Taxation of Derivatives Transactions: Futures & Options (F&O)

Derivatives are financial contracts that derive value from underlying assets. Commonly known as Futures & Options (F&O), income from these derivatives is classified as non-speculative business income. This article explores the complexities of taxing derivatives, focusing on income classification, loss treatment, turnover calculation, and audit applicability.

What are Derivatives?

Derivatives are financial contracts agreed between two or more parties, that derive their value from underlying assets or group of Assets.

Experiencing the Stock markets, you must have heard about Futures & Options (commonly known as F&O) – broadly known ‘Derivatives’. The income earned from these ‘Derivatives’ are classified as business income, irrespective of frequency or quantum of transactions undertaken during the year. As the business income is further classified as Speculative Income and Non- Speculative Income, however there is a clear-cut guideline of the law, that Income earned from Derivates falls under the category of ‘Non-Speculative’ Business Income.

According to a recent report, the Government is planning to impose a higher taxation on Future & Options (F&O) transactions, treating it similar to the Income from Lotteries or Cryptocurrencies in Upcoming Union budget. Proposed changes include reclassifying F&O transactions from ‘Non-Speculative business income’ to ‘Speculative income’ and potentially introducing a TDS on such transaction.

Tax Intricacies of ‘Derivatives’

The taxation of Derivatives can impose significant challenges for Investors and Tax Professionals, there are lot of confusions around regarding choosing the Income head, Rate of Taxation as well as applicability of Tax Audit.

Let’s decode the Intricacies of Taxation on Derivatives –

Key Considerations-

1. Head Of Income

Income from derivatives shall always be taxable under the head of Business Income, classified as Non- Speculative Business income, irrespective of frequency or quantum of transactions undertaken during the year.

2. Losses incurred in Derivatives Transaction

i. Losses incurred from Derivatives Transactions can be carried forward to the next Eight Assessment years, provided the Income Tax return is filed on or before the due date as prescribed u/s 139 (1) of the Income Tax Act, 1961.

ii. Any loss from Derivatives can be Adjusted from Profit of any other business, including any loss from speculative business.

3. Calculation of Turnover of Derivatives-

a. In case of Futures– In case of Futures, Turnover shall be Sum total of Absolute values of Profit or loss earned in every buy and sell transaction.

For example, in first trade, Mr. A earned a profit of Rs. 1,000/-; In Second trade, Mr. A incurred a loss of Rs. 1,500/-; So here, total turnover shall be sum of Rs. 1,000/- and Rs. 1,500/-, i.e., Rs. 2,500/-.

So basically, here it doesn’t make any difference whether the difference is positive or negative, all the absolute values of such differences to be added to calculate the Turnover.

b. In case of Options– In case of Options, Turnover shall be sum total of:

i. Absolute values of Profit or loss earned in every buy and sell transaction.

ii. Premium received on Sale of Option

In the above example, if it would be an Option trade, let’s say Mr. A has received a Premium of Rs.600/- in first trade and Rs. 500/- in second trade; So here, total turnover shall be sum of Rs.2,500/- (sum of absolute values) and Rs. 1,100/- (sum of Premium received), i.e. Rs.3,600/-.

4. Applicability of Audit- Different Scenarios

As discussed earlier, Income from Derivatives are classified as Non-Speculative business income, therefore Audit of Business provisions shall be applicable. Tax Audits are governed by the provisions of Section 44AB of the Income Tax Act. 1961. The relevant provisions is reiterated hereunder:

“As per Section 44AB: (a) Every person carrying on business shall, if his total sales, turnover or gross receipts, as the case may be, in business exceed or exceeds one crore rupees in any previous year:

Provided that in the case of a person whose—

(a) aggregate of all amounts received including amount received for sales, turnover or gross receipts during the previous year, in cash, does not exceed five per cent of the said amount; and

(b) aggregate of all payments made including amount incurred for expenditure, in cash, during the previous year does not exceed five per cent of the said payment,

this clause shall have effect as if for the words “one crore rupees”, the words “Ten crore rupees” had been substituted:

Provided further that for the purposes of this clause, the payment or receipt, as the case may be, by a cheque drawn on a bank or by a bank draft, which is not account payee, shall be deemed to be the payment or receipt, as the case may be, in cash;”

Another relevant provisions of Section 44AD is reiterated as under:

“As per Section 44AD. (1) Notwithstanding anything to the contrary contained in sections 28 to 43C, in the case of an eligible assessee engaged in an eligible business, a sum equal to eight per cent of the total turnover or gross receipts of the assessee in the previous year on account of such business or, as the case may be, a sum higher than the aforesaid sum claimed to have been earned by the eligible assessee, shall be deemed to be the profits and gains of such business chargeable to tax under the head “Profits and gains of business or profession”:

Provided that this sub-section shall have effect as if for the words “eight per cent”, the words “six per cent” had been substituted, in respect of the amount of total turnover or gross receipts which is received by an account payee cheque or an account payee bank draft or use of electronic clearing system through a bank account or through such other electronic mode as may be prescribed during the previous year or before the due date specified in sub-section (1) of section 139 in respect of that previous year.

Explanation.—For the purposes of this section,—

(a) “eligible assessee” means, —

i. an individual, Hindu undivided family or a partnership firm, who is a resident, but not a limited liability partnership firm as defined under clause (n) of sub-section (1) of section 2 of the Limited Liability Partnership Act, 2008 (6 of 2009); and

ii. who has not claimed deduction under any of the sections 10A, 10AA, 10B, 10BAor deduction under any provisions of Chapter VIA under the heading “C.—Deductions in respect of certain incomes” in the relevant assessment year;

(b) “eligible business” means,—

i. any business except the business of plying, hiring or leasing goods carriages referred to in section 44AE; and

ii. whose total turnover or gross receipts in the previous year does not exceed an amount of two crore rupees.

Following provisos shall be inserted after sub-clause (ii) of clause (b) of Explanation to section 44AD by the Finance Act, 2023, w.e.f. 1-4-2024:

Provided that where the amount or aggregate of the amounts received during the previous year, in cash, does not exceed five per cent of the total turnover or gross receipts of such previous year, this sub-clause shall have effect as if for the words “two crore rupees”, the words “three crore rupees” had been substituted:

Provided further that for the purposes of the first proviso, the receipt of amount or aggregate of amounts by a cheque drawn on a bank or by a bank draft, which is not account payee, shall be deemed to be the receipt in cash.”

So, here we see, that if Cash receipt and cash payments (as explained above, in the provision) does not exceed 5% of aggregate of Cash receipts and Cash payments respectively, the applicable turnover limit for Audit shall be Rs. 10 Crores, so here we can conclude that-

5. Turnover exceeding Rs. 10 Crores– Tax Audit u/s 44AB is mandatory.

In this case, proper books of account to be maintained and one can claim expenses like- Demat Charges, Brokerage, Electricity, Audit expenses etc. that are incurred during the course of business. Books of Accounts shall be Audited by a Chartered accountant within the meaning of act.

Since the derivative trades are undertaken through digital mode, the Audit Applicability limit of Turnover shall be Rs. 10 Crores, i.e. If turnover during the year exceeds Rs. 10 Crores, Audit shall apply, provided Cash payments are also taken care of, i.e. not exceeding 5% of aggregate payments.

On the other hand, if the condition of 5% Cash receipts and cash payments is not justified, Standard limit of Tax Audit shall be applicable i.e., Audit shall be conducted if turnover during the year exceeds Rs. 1 Crore.

6. Opting out of Presumptive Taxation– As per the presumptive scheme laid down under Section 44AD of the Act, In case the amount or aggregate of the amounts received during the previous year, in cash, does not exceed five per cent of the total turnover or gross receipts, i.e. in case of derivatives where transactions are undertaken through digital mode and turnover does not Rs. 3 Crores (Applicable from FY 2023-24) during the year- One can opt for Presumptive Taxation scheme and show profits equivalent to Six percent of the Total Turnover or gross receipts during the year. But if you want to show Profits below 6% of Gross Turnover, then Audit shall be mandatory u/s 44AB of the Act.

7. In case of Loss: In case of losses incurred from Derivatives Transaction, Tax Audit shall be conducted since the profits are less than Six Percent of Gross turnover or receipts as per the provision explained in earlier paragraph, i.e. opting out of Presumptive Taxation scheme.

Conclusion

From the above context, now you are aware of the Tax integrities in case of Derivatives transactions, you can make your investing journey smoother and hurdle free, empowering one to effective tax planning and compliances. However, one should accurately and carefully report derivatives transactions in Income Tax Return to prevent any non-compliance and litigations in the matter.