Legalising black money: HNIs take F&O route to give taxman the slip on capital gains tax

Out-of-money call and put stock options on the bourses are suddenly seeing a flurry of activity, as many high networth individuals (HNIs) are said to be using this route to suppress their tax liability or legalise unaccounted money before this accounting year ends. An out-of-money call option is one in which the strike price is higher than the spot price, and an out-of-money put option is one which the strike price is lower than the spot price.

Short term capital gains tax liability can be lowered by showing fake losses through derivatives trading, and unaccounted money can be shown as profits earned from the trades. For stock market traders, money earned from trading shares is treated as business income ad so the tax rate is more than twice that of short term capital gains tax.

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Brokers say there is a huge demand for ’losses’ as most market players have made handsome profits from the one-sided bull run since the start of this financial year.

A client looking to buy fake losses will buy out-of-the money options, which have no realistic chance of making profits. On settlement day, the options will expire worthless, causing a loss to the buyer to the extent of premium paid on those options. The writer of that option contract will make a profit equivalent of the premium collected.

Usually, both sets of clients trade with the same broker. The book profits and losses made from these trades are later swapped in hard cash, and the broker gets a cut. For instance, if client A makes a fake loss of Rs 1 lakh and client B makes a fake profit of Rs 1 lakh, B will get a cheque of Rs 1 lakh pay back A that amount in cash.

Players familiar with these activities say some of the brokers co-operate with each other since there are occasions when one broker may have more requests for ’losses’ and another broker may have more requests for ‘profits’.

Sources say the less liquid equity options segment on the BSE is the preferred playing ground for these transactions. If the contracts are too liquid, the broker will not be able to put through the negotiated trades. That is because there is a risk of the trades getting matched with some other broker’s clients.

The huge volumes on Wednesday in many of the out-of-money options expiring today do appear suspicious.

For instance, a day ahead of the expiry today, 10.8 lakh shares (equivalent) of call options of IDBI Bank strike price Rs 80 were purchased, compared to the spot price of less than Rs 75. Adding the cost of premium, the buyer will need the stock price to jump more than 10 percent within a day to be able to make a profit on that deal.

Similarly, 2.04 lakh shares (equivalent) of Dish TV put options with a strike price of Rs 55 were purchased, compared to the spot price of over Rs 65. The stock will have to fall more than 20 percent within a day for the buyers to make a profit. Similar trades were seen in option contracts of JSW Energy, SAIL, Andhra Bank, Indian Overseas Bank, to name a few.

Till a couple of years back, many brokers used to help clients fake short term capital gains tax and legalise unaccounted money through cash market trades by altering the client codes at the end of the day. But with the Sebi and exchanges imposing a hefty fine for client code modifications, the action now has shifted to the F&O segment.

Tax evasion/money laundering through the F&O route is nothing new.

In 2007, Sebi had pulled up 25 firms for entering synchronised trades in the F&O segment on the NSE, ostensibly for tax liability adjustments.

One of the entities, Rakhi Trading was fined Rs 1.08 crore in 2009 for the violation. Rakhi Trading moved SAT, which in 2010 set aside the Sebi order saying that even if the trades were done solely for the purpose of ’tax planning’, there was no evidence of market manipulation.

Excerpts from the SAT order:

“It is obvious that the impugned trades were executed for the purpose of tax planning. The arrangement between parties was that profits and losses would be booked by each of them for effective tax planning to ease the burden of the liability and it is for this purpose that they synchronised trades and reversed them.

Even if we consider transactions undertaken for tax planning as being non-genuine trades, such trades in order to be objectionable must result in influencing the market one way or the other. We do not find any evidence of that.”

Sebi is contesting this verdict in the Supreme Court.

Technically SAT may have been right, but that does make life tough for the Income-Tax department as it tries to achieve its revenue targets for the year.