Taxation of Derivatives

A derivative means an instrument whose value is derived. It has no value of its own. Its price is based on the underlying asset. Derivatives of stocks and indices can be traded on Indian stock exchanges. The most popular form of derivatives are futures & options (F&O). Today we are discussing the tax treatment for derivative.

Tax treatment of derivative

Since, there is no transfer or delivery of the underlying asset in case of futures, the income or loss from it cannot be taxed under the head “capital gains. Therefore, depending upon the fact whether the assessee is a trader or an investor, the head of income — that is, income from business and profession or income from other sources (IFOS) — will be determined, but in either case the income will be taxed on net basis at the rates of tax applicable to the assessee.

The option premium is an income for the writer of the option and a tax-deductible expense in the hands of the buyer of the option. In case of a trader, the taxability of the gains on exercise of the option is akin to that in the case of futures trading.

However, in case of an investor, since there is an extinguishment of a right, ”the gain therefrom will be treated as a capital gain, rather than an IFOS, and the premium will be allowed as the cost of acquisition.

Open interest refers to a situation, wherein on the date of the financial year end, there are outstanding derivatives contracts in the hands of the market participants. Since, under the prudent accounting principles, derivatives contracts are marked-to-market (MTM), there can be unrealised MTM gains or losses prevailing as on March 31. Whether the assessee will be liable to tax on the gains or take the benefit of the losses in such a case.

Only real income/loss attracts tax provisions and not the notional gains/losses. However, in certain judicial decisions notional losses have also been allowed as a deductible expense. Nevertheless, this is one area which can attract litigative exercise.

With the insertion of Section 43(5)(d), eligible transactions on notified stock exchanges have been rendered non-speculative in nature. So far only BSE, NSE and MCX-SX have been notified for this purpose. Therefore, trading in commodity and equity derivatives traded on stock exchanges other than those mentioned above, is still treated as speculative, the loss where from cannot be adjusted against any other sources of income.

CALCULATION OF TURNOVER OF DERIVATIVE

For every trade, contract notes are issued which show the value of derivative bought or sold. While for the recording purpose only the difference between is used. Take this example:

1. Mr. A bought one lot of XYZ Ltd at 4 lakhs and sold it for 4.8 lakhs (Profit = Rs 80,000)
2. Mr. A bought one lot of ABC Ltd at 3.5 lakhs and sold it for 3 lakhs (Loss= Rs 50,000)

The turnover shall be calculated as Rs 80,000 + Rs 50,000 = Rs. 1.30 lakhs. Also, any premium received when you’re writing an option must be added to the turnover value.

When Tax audit mandatory for Derivative Transactions (F&O Trading)

An audit is required if you have a business income and if your business turnover is more than Rs 1 crores. Audit is also required as per section 44AD in cases where turnover is less than Rs. 2 Crores but profits are lesser than 8% (6%, if all trades are digital) of the turnover and total income is above minimum exemption limit.

Therefore, the applicability of tax audit will be as follows in case of F&O Trading:

In case of Profit from transactions of F&O Trading:

1. In the case of profit from derivative transactions, tax audit will be applicable if the turnover from such trading exceeds Rs. 1 crore.
2. Tax audit u/s 44AB row’s. 44AD will also be applicable, if the net profit from such transactions is less than 8% (6%, if all trades are digital) of the turnover from such transactions.

In case of Loss from F&O Trading:

1. In case of Loss from derivative trading, since profit (Loss in this case) is less than 8% (6%, if all trades are digital) of the turnover, therefore Tax Audit will be applicable u/s 44AB r.w.s. 44AD.

Treatment of adjustment for loss

Loss in respect of Non Speculative Business Income:

As per the Section 71 of the Income Tax Act, loss in respect of such business can be set off against any other heads of income including income from speculative business but excluding income under the head “salaries” of that year.

As per Section 72 of the Income Tax Act, if there is any such loss which is not set off against the above said incomes, such losses are eligible to be carried forward and set off against the other incomes excluding income from salary for a period of 8 subsequent assessment years in the manner as specified in the above order of set off.

Loss in respect of Speculative Business Income:

As per the Section 73 of the Income Tax Act, loss in respect of speculative business cannot be set off against any other heads of income i.e. it can be set off only against other speculative incomes if any in that year.

If there is any such loss which is not set off, such losses are eligible to be carried forward and set off only against speculative incomes for a period of only 4 subsequent assessment years.

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Republished with Amendments