing true and fair accounts relating to remittance of initial corpus of buying and selling and realizing capital gains on investments and accounts of remittance to India for investment in India and realizing capital gains on investment from such remittances. The third principle suggests that ordinarily purchases and sales of shares with the motive of realizing profit would lead to inference of trade/adventure in the nature of trade; where the object of the investment in shares of companies is to derive income by way of dividends etc., the transactions of purchases and sales of shares would yield capital gains and not business profits.
10. CBDT also wishes to emphasise that it is possible for a tax payer to have two portfolios, i.e., an investment portfolio comprising of securities which are to be treated as capital assets and a trading portfolio comprising of stock-in-trade which are to be treated as trading assets. Where an assessee has two portfolios, the assessee may have income under both heads i.e., capital gains as well as business income.
11. Assessing officers are advised that the above principles should guide them in determining whether, in a given case, the shares are held by the assessee as investment (and therefore giving rise to capital gains) or as stock-in-trade (and therefore giving rise to business profits). The assessing officers are further advised that no single principle would be decisive and the total effect of all the principles should be considered to determine whether, in a given case, the shares are held by the assessee as investment or stock-in-trade.
12. These instructions shall supplement the earlier Instruction no. 1827 dated August 31, 1989.
As is evident, the CBDT has accepted that an assessee can be both a dealer and an investor in shares. What is necessary is that there should be a clear demarcation between the two in the books of the assessee.
In Sarnath Infrastructure P. Ltd. v. ACIT the Tribunal has considered almost all the important judicial decisions laying down legal principles to determine the nature of transaction i.e. trading the transaction or investment. The Tribunal has also considered the CBDT circular No. 4 of 2007. The Tribunal has summarized these principles in para 13 of the said order.
“After considering above rulings we cull out following principles, which can be applied on the facts of a case to find out whether transaction( s) in question are inthe nature of trade or are merely for investment purposes:
(1) What is the intention of the assessee at the time of purchase of the shares (or any other item). This can be found out from the treatment it gives to such purchase in its books of account. Whether it is treated as stock-in-trade or investment. Whether shown in opening/closing stock or shown separately as investment or non-trading asset.
(2) Whether assessee has borrowed money to purchase and paid interest thereon? Normally, money is borrowed to purchase goods for the purposes of trade and not for investing in an asset for retaining.
(3) What is the frequency of such purchases and disposal in that particular item? If purchase and sale are frequent, or there are substantial transactions in that item, it would indicate trade. Habitual dealing in that particular item is indicative of intention of trade. Habitual dealing in that particular item is indicative of trade. Similarly, ratio between the purchases and sales and the holdings may show whether the assessee is trading or investing (high transactions and low holdings indicate trade whereas low transactions and high holdings indicate investment.)
(4) Whether purchase and sale is for realizing profit or purchases are made for retention and appreciation in its value? Former will indicate intention of trade and later, an investment. In the case of shares whether intention was to enjoy dividend and not merely earn profit on sale and purchase of shares. A commercial motive is an essential ingredient of trade.
(5) How the value of the items has been taken in the balance sheet? If the items 1 question are valued at cost, it would indicate that they are investments or where they are valued at cost or market value or net realizable value (whichever is less), it will indicate that items in question are treated as stock-in-trade.
(6) How the company (assessee) is authorized in memorandum of association/ articles of association? Whether for trade or for investment? If authorized only for trade, then whether there are separate resolutions of the board of directors to carry out investments in that commodity? And vice versa.
On the facts of that case, the Tribunal recorded the following findings:
(i) The assessee is dealing in shares both as a trader as well as investor. It has kept separate accounts for both types of dealings. Valuation of holdings has been done at cost (for investment portfolio). At least there is no allegation or material to come to the conclusion that valuation of investment portfolio has been done on cost or net realizable value whichever is low.
(ii) The shares which are sold out of investment portfolio, this year, were purchased two to three years ago showing that assessee had intention, while purchasing them, to hold them. They were reflected in the balance sheet as investment. The assessee has enjoyed dividend income and declared the same in return of income. The frequency of such purchase or sale in this portfolio is not large enough to doubt that this portfolio is only a device to pay lesser taxes by parking some stock-in-trade in investment portfolio. We notice that in trading portfolio the assessee had purchased during the year shares worth Rs. 21,38,353 and same shares were sold for Rs. 23,89,805. There was neither opening stock nor closing stock. In investment portfolio, opening stock of shares was Rs. 19,22,203 and closing stock was Rs. 46,23,274 whereas sales out of investment portfolio were Rs. 31,80,423. It shows that turnover to stock ratio in investment portfolio is very low as compared to that in trading portfolio.
(iii) There is no material to show that these shares in the investment portfolio were also traded in the same and like manner as those which were in stock-in-trade portfolio. The board of directors has passed resolutions for making investment whereas memorandum of association has only authorized to carry out trade in shares. It clearly shows intention of the assessee to maintain a separate investment portfolio. All the sales out of this portfolio are identifiable to purchases made in this portfolio.
(iv) The assessee has discharged its primary onus by showing that it is maintaining separate account for two portfolios and there is no intermingling. The onus now shifted on the Revenue to show that apparent is not real. The onus now shifted on the Revenue to show that apparent is not real. There is no material brought in by the Revenue to show that separate accounts of two portfolios are only a smoke screen and there is no real distinction between two types of holdings. This could have been done by showing that there is intermingling of shares and transactions and the distinction sought to be created between two types of portfolios is not real but only artificial and arbitrary.
This principle has been followed by the Bombay Bench of the Tribunal in Gopal Purohit vs. JCIT 122 TTJ (Mum) 87. In this case also, the assessee had separate portfolios and the Tribunal upheld his right to treat the investment portfolio as separate from the dealing portfolio. The Tribunal emphasized that the fact that the investment activity was an organized activity did not detract from the fact that it was a capital asset. It was noted that the stakes were high and so a person investing in shares in bound to study the news papers, business magazines, watch the business channels and use websites and other tools to keep a track of the developments which are happening on day- to-day basis and which may happen in the near future and for this, he may have assistance of the financial planner or investment consultant or may by his own expertise and capabilities do it on his own. The employment of such infrastructure did not turn an investment activity into a business activity it was held.
The fact that the AO had accepted the investment transactions in the past was held to be an important factor as well.
The Tribunal's judgement has been affirmed by the Bombay High Court in CIT vs. Gopal Purohit. The High Court upheld the following:
(a) That it was open to an assessee to maintain two separate portfolios, one relating to investment in shares and another relating to business activities involving dealing in shares. Delivery based transactions were to be treated as being in the nature of investment transactions giving rise to capital gains.
(b) That though the principle of res judicata was not attracted, there had to be uniformity in treatment and consistency when the facts and circumstances are identical. As the assessee has followed a consistent practice in regard to the nature of the activities, the manner of keeping records and the presentation of shares as investment at the end of the year in all the years and there is no justification for a different view being taken by the AO.
(c) While entries in the books of account alone are not conclusive in determining the nature of income, it does have a bearing as to whether the shares are held on capital account or on revenue account.
In Janak Rangwala 11 SOT 627 (Mum) also, the fact that the AO had treated the shares as investment in the past was held to be an important factor.
Even in the case of brokers it has been held that the shares can be held on the capital account and as an investment. See J. M. Share & Stock Brokers vs. JCIT (ITAT Mumbai) and ACIT vs. Motilal Oswal (ITAT Mumbai)
Update: May 2010
See Management Structure & Systems vs. ITO (ITAT Mumbai) & Smt. Sadhana Nabera vs. ACIT (ITAT Mumbai) where these principles were applied.
One has to be careful to ensure that there is a proper segregation of the shares held on investment account from the shares held on trading account. The investment shares must be valued at cost while the trading shares can be valued at market price if that is lower.
|SECTION(S):||28, 45, 48|
|CATCH WORDS:||business profits, capital gains, shares, stock-in-trade|
Opinion Of Eminent Legal Luminaries On Controversial Issues
If I deal in shares, will my gains on shares held for investment purposes become business profits?
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