ITAT Mumbai Dismisses Revenue's Appeal: Disallowance of Trading Loss Unsustainable Without Direct Incriminating Evidence

Overview of the Case

The Income Tax Appellate Tribunal (ITAT), Mumbai Bench, has ruled in favor of the assessee in the matter of DCIT Vs Jainam Investments. The Tribunal upheld the decision of the Commissioner of Income Tax (Appeals) to delete additions made by the Assessing Officer (AO) concerning alleged fictitious trading losses. The tribunal emphasized that without direct incriminating material linking the assessee to fraudulent activities, such disallowances cannot be sustained under the Income Tax Act, 1961.

Background and Material Facts

Jainam Investments, operating as a partnership firm, has been actively engaged in the business of trading shares, derivatives, and futures & options for numerous years. For Assessment Year 2016-17, the firm filed its return of income on 27.08.2016, declaring a total income of Rs. 1,89,05,300. The return was selected for scrutiny assessment, which was completed under Section 143(3) of the Income Tax Act, 1961 on 12.12.2018, determining the total income at Rs. 6,60,25,080.

Initiation of Reassessment Proceedings

Subsequently, the Assessing Officer received intelligence from the Investigation Wing, Mumbai, alleging that the assessee had:

  1. Booked fictitious losses aggregating Rs. 1,96,04,400 through coordinated and premeditated trading in illiquid stock options on the stock exchange
  2. Availed accommodation entries amounting to Rs. 11,50,557 in the nature of business loss arising from manipulation of penny-stock prices by Shri Naresh Jain and his associates

Based on this information, the AO recorded reasons to believe that income chargeable to tax had escaped assessment. Accordingly, notice under Section 148 of the Income Tax Act was issued on 31.03.2021. The assessee responded by filing a return on 06.04.2021, declaring the same income as originally submitted.

The recorded reasons for reopening were furnished to the assessee on 07.06.2021. The assessee filed objections on 18.08.2021, which were disposed of by the AO through a speaking order dated 19.11.2021.

Proceedings Before the Assessing Officer

During reassessment proceedings, the AO conducted an exhaustive examination of the assessee's equity derivatives segment transactions, particularly focusing on trades in illiquid stock options on the Bombay Stock Exchange. The AO's analysis revealed:

  • Transactions were confined almost entirely to highly illiquid stock option series
  • Trades were predominantly executed on expiry dates
  • The assessee incurred losses in each such trade while counterparties earned matching profits
  • Approximately 90% of trades were entered into and permitted to expire on the same day without reversal or hedging
  • Quantities purchased by the assessee matched precisely with quantities sold by counterparties

Additions Made by the Assessing Officer

Based on these observations, the AO:

  1. Treated the loss of Rs. 1,96,04,400 claimed on BSE equity derivatives segment as fictitious loss and made an addition accordingly
  2. Made an additional disallowance of Rs. 3,92,088, representing 2% commission allegedly paid for procuring such accommodation entries under Section 69C of the Act
  3. Made a further addition of Rs. 11,50,557, treating the same as bogus loss entry allegedly obtained from entities linked to Shri Naresh Jain

The AO relied heavily on the investigation report from the Directorate of Income Tax (Investigation), Mumbai, which reported large-scale tax evasion through pre-arranged trades in illiquid options. The AO also relied upon the judgment of the Hon'ble Supreme Court in Rakhi Trading Pvt. Ltd. (2018), which held that synchronized transactions executed with prior meeting of minds constitute manipulative devices rather than genuine trading activity.

Proceedings Before CIT(A)

The assessee challenged both the validity of reassessment proceedings and the merits of additions before the CIT(A). The assessee submitted:

Documentary Evidence Provided

  • Contract notes evidencing all transactions through BSE & NSE
  • Proof of Securities Transaction Tax (STT) payment
  • Margin money payment records as per Stock Exchange and SEBI rules
  • Demat account statements showing receipt and transfer of securities
  • Bank statements reflecting all payments/receipts through proper banking channels
  • Broker-wise ledger accounts
  • Complete profit and loss account showing revenue of Rs. 25,35,10,605 from share trading activities

Key Contentions

The assessee contended that:

  1. It is a whole-time trader/speculator in the capital market with turnover exceeding Rs. 147 crores
  2. All transactions were executed through recognized stock exchanges on an anonymous trading platform
  3. Each transaction was supported by unique contract numbers, settlement numbers, and trade identifiers
  4. The firm traded in approximately 34 scrips during the year, showing both profits and losses
  5. The alleged loss in the scrip JSWE was only Rs. 1,98,450, making the AO's conclusion factually incorrect
  6. The firm has not been investigated by SEBI or any regulatory authority
  7. No adverse finding exists against the assessee's broker

CIT(A)'s Decision

After considering the submissions and material on record, the CIT(A):

  1. Upheld the validity of reassessment proceedings but deleted additions on merits
  2. Noted that the assessee is a regular trader with substantial trading volumes across multiple segments
  3. Observed that trading inherently carries risk of significant losses in particular scrips, which are typical in a trader's normal business course
  4. Found that merely purchasing options on expiry date does not render transactions fictitious
  5. Held that letting options expire instead of exercising them is a strategy to curtail further losses
  6. Distinguished the facts from Rakhi Trading Pvt. Ltd., noting it was not a case of trade reversal

The CIT(A) directed deletion of:

  • Addition of Rs. 1,96,04,400 (alleged fictitious loss)
  • Addition of Rs. 3,92,088 (estimated commission)
  • Addition of Rs. 11,50,557 (alleged bogus loss entry related to Shri Naresh Jain)

Proceedings Before ITAT Mumbai

Aggrieved by the CIT(A)'s order, both parties approached the ITAT: