The significant aspect of this definition is that 'stocks' and 'shares' are treated as 'capital assets', even where held as stock-in-trade by a taxpayer. This result in the taxation of the income arising from the disposal of such assets under section 37, and not income from business. This issue was discussed in detail by the Income Tax Appellate Tribunal of Pakistan and held that even where a broker dealing in stocks and shares earn income from disposal of these commodities, he will be taxed under the head 'Capital Gains' and not under the head Income from Business.
The Central Board of Revenue (CBR) in Circular No 5 of 1960 also concluded that profits and gains from sale of stocks and shares are to be treated as capital gain, even in the hands of taxpayers who are engaged in the business of purchasing and selling of these items.
The principles for computing capital gains are provided in section 37 of the Ordinance, which reads as under:
" 37. Capital gains.- (1) Subject to this Ordinance, a gain arising on the disposal of a capital asset by a person in a tax year, other than a gain that is exempt from tax under this Ordinance, shall be chargeable to tax in that year under the head "Capital Gains".
(2) Subject to sub-sections (3) and (4), the gain arising on the disposal of a capital asset by a person shall be computed in accordance with the following formula, namely:-
A - B
WHERE-
A is the consideration received by the person on disposal of the asset; and
B is the cost of the asset.
(3) Where a capital asset has been held by a person for more than one year, the amount of any gain arising on disposal of the asset shall be computed in accordance with the following formula, namely:-
A X 3/4
where A is the amount of the gain determined under sub-section (2).
(4) For the purposes of determining component B of the formula in sub-section (2), no amount shall be included in the cost of a capital asset for any expenditure incurred by a person-
(a) that is or may be deducted under another provision of this Chapter; or
(b) that is referred to in section 21.
Income from business and profession is determined under section 18 which says:
"18. Income from business.- (1) The following incomes of a person for a tax year, other than income exempt from tax under this Ordinance, shall be chargeable to tax under the head "Income from Business"-
(a) the profits and gains of any business carried on by a person at any time in the year;
(b) any income derived by any trade, professional or similar association from the sale of goods or provision of services to its members;
(c) any income from the hire or lease of tangible movable property;
(d) the fair market value of any benefit or perquisite, whether convertible into money or not, derived by a person in the course of, or by virtue of, a past, present, or prospective business relationship; and
(e) any management fee derived by a management company (including a modaraba management company).
(2) Any profit on debt derived by a person where the person's business is to derive such income shall be chargeable to tax under the head "Income from Business" and not under the head "Income from Other Sources"."
The deductibility of expenses under the two heads is quite different. For computing income under the head 'Capital Gains' only limited expenses are allowed as envisaged in section 37(2) and section 39 that provide as under:
"(2) Subject to sub-sections (3) and (4), the gain arising on the disposal of a capital asset by a person shall be computed in accordance with the following formula, namely:-
A - B
WHERE-
A is the consideration received by the person on disposal of the asset; and
B is the cost of the asset."
"38. Deduction of losses in computing the amount chargeable under the head "Capital Gains".- (1) Subject to this Ordinance, in computing the amount of a person chargeable to tax under the head "Capital Gains" for a tax year, a deduction shall be allowed for any loss on the disposal of a capital asset by the person in the year.
(2) No loss shall be deducted under this section on the disposal of a capital asset where a gain on the disposal of such asset would not be chargeable to tax.
(3) The loss arising on the disposal of a capital asset by a person shall be computed in accordance with the following formula, namely:-
A - B
WHERE-
A is the cost of the asset; and
B is the consideration received by the person on disposal of the asset.
(4) The provisions of sub-section (4) of section 37 shall apply in determining component A of the formula in sub-section (3).
(5) No loss shall be recognised under this Ordinance on the disposal of the following capital assets, namely:-
(a) A painting, sculpture, drawing or other work of art;
(b) jewellery;
(c) a rare manuscript, folio or book;
(d) a postage stamp or first day cover;
(e) a coin or medallion; or
(f) an antique."
The allowances, expenses and deductions with respect to income from business are governed by sections 20, 22 to 31. Broadly speaking all kinds of expenses and allowances are deductible if they are of revenue nature and are incurred in deriving income chargeable under the head 'Income from Business' [section 18].
Forward transactions on the stock exchange
In forward business at the stock exchange, the purchase and sale are made in advance based on the parties' estimate as to what the price will be of particular scrip on a specified future date. The transactions have the nature of futures contracts (called "speculation business" under the Ordinance) and the contracting parties generally do not take actual delivery of scrip but settle the difference in price on the agreed date. Actual delivery can, however, be enforced on the registered stock exchanges of Pakistan (at Karachi, Lahore, and Islamabad), as their rules do not permit "speculation". The CBR is of the opinion that profit or loss on forward transactions constitutes "speculation business" as defined in section 19(2).
A question arises as to whether a loss sustained by a taxpayer from a forward contract will be a business loss or a loss under the "capital gains" heading. Since the law provides that profits of such business are to be charged as capital gains, it is logical to conclude that any loss arising from a forward contract will be treated as a loss under the head "Capital Gains". This view was upheld by the Income Tax Appellate Tribunal in 1998 and therefore the CBR Circular should be ignored as expressing a contrary view.
Taxation of futures contracts as speculation business income. The most important aspect of the taxation of futures contracts and other like financial instruments under the income tax law is that income therefrom is treated as income of a distinct heading (ie a sub-heading under the "income from business" heading).
SECTION 19(1) STATES:
"(1) Where a person carries on a speculation business-
(a) that business shall be treated as distinct and separate from any other business carried on by the person;
(b) this Part shall apply separately to the speculation business and the other business of the person;
(c) section 67 shall apply as if the profits and gains arising from a speculation business were a separate head of income;
(d) any profits and gains arising from the speculation business for a tax year computed in accordance with this Part shall be included in the person's income chargeable to tax under the head "Income from Business" for that year; and
(e) any loss of the person arising from the speculation business sustained for a tax year computed in accordance with this Part shall be dealt with under section 58."
The taxation of futures contracts, if these constitute business, will be under the distinct heading of "speculation business". The definition of "speculation business" is provided in the section 19(2):
"(2) In this section, "speculation business" means any business in which a contract for the purchase and sale of any commodity (including stock and shares) is periodically or ultimately settled otherwise than by the actual delivery or transfer of the commodity, but does not include a business in which-
(a) a contract in respect of raw materials or merchandise is entered into by a person in the course of a manufacturing or mercantile business to guard against loss through future price fluctuations for the purpose of fulfilling the person's other contracts for the actual delivery of the goods to be manufactured or merchandise to be sold;
(b) a contract in respect of stocks and shares is entered into by a dealer or investor therein to guard against loss in the person's holding of stocks and shares through price fluctuations; or
(c) a contract is entered into by a member of a forward market or stock exchange in the course of any transaction in the nature of jobbing arbitrate to guard against any loss which may arise in the ordinary course of the person's business as such member."
This definition includes futures contracts. A transaction constituting a purchase and sale of anything other than stock, shares, or commodities would not be a speculative transaction under this provision; in any case, where actual delivery or transfer of the commodity or scrip takes place, the transaction cannot be regarded as a speculative transaction, even if it is highly speculative in nature. In addition, compensation received for the breach of a sales contract is not receipt from a speculative transaction. In fact, the latter will not true of a "settled" contract, which is a requirement of the above section. Besides, certain transactions (eg hedging contracts entered into by manufacturers and merchants in the course of business to guard against loss from future price fluctuations) are excluded from the definition of "speculative transactions" in section 19(2). The burden of proving that the transactions are hedging transactions is on the taxpayer.
FORWARD FOREIGN CURRENCY CONTRACTS: According to CBR where a trading contract, or a contemplated commercial operation, involves receipt or payment in foreign currency at a future date and in anticipation thereof foreign currency is bought or sold in advance, the transaction shall be treated as ordinary business activity of the taxpayer. 'If a concern trading in Pakistan had made a forward contract for (say) sterling before sterling is devalued and has not used the sterling when devaluation takes place he can either have utilised the sterling and received goods worth approximately (say) 5P for each rupee. In both case the cost to the trader would be the same, and the cost of cancelling the forward exchange cover in these circumstances is an allowable expense for income tax purposes", CBR opines.
EXCHANGE OPERATIONS: Profits from exchange operations are taxable only if they are connected with business transactions. If by virtue of exchange operations profits are made during the course of business and in connection with business transactions the excess receipts arise on account of conversion of one currency into another, the same would be revenue receipts. But if the profit by exchange opera-tions comes in, not by way of business of the assessee, the profit would be capital profit which falls outside the ambit of scope on the Income Tax Law.
DEDUCTIBILITY AND SET-OFF OF LOSSES:
Under section 58, a loss in a speculation business, unlike other losses, cannot be set off against any income under the same heading (ie business or profession), nor, according to section 57, can it be set off against income under any other heading; however, it can be set off only against profits, if any, of another speculation business (section 19). Losses from a speculation business cannot be set off even against the profits of the same business of which the speculation actually forms a part, because speculation is deemed, by a legal fiction, to be distinct and separate from any other business (section 19).
Thus, commissions earned by a broker for carrying out speculative transactions on behalf of his clients are not income from speculation business, even if the broker carries on speculation business on his own account.
If a liability of the taxpayer had been originally allowed in computing the profits or loss of a speculation business, when that liability is subsequently remitted it should be assessed as income under section 19(1) from the speculation business. A taxpayer who incurs a loss in a speculation business carried on by him individually is entitled to set it off against his share of the profits in another speculation business carried on by a firm in which he is a partner.
Under section 58, losses from a speculation business can be carried forward to a subsequent year and set off only against the profits of any speculation business carried on in that year, even if the profits are of a speculation business distinct and separate from the speculation business in which the loss had been incurred, and even if that speculation business in which the loss had been incurred was discontinued prior to such subsequent year. Like other business losses under section 52, losses from a speculation business under this section can be carried forward only for a period of six years.
Although the taxation of derivative is highly complex and intricate, the relevant provisions indicate certain features as the key points of the tax regime. Taxpayers are not entitled to deduct all the expenses which can normally be claimed under the business heading. In addition, these transactions are to be treated separate from all other business activities. As a result, any loss arising out of such transactions cannot be claimed or set off against any other source of income or any other speculative transaction (with the exception provided by section 58).
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