For those looking to evade taxes or launder black money, buying and selling thinly-traded options contracts has become a preferred route over the last few years.

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And it has reached such a scale that market regulator SEBI has chosen to offer a one-time settlement to nearly 15,000 practitioners of the technique, instead of fighting long drawn-out cases in the court. These trades took place on the BSE’s derivatives segment between April 2014 and April 2015.

Modus operandi

Consider Person A wants to fake a loss of Rs 10 lakh (to reduce his tax outgo) while Person B wants to launder Rs 10 lakh of ill-gotten money.

A friendly broker will put A and B on the opposite of a series of trades in some options contracts that no sensible trader will touch. The trades will be matched such that B makes a profit of Rs 10 lakh and A will show a loss of the same amount. SEBI calls such trades as reversal trades, which were pre-mediated.

Later, B will return the money to A in cash or some other way. (Remember, this is a bogus trade purely to evade tax and launder money.)

One can’t blame the regulator for deciding to take the settlement route, given that it doesn’t have the manpower to fight so many cases.

Familiar script

The argument between SEBI and the options traders follows a predictable pattern.

SEBI says the trades are not genuine, and that much seems obvious. The trader says that his broker put in the trade, so he was not aware of the counterparty. He invested his idle funds for the short term, and that neither the exchange nor his broker had warned him about the trades.

SEBI imposes a penalty, and usually, the trader will challenge the order.

While it may seem apparent that the trades were done for tax adjustments, SEBI cannot make a case for tax evasion.

The tax angle

And yet, such trades are not so much SEBI’s problem as much as they are a headache for the Income Tax department. While the SEBI charges these entities for unfair trade practices, the main motive of these trades is to dodge the taxman, not to manipulate the prices and mislead other investors.

Tax evasion through bogus trades in thinly traded options contracts has become the preferred route for tax evasion because of the restrictions of client code modification, which was earlier the most common route for tax evasion/money laundering.

Till 2011, the easy way to evade taxes or launder money through the stock market was by misusing the client code modification facility.

Brokers would change the client codes after market hours, claiming that they had erroneously punched in the order in the wrong client’s account. By changing the client code, they would shuffle trades around such that loss-making trades were moved to the accounts of clients who wanted to suppress their tax liability and profitable ones into the accounts of those wanting to launder money. In just one month—March 2010—brokers on the NSE modified client codes for Rs 55,000 crore of trades.

To plug the loophole, in 2011, SEBI imposed a penalty on client code modification by brokers beyond a certain limit. That was good enough to hurt the economics of generating fake losses and profits by changing the client codes.

For a while, the value of ‘modified’ trades fell, but they seem to be picking up again. According to this report in The Economic Times, the Central Bureau of Direct Taxes in a letter to NSE in June last year pointed out that brokers modified client codes in trades worth Rs 78,131 crore in 2018 alone.

As a fallout, the CBDT now demands more information from stock exchanges on all transactions, covering both cash and derivatives markets, where client codes have been altered.

Money trail

And while SEBI let off the NSE light with a warning on the client code modification issue, the I-T department has been successful in a few pre-2010 cases in proving that the assessees showed fake losses with help from their brokers.

In these cases, the I-T department had data from the stock exchanges that the client codes had been modified to help shift loss-making trades into their accounts.

In the case involving thinly traded options, it is much harder to prove malafide intent. The I-T department has to establish a money trail between A and B, which is quite tough if the transaction has happened in cash.

What can SEBI can do?

The SEBI statement says that a “uniform consolidated settlement factor of 0.55 in all cases wherein the entities had executed reversal trades, would be applicable while arriving at the indicative settlement amounts.”

This can be taken to mean that for Rs 100 of notional profit or loss, those accused of having done bogus trades will have to pay Rs 55 as settlement. That could pinch, but whether it will be a sufficient deterrent, depends on how much it affects the economics of such trades.

To reduce the menace of such tax adjustment trades, SEBI must use the full firepower its regulations provide for, even it means that some of its decisions may be overruled on appeal.

The Unfair Trade Practices rules allow SEBI to impose a penalty as high as Rs 25 crore or three times the amount of profits made out of such practices.

Tax offenders are exploiting a particular loophole in SEBI regulations which allows them to indulge in an unfair trade practice while being able to show that it did not hurt other investors. The regulator will need to find some way to fix this.

At a time when tax collections are already low because of the comatose economy, plugging this leakage would help a great deal.

First Published:Jul 28, 2020 10:23 PM IST