With the boom in commodity prices worldwide, trading in commodity derivatives has attracted more and more interest, with many seeking to benefit from rising commodity prices. Is the tax treatment of commodity derivatives the same as the tax treatment of security derivatives?
Commodity derivatives versus security derivatives: There are some fundamental differences between commodity derivatives and security derivatives. Commodity derivatives are traded on commodity exchanges and not on stock exchanges, transactions being routed through commodity brokers and not through stock brokers and regulated by the Forward Markets Commission and not by the Securities and Exchange Board of India (Sebi). Further, commodity derivatives can be settled by delivery, unlike security derivatives, which could only be settled by payment or receipt of differences till recently.
Business income or capital gains? The first issue is whether transactions in commodity derivatives amount to a business with income from such transactions taxable as business income, or whether such transactions can amount to investments, with the income taxable as capital gains. The principles applicable for determining this are the same as those for security derivatives and would primarily depend upon the facts of each case. Various factors would have to be considered, such as whether the commodity derivatives transactions are linked to the other business of the individual and the frequency and volume of transactions. In most cases, since commodity derivatives are short-term products, the transactions would generally be regarded as a business.
There may, however, be cases where such transactions could be regarded in the nature of investment. For example, looking at the rising price of gold, you may decide to buy gold derivatives. Though your intention may originally have been to take delivery of the gold, you may square off the transaction within a month if the price of gold shoots up substantially in the meanwhile. In such a case, you can certainly claim that the income from this transaction is in the nature of a short-term capital gain. However, there is no benefit in treatment of such gains as short-term capital gain as opposed to a business income or as income from other sources since there is no concessional tax rate for such capital gains where the sale is not subject to securities transaction tax, unlike in the case of transactions in equity shares or units of equity-oriented mutual funds, the short-term capital gains of which are taxed at a concessional rate of 15%.
Is the business speculative? Given the fact that in most cases such transactions constitute a business, the issue that arises is whether such business is to be treated as a speculation business if the commodity derivatives are settled without taking or giving delivery. This is important because losses of a speculation business cannot be set off against any income other than income of a speculation business.
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If one looks at the definition of speculative transaction, it provides that any 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 actual delivery or transfer of the commodity or scripts. Commodity derivatives contracts are certainly contracts for the purchase or sale of commodities and, therefore, would clearly be covered by this definition if the transaction is squared off without delivery.
Cases where loss can’t be set off: There is a specific exemption for security derivatives, whereby such derivatives are not to be treated as speculative transaction. However, this exemption only applies to derivatives traded on notified stock exchanges (Bombay Stock exchange, National Stock Exchange, and United Stock Exchange) through stock brokers (i.e. security derivatives) and does not apply to commodity derivatives which are traded on commodity exchanges. Therefore, clearly commodity derivatives transactions squared up without delivery would amount to speculative transactions.
If some of the transactions in commodities derivatives are settled by taking or giving delivery of the commodity, bifurcation would need to be made between delivery-based and non-delivery-based transactions and the profit or loss on each set of transactions would need to be computed separately. Since loss from non-delivery-based transactions in commodity derivatives which are regarded as speculation losses and cannot be set off against any income other than speculation income, such loss cannot even be set off against the profit from delivery-based transactions in commodities, though both may have been transacted at the same time and through the same broker.
Since security derivatives transactions are not regarded as speculative transactions by virtue of the explicit exemption, loss from commodity derivatives transactions settled without delivery cannot be set off against the gains made from security derivatives transactions, though both series of transactions may have been made with the same speculative intent. So also such loss cannot be set off against any capital gains, whether from shares or from any other asset.
Cases where loss can be set off: Day trading transactions in shares, where no delivery is taken but the transactions are squared up the same day, would be regarded as speculation business and it would be possible to set off the loss from such commodity derivatives transactions against such profits from day trading in shares. It is important to note that the prohibition on set off applies only to loss of a speculation business and not to speculation loss if they are considered as income from other sources.
In a case where commodity derivatives are settled by delivery, just as in the case of security derivatives, the date of acquisition or sale of the commodity would be the date of delivery, while the cost or sale price would include the amount paid or received under the derivatives contract. It is important to keep the difference from security derivatives in mind when transacting in commodity derivatives, so that you are not caught unawares when you realise that you have to pay tax on income higher than your actual income, on account of the inability to set off certain losses from commodities derivatives against your other derivatives trading income.
Gautam Nayak is a chartered accountant.
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