Short-selling of securities on the stock exchanges, a market reform long-promised by the finance ministry and capital market regulator SEBI, is set to commence. The government has clarified that lending and borrowing of securities under the securities lending and borrowing scheme will not attract Securities Transaction Tax (STT) or capital gains tax. However, it is not clear if sale and repurchase transactions made on the basis of borrowed securities would be taxable.

Finance minister P Chidambaram had announced introduction of sort-selling in the 2007 budget. SEBI formally announced the scheme on December 29, 2007. The regulator has also decided to put in place a full-fledged stock lending and borrowing mechanism for all market participants in the securities market under the overall framework of Securities Lending Scheme 1997.

But there was ambiguity on the taxation of lending and borrowing of securities which has been clarified by Mondays circular. The much-awaited Central Board of Direct Taxes (CBDT) circular says that lending and borrowing of securities under the new scheme notified by market regulator SEBI will not be subject to STT and capital gains taxes.

The CBDT circular states that such transactions will not be regarded as transfer for the purpose of capital gains according to the provision in the Section 47(XV) of the IT Act. The provision under this section has been made applicable in respect of transactions under the new securities lending and borrowing scheme. The circular makes it clear that STT will not be applicable on such transactions.

However, the circular is silent on the taxability of short-selling as such. While the tax provisions were quite clear, there was a bit of ambiguity since the SEBI regulations interposed a market intermediary. To that extent, the clarifications on non-applicability of capital gains and STT are welcome.

However, there is no clarification on taxability of short sales which is a yet another grey area, said Amitabh Singh, partner at Ernst & Young. The market regulator, which was awaiting the clarification on taxation, will soon hold a meeting with the stock exchanges and clearing corporations to decide on the date of launch.

Short-selling is a transaction where an investor can sell stocks without owning them. The investor does this by borrowing stocks from another entity, sells it in the market and buys it back before the market closes to return to the lender.

Short-selling is being allowed for all institutional investors, both FIIs and domestic institutions. Retail investors are already allowed to undertake short-selling of securities.

At present, institutions are allowed to take positions in the futures and options market to go short. The move, allowing them to short-sell in the cash market is expected to deepen the market further and allow stock values to reflect more accurately the opinions of all investors.