Taxation of Derivative and Futures & options (F&O) Transactions

Derivative transactions include futures, options, forwards, and swaps, commonly used for hedging or speculation. They can be exchange-traded or over-the-counter, with exchange-traded derivatives being regulated. Under Section 43(5) of the Income Tax Act, derivatives on recognized stock exchanges are exempt from the definition of speculative transactions, thus classified as business income. Profits or losses from futures and options (F&O) transactions are treated as normal business income and can be offset against other income, excluding salary. F&O losses can be carried forward for up to 8 years. Presumptive taxation, under Section 44AD, may apply to F&O transactions, but it has limitations, such as no carry-forward of losses and disproportionate tax liabilities due to fixed profit percentages. The turnover for F&O transactions is calculated based on the sum of absolute profits and losses, as per ICAI guidelines. Audit requirements under Section 44AB apply if turnover exceeds ₹3 crores, or if income is below the presumptive tax rate but exceeds the basic exemption limit. Advance tax provisions also apply, requiring taxpayers to estimate and pay tax liabilities throughout the year.

What are derivative transactions:

• Futures Contracts: An agreement to buy or sell an asset at a future date for a price agreed upon today.
• Options Contracts: Gives the holder the right, but not the obligation, to buy (call) or sell (put) an asset at a specified price before a certain date.
• Forward Contracts: Similar to futures, but these are private agreements between two parties to buy or sell an asset at a specified future date.
• Swaps: Contracts where two parties exchange the cash flows or other financial instruments they own. The most common types are interest rate swaps and currency swaps.

These transactions are primarily used for hedging or speculation. Derivatives can be traded on exchanges or over-the-counter (OTC).

Exchange-traded derivatives are regulated and standardized, while OTC derivatives are not.

Are Derivative Transactions Speculative in Nature? (Section 43 of IT Act)

“Speculative transaction” means a transaction in which a contract for the purchase or sale of any commodity, including stocks and shares, is periodically or ultimately settled otherwise than by the actual delivery or transfer of the commodity or scrips, with following exceptions:

(a) Contracts to manage price risks for raw materials or merchandise used in manufacturing or merchanting businesses.

(b) Contracts to protect against price fluctuations in stocks and shares held by dealers or investors.

(c) Contracts entered into by market or stock exchange members to manage risks associated with jobbing or arbitrage transactions.

(d) Eligible derivative transactions made on recognized stock exchanges, as defined in clause 2(ac) the Securities Contracts (Regulation) Act, 1956.

(e) Eligible commodity derivative transactions made on recognized stock exchanges, subject to commodities transaction tax under the Finance Act, 2013.

Thus 43(5)(d) specifically excludes derivative transactions or F&O transactions from the definition of speculative transaction.

Key Observations of the Bombay High Court on Derivative Transactions   

(Bharat R Ruia 10 taxmann.com 265 (Bombay))

• The Securities Contracts (Regulation) Act of 1956 was established to oversee the securities trading industry. Initially, ‘securities’ referred to shares, stocks, bonds, and other marketable securities of incorporated companies. In 1999, the definition was expanded to include derivatives, effective February 22, 2000. This allowed derivative transactions to be legally conducted under the 1956 Act. A new section, 18A, was added to the Act, stating that derivative contracts are valid if traded on a recognized stock exchange and settled through the exchange’s clearinghouse, following its rules and bylaws. In essence, derivative transactions are only legitimate if they occur on a recognized exchange and are cleared through its clearing house.
• Section 43(5) explains that a ‘speculative transaction’ is a trade where a contract to buy or sell a commodity (including stocks and shares) is settled in a way that doesn’t involve actually delivering or transferring the commodity or ownership documents.
• The expression ‘commodity’ refers to a physical item that is bought and sold in trade and commerce, such as goods or products that can be touched or held.
• The NSE’s handbook defines a futures contract as an agreement to buy or sell an asset at a set price on a future date. The NSE offers various futures contracts, including index futures, which allow investors to trade the entire stock market with ease, without having to buy individual stocks or invest in a mutual fund.
• Futures contracts, being tradable on stock exchanges, qualify as transactions in commodities under section 43(5). Typically, commodity transactions involve tangible assets that can be delivered. However, section 18A of the 1956 Act (inserted in 2000) deems derivative contracts, like futures, legal and valid if traded on recognized stock exchanges and settled through their clearinghouses, regardless of tangibility or deliverability. This means futures transactions are valid even if the underlying securities aren’t tangible or deliverable, as long as they’re exchange-traded and cleared. Section 43(5) considers a transaction speculative if settled otherwise than by actual delivery, without requiring the commodity to be deliverable. Therefore, futures contracts for securities traded on stock exchanges and settled otherwise than by delivery are speculative transactions under section 43(5)
• According to the proviso to section 43(5), certain speculative transactions are exempt if they hedge against losses in actual delivery contracts (clauses a, b, and c). However, transactions under clause (d) are only exempt from being considered speculative from April 1, 2006, onwards. In other words, clause (d) transactions were considered speculative before April 1, 2006, but are no longer so after that date.
• Futures contracts differ from insurance contracts because they are tradable articles of commerce, whereas insurance contracts are not. As futures contracts are created and regulated under the 1956 Act, they qualify as commodities under section 43(5), making transactions in futures contracts tantamount to commodity transactions.
• The insertion of clause (d) into the proviso of section 43(5), effective April 1, 2006, is prospective and cannot be applied retroactively

Taxation of Derivatives / Futures & Options (F&O)

• Section 43(5) of the Income Tax Act defines a “speculative transaction” as a transaction where a contract for the purchase or sale of any commodity, including stocks and shares, is periodically or ultimately settled otherwise than by the actual delivery or transfer of the commodity or scrips.
• However, F&O transactions on recognized stock exchanges are not treated as speculative transactions (exempted from speculative nature) under Section 43(5)(d), provided they meet certain conditions. Thus, these transactions squarely falls under the definition of Business Income.
• Being business income, the profit/loss from the transactions are computed after the eligible deductions as envisaged in S. 28 to S. 43C.
• Losses from F&O transactions are treated as normal business losses and can be set off against any other income except salary income.
• F&O losses can be carried forward for 8 assessment years and set off against future business income. (Section 72(3)).
• The provisions of Section 44AB, of compulsory audit will apply when turnover exceeds 3 Crores.

Whether Presumptive taxation is applicable for F&O Transactions:

• Section 44AD(1), starts with non-obstante clause with regards to section 28 to section 43C, provides that a sum equal to 8% /6% of the total turnover or a sum higher than the 8% or 6% (as the case may be) claimed to have been earned by the eligible assessee shall be deemed to be the profit and gains of such business and chargeable under the head “PGBP”.
• Explanation to section 44AD doesn’t specifically exclude transactions in derivatives – F&O as not eligible business.

Advance Tax liability on F&O income:

F&O income attracts advance tax provisions under Section 208. Taxpayers are required to pay advance tax on the estimated total income if their total tax liability exceeds ₹10,000 in a financial year.

Advantages of Presumptive Taxation for F&O Transactions:

1. Simplified Tax Filing.

2. Reduced Compliance Burden as No Books of accounts are required to maintain.

3. Fixed profit percentage.

Disadvantages of Presumptive Taxation for F&O Transactions:

a) No relief for losses: Losses cannot be carried forward for set off. (Refer S.44AD(4))

b) Disproportionate tax liability: High turnover in F&O trading often yields lesser profit margins. Presumptive taxation assumes a profit percentage at definite percentage thereby leading to liability of payment of taxes accordingly.

c) No deduction for actual expenses: Business expenses like brokerage fees, software subscriptions, and operational costs which are otherwise allowable as business expenditure cannot be deducted under presumptive taxation.

d) Audit requirements: If declared income falls below the prescribed percentage (e.g., 6% or 8% as the case may be) and exceeds the basic exemption limit, an audit is required.

How to compute Turnover of the F&O (business) Transactions:

The turnover calculation for F&O trades is based on guidance provided by the Institute of Chartered Accountants of India (ICAI), and it is followed for determining audit requirements under Section 44AB:

• Sum of absolute profits and losses from all trades.
• Premium received on sale of options.
• Difference between the buy and sell amounts for contracts settled without delivery.

However, there is no direct mention of “absolute profit” under Income Tax Act,

The turnover computation as per ICAI guidelines, as mentioned above is done as under:

Scrip	Future/ Option	No of Units	Purchase price (₹)	Sale price (₹)	Absolute Profit =	Turnover
(i)	(ii)	(iii)	(iv)	(v)	[(iii)*(v)] – [(iii)*(iv)]
A	F	500	1000	1200	1,00,000	1,00,000
B	F	600	1200	900	(-)1,80,000	1,80,000
C	O	700	1400	1800	2,80,000	2,80,000
D	O	800	1600	1200	(-) 3,20,000	3,20,000
Total Turnover of F&O Transactions						8,80,000