Derivatives and Taxation

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.