I-T Department probing fraudulent F&O brokers, beneficiaries

The Income Tax (I-T) Department is probing Future and Options (F&O) brokers, bogus entry players and beneficiaries of these bogus trades for evading long term capital gain (LTCG) tax.

"I-T department conducted searches on brokers and beneficiaries over the past two days, and it may continue for another couple of days," a source close to the development told Moneycontrol.

Searches were mainly conducted in Kolkata, Mumbai, Hyderabad, Delhi, Ahmedabad and Jaipur after the I-T intelligence and criminal cell detected illiquid option trades.

In October 2018, the Central Board of Direct Tax (CBDT) had written a letter to SEBI seeking information on the same. SEBI had in FY14-15 passed an order in regard to the matter.

The action comes after reversal of trades were detected in around 14,000 entities in the illiquid derivative segment of the BSE and NSE.

Understanding the method

Let us understand this better with an example.

For a derivative trade to be executed, a specific buy quantity by investor A has to be matched with a corresponding sale transaction by investor B. Now, trader A can get into an agreement with B to buy back the illiquid contract any time before expiry at a pre-determined higher price. This will result in profit in the books of A and an equivalent loss in B’s books.

Trader A will now be able to convert his black money into white because of this profit, despite having to pay securities transaction tax and short-term capital gains on this profit. Though trader B incurred a loss, he will be paid off in black and can carry forward this loss for eight years, which can be set-off against future capital profits.

History and similar cases

This is not the first time that I-T officials have suspected tax evasion via the capital markets. In FY14-15, the Director-General of Income Tax, Kolkata prepared a report detailing how penny stocks were used to evade LTCG tax of over Rs 80,000 crore.

Later on, SEBI gave a clean chit to entities listed in the report, thus watering down the case. The market regulator at that time mentioned in its internal note to the SEBI board that they were only concerned with the price manipulation and not tax evasion, as the latter is under the I-T Department’s purview.

In 2010, unique client code modifications worth Rs 55,000 crore per month were made on the NSE by 82 brokers in the equity, equity derivative and currency segments. This amount collectively is over several lakh crores.

In September 2019, the I-T Department sent letters to stock exchanges, asking them to look more closely into cases of client code modifications to help spot tax evasion tactics.

The letter follows CBDT's thought that too many client code modifications took place on exchanges and that at least some may not be genuine. After this, from September 16, exchanges ask institutional investors the reason for any such modification. The same disclosure was being sought for non-institutional investors since July.

I-T’s letter also states that exchanges should probe whether the requested client code modifications are intended for genuine purposes. The department’s renewed glare on client code modifications as a method to evade taxes comes after it its success in plugging another loophole of tax evasion.

Modifications in client code – unique trading ID given to all clients – are required in case of a manual error on the part of investor or broker while punching in the client code at the time of order. For instance, a broker may have mixed up an order for Client A with that of Client B.

But data with the I-T's intelligence and the criminal cell shows that the current framework is not much of a deterrent and that client code modifications in the system are unusually high.