Sunday, September 6, 2009

Derivatives and Underlying Assets

In a very interesting article published in the Journal of Business Law in 2007, Professors Green and Saidov had this to say of software: “…its unique characteristics mean that it is not truly analogous to any conventional chattel with which the law is familiar… despite the fact that it is one of the most ubiquitous commodities of our commercial age, it has no readily discernible legal identity.” This is perhaps true of derivatives as well, and Indian law, over the past two or three years has witnessed a great deal of disagreement on the exact nature of a derivatives transaction. This blog has covered these issues on several occasions.


One of the most controversial questions has been whether the so-called “exotic derivative” is no more than a wagering agreement. In a comprehensive judgment on the point, the Madras High Court held that it is not, finding that exotic derivatives transactions are often intended to function as an “overall hedge” – thus, the contention that there is no underlying transaction for an exotic derivative was rejected. In a recent decision, this issue has arisen in a different context, and has produced interesting results. The decision is that of the ITAT Special Bench at Kolkata, in Shree Capital Services v. Asst. Commissioner of Income Tax, available here.


In the case, the assessee was a company engaged in the business of financing and investments in shares and securities, and suffered a loss of about Rs. 9 lakh in a particular year on account of futures and options. The assessee claimed that this constituted a business loss and should therefore lower his taxable income. The Tribunal’s decision turned on the scope of s. 43(5) of the Income Tax Act, 1961, which provided (in the relevant assessment year) that a speculative transaction is one in which a contract for the purchase or sale of any commodity, including stocks and shares, is periodically or ultimately settled otherwise than by delivery or transfer of the commodity or scrips. A Proviso to s. 43(5) states that a contract in respect of stocks and shares entered into by a dealer or investor therein to guard against loss in his holdings of stocks and shares through price fluctuations shall be covered.


The assessee argued that s. 43(5) applies only to commodities, and that a derivative is not a “commodity”. In other words, the contention sought to separate a derivative from its underlying asset. The Tribunal, apparently following the principle that it is the presence of an underlying asset that makes a derivative transaction legal, held that a derivative has no independent value, and is “entirely” derived from the value of the underlying asset. The Tribunal also referred to s. 2(ac) of the Securities Contracts (Regulation) Act, 1956, which defined the term “derivative” as, inter alia, a contract that derives its value from the prices, or index of prices, of underlying securities.


In a significant observation, the Tribunal then observed that it may be necessary to interpret settled legal terms differently in the context of rapidly changing commercial practices. It referred to a decision of the Supreme Court that had held that a “lease” may at times be construed to include a “sale” if the commercial intent of the parties was akin to a lease. If this principle is applied more extensively, it may have an impact on several areas of law. For instance, the question of how software transactions are to be treated depends essentially on the extent of adherence a court adopts to the traditional categories of sale and licence. The principle was applied in this case to reach the conclusion that “commodity” includes “shares and stocks”.


What is interesting is that this decision may not be applicable to similar transactions in the future. The Finance Act, 2005, introduced an Explanation to s. 43(5) providing that an eligible transaction in respect of trading of derivatives referred to in s. 2 of the SC(R)A shall not be deemed to be a speculative transaction. The assessee argued that this amendment was clarificatory, and therefore should apply to assessments before 2005 as well. The Tribunal rightly rejected this argument, noticing that Parliament, while enacting the provision, had expressly stated that it was necessary to amend the law in view of the growing popularity of derivatives. For assessments post-2005, however, there is no doubt that the amendment will apply.


The Tribunal’s decision has two implications – one, that a derivative transaction in Indian law is still inextricable from the underlying asset, not merely for purposes of legality (as in Rajshree Sugars) but also for collateral purposes, and two, that there may be warrant to interpret settled legal categories more widely in order to take within its ambit new commercial transactions that are outside it merely in form. Another take on this judgment is available here.



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