DISTINCTION BETWEEN SHARES HELD AS INVESTMENTS AND THOSE HELD AS STOCK IN TRADE

Distinction between shares held as stock-in-trade and shares held as investment - tests for such a distinction

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 stock-in-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.

(F.No.149/287/2005-TPL)

SOLUTION TO NOVEMBER 2007 – AUDIT PAPER

Situation analysis

Q1(a): A company has debited Rs 1.75 lakh to Delivery Van Account received from a customer against credit sales of Rs 1.5 lakh to him who is not able to pay the amount. The delivery van has not been registered in the name of the company with R.T.O. till the date of finalisation of accounts.

Since the vehicle is a movable property, it is governed by sale of goods Act, wherein title in goods passes on delivery.

In the instant case, when the company received the delivery van from the debtor, title passed on to the company since he would have signed on the necessary documents. Registration of the delivery van is merely to further secure the title in the name of the company.

Therefore, the company is justified in debiting the delivery van account on receiving it, the fact that it was not registered in its name notwithstanding.

When the sale was for Rs 1.5 lakh, debiting the delivery van with the same amount would appear reasonable.

As per AS 10, in case of exchange of assets, the company can value the asset at the value of the old asset or the new asset, whichever can be determined with reasonable accuracy.

Thus, if the delivery van was valued at Rs 1.75 lakh by an independent expert (such as an automobile engineer), it would be justified in debiting the van with the same amount.

In such a situation, the difference of Rs 25,000 should be treated as profit and taken to profit and loss account and the company can charge depreciation on Rs 1.75 lakh.

Q1(b) PQ Ltd has given donations of Rs 50,000 each to a charitable school and a trust for blinds during the year ended March 31, 2007. The average net profit of the company during last three financial years amounts to Rs 12 lakh. The Companies Act places certain restrictions on donations to political parties.

These restrictions are not applicable to donations made to non-government organisations such as those mentioned in the question.

Therefore, the company has not made any violation in making such donations.

Q1(c): AAS Ltd had provided for doubtful debts to the extent of Rs 23 lakh during the year 2004-05. The amount since had been collected in the year 2006-07. Another debt of Rs 25 lakh had been identified to be doubtful during the year 2006-07. The company made an additional provision of Rs 2 lakh during the year. The profit and loss account for the year ended March 31, 2007 disclosed in debit side — provision for doubtful debts Rs 2 lakh.

Collection of doubtful debts provided in earlier years has no relevance to the debts of current year being identified as doubtful. They belong to two accounting periods. The provision of Rs 23 lakh made in the year 2004-05 should be written back since it is no longer required. A fresh provision of Rs 25 lakh is to be made for the current year.

Setting off the provision of an earlier year against a provision to be made for the current year vitiates the true and fair view of the profit and loss account.

In the given question, the entry made by the company does not portray the information about collection of debtors pertaining to 2004-05 and that further Rs 25 lakh are identified doubtful in the current year. Therefore, the entry passed by the company is not acceptable.

Q1(d): Alagar Ltd is a company engaged in the business of chassis building and bus transportation services. It accounts all expenses and income in profit and loss account under various heads explaining clearly the nature of operations. The auditor of the company requires that the profit and loss account should depict the profit or loss from the businesses of assembly as well as of operation of bus services separately.

Preparation and presentation of the financial statements is the responsibility of the management. The auditor merely expresses an opinion whether or not the financial statements give a true and fair view of the financial position of the entity.

Provisions of the Company Law require every company to maintain its accounts so that profit or loss can be determined. AS 17 on segment reporting also requires companies to report on activities of various segments as an additional information. There is nothing in the Companies Act or in Accounting Standard that requires the profit and loss account to depict separately profit or loss from different activities.

Thus, the auditor requiring the company to depict the profit or loss from the businesses of assembly as well as of operation of bus services separately is not justified.

SOME Comments

2(a): Seeman & Co had been the company auditor for Amudhan Company Ltd for the year 2006-07. The company had three branches located at Chennai, Delhi and Mumbai. The audit of branches in Chennai, Delhi were looked after by the company auditors themselves. The audit of Mumbai branch had been done by another auditor M/s Vasan & Co, a local auditor in Mumbai. The branch auditor had completed the audit and had given his report too. After this, but before finalisation, the company auditor wanted to visit Mumbai branch and have access to the inventory records maintained at the branch. The management objects to this on the grounds of the company auditor is transgressing the scope of audit areas agreed.

The Auditor of a company has certain statutory rights under the Companies Act, which can not be restricted by the company or the directors. Such rights include right to visit the branches in India and right to access records of the company.

The fact that the branch is audited by another auditor cannot be a reason for restricting the statutory auditor from visiting the branches. The auditor enjoys independence in deciding the nature, extent and timing of audit procedures to be carried out. In the given question, the company cannot say there is any transgression of the scope of audit. Hence, the company is not justified in saying so.

2(b): AB & Associates, the auditor of Ajanta Ltd refused to deliver the Books of Account of the company, which were given to them for the purpose of audit, as the audit fees is not paid to them in full.

The provisions of auditors lien state that the books of account should come to the auditor in the normal course and that he cannot resort to unfair means to secure the books of account on lien.

He can exercise lien on those books on which the work was carried out for which remuneration was receivable. Board of directors should pass a resolution to that effect and deliver the books of account to the auditor. The auditor in the given case is not justified in refusing to return the books of account with him on the ground that audit fees is not paid in full. Since the books of account were still with him it indicates that the books of account pertain to the current year. Fees for the current year becomes payable after the completion of the audit. Current year books cannot be retained for non payment of fees of an earlier year.

2(c): Mr A was appointed as auditor of X Ltd for the year ended March 31, 2008 in the AGN held on August 16, 2007. Mr A had indebted to the company for a sum of Rs 2,500 as on April 1, 2007, the opening date of the accounting year which had bee subject to his audit. Upon learning that he might be appointed as the auditor, he repaid the amount on August 14, 2007. Mr B, a shareholder complained that the appointment of Mr A as auditor was invalid and he incurred disqualification under Section 226 of the Indian Companies Act 1956 and his independence had been vitiated in relation to the accounting year of his audit. The Section 226 states any indebtedness of an amount exceeding Rs 1,000 as a disqualification to be appointed as an auditor.

In the given question, the auditor has repaid the amount before he was appointed as auditor of the company. As on the date of his appointment, he does not have any disqualification.

An auditor is appointed at the AGM from the conclusion of one AGM to the completion of the next AGM and not for the year ended March 31, 2008. Therefore the contention of Mr B is invalid.

2(d): The financial controller of AS Ltd refuses to provide for proposed dividend in books of accounts for the year ended March 31, 2007 on the ground that it is pending approval of shareholders in Annual General Meeting to be held on September 16, 2007.

The Section 205 dealing with dividends requires that the dividends be proposed by the board of directors and declared at the AGM by the shareholders. The dividends declared by the shareholders cannot be more than the dividends as proposed by the board of directors

Once the board of directors propose dividends, the same is to be declared by the shareholders. Such dividends are to be paid out of the profit made by the company for the year ended March 31, 2007. Therefore, it is proper to make the provision for such dividends.

Declaring of dividends is an event occurring after on the date of the balance sheet, which confirms a situation existing as on the date of balance sheet.

AS 4 on events occurring after the date of balance sheet classifies such events as adjusting events and non-adjusting events. Declaring of dividends is an adjusting event, for which a provision is to be made in the accounts. For the same reason proposed, dividends merely appear as a provision (item no 9 under the head current liabilities and provisions) and not as a current liability. It assumes the nature of a current liability once the dividends are declared at the AGM. Therefore, the contention of the financial controller is not justified.

HINDU-MENTOR