Kalpesh Classes

Sale of shares - capital gain v. Business income​​ 

The Delhi High Court in CIT v. Ess Jay Enterprises (P.) Ltd.​​ [2008] 173 Taxman 1 followed the maxim that the treatment given to a transaction in the books of account is of vital importance. In this case the assessee was carrying on restaurant business and had shown a significant value of shareholding in listed company’s shares as an investment and not as a stock-in-trade of business and there was no indication that it had converted such holdings into stock-in-trade at any point in time so that the Court held the profit on sale of shares assessable to capital gains tax.

Also the Supreme Court in Ramnarain Sons (P.) Ltd. v. CIT [1961] 41 ITR 534 held that the principal consideration in determining whether income from sale of shares is revenue income or capital gain is to find out as to what was the purpose of purchase​​ of those shares, and, if the purpose was investment, the fact that, in varying the investment, the sale of those shares had resulted in a profit would not make that profit revenue income.​​ The Delhi High Court in CIT v. Raunaq Singh Swaran Singh [1972] 85 ITR 220 held that in order to find out whether a transaction of purchase and subsequent re-sale amounts to an adventure in the nature of trade or not, the sole intention of the purchase is the key.

While holding sale of shares held in the portfolio account​​ to be on capital account the Chandigarh Bench of the ITAT in Vesta Investments and Trading Co. (P.) Ltd. v. CIT [1999] 70 ITD 200 held that​​ no hard and fast rule may be laid down to determine the nature of an asset held by the assessee-whether it is a capital asset or stock-in-trade.​​ A number of factors like the nature of the asset involved;​​ the dominant intention of the assessee for acquiring it; the period of retention thereof; the attendant circumstances leading to the sale thereof; the nature of business activities carried out by the assessee, etc.,​​ are required to be taken into account before the asset-in-question is held to be capital asset or stock-in-trade. In each case it is the total effect of all relevant factors and circumstances that determines​​ the nature and character of the asset. Thereafter, the fact that the assessee had itself made demarcation between the shares held as stock-in-trade and the shares held as capital investments in its books of account, the Tribunal held as under:

“On going​​ through the facts on record, it is manifestly clear that the dominant intention of the assessee while purchasing the shares for the purposes of investment is unequivocally demonstrated by the conduct of the assessee in recording the purchases in a separate​​ investment portfolio account. It has been held by the Hon’ble Supreme Court in the case of Ramnarain Sons (P.) Ltd. (supra) and Hon’ble Allahabad High Court in the case of Sohan Lal Gupta (supra) that the intention of the assessee at the time of acquisition of the asset, whether the purchase is for the purposes of long-term investment or for the purposes of dealing in shares is the dominant factor for determining the nature of the asset. Applying this principle, in conjunction with the attendant facts and​​ circumstances narrated above, we have no hesitation in holding that the income from sale of shares reflected in the investment portfolio account is liable to be assessed under the head “capital gains” and not “business income”.”

The Supreme Court in Karam​​ Chand Thapar & Bros. (P.) Ltd. v. CIT [1971] 82 ITR 899 held that it is difficult to lay down cut and dried principles for deciding that question. It depends upon the facts and circumstances of each case. The Tribunal in this case relied only on the accounting entries and disclosure of shares as investments to which the Court pointed out that though the circumstance that the assessee had shown the shares as investment shares in its books as well as its balance-sheet is by itself not a conclusive circumstance, it is a relevant​​ circumstance for drawing the inference that the profit/loss is a capital profit/loss. Likewise the Supreme Court in the case of Ashoka Viniyoga Ltd. v. CIT [1972] 84 ITR 264 upheld the finding of the Tribunal placing reliance on the resolution of the board naming the transaction as sale/purchase of investments and also for the fact that it was so recorded in the books of account as investment and not stock in trade.

In Karnataka State Industrial Investment & Development Corpn. Ltd. v. Dy. CIT [1996] 59 ITD 643 the Bangalore Bench of the ITAT found that the assessee had all along treated the shares as investments which fact according to it goes to show the motive of the assessee even at the time of acquisition of the shares. It held that the shares were held by the assessee under investment portfolio and, therefore, the profit/loss arising to it on sale of such shares was nothing but in the nature of capital gain/loss.

In judging whether a transaction for sale of asset is to be regarded as​​ sale of capital asset per se or a business transaction, the Bangalore Bench of the Tribunal in M.V. Chandrashekar v. Dy. CIT [2004] 91 ITD 543 held that what is of significance is the intention of the assessee at the time of acquisition of such asset. The​​ Bench apparently took a clue from the Apex Court’s ruling in CIT v. Holck Larsen (H.) [1986] 160 ITR 67/26 Taxman 305. Therein the Supreme Court had to deal with the question whether the income arising from sale of shares by the assessee is to be taxed on​​ revenue account or capital account.​​ It held that in order to determine whether an assessee was a dealer in shares or an investor, the real question was not whether the transaction of buying and selling the shares lacks the element of trading, but whether the later stages of the whole operation show that the first step—the purchase of the shares—was not taken as, or in the course of, a trading transaction.

The Supreme Court in Raja Bahadur Kamakhya Narain Singh v. CIT [1970] 77 ITR 253 held that the conduct of the assessee is the​​ determinative factor in judging whether shares are held on capital or trading account. More precisely it held as under:

“It is fairly clear that where a person in selling his investment realizes an enhanced price, the excess over his purchase price is not​​ profit assessable to tax. But it would be so, if what is done is not a mere realization of the investment but an act done of making profits. The distinction between the two types of transactions is not always easy to make. Whether the transaction is of one​​ kind or the other depends on the question whether the excess was an enhancement of the value by realizing a security or a gain in an operation of profit-making. If the transaction is in the ordinary line of the assessee’s business there would hardly be any difficulty in concluding that it was a trading transaction, but where it is not, the facts must be properly assessed to discover whether it was in the nature of trade.​​ The surplus realized on the sale of shares, for instance, would be capital if the assessee is an ordinary investor realizing his holding; but it would be revenue if he deals with them as an adventure in the nature of trade.​​ The fact that the original purchase was made with the intention to resell if an enhanced price could be obtained is by​​ itself not enough but in conjunction with the conduct of the assessee and other circumstances it may point to the trading character of the transaction. For instance, an assessee may invest his capital in shares with the intention to resell them if in future their sale may bring in a higher price. Such an investment, though motivated by a possibility of enhanced value, does not render the investment of a transaction in the nature of trade. The test often applied is, has the assessee made his shares and securities the stock-in-trade of a business.”

Even the Circular No. 4/2007 issued by the Central Board of Direct Taxes (“CBDT”) which lays down principles for classification of shares as ‘investments’ and ‘stock in trade’ provides that it is possible for an assessee to have two portfolios with respect to investment in shares. The relevant extract from the Circular is provided below:​​ 

“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.”

Shares held as investment​​ 

​​ The Madras High Court in CIT v. N S S Investments (P.) Ltd. [2007] 158 Taxman 13 accepted the stance of the assessee that the profit on sale of shares, which were never treated as stock in trade,​​ should not be assessed​​ under the head business. The Court made a point that a company can hold some shares as stock in trade for the purpose of doing business of buying and sale of shares, while at the same time it can also hold some other shares as its capital for the purpose of earning dividend income.  ​​​​ 

Investment or stock-in-trade ​​ 

Following the Supreme Court’s decision in Raja Bahadur Kamakhya Narain Singh v. CIT [1970] 77 ITR 253, the Delhi High Court in CIT v. Ess Jay Enterprises (P.) Ltd. [2007] 165 Taxman 465 held that the​​ treatment given to a transaction in the books of account is of importance so that assessee’s income from sale of shares is found to be assessable as capital gains instead of business income.​​ In this case, the assessee had shown​​ shares as investments in its books of account.

Delivery based transactions

The Bombay High Court in CIT v. Gopal Purohit [2010] 188 Taxman 140 held that it is open to the assessee to maintain separate portfolios, one relating to investment in shares and another relating to business activities involving dealing in shares. And in regard to delivery based transactions, the High Court upheld the reasoning that the same should be treated as those in the nature of investment transactions and profit therefrom should be treated either as short term or, as the case may be, long term capital gain depending upon the period of the holding.​​ 

FII investments​​ 

The AAR in Fidelity Advisor Series VIII, In re [2004] 271 ITR 1/[2005]​​ 142 Taxman 111​​ (AAR - New Delhi) held that profits from the purchase and sale of shares were in the​​ nature of business profits, and, therefore, the business profits of the applicant could not be taxed in India in view of article 7 of the Double Taxation Avoidance Agreement. Once again in Morgan Stanley & Co. International Ltd., In re [2005] 272 ITR 416/142 Taxman 630​​ (AAR - New Delhi) The AAR held that the magnitude of the purchases and sales was enormous (amounting to Rs. 3,932 crores in a year) and the ratio of purchases and sales was very high. Therefore, the income from the transactions of trading in derivatives was ‘business income’ and not ‘capital gains’. Article 7 of the Agreement covered the income derived from trading in derivatives. It held that the income arising to the applicant from the transactions in exchange derivatives was not classifiable as ‘capital gains’ under article 14 of the Double Taxation Agreement but was ‘business profits’ covered by article 7 of the Agreement.

In a​​ recent ruling in Fidelity Northstar Fund, In re [2007]​​ 158 Taxman 372​​ (New Delhi) the AAR took a contrary stand when it held that income will be​​ taxable as capital gains instead and not as business income. The AAR ruled that the FIIs are not registered for trading in securities hence the gain made by them would assume the character of capital gains

Michael A. Kallivayalil v. CIT [1976] 102 ITR​​ 202 (Ker.)

Where there is an isolated transaction, some of the indicia for testing whether the transaction was a transaction in the nature of investment or of an adventure in the nature of trade are:-​​ 

• Was the purchase a trade and where the purchase of the commodity and its resale allied to his usual trade or business or incidental to it?​​ 

• What is the nature of the commodity purchased and resold and in what quantity was it purchased and resold?​​ 

• Did the purchaser, by any act subsequent to the purchase, improve the quality of the commodity purchased and thereby make it more readily resaleable?​​ 

• What were the incidents associated with the purchase and resale?​​ 

• Were they similar to the operations usually associated with trade or business?​​ 

• Are the transactions​​ of purchase and sale repeated?​​ 

• In regard to the purchase of the commodity and its subsequent possession by the purchaser, does the element of pride of possession come into the picture?​​ 

• Whether the finance required for the purchase of the commodity has been found from the surplus funds with the assessee or whether they represent borrowed money?

G.Venkataswami Naidu & Co. v. CIT [1959] 35 ITR 594 (SC)

In order to determine whether profit arising on sale is business income, the following tests can be applied:—​​ 

• The first test is whether the initial acquisition of the subject matter of transaction was with the intention of dealing in the item, or with a view to finding an investment? If the transaction, since the inception, appears to be impressed with the character of a commercial transaction entered into with a view to earn profit, if would furnish a valuable guideline;​​ 

• The second test is why and how and for what purpose the sale was effected subsequently?​​ 

• The third test is as to how the assessee dealt with the subject matter of transaction during the time the asset was with the assessee, whether it has been treated as stock-in-trade, or has been shown in the books of account and balance sheet as an investment? This inquiry, though relevant, is not conclusive;​​ 

• The fourth test is how the assesee himself has returned the income from such activities and how the Department has dealt with the same in the course of preceding and succeeding assessments? This factor, though not conclusive, can afford good and cogent evidence to judge the nature of transaction and would be a relevant circumstance to be considered in the absence of any satisfactory explanation;​​ 

• The fifth test normally applied in cases of firms and companies is whether the deed of partnership or the​​ memorandum of association, as the case may be, authorizes such an activity?​​ 

• The most important test is as to the volume, frequency, continuity and regularity of transactions of purchase and sale of the goods concerned. In a case where there is repetition​​ and continuity, coupled with the magnitude of the transaction, bearing reasonable proportion to the strength of holding, an inference can readily be drawn that the activity is in the nature of business. ​​ 

Boards clarification

CBDT's office memorandum, dated 13-12-2005 – Tests to distinguish between shares held as stock-in-trade and shares held as investments - The CBDT has also issued guidelines on tests for distinction between shares held as stock-in-trade and shares held as investment vide office memorandum, dated 13.12.2005 [F. No. 149/287/2005-TPL]which are reproduced as under:—

"Circumstances to be considered by the Assessing Officers in determining whether a person is a trader or an investor in stocks:-

• Whether the purchase and sale of securities was​​ allied to his usual trade or business/was incidental to it or was an occasional independent activity;​​ 

• Whether, the purchase is made solely with the intention of resale at a profit or for long-term appreciation and/or for earning dividends and interest. ​​ 

• Whether scale of activity is substantial;​​ 

• Whether transaction were entered into continuously and regularly during the assessment year.​​ 

• Whether purchases are made out of own funds or borrowings;​​ 

• The stated objects in the Memorandum and Articles of Association in the case of corporate assessee;​​ 

• Typical holding period for securities bought and sold;​​ 

• Ratio of sales to purchase and holding.​​ 

• The time devoted to the activity and the extent to which it is the means of livelihood.​​ 

• The characterization of securities in the books of account and balance sheet as stock-in-trade or investment.​​ 

• Whether the securities purchased or sold are listed or unlisted. ​​ 

• Whether investment is in sister/related concerns or independent companies.​​ 

• Whether transaction is by promoters of the company.​​ 

• Total number of stock dealt in​​ 

• Whether money has been paid or received or whether these are only book entries".​​ 

The above Memorandum also advised the Assessing Officers that no single criteria listed would be decisive and that the​​ total effect of all these parameters should be considered to determine the nature of an activity.