A derivative is a financial instrument, whose value is derived from some underlying source viz. share, stock-market index, bond, currency or commodity. In other words, its value fluctuates with the value or performance of the underlying source on which it is based.
So for a small premium depending on the future value of the underlying source an agreement is made to buy or sell the underlying source at a future date.
So first the derivative offers insurance to take the uncertainty out of the future value of the underlying source. Second, derivative is risky (i.e. the potential to make large losses as well as large gains) for someone who does not have a cash position to hedge because, in return for a comparatively small payment upfront, that party accepts the consequences of what transpires in the future.
Derivatives were originally sold mainly by banks, but now they are also available on the exchange.
From the above we noted that derivative could be on any underlying source. But here we will concentrate more on derivatives traded on the stock exchange.
To make trading possible the stock exchange has set up certain standards for drawing derivative contracts.
The most common derivatives available on the exchange are Futures and Options.
Let us see what each of them are:
Futures: are contracts to buy or sell shares at a particular price on a specified future date.
Option: is a right, but not an obligation, to acquire or sell a security at a particular price.
The difference between these two types of derivative instruments is in respect of the rights and obligations of the parties involved in such contracts. In case of a futures contract, both the parties are under obligation to complete the contract on the specified date. However, in case of Options Contract, the buyer/holder has a right, but no obligation to exercise the Option, whereas the seller/writer has an obligation but no right to complete the contract.
In India the settlement of the derivative is done by squaring up the position in cash only. Also the life of the derivative cannot be for more than 3 months.
Taxation of Futures & Options
According to Circular No 3/2006, dated 27-2-2006, trading in derivatives of securities carried out on a recognised stock exchange shall not be deemed as speculative transaction.
Since Derivatives trading is relatively new one has to look at the provisions of the Income Tax Act and try to reach a conclusion.
As the circular has said it is not a speculative transaction. Trading in derivatives can be Business Income, Short Term Capital Gains or Income from other sources.
If you treat it as Income from other sources, then loss cannot be considered.
How do we decide under which head the income should be booked, we are not looking at the option of Income from other sources. Let us look at the different options and reasons available:
1) Since derivatives instruments are only for 3 months, trading in derivatives would be treated as business Income.
2) If you are devoting a major portion of your productive time in trading then it would be treated as Business Income.
3) Taking the frequency and regularity of the transactions a call can be taken if it is Business Income or capital gain.
4) If a derivative transaction is carried out to hedge your investment portfolio i.e. every 3 months square up your position and take up a fresh position. It would be treated as capital gain
5) Arbitrage transaction between cash and future markets could be treated as capital gains
Whatever the stand we take Business Income or Capital gains, what would be the cost of acquisition? As per the Income Tax Act cost of acquisition is the purchase cost as well as any other cost necessary to bring the asset into a ready and deliverable stage. Taking this into account, the premium paid on the derivative can be treated as cost of acquisition.
If it is treated as short term capital gain, the concessional tax treatment under 111A would not be allowed since this section is available only to equity shares or units of equity oriented mutual funds.
If it is treated as business transaction, what would be the turnover? Since cost is only the premium and only the difference is settled in cash. Also there could be profits and losses, should they be netted to arrive at the turnover?
The view taken currently is gross amounts of the transactions are to be considered for turnover and not just the premium amounts. Also negative amounts should also be treated as positive for the purpose of arriving at the turnover.
The reason we spoke about turnover, is as per the Income Tax Act, if business turnover is above a certain amount, then the books of account need to be audited.
Wednesday, February 25, 2009
Friday, February 20, 2009
Gifts and Taxability
What is a gift?
Gift means transfer by one person to another of an existing movable or immovable property made voluntarily and without consideration in cash or kind. As per the Income tax Act only gifts received by Individuals and HUF’s are taxable.
But is any gift received taxable? Gifts received from relatives are exempt fully. Gifts received from non-relatives above Rs. 50,000/- is taxable under the head Income from other sources. The amount of Rs. 50,000/- is in aggregate for a fiscal year i.e. total of all gifts received from non-relatives up to Rs. 50,000/- is exempt.
Now the question is if gifts received from relatives are exempt, can we make anyone our relative? No, the Income Tax act defines relatives. Of course all will agree that HUF’s cannot have relatives.
So for individuals who can be defined as relatives? As per the Income Tax act, the following persons will be termed as relatives:
• Spouse;
• Brother or sister or their spouses;
• Brother or sister of the spouse;
• Brother or sister of either of the parents or their spouses;
• Any lineal ascendant or descendant and
• Any lineal ascendant or descendant of the spouse
The second part was gifts received from others above Rs. 50,000/- is taxable, but we know the act, there are exceptions to everything. Let’s have a look at these exceptions:
• Marriage: Any gift received on the occasion of marriage is not taxable.
• Gift received under a Will or by way of inheritance;
• Gift in contemplation of death of the donor;
• Gift from any local authority;
• Gift from any fund or foundation or university or other educational institution or hospital or any trust or any institution specified by the act;
• Gift from any trust or institution, which is registered as a public charitable trust and
• Gifts received in kind
There is always a question that what happens if I receive gifts from NRI’s. As per the latest provisions, there is no separate distinction based on residential status. Only the rules stated above would apply.
Clubbing of Income
Gifts made by an Individual to his or her spouse, minor children or son's wife will involve clubbing of income in the hands of the Individual.
In the case of gifts to minor children the clubbing of income, will cease upon such children attaining the age of 18 years.
The clubbing provisions will apply, in case of gift to spouse or son's wife, only to the first-stage of income from the original gift. Second-stage income arising from investment of the income from the original gift is not clubbed and this will constitute the separate income of the receiver.
Generally, the income of minor children, from any source (including income from gifts from parents) is clubbed with the income of the parent whose total chargeable income is greater.
Gift means transfer by one person to another of an existing movable or immovable property made voluntarily and without consideration in cash or kind. As per the Income tax Act only gifts received by Individuals and HUF’s are taxable.
But is any gift received taxable? Gifts received from relatives are exempt fully. Gifts received from non-relatives above Rs. 50,000/- is taxable under the head Income from other sources. The amount of Rs. 50,000/- is in aggregate for a fiscal year i.e. total of all gifts received from non-relatives up to Rs. 50,000/- is exempt.
Now the question is if gifts received from relatives are exempt, can we make anyone our relative? No, the Income Tax act defines relatives. Of course all will agree that HUF’s cannot have relatives.
So for individuals who can be defined as relatives? As per the Income Tax act, the following persons will be termed as relatives:
• Spouse;
• Brother or sister or their spouses;
• Brother or sister of the spouse;
• Brother or sister of either of the parents or their spouses;
• Any lineal ascendant or descendant and
• Any lineal ascendant or descendant of the spouse
The second part was gifts received from others above Rs. 50,000/- is taxable, but we know the act, there are exceptions to everything. Let’s have a look at these exceptions:
• Marriage: Any gift received on the occasion of marriage is not taxable.
• Gift received under a Will or by way of inheritance;
• Gift in contemplation of death of the donor;
• Gift from any local authority;
• Gift from any fund or foundation or university or other educational institution or hospital or any trust or any institution specified by the act;
• Gift from any trust or institution, which is registered as a public charitable trust and
• Gifts received in kind
There is always a question that what happens if I receive gifts from NRI’s. As per the latest provisions, there is no separate distinction based on residential status. Only the rules stated above would apply.
Clubbing of Income
Gifts made by an Individual to his or her spouse, minor children or son's wife will involve clubbing of income in the hands of the Individual.
In the case of gifts to minor children the clubbing of income, will cease upon such children attaining the age of 18 years.
The clubbing provisions will apply, in case of gift to spouse or son's wife, only to the first-stage of income from the original gift. Second-stage income arising from investment of the income from the original gift is not clubbed and this will constitute the separate income of the receiver.
Generally, the income of minor children, from any source (including income from gifts from parents) is clubbed with the income of the parent whose total chargeable income is greater.
Monday, February 16, 2009
Set off of Income
As per the Income tax act, Income is not only what has been earned but also what is lost. We will call what is lost as negative income. Therefore the income tax act has specific provisions regarding this negative income. In certain cases it is set off against Income, in some cases it is carried forward to the next financial year. Only those negative incomes which are chargeable to tax can be set off or carried forward. Of course there are restrictions, but this is only to avoid misuse of these specific provisions. Under the Income tax act Income earned is divided into the following 5 heads:
• Salary
• House Property,
• Business
• Capital Gains
• Other Sources
Each of these heads has specific rules for computation of Income. So based on these rules Salary and Other sources cannot have negative income. So that leaves us with only House Property, Business and Capital gains.
Within each of these heads you can have multiple sources of Income. When you have a positive Income as well as negative income under the same head of Income, and you set them of against each other it is called Intra head set off. As per the Income Tax Act any negative Income should always be set off against the same head. The exception to this is capital gains. As you are aware capital gains is of 2 types long term and short term. Long term capital gains cannot be setoff against short term capital gains.
Now what happens if you have negative income in a particular head of Income which cannot be setoff using intra head setoff? In such cases we can set it off against income from another head. This is called Inter head set off. As there are exceptions in Intra head set off, there are restrictions in Inter head set off as well. First negative income from Business cannot be setoff against Income from salary. Second capital gains cannot be setoff against any other head of Income.
Even after this setoff if there is still some negative Income it can be carried forward to the next financial year. Of course next year the same rules as mentioned above apply. Also there is a limit till when this can be carried forward, currently it is 8 years. Again this also comes with a condition i.e. returns for negative Income has been filed in time as per the Income Tax act.
So to summarize
Income from House Property: can have Intra head as well as Inter head set off.
Income from Business: can have Intra head setoff, but Inter head setoff cannot be done against Income from Salary
Income from Capital Gains: Short term capital gains can only have Intra head setoff. Long term capital gains can have only Intra head setoff against long term capital gains.
• Salary
• House Property,
• Business
• Capital Gains
• Other Sources
Each of these heads has specific rules for computation of Income. So based on these rules Salary and Other sources cannot have negative income. So that leaves us with only House Property, Business and Capital gains.
Within each of these heads you can have multiple sources of Income. When you have a positive Income as well as negative income under the same head of Income, and you set them of against each other it is called Intra head set off. As per the Income Tax Act any negative Income should always be set off against the same head. The exception to this is capital gains. As you are aware capital gains is of 2 types long term and short term. Long term capital gains cannot be setoff against short term capital gains.
Now what happens if you have negative income in a particular head of Income which cannot be setoff using intra head setoff? In such cases we can set it off against income from another head. This is called Inter head set off. As there are exceptions in Intra head set off, there are restrictions in Inter head set off as well. First negative income from Business cannot be setoff against Income from salary. Second capital gains cannot be setoff against any other head of Income.
Even after this setoff if there is still some negative Income it can be carried forward to the next financial year. Of course next year the same rules as mentioned above apply. Also there is a limit till when this can be carried forward, currently it is 8 years. Again this also comes with a condition i.e. returns for negative Income has been filed in time as per the Income Tax act.
So to summarize
Income from House Property: can have Intra head as well as Inter head set off.
Income from Business: can have Intra head setoff, but Inter head setoff cannot be done against Income from Salary
Income from Capital Gains: Short term capital gains can only have Intra head setoff. Long term capital gains can have only Intra head setoff against long term capital gains.
Monday, February 2, 2009
Provident Fund
Provident fund scheme was setup to help people build a retirement corpus. These are of 2 types:
• Employee provident fund
• Public Provident fund
A person can invest both these schemes. Any contribution to both the funds is allowed as a deduction from income under section 80C of the Income tax act. Though the interest rates may sound low, because of the tax exemption the return is larger. A cherry on top of this, is the interest earned is also tax free. The amount in these accounts is also exempt from wealth tax.
One important thing to remember, money cannot be transferred from Employee Provident Fund to Public Provident fund of vice versa. What is the difference between both the types of provident funds? Let’s try and understand each of them.
Employee Provident fund:
This fund is usually run by the Employee Provident Fund Organization. Though in large organizations the organization may run the fund on its own by forming a trust. 12% of an employee’s salary (Basic + Dearness Allowance) is deducted towards this corpus. The employer also contributes an equal amount. But from the Employers contribution 8.33% is transferred towards pension scheme and balance is added to the employees corpus. The Pension scheme is also run by the Employee Provident Fund Organization.
The money is returned to the employee on retirement along with Interest. Interest on the amount is declared on a yearly basis. Partial withdrawal is allowed from this fund for upto 90% of the employee’s contribution. This scheme is available only for salaried employees. If this account is closed before 5 years, the amount withdrawn is taxable.
The best part of this is employer contribution. But tax exemption is available only on own contribution.
Public Provident fund:
Any resident Indian can open a Public Provident fund account. The amount invested in this account is backed by the government. A person can invest upto Rs. 70000/- into this account in a fiscal year. A fiscal year is from April to March. The current interest payable on this investment is 8%.
The money in this account is locked for a period of 15 years. Partial withdrawal from this account is allowed after a period of 5 years limited to 50% of the balance on the date of withdrawal. If money is required earlier then the option is to take a loan. But the loan amount is limited to 25% of the balance.
• Employee provident fund
• Public Provident fund
A person can invest both these schemes. Any contribution to both the funds is allowed as a deduction from income under section 80C of the Income tax act. Though the interest rates may sound low, because of the tax exemption the return is larger. A cherry on top of this, is the interest earned is also tax free. The amount in these accounts is also exempt from wealth tax.
One important thing to remember, money cannot be transferred from Employee Provident Fund to Public Provident fund of vice versa. What is the difference between both the types of provident funds? Let’s try and understand each of them.
Employee Provident fund:
This fund is usually run by the Employee Provident Fund Organization. Though in large organizations the organization may run the fund on its own by forming a trust. 12% of an employee’s salary (Basic + Dearness Allowance) is deducted towards this corpus. The employer also contributes an equal amount. But from the Employers contribution 8.33% is transferred towards pension scheme and balance is added to the employees corpus. The Pension scheme is also run by the Employee Provident Fund Organization.
The money is returned to the employee on retirement along with Interest. Interest on the amount is declared on a yearly basis. Partial withdrawal is allowed from this fund for upto 90% of the employee’s contribution. This scheme is available only for salaried employees. If this account is closed before 5 years, the amount withdrawn is taxable.
The best part of this is employer contribution. But tax exemption is available only on own contribution.
Public Provident fund:
Any resident Indian can open a Public Provident fund account. The amount invested in this account is backed by the government. A person can invest upto Rs. 70000/- into this account in a fiscal year. A fiscal year is from April to March. The current interest payable on this investment is 8%.
The money in this account is locked for a period of 15 years. Partial withdrawal from this account is allowed after a period of 5 years limited to 50% of the balance on the date of withdrawal. If money is required earlier then the option is to take a loan. But the loan amount is limited to 25% of the balance.
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